Cost Segregation Methodologies - Key Differences

If you have hired a specialist to perform a cost segregation study of your real estate property, they will likely use one of the six most common methodologies recognized by the IRS. These methods include:

1. Detailed Engineering Cost Approach
2. Detailed Engineering Cost Estimate Approach
3. Survey or Letter Approach
4. Residual Estimation Approach
5. Sampling or Modeling Approach
6. Experience or “Rule of Thumb” Approach

It’s important to understand the differences between the approaches including which one best fits your property and the reliability of each approach.

DETAILED ENGINEERING COST APPROACH

This approach compiles the costs from construction and accounting reports to build a report. Since this approach relies primarily on true documentation rather than estimates, it is typically the most accurate. The Detailed Engineering Cost Approach is generally used for newly constructed commercial buildings.

DETAILED ENGINEERING COST ESTIMATE APPROACH

This approach is very similar to the Detailed Engineering Cost Approach, with the difference being that if there aren’t records for specific costs, an estimated cost is used rather than the actual cost. Your specialist must find a reliable source for the estimated cost and clearly document the source within the case study. The Detailed Engineering Cost Estimate Approach is typically used for the purchase of used property.

SURVEY OR LETTER APPROACH

Once a site inspection has been completed and all components of a property have been determined, your specialist will send a survey or letter to the contractors or subcontractors to request they provide the cost of each of the items. The reliability of this method depends on if the costs provided by the contractors or subcontractors were based on actual costs or estimated costs. This is an alternative approach for newly constructed buildings.

RESIDUAL ESTIMATION APPROACH

This approach determines the cost of short-lived assets, such as 5 or 7 year property and subtracts them from the total project cost. The remaining “residual” cost is then assigned to the building itself. This method is helpful if there are time constraints on obtaining a cost segregation study, but it is not the most accurate.

SAMPLING OR MODELING APPROACH

In this approach, a cost segregation study is performed over a sample of a large portfolio of properties that are very similar in terms of appearance, use and construction. The costs are taken from the model and applied on a percentage basis. The Sampling Method is typically used for properties with nearly identical blueprints such as fast food chains or nursing facilities.

EXPERIENCE OR “RULE OF THUMB” APPROACH

This approach is based upon the specialist’s experience in the industry and their ability to estimate the costs. As this approach uses very little documentation, it is the least reliable methodology in preparing a cost segregation study.

To see all of the steps included within each method, refer to Chapter 3 of the IRS Cost Segregation Audit Techniques Guide.

What methodology has your company utilized?