0225 Publ 5653 (PDF)

Official source: IRS Forms, Instructions & Publications (https://www.irs.gov/pub/irs-pdf/p5653.pdf), retrieved 2026-10-03. U.S. Government work (17 U.S.C. § 105).

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This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relied upon as such. This guide is current through the revision date. Since changes may have occurred after the revision date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the revision date. The taxpayer names and addresses shown in this publication are hypothetical.

This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relied upon as such. This guide is current through the revision date. Since changes may have occurred after the revision date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the revision date. The taxpayer names and addresses shown in this publication are hypothetical.

Publication 5653 (2-2025) Catalog Number 20884M Department of the Treasury Internal Revenue Service www.irs.gov

I. Chapter 1 - Introduction ........................................................................................... 7

A. Preface ............................................................................................................... 7

B. Purpose of the Cost Segregation Audit Techniques Guide ................................. 7

C. Background ........................................................................................................ 7

D. Summary and Conclusions ............................................................................... 10

II. Chapter 2 - Legal Framework ................................................................................ 11

A. Overview .......................................................................................................... 11

B. Early History of Depreciation ............................................................................ 11

C. Bulletin F .......................................................................................................... 12

D. Codification of Depreciation Changes .............................................................. 13

E. Guideline Life System ...................................................................................... 13

F. Asset Depreciation Range (ADR) System ........................................................ 14

G. Accelerated Cost Recovery System (ACRS) .................................................... 15

H. Modified Accelerated Cost Recovery System (MACRS) .................................. 15

I. Sections 1245 and 1250 Property .................................................................... 16

J. Investment Tax Credit - § 48 ............................................................................. 17

K. Tests for Distinguishing §§ 1245 and 1250 Property ........................................ 19

L. Inherently Permanent Test ................................................................................ 20

M. Hospital Corporation of America Case ............................................................. 22

N. Electrical Distribution Systems ......................................................................... 22

O. Incentives for Cost Segregation and Cost Recovery ........................................ 24

P. Audit Guidance ................................................................................................. 24

Q. Summary .......................................................................................................... 25

III. Chapter 3 - Cost Segregation Approaches ....................................................... 26

A. Introduction ....................................................................................................... 26

B. What are the Most Common Approaches Utilized for Cost Segregation Studies? 27

C. What are the Attributes of the Various Cost Segregation Approaches? ............ 28

C.1. Detailed Engineering Approach from Actual Cost Records ........................ 28

C.2. Detailed Engineering Cost Estimate Approach .......................................... 29

C.3. Survey or Letter Approach ......................................................................... 30

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C.4. Residual Estimation Approach ................................................................... 31

C.5. Sampling or Modeling Approach ................................................................ 31

C.6. “Rule of Thumb” Approach ......................................................................... 32

D. What approach is Required by the IRS? .......................................................... 32

E. Summary and Conclusions ............................................................................... 33

IV. Chapter 4 - Principal Elements of a Quality Cost Segregation Study and Report 35

A. Introduction ....................................................................................................... 35

B. What is a “Quality” Cost Segregation Study? ................................................... 35

C. Principal Elements of a Quality Cost Segregation Study .................................. 35

C.1. Preparation by an Individual with Expertise and Experience ..................... 36

C.2. Detailed Description of the Methodology ................................................... 36

C.3. Use of Appropriate Documentation ............................................................ 36

C.4. Interviews Conducted with Appropriate Parties ......................................... 38

C.5. Use of Common Nomenclature ................................................................. 39

C.6. Use of a Standard Numbering System ...................................................... 39

C.7. Explanation of the Legal Analysis .............................................................. 39

C.8. Determination of Unit Costs and Engineering “Take-off” ............................ 39

C.9. Organization of Assets Into Lists or Groups ............................................... 40

C.10. Reconciliation of Total Allocated Costs to Total Actual Costs ..................... 40

C.11. Explanation of the Treatment of Indirect Costs .......................................... 40

C.12. Identification and Listing of § 1245 Property .............................................. 41

C.13. Consideration of Related Issues (i.e. § 263A, Change in Accounting Method, and Sampling Techniques) ....................................................................... 41

D. Principal Elements of a Quality Cost Segregation Report ................................ 42

D.1. Summary Letter/Executive Summary ........................................................ 42

D.2. Narrative Report ........................................................................................ 42

D.3. Schedule of Assets .................................................................................... 43

D.4. Schedule of Direct and Indirect Costs ....................................................... 43

D.5. Schedule of Property Units and Costs ....................................................... 43

D.6. Engineering Procedures ............................................................................ 43

D.7. Statement of Assumptions and Limiting Conditions ................................... 43

D.8. Certification ................................................................................................ 43

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D.9. Exhibits ...................................................................................................... 44

E. Summary and Conclusions ............................................................................... 44

V. Chapter 5 - Review and Examination of a Cost Segregation Study ....................... 45

A. Introduction ....................................................................................................... 45

B. Steps for Examining a Cost Segregation Study and Report ............................. 45

B.1. Initial Risk Analysis .................................................................................... 45

B.2. Examination ............................................................................................... 50

B.3. Other Considerations ................................................................................. 57

C. Summary and Conclusions ............................................................................... 73

VI. Chapter 6 - Special Topics ................................................................................ 74

A. Uniform Capitalization ...................................................................................... 74

A.1. Introduction ................................................................................................ 74

A.2. Application of the Capitalization Rules Under § 263A ............................... 74

A.3. Capitalization of Costs Under § 263A ........................................................ 75

A.4. Capitalization of Interest Under § 263A(f) .................................................. 76

B. Change in Accounting Method .......................................................................... 78

B.1. Introduction ................................................................................................ 78

B.2. Historical Service Position ......................................................................... 78

B.3. Change in Litigating Position ..................................................................... 80

B.4. Peco Foods Case ...................................................................................... 81

B.5. Tangible Regulations – Treas. Reg. §§ 1.263(a)-1, -2, -3 .......................... 81

B.6. Revenue Procedures Involving Method Changes ...................................... 82

B.7. Summary ................................................................................................... 83

C. Depreciation Overview ..................................................................................... 84

C.1. Introduction ................................................................................................ 84

C.2. MACRS ...................................................................................................... 84

C.3. Depreciation Periods and Conventions ..................................................... 84

C.4. Recovery Periods ...................................................................................... 85

C.5. Class Lives ................................................................................................ 88

C.6. Revenue Procedure 87-56 ......................................................................... 89

C.7. Examples ................................................................................................... 91

C.8. Additional References for Determining the Proper Activity Category for Property ................................................................................................................. 92

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D. Relevant Court Cases ...................................................................................... 93

D.1. Introduction ................................................................................................ 93

D.2. Arrangement of Information ....................................................................... 93

D.3. Table 1: Case Law by Case Name (Reverse Chronological Order) ........... 94

D.4. Table 2: Case Law by CSI MasterFormat Divisions (2020 and 1995) ...... 105

D.5. Table 3: Listing of CSI MasterFormat Divisions (2020 and 1995) ............ 119

E. Inherently Permanent Standard ...................................................................... 121

E.1. Introduction .............................................................................................. 121

E.2. Inherently Permanent Standard Under § 168 .......................................... 121

E.3. Inherently Permanent Standard Under § 263A ........................................ 124

E.4. Comparison of Inherently Permanent Standard Under §§ 168 and 263A 126

E.5. Inherently Permanent Standard Under § 199 .......................................... 128

E.6. Comparison of Inherently Permanent Standard Under §§ 168 and 199 .. 129

E.7. Conclusion ............................................................................................... 130

F. Construction Process ..................................................................................... 131

F.1. Introduction .............................................................................................. 131

F.2. Stages in the Construction Process ......................................................... 131

F.3. Other Project Delivery Methods ............................................................... 147

G. Information Document Requests .................................................................... 147

G.1. Introduction .............................................................................................. 147

G.2. IDR 1 Purpose – To Identify the Participants and their Respective Roles in the Preparation of a Cost Segregation Study/Analysis ......................................... 148

G.3. IDR 2 Purpose –To Identify the Specific Properties Subject to Cost Segregation Study/Analysis ................................................................................. 148

G.4. IDR 3 Purpose – To Locate the Source of Property Blueprints and Drawings 148

G.5. IDR 4 Purpose – To Obtain a Copy of the Cost Segregation Study ......... 149

G.6. IDR 5 Purpose – To Obtain a Copy of the Study Computations and Formulae .............................................................................................................. 149

G.7. IDR 6 Purpose – To Ask Specific Questions about Segregated Properties 149

G.8. IDR 7 Purpose – Request for Specific Items and Amounts...................... 150

H. IRC §§ 179, 179D and Bonus Depreciation.................................................... 151

H.1. Significant Law ........................................................................................ 151

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H.2. IRC § 179 Deduction ............................................................................... 151

H.3. IRC § 179D Deduction ............................................................................. 153

H.4. Bonus Depreciation – In General ............................................................. 154

H.5. Acquisition Requirements and Placed in Service Dates .......................... 157

H.6. Bonus Depreciation Rates After 9/27/2017 .............................................. 159

H.7. Acquisition Requirement – In General ..................................................... 160

H.8. Chief Counsel Guidance on the Application of Bonus Depreciation Regulations to a Cost Segregation Study – FAA 20140202F ............................... 165

H.9. Method of Accounting Issues Related to Bonus Depreciation ................. 167

H.10. Election Out of Bonus Depreciation ......................................................... 169

VII. Chapter 7 - Industry Specific Guidance .......................................................... 171

A. Introduction ..................................................................................................... 171

B. Retail Industries .............................................................................................. 171

C. Restaurants .................................................................................................... 183

D. Pharmaceutical and Biotechnology ................................................................ 195

E. Casinos and Gaming Industry ........................................................................ 210

F. Auto Dealership Industry ................................................................................ 225

G. Auto Manufacturing Industry ........................................................................... 239

H. Residential Rental Property ............................................................................ 296

H.1. Planning and Examination Guidance ....................................................... 296

VIII. Chapter 8 - Issue Specific Guidance .............................................................. 323

A. Electrical Distribution System ......................................................................... 323

A.1. Introduction .............................................................................................. 323

A.2. Definitions and Building Electrical System Illustration ............................. 323

A.3. Legal Background .................................................................................... 326

A.4. Functional Allocation – Illustration ........................................................... 328

A.5. Summary ................................................................................................. 336

B. Stand-Alone Open-Air Parking Structures ...................................................... 336

B.1. Introduction .............................................................................................. 336

B.2. Description of Stand-Alone Open-Air Parking Structures ........................ 337

B.3. Applicable Tax Law .................................................................................. 337

B.4. Parties Positions ...................................................................................... 338

B.5. Analysis ................................................................................................... 340

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B.6. Penalties .................................................................................................. 342

B.7. Summary ................................................................................................. 347

(1) The 2024 update of the Cost Segregation Audit Technique Guide involved

collaboration led by the Deductible & Capital Expenditures Practice Network (DCE PN), the Methods of Accounting and Timing (MAT) Practice Network, and the Inventory & 263A Practice Network. In addition to clarifying modifications, updates reflect changes in the tax law from the passage of P.L. 117-169, commonly known as the Inflation Reduction Act of 2022 (IRA). Topics modified include Internal Revenue Code (IRC) § 263A, Depreciation, Bonus Depreciation, § 179D deduction, detailed cost estimate approach, and penalties as well as the addition of industry specific guidance for residential rental property.

