Issues with implementing cost segregation and other depreciation changes
Recently, I received a call from a CPA firm whose client had incorrectly handled a retroactive cost segregation study. In this case, their team did not realize they had to file a Form 3115 in order to correctly change the accounting method. This started a conversation about the difficulties in executing cost segregation and other specialty tax services.
I regularly field questions from CPA firms and taxpayers about mistakes made even after high-quality studies and analyses are completed. These range from minor errors to major mistakes that can drastically affect the expected results.
The most common error is also the simplest one: not utilizing the results of an analysis.
Companies will commission a cost segregation study, but its analysis never gets implemented on the tax return. Sometimes this happens because book records get more attention than tax records, or simply because there’s a lack of communication within the company. In rare cases, the cost segregation study has been completed and the results are put on the tax return, but the fixed asset listing is never updated.
In nearly all cases, the cause is a lack of communication among providers, accountants and the fixed asset team. Luckily, this is typically an easy fix by filing a Form 3115 to update the records. However, this does add cost and limits the benefits of the study.
Another common mistake relates to Form 3115. By now, most CPAs know a cost segregation study can be completed on a retroactive basis by filing a change in accounting method on Form 3115. This allows a taxpayer to recapture missed depreciation through a catch-up adjustment, also known as a 481(a) adjustment.
However, I often see situations where the 3115 is not filed or is filed incorrectly. Once again, this is often due to miscommunication.
Sometimes it is a lack of experience with the form or simply an oversight. This problem can be handled in several ways, depending on when the mistake is found and how large the issue is. In some cases, a new form can be filed or the return amended, though potential penalties may result if not handled correctly.
Due to the intersection of depreciation with other areas of tax law, cost segregation can affect other seemingly unrelated areas. For example, when taking historic or rehabilitation tax credits, companies need to understand their work’s relation to depreciation.
Historic tax credits can significantly reduce the cost of historic rehabilitation. Federal historic tax credits are 20 percent of qualified expenditures, and these are often strengthened by state credits. Developers and business owners taking these credits are often looking for other ways to reduce their tax liability. Cost segregation is one way, though it is important that companies understand how these two areas interact.
Historic tax credits can be taken only on qualifying “real property” (1250 property), though cost segregation studies are designed to maximize “personal property” (1245 property). A cost segregation study that reduces 1250 property to maximize 1245 property will reduce the amount eligible for a historic tax credit.
Consider a taxpayer who took a historic tax credit on a 2016 return: if in 2018 they choose to complete a cost segregation study on the same property and file a change in accounting method, they would also have to amend the 2016 return to reduce the amount of the tax credit, because the cost segregation study is identifying personal property that should not have been included in the earlier return.
Companies looking at historic tax credits must discuss with their tax counsel how to balance these two areas. By working together, they can achieve the best outcome: balancing depreciation deductions with lucrative tax credits. However, all sides must understand the tax position of the taxpayer and all the services being performed.
All of these issues have one thing in common: communication.
Be sure the cost segregation team is communicating with the CPA. While communication can solve many issues, mistakes do happen. However, most of these can be fixed when addressed immediately.