Cost segregation is alive and well in 2005.

Cost segregation studies, a well utilized technique to accelerate depreciation deductions on real estate since 1999, have gone through many changes over the past years.

Most recently, the Internal Revenue Service (IRS) issued an Audit Techniques Guide (ATG) on the topic, and as recently as January 14, 2005, made revisions to the ATG. The ATG was developed to assist IRS examiners in the review and examination of cost segregation studies. These revisions do not mean that cost segregation studies are no longer acceptable, but rather the ATG helps to identify acceptable methodology for such a study.

As most of you know, the main purpose of doing a cost segregation study is to allocate or reallocate the total cost of a property into appropriate property classes for the sole purpose of accelerating depreciation deductions for Federal tax purposes. More specifically, the purpose is to allocate or reallocate the total cost of the property between structural and non-structural components of the property.

Structural components are depreciated over 39 years for commercial property and 27 1/2 years for residential property, while non-structural components are depreciated primarily over 5 or 7 years, using accelerated methods.

The ATG identifies six commonly used methods. The methods are listed in order of their accuracy and are as follows:

1. Detailed engineering approach from Actual Cost Records.

2. Detailed engineering cost estimate approach. This method is commonly used for new construction and current renovations. Based on my experience, this is the most commonly used method for current and past acquisitions of property, as well as past construction projects where actual cost records are not available.

3. Survey or letter approach. My experience has found that this method is used to supplement the first 2 methods and is not used for an entire study.

4. Residual estimation approach.

5. Sampling or modeling approach.

6. "Rule of Thumb" approach. Methods 3, 4 and 5 are not commonly used, with Method 4 being the exception at this time. Method 5, sampling and modeling, can be used when you have many properties with similar construction and improvements, such as fast food establishments.

Besides indicating the acceptable methodology to be used, the ATG states three components to the cost segregation report which an IRS examiner looks for. The report should include the following:

1. Classification of assets into property classes.

2. Explanation of the rationale for classifying assets as either Sec. 1245 (tangible personal property) or Sec. 1250 (real property).

3. Substantiation of the cost basis of each asset and a reconciliation of the total costs.

Another very important point raised in the ATG is that a cost segregation study should be performed by qualified professionals. Although the ATG does not specifically identify who is a qualified professional, it does state that there are two important parts to a cost segregation study and that a professional qualified in these areas should perform the study. The areas cited include knowledge of the construction process and the tax law involving property classifications for depreciation purposes. Therefore, a study that is done by an accountant along with an engineer or appraiser would meet these qualifications.

Remember, it is never too late to do a cost segregation study. Studies can be done years after acquiring or constructing a property without the need to amend tax returns.

In conclusion, cost segregation studies remain an extremely beneficial method of reducing taxable income from real estate operations. When selecting a professional to perform the studies on your properties, be aware of the quality of the methodology to be applied and which qualified professional will be involved in the study.

You want to be comfortable that the results are defensible against IRS challenge, should such a challenge occur.

MARC WIEDER, CPA, ANCHIN, BLOCK & ANCHIN