(1) This Audit Techniques Guide (ATG) will assist Internal Revenue Service

(Service) examiners in the review and examination of cost segregation studies. The primary goals are to provide examiners with an understanding of:

• Why cost segregation studies are performed for Federal income tax

purposes;

• How cost segregation studies are prepared;

• What to look for in the review and examination of these studies; and,

• When certain issues identified in the cost segregation study need further

examination.

(2) The ATG was originally developed by a cross-functional team of Service

Engineers and Revenue Agents, and was updated by members of the DCE PN. This ATG is not an official IRS pronouncement and may not be cited as authority.

(1) To calculate depreciation for Federal income tax purposes, taxpayers must use

the correct method and proper recovery period for each asset or item of property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Property is typically separated into individual items or asset groups having the same recovery

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periods and placed-in-service dates to properly compute depreciation. When the actual cost of each asset or item of property is available, this procedure is simple. When only lump-sum costs are available, however, cost estimating techniques may be required to "segregate" or "allocate" costs to individual assets or items of property (e.g., land, land improvements, buildings, equipment, furniture, and fixtures, etc.). This type of analysis is generally called a "cost segregation study," "cost segregation analysis," or "cost allocation study."

(2) An increasing number of taxpayers have submitted either original tax returns or

claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for Federal income tax purposes is the significant tax benefits derived from using shorter recovery periods and accelerated depreciation methods (including bonus depreciation pursuant to IRC § 168(k) and § 179 deductions) for computing depreciation deductions. Examiners need to understand both the rationale and methodology used to segregate total property costs into various items of property.

(3) Cost segregation studies are most commonly prepared for the allocation or

reallocation of building costs to tangible personal property. A building, termed "§ 1250 property,” is generally non-residential real property (with a 39-year recovery period) or residential rental property (with a 27.5-year recovery period) that must use straight-line depreciation. Equipment, furniture, and fixtures, termed "§ 1245 property,” are tangible personal property. Tangible personal property has a shorter recovery period (e.g., 5 or 7 years) and can be also eligible for accelerated depreciation (e.g., double declining balance, bonus depreciation, and § 179 deduction). Therefore, a faster depreciation write-off (and tax benefit) can be obtained by allocating costs to § 1245 property.

(4) The following example illustrates the tax benefits of a cost segregation study. In

general, a turnkey construction project includes elements of tangible personal property (phone system, computer system, process piping, storage tanks, etc.). It is relatively easy to identify these items as § 1245 property and allocate a portion of the total project costs to them. A taxpayer’s cost segregation study might also report certain parts of the building (e.g., carpeting, wall coverings, partitions, millwork, and lighting fixtures) as § 1245 property that likely would have been classified or grouped under § 1250 property without the completion of a cost segregation study. These items may or may not constitute § 1245 property depending on the particular facts and circumstances for which the project was designed.

(5) This next example illustrates the complexity of cost segregation issues. In

addition to identifying specific assets that qualify as § 1245 property, cost segregation studies may treat portions of building components as § 1245 property. For example, some portions of the building’s electrical system support both § 1245 property and § 1250 property. The cost segregation study will typically identify the costs of the branch circuits feeding the § 1245 property and classify according to the recovery period of the § 1245 property (i.e., 5 or 7-year recovery period). It may also identify that, for example, 15 percent of a

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building’s electrical distribution system (EDS) directly supports § 1245 property, such as specialized kitchen equipment. Based on that conclusion, the study will then treat 15 percent of the EDS cost as § 1245 property along with the identified § 1245 branch circuits. See Chapter 8.A - Electrical Distribution System for further details. The allocation of building components to § 1245 property is often a contentious issue.

(6) Property allocations and reallocations are typically based on criteria established

under the Investment Tax Credit (ITC) laws under § 48. Complex and often conflicting guidance relating to property qualifying for ITC, resulting from numerous legislative acts, court decisions and Service rulings, and a lack of bright-line tests, have impacted the ease of distinguishing § 1245 property from § 1250 property. Related issues, such as the capitalization of interest and production costs under § 263A and changes in accounting method, add to the complexity of this issue. For additional guidance on court rulings refer to Chapter 6.D. - Relevant Court Cases included in this ATG.

(7) In a landmark decision, the Tax Court ruled that, to the extent tangible personal

property is included in an acquisition or in overall costs, it should be treated as such for depreciation purposes. The court also decided that the rules for determining whether property qualifies as tangible personal property for purposes of ITC (under pre-1981 tax law) are also applicable to determining depreciation classification under current law. See, Hospital Corporation of America, 109 T.C. 21 (1997). The Service acquiesced to the use of ITC rules for distinguishing § 1245 property from § 1250 property.

(8) This ATG provides technical information, audit techniques and examples of

proper cost segregation studies to focus the efforts of examiners. The use of cost segregation studies will likely continue to increase, and there are currently no standards regarding the preparation of these studies. These studies vary widely in terms of the methodology, documentation, depth, format, and expertise of the study’s preparer. This lack of consistency, coupled with the complexity of the law in this area, often results in an examination that can be controversial and burdensome for all parties.

(9) Examiners reviewing cost segregation studies must determine the proper

classification and correct costs of property. In some cases (e.g., small projects) examiners may be able to evaluate a study without assistance. However, other studies may require specialists with expertise, industry experience, and specialized training (e.g., Engineers, Computer Audit Specialists and/or DCE PN Senior Engineers and Revenue Agents). Examiners should perform a risk analysis as early as possible to determine the depth of an examination and the need for additional assistance.

(10) Technical and/or procedural cost segregation questions may be submitted to

the DCE PN.

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(1) Depreciation issues involving cost segregation studies cross all Large Business

and International (LB&I) industry lines and impact Small Business and Self Employed (SB/SE) taxpayers as well. The lack of consistency in cost segregation studies and the absence of bright-line tests for distinguishing property contribute to the difficulties of this issue. The purpose of this ATG is to provide the foundation to a better understanding of cost segregation studies and to provide the examination steps that will facilitate the audit process and minimize burden on taxpayers, practitioners, and Service examiners alike.

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(1) To better understand tax controversy surrounding the use of cost segregation

studies, it is important to review the relevant legal history and the motivations of taxpayers to allocate costs to personal property. The legislative and judicial history of asset classification, depreciation, and Investment Tax Credit (ITC) are closely related. Accordingly, much of the discussion will focus on the rules and decisions impacting several interrelated sections of the IRC (including ITC that was revoked in 1986).

(2) The IRC has historically authorized depreciation deductions as an allowance for

the exhaustion, wear and tear, and obsolescence of property used in a trade or business or for the production of income (§ 167 and the regulations thereunder). The deduction has generally been calculated with respect to the adjusted basis and useful life (or recovery period) of the property by utilizing an appropriate depreciation method. At one time, salvage value was also a factor in the computation. Buildings and structural components have substantially longer depreciable lives than tangible personal property. The shorter the useful life (or recovery period) of any given property will result in a larger annual tax deduction to the taxpayer. Therefore, it is desirable for taxpayers to maximize costs allocable to tangible personal property to accelerate depreciation deductions and reduce tax liability. This chapter provides a brief historical perspective of the statutes, regulations and major court cases that relate to cost segregation studies.

(1) For about 20 years after the introduction of our present income tax system in

1913, taxpayers were generally given freedom to determine depreciation allowances. Both individuals and corporations could claim a reasonable allowance for depreciation of property arising out of its use or employment in the business or trade. The deductions claimed were not challenged unless it could be shown by clear and convincing evidence that they were unreasonable. Prior to 1934, a taxpayer had wide leeway as to the amount which could be written off each year against current income as an allowance for the cost of machinery, equipment, and buildings. As long as the taxpayer’s policy was consistent and in accordance with sound accounting practice, the tax authorities raised little question, realizing that the cost could be written off only once. See Announcement 71-76, 1971-2 C.B. 503.

(2) In 1934, the Treasury Regulations (Treas. Reg.) were amended to provide that

the burden of proof would rest upon the taxpayer to sustain the depreciation deduction claimed. Taxpayers became responsible to furnish full and complete information with respect to the cost or other basis of the assets related to the claimed depreciation. The required information for each asset included the age, condition and remaining useful life, the portion of their cost or other basis, which

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had been recovered through depreciation allowances for prior taxable years, and any other information as the Commissioner may require in substantiation of the deduction claimed. Whatever plan or method of depreciation a taxpayer would choose to adopt, it “must be reasonable and must have due regard to operating conditions during the taxable period.” T.D. 4422, 1934-1 C.B. 58.

(1) The earliest edition of Bulletin “F” was a pamphlet issued in 1920, which

contained no schedule of suggested average lives, but defined depreciation as follows: “Depreciation means the gradual reduction in the value of property due to physical deterioration, exhaustion, wear, and tear through use in trade or business.” Obsolescence was treated as a separate and supplemental factor in computing the depreciation allowance where the facts supported an additional amount. Bulletin “F” was first revised in 1931, at which time the first schedule of suggested lives was published as a separate pamphlet. The schedule provided useful lives for individual assets used by industry groups. In Bulletin “F,” the Internal Revenue Service (Service) explicitly frowned on the use of a composite rate of depreciation; rather, the Service advocated depreciation by items or by groups of items having practically identical physical characteristics and length of life. In conjunction with the burden shifting from the Service to the taxpayer regarding depreciation deductions, useful life became largely determined by reference to standardized lives prescribed in Bulletin “F” and a taxpayer had a heavy burden of proof to sustain any shorter life for an individual asset.

(2) Bulletin “F" underwent a second revision in 1942 and provided a useful life

guide for various types of property based on the nature of a taxpayer's business or industry. Bulletin “F” identified over 5,000 assets used in 57 different industries and activities and described two procedures for computing depreciation for buildings:

1. Composite Method: A depreciation chart provided a composite rate for fourteen different types of buildings, including all installed building equipment. The recommended rates ranged from 1.5% per year for good quality warehouses and grain elevators to 3.5% per year for lesser quality theaters. These composite depreciation rates correspond to useful lives ranging from 28.5 years to 66.7 years.
2. Component Method: Taxpayers could elect to depreciate building equipment separately from the structure. A list provided lives for various types of structures, ranging from 50 years for apartments, hotels, and theaters, to 75 years for warehouses and grain elevators. A separate list provided lives for over 100 items of installed building equipment, ranging from 5 to 25 years, with certain installed building equipment listed as having the same life as the life of the building in which it was installed.

(3) Bulletin “F” also allowed taxpayers to either depreciate individual items on a

separate basis or to combine assets into composite, classified, or group

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accounts and depreciate the group account as a single asset. Historically, some taxpayers have interpreted this to mean that assets can be segregated into components and depreciated separately.

(1) In 1954, major changes were made to depreciation laws. Aside from the

authorization of new methods of depreciation, § 167(d) was added which authorized written agreements between the Service and taxpayers specifically dealing with the useful life and rate of depreciation of any property.

(2) In 1956, the ability to depreciate on an account basis (first allowed in Bulletin

“F”) was codified in Treas. Reg. § 1.167(a)-7(a). The regulations moved away from the concept of physical life, focusing instead on the period of time the property was used in the trade or business of the taxpayer. See Treas. Reg. § 1.167(a)-1(a). Also, as part of a policy designed to reduce administrative controversies, the Service codified a policy that it would only re-determine estimated useful life when the change in the useful life is significant and there is a clear and convincing basis for the redetermination. See Treas. Reg. § 1.167(a)-1(b).

