Cost Segregation Studies
Purchasers of real estate can gain tremendous tax benefits by using a popular asset depreciation technique called Cost Segregation. IRC Section 1245 provides for a reallocation of the cost basis of a building to be depreciated over 5 or 7 year basis based on an engineering study often performed under the supervision of an accounting firm. Using this method, buyers view a real estate acquisition as consisting not only of land and buildings; but, also, tangible personal property and land improvements. The tax savings come from accelerated depreciation deductions and possible easier property write-offs. A taxpayer can use cost segregation when constructing a building, buying an existing one, or, in certain circumstances, years after disposing of one so long as the year of disposition still is open under the statute of limitations (see Revenue Procedure 2004-11).
Under prior law taxpayers would separate a building's parts into its various components-doors, walls and floors. Once these components were isolated, taxpayers would depreciate them using a short cost-recovery period. CPAs referred to this practice as component depreciation.
The introduction of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS) eliminated the use of component depreciation, but not the use of cost segregation. Hospital Corporation of America [HCA] v. Commissioner, 109 TC 21 (1997), is the seminal cost segregation case. In it the Tax Court permitted HCA to use cost segregation with respect to a multitude of improvements. Critical to the Tax Court's analysis was that in formulating accelerated depreciation methods, Congress intended to distinguish between components that constitute IRC section 1250 class property (real property) and property items that constitute section 1245 class property (tangible personal property). This distinction opened the doors to cost segregation.
Armed with this victory, taxpayers have increasingly begun to use cost segregation to their advantage. The IRS reluctantly agreed that cost segregation does not constitute component depreciation (action on decision (AOD) 1999-008). Moreover, cost segregation recently was featured in temporary regulations issued by the Treasury Department (regulations section 1.446-1T). In a chief counsel advisory (CCA), however, the IRS warned taxpayers that an "accurate cost segregation study may not be based on non-contemporaneous records, reconstructed data or taxpayers' estimates or assumptions that have no supporting records" (CCA 199921045).