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Cost segregation: Understanding a complex history to maximize future value

In recent years, knowledge of and access to cost segregation services have grown significantly. While most CPA firms today offer varying levels of this specialization, this was not always the case. Understanding the origination of cost segregation studies can help CPAs and their clients choose the best specialty tax partners for their area of need to maximize short- and long-term opportunities in the U.S. Tax Code.

Cost segregation is the process of separating tangible personal property — “1245 property” — from real estate, or “1250 property.” This is done to accelerate assets out of the 39-year depreciable life for real estate (27.5 years for residential real estate) and into a five-, seven- or 15-year life for personal property and land improvements. By accelerating depreciation, a taxpayer can increase deductions in the early years of an investment.

Due to the time value of money, deductions are worth significantly more today than in the future. Thus, acceleration creates a considerable opportunity for financial benefit.

To fully understand the history of cost segregation, we must first understand depreciation methods. Current depreciation methodologies were established under the Modified Accelerated Cost Recovery System (MACRS) in 1986. While the MACRS classification was new, it retained the definitions of 1245 and 1250 property established in the IRS Code in 1962.

Under MACRS — and prior rules under the Accelerated Cost Recovery System (ACRS) established in 1981 — component depreciation was prohibited. However, due to the inclusion of 1245 and 1250 property definitions, many practitioners saw value in completing cost segregation studies.

In the early years, large accounting firms created small practices to work on cost segregation studies. This included the Big Four accounting firms (or the Big Five or Six, if we go back far enough). Several practice leaders transitioned from firms such as American Appraisal and others, although boutique firms were few and far between until the mid-1990s.

The legal case of Hospital Corporation of America v. Commissioner, 109 T.C. 21, served as a significant turning point in this dynamic. The 1997 decision featured a taxpayer successfully defending the use of a cost segregation study to differentiate real and personal property. The decision’s landmark status was cemented when the IRS issued an Action on Decision (AOD-1999-008) in 1999 acquiescing to the use of cost segregation studies.

However, broad usage of this methodology was slow to take hold. Completing a cost segregation study required both engineering and accounting expertise. Due to the odd pairing of these business functions, it was difficult for professionals outside of large national firms to build practices.

A second major shift occurred in 2004 when the IRS first issued an Audit Techniques Guide for cost segregation, which provided a blueprint for how it would view cost segregation upon audit. Around the same time, smaller boutique firms began popping up around the country, making cost segregation services available to more and more taxpayers.

As cost segregation services spread, prices dropped and allowed even more companies to access this specialized field. However, the trend was not immune to negative consequences. Similar to other service offerings seen as commodities, the work started to be sold by sales people with less and less technical expertise to back it up.

Today, we still see cost segregation frequently sold as a commodity. This has become increasingly problematic with recent changes in regulations.

With the recent passage of tangible property regulations as well as the PATH Act and now the Tax Cuts and Jobs Act, it is more important than ever for specialty tax professionals — with both engineering and accounting expertise — to consult on these studies and related issues. Firms with demonstrated industry experience have a greater ability to interpret the Tax Code, consult with their clients and work with CPAs to ensure the best results.

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