For those who live and breathe cost segregation work, there’s an element of surprise surrounding how little most people — CPAs included — know about the tax-savings strategy.“On a recent proposal opportunity, a tax principal and I met with a potential client who owns 15 properties,” said Lawrence Knutson, CPA/ABV and consulting senior manager at Ehrhardt Keefe Steiner & Hottman PC in Denver. “The potential client had developed the properties over the last 20 years. He had a sole proprietor doing his tax return who is retiring. We came in and the first thing we mentioned was cost segregation. He had never heard of it. We see that more and more. I don’t think we’ve fully realized the size of the cost segregation market.”
Cost segregation, or “cost seg” as those in the niche call it, is an engineering-based study of a building, with the goal of allocating as much value as possible to assets with the shortest depreciable life, according to Paul G. DiNardo, a CPA and shareholder of The Cost Segregation Group in Norfolk, Va. It can often save clients thousands of dollars — if they’re willing to invest in a study that will categorize the real and personal property of their real estate.
Pricing for studies varies according to the firm retained, but can be anywhere from $7,000 for a small retail shopping center to $35,000 on buildings in excess of 1 million square feet.
The reason for this type of study can perhaps be explained best by a post that Gina Gwozdz, CPA, has on her blog, www.glgcpa.blogspot.com: “The faster items can be depreciated, the larger your depreciation deduction,” she wrote. “The larger your depreciation deduction, the lower your taxable income, and the lower your taxable income, the lower your taxes.”
“Anybody who is buying depreciable, commercial real estate should have some form of a cost seg study done,” added DiNardo’s colleague, Cathy A. Harris, a CPA and director at The Cost Segregation Group. “There is a certain cut-off that we use for cost versus benefit, but pretty much anybody who has commercial real estate that can use extra depreciation deductions would benefit.”
STUDY THIS
Cost segregation studies can be performed when someone purchases a building or when a building is being constructed. The study can take place before, during or after the buyer’s acquisition of the property.
“Generally, somebody who is buying a building will contact us — either the CPA or the owners — and give us some basic information, [such as] what kind of building they’re buying and how much they are spending, just to see if it’s a viable option for cost segregation,” Harris explained. “With just a few pieces of information, we can estimate what kind of benefit we can get from a study based on using our database of prior studies, and we can also do a budget on how much it’s going to cost.”
Once the provider and the client agree upon the engagement, Harris said that her team will then gather what blueprints of the building are available and schedule site visits to check out the property. Depending on the size of the facility, walking through a site can sometimes take up to two days to complete.
“Once you come back to the office, you’re taking all that data and running it through spreadsheets, allocating all the cost and then choosing the class for each asset,” Harris continued. “Then all that information gets put into a report which follows the IRS’s guidelines on what they’d like to see.”
The IRS Audit Technique Guide defines a “quality” cost segregation study as one that is both accurate and well-documented in regards to classifying assets into property classes (e.g., land, land improvements, building, equipment, furniture and fixtures); explaining the rationale (including legal citations) for classifying assets as either personal or real property; and substantiating the cost basis of each asset and reconciling total allocated costs to total actual costs.
“To do a good study, you have to have an engineering group knowledgeable in tax law,” said Patrick Malayter, a CPA and partner at BKD in Indianapolis. “That’s just a tough mix to put together. I think a lot of people try to jimmy-rig studies by buying some canned software and working on that type of basis, but in the end, when you’re subject to IRS examination and the IRS brings in its engineer who is well-versed in the law, you are essentially in a difficult situation.”
Once the study is done, according to Grant Keppel, a CPA and national director for Cost Segregation Partners in Buffalo, N.Y., the report goes back to the client, if that is the direct contact in the engagement.
“What we always recommend is please pass this along to your accountant and then have them call us to make sure it gets impacted on your tax return,” Keppel said. “If we’re working with a CPA as an outsource, we will always give a draft to the CPA firm and to the client so we can review it together. We try to get the CPA involved as soon as possible if we’re working direct with the client. We don’t want the client to pay for the service and then find two years later, ‘Gee, I don’t know if I ever got a benefit for that.’”
