Cost Segregation is not only legitimate but, in fact, it’s basis for existence is rooted in MACRS, or Modified Accelerated Cost Recovery System, the preferred method of depreciation required by the IRS. Prior to MACRS, however, was ACRS or Accelerated Cost Recovery System. Here is a brief history:
- Pre-ACRS/ MACRS Depreciation Methods – Prior to 1981
Prior to the enactment of ACRS in 1981, depreciation deductions were generally calculated by applying the appropriate depreciation method to the basis, useful life, and salvage value of the asset. Taxpayers were permitted to use component depreciation, whereby assets were segregated into separate components with different useful lives, which were depreciated separately. Alternatively, taxpayers could elect to use the Asset Depreciation Range (ADR) system for computing depreciation deductions. Property was generally classified as either § 1245 or § 1250 property, based on the rules governing Investment Tax Credit (ITC), pursuant to Code § 48 and the regulations thereunder.
- ACRS /MACRS Depreciation Methods – Post-1980
Following the enactment of the ACRS depreciation system in 1981, component depreciation was specifically prohibited. The Service position has been that this prohibition continued under the MACRS depreciation system, enacted in 1986. Generally, ACRS is effective for property placed in use between 1981 and 1986, and MACRS is effective for property placed in use after 1986.
- Hospital Corporation of America, Inc. v. Commissioner, 109 T.C. 21 (1997) (“HCA”)
In HCA, the Tax Court concluded that the taxpayer was permitted to apply ITC principles to classify property as either § 1245 property or § 1250 property for purposes of determining asset classes and recovery periods under ACRS and MACRS. In effect, the HCA decision has reinstated a form of component depreciation.
- Action on Decision (AOD) Number CC-1999-008
In Action on Decision (AOD) Number CC-1999-008, the Service acquiesced to the application of ITC principles in the HCA case. However, the Service did not acquiescence to the particular results in this case (i.e., the Service did not agree with the classification of specific assets as qualifying § 1245 property).
- Use of Cost Segregation Studies to Compute Depreciation Deductions
Based on these developments, the use of cost segregation studies by taxpayers to accelerate depreciation deductions is expected to increase. The assignment of assets to the appropriate asset class is critical in determining the proper recovery period and, accordingly, the amount of depreciation.
Additionally, IRS 6 Publication 946 explains how to compute depreciation deductions. Appendix B in the publication reproduces the “Table Of Class Lives And Recovery Periods” from Rev. Proc. 87-56, which provides guidance for classifying an asset according to the business activity in which the asset is primarily used.
Furthermore, due to the increase in the numbers of cost segregation studies being submitted to the IRS the Cost Segregation Audit Techniques Guide was published. This “guide” is just that…a reference guide for IRS examiners to use in determining the validity of the submitted changes to the depreciation method used prior by property-owners…this request for change (IRS Form 3115) provides for an “automatic acceptance” protocol when it is submitted with a completed cost segregation study.
Finally, neither the Service nor any group or association of practitioners has established any requirements or standards for the preparation of cost segregation studies. The courts have addressed component depreciation, but have not specifically addressed the methodologies of cost segregation studies. The Service has addressed this issue but only briefly, i.e., Revenue Ruling 73-410, 1973-2 C.B. 53, Private Letter Ruling (PLR) 7941002 (June 25, 1979), Chief Counsel Advice Memorandum 199921045 (April 1, 1999). These documents all emphasize that the determination of § 1245 property is factually intensive and must be supported by corroborating evidence. In addition, an underlying assumption is that the study is performed by “qualified” individuals or firms, such as those employing “…personnel competent in design, construction, auditing, and estimating procedures relating to building construction” (PLR 7941002). 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.
A simple internet search will uncover a plethora of knowledge and information about cost segregation and it’s legality/legitimacy, not the least of which is the Internal Revenue Service itself!