Imagine you own multiple commercial buildings. (If you’re reading this blog, you probably do or know someone who does.)  All have been purchased over the last few years. Your accountant advises you to do a cost  segregation study on the buildings to reduce your tax liability and create additional cash flow – which will allow you to do more of what you do best:  purchase additional properties. 

Your smart accountant recommends using a cost seg expert.  But you think to yourself:  Why can’t I just segregate the costs myself? Why bother hiring someone to prepare a study? I know what these buildings cost me.  I can use a “rule of thumb approach” and estimate the costs.  Before you go down that road, you may want to hear the story of what happened to Ronald and Daryl Pearce.

Ronald Pearce and Daryl Pearce, Plaintiffs, v. Department of Revenue, State of Oregon, Defendant.

Ronald Pearce and Daryl Pearce owned properties that qualified for depreciation deductions under federal and Oregon law. Those properties were ordinarily depreciable on the 39-year schedule applicable to buildings. To distinguish the buildings from their related “tangible personal property,” such as equipment, furniture, and fixtures, which qualified for depreciation deductions on an accelerated schedule of between five to seven years, they prepared their own cost-segregation analysis of their properties. Although they had no special experience in applying the cost-segregation methodology, Ron and Daryl Pearce believed that their analysis was proper because it followed the ‘rule of thumb’ approach, which was based upon “a preparer’s ‘experience in a particular industry.”  They included their results of the accelerated depreciation deductions of their cost segregation analysis in their 2004 return.

Fast-forward five years.  In August, 2009, the State of Oregon’s Department of Revenue sent the Pearces Notices of Tax Deficiency. The tax deficiencies arose from denial of their 2004 cost segregation analysis and consequent disallowance of their accelerated depreciation deductions. The Department of Revenue explained that the “rule of thumb” approach they used was “viewed by the Department of Revenue with caution, since it lacked sufficient documentation to support its allocation of costs” and that they had failed to substantiate their costs or prepare a timely analysis.

Rule Of Thumb Approach Fails Litmus Test

The Pearces were found to have failed to satisfy their burden of proof in regards to accelerated depreciation through cost segregation. Why?  The “rule of thumb” approach lacked sufficient documentation to support its allocation of project costs. The IRS-issued Audit Technique Guide (ATG) states that “Despite the lack of specific requirements for preparing cost segregation studies, taxpayers still must substantiate their depreciation deductions and classifications of property. Substantiation using actual costs is generally preferable to the use of estimates. However, in situations where estimation is the only option, the methodology and the source of any cost data should be clearly documented. In addition, estimated costs should be reconciled back to actual costs or purchase price.”

What Constitutes A Good Cost Seg Study?

A “quality” cost segregation study is both accurate and well documented. A taxpayer’s estimated assumptions, based on guesses without supporting records, cannot form the basis for acknowledgement of a claim. In the case of Ron and Daryl Pearce, a “written inventory” was used to allocate values to fixtures and cabinets. But they did not substantiate their cost allocation using actual costs. Instead, they merely used their own estimations or assumptions without supporting records. They failed to clearly document the methodology and the source of any cost data. As such, they did not prove by the preponderance of the evidence that their cost segregation was appropriate.  As their case demonstrated, when performing a cost segregation study it is crucial to use a reliable expert experienced in all aspects of cost segregation studies.

What’s the moral of the story?  To ensure your study meets IRS approval, use an experienced cost segregation company with in-house tax, engineering and accounting experts who have many years experience doing hundreds of cost seg studies for all types of properties all over the nation.   Otherwise your efforts to generate cash flow and tax benefits will end up backfiring… and no one wants that.