(3) In Shainberg vs. Commissioner, 33 T.C. 241 (1959), the Service challenged the

taxpayer’s method of depreciation of segregating buildings and the various items of equipment in the buildings into separate component groups. The Tax Court held that the taxpayer could calculate depreciation using a component grouping method as was their right under the regulations. In general, the courts have sustained the estimated useful lives assigned by taxpayers such as a 40year life for the building structure, a 15-year life for the roofs, plumbing, wiring and elevators, and a 10-year life for the paving, ceilings, and heating and air conditioning systems.

(1) Revenue Procedure (Rev. Proc.) 62-21, 1962-2 C.B. 418, superseded Bulletin

“F.” Instead of thousands of asset classifications, assets were grouped into approximately 75 broad industrial classifications and by certain broad general asset classifications, with a “Guideline Life” established for each of these classes. The guideline lives were about 30-40 percent shorter than Bulletin “F” lives and about 15 percent shorter than the lives in actual use by taxpayers. Use of the guideline lives required taxpayers to meet a reserve ratio test (complex provision). The Rev. Proc. represented a fundamental change by treating assets as a class rather than as individual assets; even though assets within a class were heterogeneous with respect to ages, useful lives, and physical characteristics. The asset class for buildings included "the structural shell of the building and all integral parts thereof,” as well as “equipment which services normal heating, plumbing, air conditioning, fire prevention and power requirements, and equipment such as elevators and escalators.” The Rev. Proc. listed 13 different types of buildings, with guideline lives ranging from 40

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years for apartments, hotels, and theaters, to 60 years for warehouses and grain elevators. The Guideline Life system did not address repair and maintenance expenditures.

(2) Revenue Ruling (Rev. Rul.) 66-111, 1966-1 C.B. 46, addressed the use of

component depreciation for used real property and distinguished its facts from those in Shainberg, Rev. Rul. 66-111 decided that "when a used building is acquired for a lump sum consideration, separate components are not bought; a unified structure is purchased” such that the value of components (e.g., ceilings, floors, electrical systems, etc.) of a used building cannot be separated from the value of the building as a whole. Thus, the cost basis of used real property cannot be allocated into separate component accounts for determining a composite life in computing depreciation; rather, an overall useful life for the building must be determined based upon the building as a whole. The ruling was later modified by Rev. Rul. 73-410, 1973-2 C.B. 53, which held that the component method of computing depreciation may be utilized for used real property if: 1) the cost of acquisition is properly allocated to the various components based on their value; and 2) useful lives are assigned to the component accounts based on the condition of such components at the time of acquisition. See also Lesser v. Commissioner, 352 F.2d 789 (9th Cir. 1965).

(3) Rev. Rul. 68-4, 1968-1 C.B. 77, concluded that “it is not proper to use the

component method of computing depreciation by assigning the guideline class life from Rev. Proc. 62-21 to the structural shell of a building and assign different useful lives to the other integral parts or components of the building. Rev. Proc. 62-21 may only be used where all the assets of the guideline class (building shell and its components) are included in the same guideline class for which one overall composite life is used for computing depreciation."

(1) Rev. Proc. 72-10, 1972-1 C. B. 721, superseded Rev. Proc. 62-21 and set forth

the Class Life Asset Depreciation Range (ADR) system for tangible assets placed in service after 1970. The purpose of the ADR system was to minimize controversies about useful life, salvage value, and repair and maintenance expenditures. It also abolished the controversial reserve ratio test. Under the elective ADR system, all tangible assets were grouped into more than 100 asset guideline classes (generally corresponding to those set out in Rev. Proc. 62-21) based on the business and industry of the taxpayer. Each class of assets (other than land improvements and buildings) was given a class life as well as a range of years (called "asset depreciation range") that was approximately 20 percent above and below the class life. A taxpayer could select a depreciation period from this range, and it would not be challenged by the Service. Thus, the ADR system disassociated an asset’s depreciation period from its useful life but treated it as the useful life for all income tax purposes, even though the depreciation period could be significantly shorter than the actual useful life. However, buildings were generally excluded from the ADR system (except for a 3-year transitional period). The ADR system served

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as a comprehensive scheme for dealing with property, including repair and maintenance expenditures (via an optional repair allowance) and salvage value. The asset guideline set forth in Rev. Proc. 72-10, was superseded by Rev. Proc. 77-10, 1977-1 C.B. 548, and served as an update to the asset guideline classes and class lives.

(1) In 1981, Congress enacted the ACRS (Economic Recovery Tax Act of 1981 –

P.L. 97-34) to simplify the depreciation rules and to stimulate the economy by allowing greater deductions over shorter periods. ACRS eliminated salvage value, minimized exceptions and elections, and moved away from the useful life concept. ACRS allowed depreciation deductions (this term is used for convenience; since ACRS is not based on estimated useful lives, cost recovery under it may not technically qualify as depreciation) for recovery property over a predetermined recovery period by applying a statutory percentage to its basis (cost). These statutory percentages were set forth in a series of tables. In contrast to the elective ADR system, ACRS was mandatory and provided only five (later six) recovery periods. ACRS allowed for a faster cost recovery of assets than had been allowed under previous rules (e.g., the 40-year life for real property was reduced to a 15, 18, or 19-year recovery period, depending on the placed-in-service date of the property). ACRS was generally applicable for property placed in service from 1981 through 1986.

(2) ACRS prohibited component depreciation as a method of computing

depreciation for buildings. ACRS required the depreciation deduction for any component of a building to be computed in the same manner as the deduction allowable for the building, beginning on the later of the date the component is placed in service, or the building is placed in service. See former § 168(f)(1); Proposed Treas. Reg. §§ 1.168-2(e) and 1.168-6. The driving force behind this action was to eliminate controversies surrounding the determination of qualifying § 1245 property (as explained below).

(1) In 1986, Congress enacted the Modified Accelerated Cost Recovery System

(Tax Reform Act of 1986 – P.L. 99-514). Cost recovery is now based on the applicable depreciation method, the applicable recovery period, and the applicable convention, as outlined in § 168. MACRS provided two depreciation systems: the general depreciation system and the alternative depreciation system (applicable for property used outside the United States, tax-exempt use property, property for which an alternative depreciation system election has been made, and a couple of other finite categories not germane to this discussion). MACRS also required appropriate basis adjustments to compute subsequent year deductions and modified other ACRS provisions including property classifications. The recovery period for buildings and structural components increased dramatically. For example, the 15, 18, or 19-year recovery periods for real property became 39 years for nonresidential real

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property (31.5 years for nonresidential real property placed in service before May 13, 1993) and 27.5 years for residential rental property, under the general depreciation system. Under the alternative depreciation system nonresidential real property has a 40-year recovery period and residential rental property has a 40-year recovery period if placed in service before January 1, 2018, and a 30year recovery period if placed in service after December 31, 2017 (for more information, see Rev. Proc. 2021-28, 2021-27 I.R.B. 5). In Rev. Proc. 87-57, 1987-2 C.B. 687, as modified by Rev. Proc. 2019-08, 2019-03 I.R.B. 347, the Service furnished optional tables to provide applicable deduction percentages under MACRS.

(2) The classification of property under MACRS is important because it affects the

applicable depreciation method, recovery period, and convention. Each item of property depreciated under MACRS is assigned to a property class, which establishes the item’s recovery period. The applicable recovery periods for MACRS are determined by statute or by reference to class lives. Class lives for MACRS are set forth in Rev. Proc. 87-56, 1987-2 C. B. 674. This Rev. Proc. establishes two broad categories of depreciable assets: 1) asset classes 00.11 through 00.4 that consist of specific assets used in all business activities; and 2) asset classes 01.1 through 80.0 that consist of assets used in specific business activities. The same item of depreciable property can be described in both an asset category (asset classes 00.11 through 00.4) and an activity category (asset classes 01.1 through 80.0), in which case the item is classified in the asset category (unless it is specifically included in the activity category). See Norwest Corp. & Subs. v. Commissioner, 111 T.C. 105 (1998) (item described in both an asset and an activity category should be placed in the asset category). Chapter 4 - Principal Elements of A Quality Cost Segregation Study and Report provides an overview of asset classifications and recovery period determinations.

(3) MACRS continued the prohibition against the use of the component method of

depreciation. Although MACRS repealed ACRS § 168(f)(1), which related specifically to components of § 1250 class property, it enacted § 168(i)(6), which provides that improvements made to real property are depreciated using the same recovery period applicable to the underlying property as if the underlying property were placed in service at the same time the improvements were made. Regarding improvements, the statute refers to § 1245 property and § 1250 property. Section 168(i)(12) provides that the terms “§ 1245 property” and “§ 1250 property” have the meanings given such terms by § 1245(a)(3) and § 1250(c), respectively.

(1) In 1962, Congress enacted the provisions of §§ 1245 and 1250 (Revenue Act of

1962 – P.L. 87-834). These Code sections result in the conversion of capital gain to ordinary income on the disposition of a property, to the extent its basis has been reduced by an accelerated depreciation method. The definitions of property for purposes of §§ 1245 and 1250 are essential for determining

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eligibility for a number of other Code provisions (including §§ 167, 168, 179, and former § 48). One of the primary issues in cost segregation studies is the proper classification of assets as either § 1245 or § 1250 property. The main difference between §§ 1245 and 1250 is whether the provisions apply to the entire amount or an applicable percentage of the gain.

(2) Section 1245(a)(3) provides that "§ 1245 property" is any property which is or

has been subject to depreciation under § 167 and which is either personal property or other tangible property (not including a building or its structural components) that was used as an integral part of certain activities. Such activities include manufacturing, production, or extraction; furnishing transportation, communication, electrical energy, gas, water, or sewage disposal services. Certain other "special use" property also qualifies as § 1245 property but is not relevant to this discussion. It is important to note that a building or its structural components is specifically excluded from the definition of § 1245 property.

(3) Treas. Reg. § 1.1245-3 defines "personal property," "other tangible property,"

"building," and "structural component" by reference to Treas. Reg. § 1.48-1. This regulation relates to former § 48 which was enacted in 1962 along with §§ 1245 and 1250. § 48 allowed an Investment Tax Credit (ITC) based on the "applicable percentage" of the investment in tangible depreciable property placed in service during the taxable year. The ITC was later repealed in 1986.

(4) Section 1250(c) defines "§ 1250 property" as any real property, other than §

1245 property, which is or has been subject to an allowance for depreciation. In other words, § 1250 property encompasses all depreciable property that is not § 1245 property.

(1) Eligible ITC property is defined in former § 48(a)(1) with reference to § 38 (in

fact, eligible property is often referred to as "§ 38 property"). Eligible property included tangible personal property (other than heating or air conditioning units) and other tangible property (primarily machinery and equipment) that was closely integrated into the taxpayer's trade or business. Land, buildings, structural components contained in or attached to buildings, and other inherently permanent structures generally were not eligible for ITC. Local law was not controlling with regard to classifying property as tangible personal property for purposes of ITC.

(2) Treas. Reg. § 1.48-1(c) defines “tangible personal property” as any tangible

property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures). Thus, buildings, swimming pools, paved parking areas, wharves and docks, bridges, and fences are not tangible personal property. Tangible personal property includes all property (other than structural components) which is contained in or attached to a building. Thus, such property as production machinery, printing presses, transportation and

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office equipment, refrigerators, grocery counters, testing equipment, display racks and shelves, and neon and other signs, which is contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by § 38. Further, all property that is in the nature of machinery (other than structural components of the building or other inherently permanent structure) is considered to be tangible personal property even though located outside a building. For example, a gasoline pump, hydraulic car lift or automatic vending machine, although annexed to the ground, is considered to be tangible personal property.