SEGREGATING THE BENEFITS
Many cost segregation providers will point to the 1996 legal dispute between the IRS and the Hospital Corporation of America as the watershed event that pushed these studies forward. Prior to that skirmish, the IRS had eliminated investment tax credits, which was problematic because tax credits were what depreciation rules were based upon, according to Phil Mann, managing director of MS Consultants LLC, a subsidiary of The Bonadio Group in Buffalo, N.Y.
“The IRS took the position that since investment tax credits were gone, they could redefine what the depreciation rules were after that period,” Mann explained, adding that HCA argued for more than $1 billion in assets. “The courts finally decided that you were still allowed to do a cost segregation study and that the rules for investment tax credits still applied to depreciation, even though the investment tax credit rules were gone.”
The IRS has since allowed cost segregation studies to be done on properties as far back as January 1987, without taxpayers having to amend their tax returns. Instead, an Application for a Change in Accounting Method, or Form 3115, can be filed, even on closed years.
“Really, the opportunity is, we are able to go back now and say maybe I should look into this, which one of my clients would benefit,” Keppel said. “They are allowing you to go back and change the depreciation to what it should have been, then compare that back to where you were under the old system. You are allowed to take that adjustment on your tax return. That is the power of this revenue procedure.”
GET WITH THE PROGRAM
The problem, according to experts, is that because many CPAs still aren’t familiar with the technique and are daunted by what it entails, they aren’t offering up the service to their clients. Additionally, many CPAs aren’t aware that their clients can file Form 3115 as an added tax savings benefit.
“Essentially what they were telling their clients was, ‘I don’t know anything about cost segregation,’” said DiNardo. “‘I don’t want to learn anything about cost segregation, so I’m going to tell you that it’s too risky and transfer that risk of loss to you.’ It’s easier to stick their head in the sand and tell their client not to worry about it, rather than try to find a solution to the issue.”
“Most CPA firms don’t know you can go back,” Keppel added. “They think it’s all prospective of current-year acquisitions or current-year construction. They don’t realize you can go back in time and re-examine the way they depreciated their assets. That’s the greatest opportunity. It’s very rare that I find a firm that knows about this revenue procedure. It’s not aggressive; it’s black and white and it’s taxpayer- and CPA-friendly.”
What firms are doing, however, is partnering with other firms that do offer the service when their clients come knocking for the expertise. Clients can get their cost segregation needs met by a firm that hires engineers, appraisers and architects to do a piece of the project; their CPAs can point them to an engineering firm that deals strictly with the engineering aspects of the study; or clients can engage a full-service cost segregation firm that encompasses engineers, appraisers and tax experts on staff, according to MS Consultants’ Mann.
“Ninety-five percent of what we do, we do for accounting firms,” he said, describing his firm as a “turnkey” operation that can do anywhere from 300 to 500 studies a year.
Some cost segregation service providers are finding that CPAs are frantically calling them because they don’t want to say no to their clients’ requests, yet lack the expertise and resources to address their cost segregation needs.
“It’s an afterthought, and all of a sudden their clients are contacting them, almost mad,” Keppel said. “Then I get a fearful, panicked call from the CPA firm saying, ‘We need to do this now because the CPA firm down the street has contacted my client and I don’t want them in there.’ Obviously, we’ll help them, but after the project, we start talking about the opportunity to enhance revenue by offering this and working with a firm.”
BKD’s Malayter said that he has seen CPAs enter the niche, only to duck out once they realize the implications of what offering this service brings. “We saw a number of competitors enter into this business of cost segregation. We’d either see people with an engineering background but no tax background, or tax professionals with no engineering background move forward and put out a shingle saying they can do these studies,” he said. “Largely, what we’ve seen is people who frankly were not qualified to do this work are getting out of the business. ... A lot of the folks looking for a quick buck are gone.”
As for clients, awareness of cost segregation is percolating, but word still needs to get out on how a study can benefit their bottom line.
“Clients are getting more sophisticated,” said Yunna Barats, a partner in the real estate group at CPA and business advisory firm RBZ in Los Angeles. “It is not nearly as prevalent in the marketplace as it should be. It’s not some magic bullet that people came up with a couple of years ago. Cost segregation has been around for 20 years, if not more. We’re finding once we educate the client as to what it is, clients will do it. [But] it has to be the right client, the right circumstance and you can’t recommend it blindly.”
