A Cost Segregation Study (“Study”) is often described as “a tax study to lower federal and state income taxes for newly constructed or acquired buildings and site improvements” or “the reclassification of real property from long-lived property to short-lived property as it applies to the filing of federal and state income taxes”. Did you know, however, that a Cost Segregation Study can be used for other tax and non-tax accounting purposes?
A Cost Segregation Study, and the componentization process that takes place is an ideal tool for Fixed Asset Record (“FAR”) accounting. In this article, we examine the alternative and complimentary use, of a Cost Segregation Study.
FEDERAL AND STATE INCOME TAXES
The concept of a Cost Segregation Study originated in 1997 with Hospital Corporation of America [HCA] v. Commissioner, 109 TC 21. It was then that the tax courts ordered the Internal Revenue Service to develop a system of tax depreciation for reclassifying short-lived property from 31.5-year long-lived property, now 39-year, to short-lived (3, 5, 7, 10, 15, and 20-year) property.
The techniques employed in producing a quality Study are also helpful in other areas within the tax and accounting disciplines. Depreciation, component identification, component classification, economic useful fife, component depreciation and remaining useful life analyses are all key elements in a Cost Segregation Study. These elements may not only save the property owner thousands to millions of dollars in federal and state income tax filings over time but can also serve as a tool in the development of a healthy FAR.
FIXED ASSET RECORD ACCOUNTING
When a FAR is developed for real property, the entries made are generally very simple, minimal and/or lacking detail. Only a few journal entries, like those presented in Table 1 below, may be booked to the FAR to account for the real property developed or acquired for commercial use.
Built or acquired properties (“Properties”) booked using low-level entries, shown above, give the in-house and/or outside accounting teams little to work with when building and site improvements need to be replaced, taken out of service or retired at the end of their physical useful life. Those assets might also be damaged, removed or replaced by management or ownership. Compounding the uncertainty is the lack of economic useful life, depreciation and remaining useful life data.
The costs detailed on the FAR may not reflect the cost of an asset when first put into service (the “Historical Cost”), but rather the date the property was acquired by the current or purchasing owner (the “Original Cost”). Is the in-service date of 1/1/2017 for all three types of property shown above a “Historical Date” or an “Original Date”? If I had to make an educated guess, based on the data shown in the above table, I would conclude we are looking at Original Cost data. Why do I surmise that? Normally, when land is first acquired, it is booked on the FAR with building and site improvements booked at a point in the future when the development projects are completed. We would conclude that the above land and associated land improvements were acquired by a new owner (the current owner) on January 1, 2017.
If no additional analysis is performed, we would improperly book the building and site improvements as Historical Costs first going into service in 2017. The property improvements could be 100 years old but treated as ‘new’ with no regard for the physical and functional obsolescence that has occurred over time. If no physical or effective age adjustments are made, the Properties condition will be overstated and will not reflect the physical depreciation of the property. Remaining useful life of the property will be overstated as well. The consideration of Depreciation is a necessary component of a Cost Segregation Study of an acquired property and will assist in the proper set-up of the FAR.
A Cost Segregation Study provides more than just a low level of detail, for example land, buildings and site improvements. It can also provide an accounting professional with remaining useful life data by asset type and location. For example, let’s assume this property is a hotel and in the future, it will have a complete remodel of the 7th floor. A Cost Segregation Study with remaining useful life estimates would allow for the retirement of components taken out of service by room and floor location on the FAR. The table below provides a small sampling of the components that you would typically find in a Cost Segregation Study of a hotel.
The above table demonstrates the high degree of detail that can be captured and booked on a company’s FAR, allowing for proper retirement of those components when removed and/or replaced. Like many accounting tools, that have multiple uses, a Cost Segregation Study can provide not only federal and state tax depreciation saving to your clients, but can help develop and manage your Fixed Asset Record.