(3) The Senate Report accompanying the enactment of the Revenue Act of 1978

provided additional insight into Congressional intent by providing further examples of qualifying and non-qualifying property:

• [T]he committee wishes to clarify present law by stating that tangible personal property already eligible for the investment tax credit includes special lighting (including lighting to illuminate the exterior of a building or store, but not lighting to illuminate parking areas), false balconies and other exterior ornamentation that have no more than an incidental relationship to the operation or maintenance of a building, and identity symbols that identify or relate to a particular retail establishment or restaurant such as special materials attached to the exterior or interior of a building or store and signs (other than billboards). Similarly, floor coverings which are not an integral part of the floor itself such as floor tile generally installed in a manner to be readily removed (that is it is not cemented, mudded, or otherwise permanently affixed to the building floor but, instead, has adhesives applied which are designed to ease its removal), carpeting, wall panel inserts such as those designed to contain condiments or to serve as a framing for picture of the products of a retail establishment, beverage bars, ornamental fixtures (such as coats-ofarms), artifacts (if depreciable), booths for seating, movable and removable partitions, and large and small pictures of scenery, persons, and the like which are attached to walls or suspended from the ceiling, are considered tangible personal property and not structural components. Consequently, under existing law, this property is already eligible for the ITC. [S. Rep. No. 1263, 95th Cong., 2d Sess. 117 (1978), reprinted in 1978-2 C.B. Vol. 1 315, 415.]

(4) Treas. Reg. § 1.48-1(e)(1) defines a "building" as any structure or edifice

enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. The term includes, for example, structures such as apartment houses, factory and office buildings, warehouses, barns, garages, railway or bus stations, and stores. It also includes any such structure constructed by, or for, a lessee even if such structure must be

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removed, or ownership of such structure reverts to the lessor, at the termination of the lease.

(5) Specifically excluded from the definition of the term "building" are: (i) a structure

which is essentially an item of machinery or equipment, or (ii) a structure which houses property used as an integral part of an activity specified in [former] § 48(a)(1)(B)(i) if the use of the structure is so closely related to the use of such property that the structure clearly can be expected to be replaced when the property it initially houses is replaced. Factors which indicate that a structure is closely related to the use of the property it houses includes the fact that the structure is specifically designed to provide for the stress and other demands of such property, and the fact that the structure could not be economically used for other purposes. Thus, the term “building” does not include such structures as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns and coal tipples.

(6) Treas. Reg. § 1.48-1(e)(2) provides that "structural components" includes such

parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.

(7) However, the term "structural components" does not include machinery the sole

justification for the installation of which is the fact that such machinery is required to meet temperature or humidity requirements, which are essential for the operation of other machinery or the processing of materials or foodstuffs. Machinery may meet the "sole justification" test provided by the preceding sentence even though it incidentally provides for the comfort of employees, or serves, to an insubstantial degree, areas where such temperature or humidity requirements are not essential. For example, an air conditioning and humidification system installed in a textile plant to maintain the temperature or humidity within a narrow optimum range, which is critical in processing particular types of yarn, or cloth is not included within the term "structural components."

(1) There is no general bright-line test for segregating property into § 1245 property

and § 1250 property classifications. Each situation is factually intensive and is dependent on the particular facts and circumstances involved.

(2) From a regulatory standpoint, the primary test for determining whether an asset

is § 1245 property eligible for ITC is to ascertain that it is not a building or other inherently permanent structure, including items which are structural components of such buildings or structures. In other words, if an asset is not a

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building or a structural component of a building, then it can be § 1245 property. The determination of structural component hinges on what constitutes an inherently permanent structure, how permanently the asset is attached to such a structure and whether it relates to the operation or maintenance of the structure. See Treas. Reg. §§ 1.48-1(c)-(e).

(3) Early administrative rulings by the Service on ITC focused on the use of a

"functional” or “equivalency” test. This test is based on the determination that if the primary use of property is to provide for the functions normally served by inherently permanent structures or structural components thereof, then the property should be so classified. Several courts, however, rejected this approach.

(4) In Rev. Rul. 75-178, 1975-1 C.B. 9, the Service reconsidered its position based

on the contrary case law. It states, “The use of a functional or equivalency test (1) to classify property as inherently permanent where it is not itself physically attached to the land, or (2) to classify property as a structural component where it is not an integral part of (and therefore a permanent part of) a building, is no longer the criteria to be used to classify property. Rather, the problem of classification of property as ‘personal’ or ‘inherently permanent’ should be made on the basis of the manner of attachment to the land or the structure and how permanently the property is designed to remain in place.” Thus, the test to be used to determine whether an asset is tangible personal property is the inherently permanent test.

(1) The seminal case involving the determination of whether an asset is inherently

permanent is Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975). The Tax Court noted that “tangible personal property” is not intended to be defined narrowly, nor to follow the rules of State law where fixation to the land is a basis for distinguishing personal property from other property. It further stated that assets accessory to the operation of a business, such as machinery, printing presses, office equipment, individual air-conditioning units, display racks and shelves, etc., generally constitute tangible personal property for purposes of § 48, even though such assets may be termed fixtures under local law. Based on an analysis of prior case law, the Tax Court put forth six questions designed to ascertain whether a particular asset qualifies as tangible personal property. These questions, also referred to as the six " Whiteco factors," are:

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1. Is the property capable of being moved, and has it in fact been moved?

2. Is the property designed or constructed to remain permanently in place?

3. Are there circumstances, which tend to show the expected or intended lengths of affixation, i.e., are there circumstances, which show that the property may or will have to be moved?

4. How substantial of a job is the removal of a property and how timeconsuming is it? Is it “readily removable”?

5. How much damage will the property sustain upon its removal?

6. What is the manner of affixation of the property to the land?

(2) It should be noted that movability is not determinative in measuring

permanence. The court in Whiteco held that affixation to land does not per se exclude the property from the category of tangible personal property. Additionally, in L.L. Bean, Inc. v. Commissioner, T.C. Memo. 1997-175, aff'd, 145 F.3d 53 (1st Cir. 1998), the court held that the mere fact that a structure is theoretically capable of being moved does not conclusively establish that it is not inherently permanent.

(3) Examiners should also consider the following additional factors when

addressing permanency (some of which may overlap with the Whiteco factors):

• History of the item or similar items being moved;

• Manner in which an item is attached to a building or to the land;

• Weight and size of the item;

• Function and design of the item;

• Intent of the taxpayer in installing the item;

• Time, cost, manpower, and equipment required to move the components;

• Time, cost, manpower, and equipment required to reconfigure the existing space if the item is removed;

• Effect of the item’s removal on the building; and

• Extent the item can be reused after removal.

(4) See AmeriSouth XXXII, Ltd. V. Commissioner, T.C. Memo. 2012-67; Trentadue

v. Commissioner, 128 T.C. 91 (2007); PDV America, Inc. and Subs. v. Commissioner, T.C. Memo. 2004-118; Hospital Corp. of America and Subs. v. Commissioner, 109 T.C. 21 (1997).

(5) Please note that land improvements may or may not be inherently permanent.

Asset Class 00.3 of Rev. Proc. 87-56 describes land improvements as depreciable improvements made directly to or added to land, whether such improvements are § 1245 property or § 1250 property. Examples of land improvements include sidewalks, roads, canals, waterways, drainage facilities, sewers, wharves and docks, bridges, fences, landscaping, shrubbery, and radio and television transmitting towers. Buildings and structural components are specifically excluded from the category of land improvements. Land

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improvements may also be included in some activity asset classes such as asset class 57.1 of Rev. Proc. 87-56.

(1) In Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997) ( HCA ),

the taxpayer classified as tangible personal property certain items relating to hospital facilities and claimed depreciation deductions using a 5–year recovery period. The Service took the position that a number of those items were structural components of the related buildings and that they must be depreciated over the same recovery period as the buildings to which they related. The Service also argued that using a different recovery period for the disputed property items than for the buildings to which they relate in effect results in component depreciation, which is a method that is no longer permitted under ACRS and MACRS (§ 168(f)(1) and § 168(i)(6), respectively). Thus, according to the Service, the tests developed under the ITC to differentiate between § 1245 property and § 1250 property were inapplicable to ACRS and MACRS.

(2) The Tax Court held that at the time ACRS was enacted, Congress did not

intend to redefine § 1250(c) to include property which was considered under long-standing precedent to constitute § 1245 property. Thus, the precedent that was developed to ascertain whether property constituted eligible § 38 property for purposes of ITC was equally applicable to ascertain whether property constituted § 1245 property for purposes of ACRS/MACRS. Conversely, to the extent that property did not qualify as eligible § 38 property for purposes of ITC, the property cannot constitute § 1245 property for purposes of ACRS/MACRS. The Court further held that the prohibition contained in § 168 against the use of component depreciation applied only to § 1250 property.

(3) In an Action on Decision (AOD-1999-008), the Service acquiesced to the

decision in HCA to the extent that the term “tangible personal property” as defined under the ITC remained applicable under both ACRS and MACRS. The Service, however, did not agree with the court’s determinations as to whether the various assets at issue constituted tangible personal property.

(1) Pursuant to HCA, cost segregation methodologies previously used to allocate

the cost of a building between ITC property and structural components likewise can be used for segregating § 1245 property from § 1250 property. However, this does not necessarily mean that an asset is exclusively either § 1245 property or § 1250 property; certain assets can contain characteristics of both code sections. Regarding primary and secondary electrical distribution systems, the court in HCA concluded that the portion of the cost of the primary and secondary electrical distribution systems corresponding to the percentage of the electrical load carried to the hospitals' equipment constituted as § 1245 property, whereas the portion corresponding to building operations constituted

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as § 1250 property. As a result of the ruling in HCA, the Tax Court followed its precedent in Morrison, Inc. v. Commissioner, T.C. Memo. 1986-129, and Scott Paper Co. v. Commissioner, 74 T.C. 137 (1980).

(2) In Scott Pape r, the court focused on the ultimate uses of power at the

taxpayer's facility and distinguished the power used in the overall operation or maintenance such as lighting, heating, ventilation, and air-conditioning of the building from the power used to operate the taxpayer's machinery. It held that items which occur in an unusual circumstance and do not relate to the operation or maintenance of a building should not be structural components despite being listed in Treas. Reg. § 1.48-1(e)(2). To the extent that the primary electric carried electrical loads to be used for the taxpayer’s production processes or other such qualifying uses, the investment credit was allowed for the primary electric improvements; to the extent that the primary electric related to the overall operation or maintenance of buildings, they were structural components of such buildings such that they did not qualify as tangible personal property for purposes of the ITC. This became known as the functional allocation approach. Hence, the court made an allocation of the facility’s primary electric between § 1245 property and § 1250 property.

