A proper understanding of the depreciation of building components and site improvements of acquired properties is key to developing a qualified cost segregation study and limiting unwanted audit exposure. The IRS Cost Segregation Audit Techniques Guide (IRS Cost Segregation Audit Techniques Guide – Chapter 4 – Principal Elements of a Quality Cost Segregation Study and Report) states that depreciation is property handled by addressing physical deterioration and functional obsolescence. Physical deterioration, also known as physical depreciation, is defined by the IRS as the gradual reduction in the value of property due to physical deterioration. Physical deterioration is always present when analyzing acquired properties. From the moment that a property is placed into service, deterioration begins. Physical deterioration can take place slowly in fair weather climates and/or lightly used property. It can also take place quickly in harsh weather climates and/or heavily used property. Functional obsolescence is when a property can no longer adequately perform the function for which it was created. Though physical deterioration and functional obsolescence must ‘always’ be considered for each building and site improvement analyzed within a cost segregation study, functional obsolescence is rarely observed. Apartments, offices, hospitals, hotels, retail and other professional and residential facilities do not normally suffer from a lack of functionality over time. Some industrial, data and/or biochemical properties may suffer from technical functional obsolescence due to technological advances that take place within a specialized industry. For example, let’s assume identical carpeting is installed at two locations at the same time. One location is a small office with light floor traffic and the other location is an industrial environment with heavy floor traffic. We would expect the carpeting in the small office with light floor traffic to be in better condition after a three-year period than the carpeting in the industrial environment with heavy floor traffic.
Measuring Physical DeteriorationThere are several different ways that physical deterioration can be measured. The most common way is through a physical age analysis. Physical age is defined as the age of the property since being placed into service. Physical age is determined through document review and/or a professional estimate. If a property is observed to be in better or worse physical condition then the physical age, an adjustment can be made to better represent the physical condition of the property. This adjustment to physical age based on observed physical deterioration is referred to as effective age. In the example above, utilizing a nationally recognized source, we determine that the expected physical life, also referred to as normal useful life, of the of carpeting is seven years. For purposes of this example we will assume that the carpet went into service four years ago:
- If the wear and tear of the carpet looks to be 4-years old, based on our 7-year carpet life, the physical age equals effective age, and thus the carpet has a depreciated cost adjustment of 57.14% (4-years ÷ 7-years).
- If the wear and tear of the carpet looks to be 2-years old, based on our 7-year carpet life, the effective age is 2- years, and thus the carpet has a depreciated cost adjustment of 28.57% (2-years ÷ 7-years).
- If the wear and tear of the carpet looks to be 5 years old, based on our 7-year carpet life, the effective age is 5- years, and thus the carpet has a depreciated cost adjustment of 71.43% (5-years ÷ 7-years).