(3) In Morrison, the court followed the functional allocation approach from Scott

Paper and held that the electrical distribution systems were not structural components to the extent of the load percentages that were carried to equipment (§ 1245 property). On appeal, 891 F.2d 857 (11th Cir. 1990), the Circuit Court affirmed the decision in the Tax Court. It also made three broad announcements with regard to the electrical distribution system issue. First, taxpayers can claim ITC on a percentage basis. Second, it adopted the Tax Court’s method of focusing on the ultimate use of electricity distributed with regard to the electrical system. Third, the Tax Court’s method is consistent with the ITC’s purpose to provide an incentive for businesses to make capital contributions. Subsequent to the Eleventh Circuit’s opinion in Morrison, the Service issued AOD-1991-019 in which it stated that the Service would not challenge the functional allocation approach set forth in Scott Paper to determine the eligibility of electrical systems of a building to qualify as § 38 property. For a more detailed explanation of the functional allocation approach, please see Chapter 8.A. - Electrical Distribution Systems.

(4) Case law has extended the reasoning of Scott Paper to such items as electrical

wiring, outlet receptacles, electrical connectors, telephone connection equipment, fire protection systems, water piping and lines, drain lines, gas lines, and plumbing and gas connectors. See AmeriSouth, supra, HCA, supra; Morrison, supra; Texas Instruments, Inc. v. Commissioner, T.C. Memo 1992306; Duaine v. Commissioner, T.C. Memo.1985–39. Please note, however, that the functional allocation approach is only applied to a building’s primary and secondary electrical distribution systems.

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(1) The IRC provides numerous incentives for taxpayers to perform cost

segregation studies and allocate costs to § 1245 property. Aside from a shortened cost recovery period (since § 1245 property has shorter recovery periods than § 1250 property), certain incentives generally apply to tangible personal property (§ 1245 property) and not real property (§ 1250 property). Some of these incentives include:

• § 168(k), Special Allowance for Certain Property (i.e., Bonus Depreciation)

• § 179, Election to Expense Certain Depreciable Business Assets

(2) Other incentives included in the IRC, however, may reduce the need for a

taxpayer to perform a cost segregation study because they give preferential treatment for certain qualifying § 1250 property. Some of these incentives include:

• § 168(e)(6), Qualified Improvement Property

• Former § 168(e)(6), Qualified Leasehold Improvement Property

• Former § 168(e)(7), Qualified Restaurant Property

• Former § 168(e)(8), Qualified Retail Improvement Property

• Former § 1400L, Tax Benefits for New York Liberty Zone

• Former § 1400N, Tax Benefits for Gulf Opportunity Zone

(3) The requirements and restrictions for using the above incentives can be

complex. In addition, the eligibility and the amount of the deduction allowed by the above incentives has changed over time. Exercise special attention to the placed-in-service date of the property at issue. You may wish to contact the Practice Network that has jurisdiction over the incentive to ensure proper allocation of the provisions.

(1) The Service issued a series of Field Directives to effectively use resources in

the classification and examination of a taxpayer who is recovering costs through depreciation of tangible property used in the operation of a business. The directives were issued for a variety of industries including casinos, restaurants, retail industries, biotech and pharmaceutical industries, and auto dealerships. The directives contained matrices and related definitions as tools to reduce unnecessary disputes and foster consistent audit treatment. The directives specified that if the taxpayer’s tax return position was consistent with the recommendations in the matrix, then examiners should not make adjustments to categorization and lives. If the taxpayer reported assets differently, however, then adjustments should be considered. See Chapter 7 - Industry Specific Guidance of this Guide for matrices applicable to various industries.

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(1) This chapter has provided a legal framework for cost segregation by providing a

brief history of depreciation, discussing various asset classification and cost recovery models, defining relevant terms, examining the former ITC, explaining tests for distinguishing § 1245 property from § 1250 property, showing how cost segregation principles transferred from the ITC to current cost recovery systems, clarifying how cost segregation applies to building systems, enumerating incentives for cost segregation, and conversing about audit tools.

(2) It cannot be overemphasized that the classification of assets is a factually

intensive determination. There are no bright-line tests for segregating property into § 1245 property and § 1250 property classifications. The use of cost segregation studies by taxpayers has increased since the 2013 publication of the final tangible regulations. Thus, examiners need to examine and evaluate a cost segregation study in light of the applicable statutes, regulations, and judicial precedent.

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(1) Cost segregation studies are conducted for a variety of reasons (e.g., income

tax, financial accounting, insurance purposes, and property tax). For income tax purposes, cost segregation studies involve the allocation (or reallocation) of the total cost (or value) of property into the appropriate property classes and recovery periods in order to properly compute depreciation deductions. The results of cost segregation studies are typically summarized in an accompanying cost segregation report. Currently, there is no standard format for either cost segregation or cost segregation reports.

(2) The methodology or approach utilized in allocating total project costs to various

assets is critical to achieving an accurate cost segregation study. The terms “methodology” and “approach” are often used interchangeably in discussions of cost segregation; however, to simplify, the term “approach” is used in this ATG. Also, in this ATG, the term “cost segregation” refers to the process of performing cost segregation and the term “cost segregation study” refers to the written report that conveys the results of the cost segregation. This chapter summarizes some of the more common approaches to cost segregation and their potential drawbacks. This discussion should assist the examiner in evaluating the accuracy of the cost segregation and in performing a risk analysis with respect to the depreciation deductions based on the cost segregation.

(3) Cost segregation is generally performed for either newly constructed property or

acquired property. Each of these situations requires a very different overall approach.

(4) Newly constructed property, which includes remodels of existing properties and

additions to existing properties, usually involves construction that was completed for the taxpayer that has occurred relatively recently. The cost segregation is normally performed either at the completion of the construction project or soon after. At this point, direct cost information (from contractors, vendors, suppliers, etc.) and indirect cost information (from architects, engineers, construction testing firms, local government building departments, etc.) is generally readily available from the taxpayer. Also, construction documents that were used for the construction project (construction drawings, specifications, contract documents, etc.) are generally readily available as well.

(5) Acquired property typically includes a combination of land, buildings, land

improvements, and personal property located on the land or in the buildings purchased by the taxpayer. The acquired property could have been constructed recently or far in the past. The available cost and construction information may range from as much as that available for a newly constructed property down to nothing more than the purchase price of the acquired property.

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(6) When construction cost information for the acquired property is not available, it

must be estimated using the construction cost data, methods, and techniques normally employed for a property appraisal. These estimated property costs (replacement cost new (RCN)), which include indirect costs, are then adjusted for the asset’s age and condition at the acquisition date, including physical depreciation, functional obsolescence, and economic obsolescence. These adjustments are generally expected to be different among the various items of acquired property (e.g., a building and its structural components, land improvements, and personal property), given that each of these items of property have varying expected useful lives, levels of use, and may have been constructed and/or installed on different dates. The total replacement cost new less depreciation (RCNLD) of the acquired items of property, along with the fair market value (FMV) of the land, should reasonably approximate the total purchase price of the acquired property.

(1) Various approaches may be used in completing cost segregation, including:

1. Detailed Engineering Approach from Actual Cost Records,

2. Detailed Engineering Cost Estimate Approach,

3. Survey or Letter Approach,

4. Residual Estimation Approach,

5. Sampling or Modeling Approach, and

6. “Rule of Thumb” Approach.

(2) Examiners should not necessarily expect to see the approach that was used for

a cost segregation mentioned in a cost segregation report. Some cost segregation reports may describe the approach that was used for the cost segregation in great detail and some cost segregation reports may not mention the approach that was used at all. However, based on the information in this chapter, an examiner should be able to recognize the attributes of the cost segregation and identify the approach that was used (and also identify the potential drawbacks of the approach). Other approaches not mentioned here may be used, although most are merely derivatives of the approaches discussed in this chapter.

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(1) The following discussion takes a closer look at the steps involved and the attributes

of each of the approaches listed above. Keep in mind that these are the steps normally taken when completing cost segregation. The examiner's responsibility is to review the steps taken in the cost segregation and to evaluate the accuracy of the cost segregation and, additionally, to evaluate the quality of the accompanying cost segregation report. Chapter 5 - Review and Examination of Cost Segregation Study provides guidance in how to review cost segregation and cost segregation reports.

(1) The detailed engineering approach from actual cost records, also called the

“detailed cost approach” or “direct cost method,” uses cost information from contemporaneous construction and accounting records. In general, it is the most methodical and accurate approach, relying on solid documentation of the construction costs and minimal cost estimating. Construction documentation, such as construction drawings, specifications, contracts, job reports, change orders, payment requests, and vendor and supplier invoices, are used to determine unit costs. The use of actual cost records in this approach contributes to the overall accuracy of cost allocations, although issues may still arise as to the proper classification of specific assets. Refer to Chapter 6.F. Construction Process, for a discussion of a typical construction project and an explanation of the construction cost information and documentation mentioned above.

(2) The detailed engineering approach from actual cost records is generally

applicable only to new construction, where detailed direct cost information (from contractors, vendors, suppliers, etc.) and indirect cost information (from consultants, testing firms, local government building departments, etc.) is readily available.

(3) The detailed engineering approach from actual cost records typically includes

the following activities:

a. Identify the specific project and assets that will be analyzed in the cost

segregation.

b. Obtain information on all direct and indirect project costs and

substantiate the total project cost.

c. Conduct a site visit to inspect the facility. Determine the nature of the

facility, its intended use, and identify the specific assets that are contained within the facility and on the facility site.

d. Photograph specific assets for reference. Request any available

photographs that document the condition of the property prior to the

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start of construction as well as progress photographs that document the progress of the construction during the construction project.

e. Review record drawings, specifications, contracts, bid documents,

contractor pay requests, change order detail, and any other construction cost information or documentation that is available.

f. Assign the specific assets identified in the document review and site

visit to property classes and recovery periods (e.g., land, land improvements, building, equipment, furniture and fixtures, and other items of tangible personal property).

g. Prepare quantity take-offs for all assets and use contractor cost

information to compute unit costs.

h. Apply unit costs to each asset to determine its total cost basis.

Reconcile the total costs basis obtained from quantity take-offs to the total actual contractor costs.

i. Allocate indirect costs to the appropriate assets. This allocation is

normally done on a pro rata basis for indirect costs applicable to the entire project and on a specific basis for indirect costs applicable only to specific assets.

j. Group assets with similar class lives, recovery periods, and placed-in service dates to simplify depreciation computations and the entry of the assets into the taxpayer’s fixed assets system.

(4) Even though the detailed engineering approach from actual cost records

generally provides the most accurate cost allocations for the assets, the examiner should recognize that the proper cost basis and recovery periods of the § 1245 property analyzed in the cost segregation could still be an issue even when this approach is used.

(1) The detailed engineering cost estimate approach (or detailed estimate

approach) is similar to the detailed cost approach. The difference is that the detailed estimate approach estimates costs, rather than using actual costs. This approach is used when cost records are not available such as for an acquisition of property comprised of land, existing buildings, land improvements, and personal property. In the context of an acquisition, additional steps must be taken to determine the values of the acquired assets, such as addressing physical depreciation and functional obsolescence in the detailed cost approach.

(2) The detailed estimate approach is methodical, relying on solid documentation

and using construction-based documents such as blueprints, specifications, contracts, job reports, change orders, payment requests, invoices, appraisals, etc. When estimates are required, they are based on costing data, either from contractors or from reliable published sources (e.g., R. S. Means or Marshall

29

Valuation Service). The sources of estimating data are clearly referenced, including identification of the specific volume, page, and item number. Further, consistent estimating techniques and unit cost data sources are used for all of the items that comprise the actual cost.

(3) In essence, the steps for this approach are the same as the detailed cost

approach, except for Step C.1.g (in which costs come from contractor estimates or estimating guides). However, if detailed cost estimates are prepared methodically, then the total RCNLD of the buildings, land improvements, and personal property should reasonably approximate the total purchase price of the property less the FMV of the land.

(4) A field inspection is recommended for all quality studies, whether the studies

are for new or used properties. When construction drawings and specifications are limited or are not available, which is often the case for used or acquired property, field inspection of the property is a critical step. This field inspection should document the physical details of the building, type of construction, materials used for construction, the assets contained in the building, the size, and types of building systems (HVAC, plumbing, fire protection, electrical, data and communications, etc.), and any land improvements (such as parking lots, sidewalks, site lighting, etc.) that were included in the purchase of the property and the condition of that property at the time of purchase. It is important that this field inspection be completed thoroughly and accurately as it forms the starting point for estimating the construction costs and depreciation for each item of property.

(1) The survey or letter approach is an alternative method for estimating costs for

newly constructed property. In this approach, contractors and subcontractors are contacted via a survey or letter to provide information on the cost of specific assets that they installed on a particular project. These costs are then used in one of the engineering approaches or in the residual estimation approach (discussed in the following section). Cost allocation using the survey approach involves the following steps:

• Complete Steps C.1.a – 1.f of the detailed engineering approach from the

actual cost records to identify the specific property items that require cost estimates. Estimates should be reconciled to an actual cost, either to a line-item cost or to an individual system cost (e.g., plumbing, electrical).

• Divide property items by contractor and/or subcontractor.

• Ask contractors and/or subcontractors to provide the quantities and prices

of specific property items.

• Use unit cost estimates obtained from the surveys to determine and

allocate property costs.

(2) In situations where the contractor provides actual cost data, the allocations may

be reasonably reliable. However, when contractor data is obtained from other sites or projects, the data may not be comparable or reliable. The amount of

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detail provided by different contractors may also vary. The wide disparity in cost estimation methods dictates the use of caution to ensure that the total allocated costs do not exceed the actual total project cost.

(1) The residual estimation approach is an abbreviated method in which only short lived asset costs (e.g., 5- or 7-year property) are determined. Short-lived asset costs are added together and then subtracted from the total project cost. The remaining or “residual” cost is then simply assigned to the building and/or other long-lived assets. Although this method is simpler and less time consuming than the engineering approaches, it can also be less accurate.

(2) It should be recognized that this method generally does not reconcile project

costs. In general, residual costs are not estimated or checked for reasonableness. A proper and “reasonable” residual cost should always be determined and then added back to the total of all short-lived asset costs to check if the total project cost is reconciled.

(3) It should also be understood that different estimation techniques for short-lived

assets can produce a skewed result in favor of § 1245 property (e.g., § 1245 property based on single-unit costs for high quality construction, while the building is based on gross square footage).Sampling or Modeling

(1) The sampling or modeling approach uses a created model (or template) to

analyze multiple facilities that are nearly identical in construction, appearance, and use (e.g., fast food chains and retail outlets). The use of sampling minimizes resources and costs compared to conducting studies on all properties.

(2) Typical steps are:

• Stratify properties by facility type (e.g., free-standing facility, mall location,

leased or owned property, etc.).

• Perform a cost segregation study by sampling properties within each

stratum.

• Based on the results in the prior step, develop a standard model for each

type of facility.

• Apply the costs derived from the model(s) to the population on a

percentage basis. For example, the model may indicate that 10% of the project costs are allocable to 5-year property. This same percentage is then applied to each facility within the same stratum.

(3) A frequent issue is the accuracy of the sampling results. In some cases, the

sampling method may not be statistically valid. In addition, a population less than 50 could limit the accuracy of a sampling technique, unless an appropriate sampling error is considered. Also, despite the fact that facilities within certain

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strata may appear to be very similar, variations in building codes, geographic location, and material and labor costs may make it difficult to determine an appropriate model. Statistical sampling is discussed in more detail in Chapter 5

- Review and Examination of a Cost Segregation Study.

(1) Some cost segregation studies are merely based on a “rule of thumb”

approach. In general, this approach uses little or no documentation and is based on a preparer's “experience” in a particular industry or with a particular type of property (e.g., residential rental property). For example, a preparer will estimate the amount of § 1245 property as a fixed percentage of project cost by relying on previously determined “industry averages” (e.g., 40% for a manufacturing facility). An examiner should view this approach with caution since it lacks sufficient documentation to support its allocation of project costs.

(1) The Internal Revenue Service (Service) has not 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.

(2) The Service has addressed this issue but only briefly, i.e., Revenue Ruling 73 410, 1973-2 C.B. 53, Technical Advice Memorandum (TAM) 7941002 (June 25, 1979), Chief Counsel Advice 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” and “professional firms” that are competent in design, construction, auditing, and estimating procedures relating to building construction. See TAM 7941002.

(3) 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 more accurate than using estimates. However, in situations where estimation is the only option, the methodology and the source of any cost data should be clearly documented. If estimated properly, the total RCNLD of the improvements and personal property should reasonably approximate the difference between the total purchase price and the FMV of the land. It is not an appropriate cost estimation methodology to apply a pro-rata step-up factor to the individual costs estimated for the various improvements and personal property merely to reconcile to the total purchase price of the improvements and personal property, as established by reducing the property’s purchase price by the FMV of the land.

(4) For example, assume the total purchase price of an acquired warehouse

property is $5 million and the FMV of the land is $1.88 million, which leaves

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$3.12 million as the purchase price of the improvements and personal property. A cost segregation study estimated the total RCNLD of the improvements at $2.6 million including $1.2 million for the building. The § 1245 property was estimated at $800,000 and the land improvements at $600,000 totaling $1,400,000. The study then multiplied the estimated costs of each of these items by a factor of 1.2 to step up the total estimated RCNLD of the items to the total purchase price of the improvements and personal property. The results of this step-up ($520,000) increased the RCNLD of the § 1245 property to $960,000 and the RCNLD of the land improvements to $720,000 totaling $1,680,000. The step-up also increased the RCNLD of the building by $240,000 to $1,440,000.

(5) This step-up should be scrutinized by the examiner because the sum of the

RCNLD estimates ($2,600,000) does not tie to the total purchase price of the improvements and personal property ($3,120,000). This is indicative of inaccuracies in the cost segregation study. Taxpayers must substantiate their segregation of buildings, land improvements, and § 1245 property from the total purchase cost of the acquired property less the FMV of the land. Applying a pro-rata step-up factor to the improvements and personal property is not an acceptable method of establishing the depreciable basis of the acquired items. An analysis of the available data and methodology should be conducted to assess and determine the source of the difference (i.e., is the difference attributable to items of depreciable property or to land).

(6) Typical reasons for the estimated RCNLD of the items of depreciable property

to be in error include:

• Incorrect FMV of the land;

• Failure to properly identify all the parcels of land, assets, building

components, quantities, etc.;

• Utilizing incorrect cost estimates and factors;

• Utilizing incorrect depreciation/obsolescence factors; and

• Failure to properly account for indirect costs.

(1) Cost segregation studies are prepared for a variety of reasons (e.g., income

tax, financial accounting, insurance purposes, property tax), and many different methodologies and procedures are used. While the Service does not prescribe a specific methodology, there are certain approaches (e.g., studies based on actual costs or on proper estimation techniques) that produce more accurate and reliable allocations. Despite the use of one of these more reliable methods, issues may still arise with respect to the proper classification of § 1245 property.

(2) Approaches that yield accurate cost allocations expedite the Service's review,

saving time and resources for taxpayers, practitioners, and Service examiners alike. A study that is both accurate and well documented is considered (in this ATG) a “quality” cost segregation study. The specific characteristics that

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comprise a quality study are described in Chapter 4 - Principal Elements of a Quality Cost Segregation Study and Report.

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(1) As discussed in the last chapter, there is no standard format for cost

segregation studies. Thus, examiners will encounter a wide variety of studies and reports, as well as supporting documentation. For example, some studies will be very brief and other studies may be quite voluminous and complex. Regardless of the length of a study or the methodology used, a cost segregation study and report should always:

• Classify assets into property classes (e.g., land, land improvements,

building, equipment, furniture, and fixtures);

• Explain the rationale (including legal citations) for classifying assets as

either IRC § 1245 or § 1250 property; and

• Substantiate the cost basis of each asset and reconcile total allocated

costs to total actual costs.

(1) A “quality” cost segregation study is a study that is both accurate and

well-documented with regard to the three points above. Quality studies greatly expedite the Service’s review, thereby minimizing the audit burden on all parties. A quality study contains a number of characteristics, which are set forth below.

(1) The 13 principal elements of a quality study are:

• Preparation by an Individual with Expertise and Experience,

• Detailed Description of the Methodology,

• Use of Appropriate Documentation,

• Interviews Conducted with Appropriate Parties,

• Use of a Common Nomenclature,

• Use of a Standard Numbering System,

• Explanation of the Legal Analysis,

• Determination of Unit Costs and Engineering “Take-Off,”

• Organization of Assets into Lists or Groups,

• Reconciliation of Total Allocated Costs to Total Actual Costs,

• Explanation of the Treatment of Indirect Costs,

• Identification and Listing of § 1245 Property, and

• Consideration of Related Aspects (e.g., § 263A, Change in Accounting

Method, and Sampling Techniques).

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(1) The preparation of cost segregation studies requires knowledge of both the

construction process and the tax law involving property classifications for depreciation purposes. Unfortunately, there are no prescribed qualifications for cost segregation preparers. However, a preparer’s credentials and level of expertise may have a bearing on the overall accuracy and quality of a study.

(2) In general, a study by a construction engineer is more reliable than one

conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable tax law are also important criteria.

(3) A quality study identifies the preparer and always references their

credentials, experience, and expertise in the cost segregation area .

(1) Chapter 3 – Cost Segregation Approaches discusses the most common

approaches and methodologies used in preparing cost segregation studies. However, an actual study may be based upon a variant or combination of methods and, in fact, may not even identify by name the method used.

(2) A quality study always describes the methodology that was used and

details the steps that were taken to classify assets and determine costs .

(1) A quality study uses the best available documentation to classify assets

and determine costs. Documentation supporting a quality study will vary, depending on whether a property is new or used or whether original construction documents are available. Contemporaneous documentation is the most reliable and trustworthy. The documentation in a quality study for both new and used properties is detailed below.

• New construction

o Allocation of Land and Land Development Costs

• A quality study explains the treatment of land and land

development costs, (e.g., survey, subdivision costs, and temporary roads). Generally, these costs are allocated to nondepreciable land accounts. Also included in this account are the costs of improvements or land that are transferred to a local municipality (to obtain approval for subdividing or for a change in use).

o Site Visit.

• A quality study includes a site visit to gain a better perspective

and understanding of the design and purpose of the project, as

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well as the use of specific assets. Before-and-after photographs are used to establish land and site preparation costs (i.e., surveying, clearing, grubbing, general grading, and compaction).

o Construction Documents, Blueprints, Construction Drawings,

Specifications and Contractor Payments

• A quality study reviews all pertinent construction

documentation . The taxpayer’s capital expenditure request is reviewed to ascertain the intended functional use of a building and other assets included in the project. Site, architectural, and engineering plans, as well as "as-built" or record drawings, blueprints and bid documents, are all reviewed and referenced in a quality study. The specific assets deemed to be § 1245 property are clearly highlighted or otherwise identified on the “as-built” or record drawings. Project specifications are analyzed to determine conformity to the blueprints. Purchase and change orders are also reviewed to ascertain cost information, changes in costs, and details of the work performed.

• A quality study reviews the “General Contractor's

Applications for Payment” (AIA Forms G-701, G-702, G-703, and G-704) to ascertain what was actually paid for during construction. In addition, subcontractor payment applications, as well as invoices paid for items outside the scope of the general contractor’s work, will be reviewed to provide greater insight and detail of the construction. Actual or estimated costs are crossreferenced to the supporting documentation.

• Acquired or Used Properties

o Cost segregation studies on used real property should be performed

by qualified appraisers and should properly allocate the purchase price between the non-depreciable land, building and personal property based on their value as of the date of purchase. See AmeriSouth XXXII, Ltd. v. Commissioner, T.C. Memo. 2012-67.

o Purchase Price Allocations

• A quality study documents how the purchase price was

allocated between land, land improvements, building and other assets. Land value is always determined first and is based on “highest and best use.” In simple terms, highest and best use means the probable use of land that results in its highest value. The balance of the purchase price is then allocated to the building and to other assets based on their value as of the date of purchase.

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o Address Physical Deterioration and Functional Obsolescence

• The lack of cost records and the age of a property add to the

uncertainty in determining its value or cost. In making this determination, a quality study always accounts for the physical deterioration and functional obsolescence of assets. It also provides the documents and the corroborating evidence used to determine values or costs.

o Site Visit

• Similar to quality studies completed for new construction, a quality

study for acquired or used properties includes a site visit, as well as photographic evidence, to assist in identifying the assets and in determining the allocations of values or costs.

o Review of Purchase or Lease Agreements and Appraisals

• As discussed above under new construction, original construction

documents, such as construction drawings, specifications, change orders and contractor pay applications, are used in a quality study to classify assets, and determine costs. When original construction documents are not available, as is often the case with acquired or used property, a quality study will support its allocations by using other corroborating evidence (e.g., purchase/lease agreements, appraisals). A quality study will review the purchase agreement as a first step. This is important to identify the assets acquired and to identify any contract allocations of the purchase price. If the property is leased, the lease agreement will be reviewed and documented. A quality study will also review any appraisals, if applicable. The availability of historical construction records will also be addressed in a quality study (i.e., if these are not available, the study will indicate what efforts were made to obtain these records).

(1) Interviews with contractors and subcontractors, as well as with taxpayers and

property managers, are quite valuable in ascertaining the specific use of a property and the construction process involved. A quality study documents all interviews conducted with appropriate parties, thus adding credibility to the depth and accuracy of its study. However, the Examiner should recognize that subcontractor work details can be difficult to obtain since taxpayers generally have had no direct contact with them. In addition, general contractors may also be reluctant to share certain information because of confidentiality (e.g., profit margins).

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(1) The use of creative or misleading nomenclature to describe property items,

rather than common and clearly understood terms, detracts from the quality of a study. “Creative” descriptions may be used to disguise the true nature or character of an asset (e.g., a building sewage or water piping system referred to as "process piping"; an emergency exit sign termed "decorative placard").

(2) A quality study always uses terminology consistent with the blueprints

and other project documents (e.g., contract specifications, pay requests, etc.) . The use of common and clearly understood terms facilitates the Service’s review and avoids the confusion caused by misleading terms.

(1) The use of a standard numbering system, such as the Construction

Specification Institute (CSI) Master Format Division, is helpful. A quality study numbers assets consistent with the contract bid documents and pay requests. This numbering system facilitates classifying property for computing depreciation and thus expedites the Service’s exam.

(2) The CSI format categorizes costs by specific building systems or components,

such as concrete, carpentry, metals, woods, and plastics, mechanical, electrical, and lighting. Other typical groupings of assets may include land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment, etc. Refer to Special Topics Chapter 6.F. – Construction Process, which provides a more detailed discussion of standard numbering systems.

(1) A quality study contains a thorough legal analysis, including relevant

citations, to support its § 1245 property classifications. While the treatment of some items may be fairly clear based on consistent judicial decisions, there are instances in which court decisions appear inconsistent or are decisions to which the Service has not acquiesced. These apparent incongruities generally reflect the intensely factual basis that underlies the proper classification of property. As might be expected, the proper classification of property is the source of much audit controversy.

(2) The legal discussion in a quality study recognizes these conflicts and attempts

to reconcile them to the specific facts and circumstances of the property at issue. An accurate analysis of the statutes and judicial precedent adds to the overall quality of a study and facilitates the Service’s review.

(1) Once property items or assets have been identified and assigned to property

classes (e.g., building and personal property), their respective costs must be determined. To determine a cost for each unit or class of property in a project, total project costs must generally be broken down. This breakdown process is commonly known as engineering “take-offs”.

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(2) In a quality study, engineering "take-offs" are carefully documented to

show derived unit costs, and individual property units are clearly identified or highlighted on the "as-built" blueprints. For new construction, the cost of property items in an engineering take-off can generally be obtained from actual cost records. However, when actual costs are not available, costs must be estimated.

(3) Cost estimates can vary widely depending on which estimating guide is used

and whether costs are for "high" or "low" quality construction. In a quality study, cost estimates are always reconciled to an acquisition price or a total project cost to ensure the accuracy of an allocation. The proper use of an estimation technique is another frequent source of audit controversy. A quality study minimizes this controversy by clearly explaining and documenting the methodology used to assign costs to each asset.

(1) Typically, a study lists assets by recovery period (e.g., land, land improvements,

furniture and fixtures, electrical systems, plumbing systems, equipment). To facilitate the Service’s review, a quality study should list assets and generally tie to a taxpayer's fixed asset ledger.

(1) It is important that the same estimating technique be used on all of the items

that reconcile to a purchase price, a project cost, or to a particular property cost. If different methods or cost guides are used on different property items (e.g., one method for tangible personal property and a different method for the building), cost distortions arise. A quality study always reconciles total allocated costs to total actual costs, to ensure the accuracy of its allocations.

(2) A quality study also considers and lists separately acquired § 1245

property to pre-vent possible duplication. For example, if the total project cost includes furniture, fixtures, and equipment (FFE), then it is appropriate to allocate costs to those items. However, if FFE is acquired separately and not included in the total project cost, then it is not appropriate to assign costs to FFE.

(1) A quality study lists all the costs associated with a particular project,

including both direct and indirect costs, and explains the treatment of any indirect costs. Direct costs are the labor and material costs for specific items or assets. Indirect costs, also referred to as "allocables," are intangible costs that are incident to the construction of a facility. Indirect costs must be allocated proportionately to the basis of the specific assets to which they relate.

(2) Indirect costs may also include expenditures that should not be allocated to the

entire project but rather assigned to the property class to which they relate. Costs to survey and sub-divide land, and general grading are typically allocable

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only to land. On the other hand, costs for building permits, general conditions, and contractor overhead and profit are typically allocated to assets on a prorata basis.

(3) Generally, indirect costs do not relate to the placement of business machinery,

or furniture and fixtures since these assets are typically purchased and installed under separate con-tracts. However, indirect costs that specifically relate to components of personal property may be assigned to § 1245 property. For example, costs for special consultants (e.g., for computer wiring and process engineering) or costs to design the computer system may be assigned directly to that system. In addition, it may be reasonable to allocate certain indirect costs, such as liability insurance, bonds, and overhead/profit, where it can be shown that the total amount of the indirect cost is based upon the pro rata cost of each class of property.

(4) The treatment of indirect costs is another area of frequent controversy. A

quality study explains the purpose of each indirect cost and describes its allocation.

(1) A quality study lists § 1245 property (including amounts) and shows any

property originally classified as § 1250 property that is reclassified to § 1245 property.

(1) A quality study addresses related issues, such as § 263A, Change in

Accounting Method, and Sampling Techniques.

(2) The uniform capitalization (UNICAP) rules of § 263A(a) require the

capitalization of all direct costs and certain indirect costs allocable to real property and tangible personal property produced by the taxpayer. Selfconstructed assets and property built under contract are treated as property “produced” by the taxpayer. Furthermore, § 263A(f) requires the capitalization of certain interest expenses incurred in connection with the production of property.

(3) Although the courts have not uniformly agreed, it is the position of the Service

that a change in depreciation method, recovery period or convention for depreciable property constitutes a change in accounting method. Therefore, the use of a cost segregation study to reclassify property and/or reallocate costs requires the consent of the Commissioner. Refer to Special Topics Chapter 6.B.

– Change in Accounting Method for more information regarding the current status of this issue.

(4) Studies may utilize sampling techniques when taxpayers have a large number

of substantially similar properties, such as in retail or food stores. Studies may use techniques such as statistical sampling, modeling, or judgmental sampling.

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(5) When conducted properly, statistical sampling can be a reliable technique.

However, improper sampling techniques may result in a final answer that does not accurately reflect a valid estimate. Factors addressed in a quality study’s sampling technique include the definition of the population being sampled, the size of the population, a description of stratification techniques, and the consideration of sampling error.

(6) A modeling approach may also be used to segregate property costs. This

approach uses created models to approximate the different types of units involved. If the models are properly analyzed, then this method may be reasonably accurate when applied to the entire population. However, as discussed in Chapter 3 – Cost Segregation Approaches, the delineation of strata may be difficult and is often an area of controversy. Furthermore, issues may arise as to whether the sampling method is statistically valid.

(7) Some studies may rely solely on a judgmental sampling technique, which

carries a higher level of risk due to the elements of subjectivity involved. A judgment sample is typically selected on the basis of perceived similarities and is not statistically valid. However, under certain, limited circumstances, the use of a judgment sample may be appropriate. In such a case, the underlying basis for the selection of particular units in a judgment sample must be rational and supported by adequate data.

(8) A quality study addresses these related audit issues and comments on

the treatment of these items for tax purposes, especially where the amounts are restated for prior tax years.

(1) A cost segregation report reflects a study’s methodology and conclusions. The

amount of detail included in a report varies considerably since there is no standard or prescribed format. The following elements are found in a quality report:

(1) A quality report contains a summary to identify: the preparer, the date of

the study, the taxpayer (or client), the subject property, and the property units classified as land, land improvements, building or personal property.

(1) A quality report discusses the theory, definitions, and the rationale behind

the study in the narrative section. This section generally includes a more detailed description of the property/facility (i.e., a physical description and an explanation of the use for which it is intended, as well as a legal description of the property and its location). In addition, the narrative section provides a thorough discussion of the regulations, rulings and court cases that support classifying certain assets as § 1245 property. The narrative also discusses the types and sources of data used (e.g., cost records, contracts, purchase

42

agreements, published estimates) as well as how they were used. A list of potential data sources is included in Special Topics Chapter 6.F. – Construction Process.

(1) A quality report has a schedule of assets that are the focus of the study.

Generally, this schedule ties directly to the taxpayer's depreciation records. When a taxpayer reallocates costs of assets already "on the books," a quality report clearly identifies the specific assets impacted (and includes depreciation records from both before and after the reallocation).

(1) A quality report lists all direct and indirect costs associated with a project.

Indirect costs allocated to § 1245 property are clearly identified and explained. Separately-acquired assets are listed and discussed in the report to avoid duplication errors. Costs subject to § 263A are also addressed.

(1) A quality report provides a detailed schedule of property units and costs

(with property descriptions) that are segregated into land, § 1245 property, and § 1250 property. This schedule is the final product of the study and serves as the basis for computing depreciation.

(1) A quality report describes the engineering procedures and methodology

for determining the cost of each property unit. It also identifies the specific taxpayer records that were reviewed and discusses whether actual cost records or estimating techniques were utilized to break costs into smaller property units. A record of inspections and/or interviews is included as well. The use of a common nomenclature or a standard numbering system is also referenced and/or explained. Note that the engineering procedures used to perform a quality study will differ based on whether the subject of the study is new construction or used properties, as well as on the amount of the contemporaneous construction documentation available. The engineering procedures used for quality studies of new properties and used or acquired properties are discussed in step C.3. – Use of Appropriate Documentation of this chapter.

(1) A quality report describes the general understanding and conditions

applicable to the report. This information may also provide an indication of the overall quality of the study.

(1) A quality report certifies that the person who signed the report actually

developed the analysis, opinions, and conclusions of the report. This

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section may also include the resume or state the credentials and/or level of experience of the preparer.

(1) A quality report generally includes various exhibits, such as the “Client

Cost Sources” and the “Cost Source Reconciliation.” These exhibits show the “book” (accounting) records on which the preparer relied in deriving total costs and may include a reconciliation of the study to the fixed asset ledger. Photographs and/or videos may also be included as exhibits to assist in identifying and understanding the assets in the study.

(1) This chapter described the principal elements of a "quality" cost segregation

study and report. The degree to which a cost segregation study/report conforms to these elements will likely dictate the scope and depth of an examination. A quality study and report will expedite the exam process, as indicated in Chapter 5 – Review and Examination of a Quality Cost Segregation Study and Report and ultimately minimize audit burden on taxpayers, practitioners, and examiners alike.

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(1) The preceding chapters described the legal framework for classifying assets

(Chapter 2), common methodologies used to segregate costs (Chapter 3), and elements of a quality cost segregation study and report (Chapter 4).This chapter provides suggested audit steps for reviewing and examining a cost segregation study.

(2) The appropriate audit steps depend on the nature and size of the cost

segregation project as well as on the overall quality of the study. Cost segregation is a factually intensive determination that is based on complex tax law and engineering analysis. While examiners may be able to evaluate the adequacy of some cost segregation studies, other studies may require specialists with expertise, industry or construction experience and specialized training.

(3) The Engineering Program in LB&I business unit of the IRS is the principal

source of technical expertise for examining cost segregation studies. The Computer Audit Specialist (CAS) Program in LB&I is also available to provide assistance when a study is based on statistical sampling. Formal advice, using the referral process, should be solicited through the LB&I website and the Specialist Referral System (SRS). Informal advice through consultation is also available by contacting your engineering or computer audit specialist group. The Senior Revenue Agents in the Deductible and Capital Expenditures Practice Network (DCE PN) are also available to assist examiners with this issue. Refer to the DCE PN website for up-to-date information and guidance on this issue or to submit an inquiry.

(4) Cost segregation studies and fixed asset reviews typically utilize documents

and cost information prepared for purposes of the construction process; Special Topics Chapter 6.F. – Construction Process, provides a brief overview of the construction process. Cost segregation studies can be examined using a step- by-step approach. The suggested audit steps below may not apply to all cost segregation studies, however, each step should be carefully considered and determined to be applicable or not before moving on to the next one.

(1) Risk analysis is the process that compares the potential benefits to be derived

from examining a specific area on a tax return with the resources needed to complete the examination.

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(2) Step 1: Review Copy of The Cost Segregation Study Report for Initial Risk

Analysis Purposes.

• Every cost segregation study should have a report that summarizes the results of the cost segregation study. The report should provide:

o Background regarding the subject property,

o An explanation of the methodology used by the preparer,

o Details regarding the assets classified in the study,

o The applicable class lives and recovery periods of the assets, and

o The rationale and authority for the property classifications made in the

Study.

• Refer to Chapter 4 for a discussion of the principal elements of a quality cost segregation study and report.

• In reviewing a cost segregation study report for risk analysis purposes, one must read the report to obtain a general understanding of the study methodology and the property classifications made therein. The following steps are suggested when reviewing a cost segregation report for risk analysis purposes:

o Request a Copy of the Cost Segregation Study Report. Refer to the

IDR Exhibits in Special Topics Chapter 6.G. – Information Document Requests for suggested language.

o Read the Entire Report with Emphasis on the Property

Classifications.

o Review the Property Units and the Types of Assets.

• Assets are generally classified by cost segregation studies into

various units or groups of assets and are often listed in both a "Summary" and a "Detail" format.

A “Unit (or Asset) Group” is a group of individual assets that

together form a larger assembly that is considered to be and treated as a single asset. The “Property Unit Summary” is a list summarizing the Unit

Groups by asset class or recovery period (i.e. land, 3, 5, 7, 10, 15, 20, 27.5 and/or 39-year property.) The “Property Unit Detail” is a listing of the individual assets

that comprise each Unit Group. This list describes the individual assets and indicates the cost basis of the asset as determined in the study.

• An example of a Unit Group is “Kitchen Equipment Plumbing” (which is made up of a group of individual assets). For this Unit Group, the Property Unit Detail would list the

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individual assets (for example floor drain, grease trap, sanitary piping, sink, water supply piping, etc.) that make up the “Kitchen Equipment – Plumbing” Unit Group and provide the cost basis of each of the individual assets as determined in the cost segregation study.

• Abbreviated methodologies may not classify assets into Unit

Groups, Property Unit Summary or Property Unit Detail. Nevertheless, assets should be identified, sup-ported and documented in a cost segregation report.

(3) Step 2: Verify the Cost Basis and Reconcile Depreciation Records

• Cost Segregation Studies are used to classify taxpayer assets into shorter recovery periods to accelerate the depreciation deductions for the assets. The study results should be easily reconcilable to the taxpayer’s depreciation or fixed asset schedules.

  • Examiners should reconcile the cost basis of property in a study to the cost basis contained in the taxpayer's books and records.

o Request Detailed (Asset-by-Asset) Depreciation Schedules that tie

to the tax return. Determine how the study assets are shown on the depreciation schedules.

o Review Tax Depreciation Schedules to verify that tax basis

reconciles with the study and note any differences. Are fixtures, furnishings and equipment included in the study? Are they located on other depreciation or fixed asset schedules? Have these costs been duplicated?

o Request Prior Year Tax Depreciation Schedules that correspond to

the study’s assets. Do these schedules reconcile to depreciation for prior year returns? Property reclassified to a shorter recovery period must be depreciated using the proper method pursuant to IRC § 168(b). For example, if straight-line depreciation was used for other property placed in service for a given recovery period during the same year that the reclassified assets were placed in service, then § 168(b)(3) requires that the reclassified assets must also be depreciated using the straight-line method. The election to use straightline depreciation is irrevocable pursuant to § 168(b)(5).

(4) Step 3: Conduct A Risk Analysis to Evaluate Audit Potential

• Conduct a risk analysis to evaluate the audit potential and determine audit scope.

o Review the descriptions in the Property Unit Detail schedule to

determine the type of property in each unit (or group).

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o Review the individual assets in each Property Unit Detail

schedule. Is each asset classified properly? (The asset matrices included in Chapter 7 can be of great assistance in this review.)

o Compare the Study’s Property Descriptions and Classifications to

Revenue Procedure 87-56, 1987-2 C.B. 674. Is the property included in the proper Asset Class? Are there any deviations that may indicate a potential audit issue? Identify specific assets that might need to be viewed during a tour of the facility.

• Common situations suggesting audit potential include:

o Mixed asset types in the same unit (or group). (i.e., assets with

different recovery periods).

o Building structural components or leasehold improvements classified

with improper shorter-lived § 1245 recovery periods.

o Minimal or no dollar amounts assigned to land, non-depreciable land

improvements, building, or other longer-lived assets.

o Use of “creative” nomenclature, inconsistent titles and/or descriptions

to disguise the true character of an asset. All asset descriptions should be clear and understandable. Does the nomenclature used for assets in the study agree with the nomenclature used in the construction records and documents?

• Request Additional Information (as needed) to determine audit potential. In some cases, it may be more appropriate and efficient for the preparer of the study to respond to the document requests. Supporting documents may include computer files, hardcopy files, plans, etc. A CAS can assist in viewing computer files not ordinarily viewable on IRS computers.

o Issue IDRs to determine the classification of items not readily

understood or that are described in the report using an ambiguous description. Refer to Special Topics Chapter 6.G. – Information Document Requests for suggested language.

o Request contemporaneous records (permits, design studies, contractor

payment records, AIA payment documents such as G702 and G703, contracts, purchase orders, invoices) to verify the costs and descriptions of property as well as to ascertain their functional use. This will facilitate the determination of the proper asset classification pursuant to Revenue Procedure 87-56. For example, machinery located in a chemical plant is 5-year property instead of 7-year property if it meets the requirements of Asset Class 28.0 (refer to Special Topics Chapter 6.C. – Depreciation Overview for information on asset classes).

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o Request project information, such as the Capital Expenditure Request

(CER) or Authorization for Expenditure (AFE), to verify project costs and identify related purchases. This information may also help determine the intended use of the property.

• Summarize Your Preliminary Findings. Determine the tax impact of potential audit issues, such as:

o Assets with a cost basis that is questionable, disputed, or

unsubstantiated.

o Assets that have been misclassified and given an improper recovery

period.

o Double deductions for separately acquired assets.

o The use of improper depreciation methods.

o Incorrect placed-in-service dates.

o Large look-back computations (i.e., the study reflects a change in

method of accounting, with the return reflecting a deduction for depreciation not deducted in prior years).

• Determine the Need for Specialists (e.g., Engineers and/or Computer Audit). Specialists may be required to assist in the examination of complex projects. It is important that specialists be involved in the audit as early as possible. Informal assistance may also be requested when needed.

o A study with significant tax impact generally requires the assistance of

specialists. These studies will typically have a large number of assets, or complex assets.

o A study that allocates estimated costs between § 1245 and § 1250

property (particularly electrical or plumbing component systems) typically requires the assistance of an Engineer who is experienced in construction and construction estimating. Engineers can provide the expertise needed for the proper development and resolution of the issue.

o Studies involving numerous assets or allocations may require the

assistance of a CAS to process the data and/or evaluate any statistical sampling methods.

• Determine the Scope and Depth of Your Examination. Risk analysis is a subjective process based on the experience, knowledge, and judgment of the examiner. Guidelines provided in the previous chapters will assist Examiners in evaluating the overall accuracy and adequacy of a study as well as in determining audit potential and scope. Studies with little tax impact should be closed expeditiously. Studies with significant tax impact

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may require specialist assistance and should be considered for additional review and examination.

(1) The examination of the cost segregation issue should proceed if the Risk

Analysis identifies audit potential due to the asset classifications in the study, and required materiality thresh-olds of the specific examination are met.

(2) Step 4: Review the Cost Segregation Study Report for Examination

Purposes

• Request a copy of the Cost Segregation Study Report, if not

previously done for the Risk Analysis. Refer to the IDR Exhibits in Special Topics Chapter 6.G – Information Document Requests for suggested language.

• Request a copy of the Letter of Engagement to determine the scope of

the study.

• Determine the Nature of the Fee Arrangement.

o Many firms charge a fee based primarily on the size of the project. Out of-pocket expenditures are generally added to this cost.

o Some firms use contingency fees where cost is based primarily on the

tax benefits received from a study. Contingency fee arrangements create the incentive to maximize the amount of costs attributed to § 1245 property, usually through "aggressive" legal interpretations and/or by inappropriate cost or estimation techniques. Accordingly, examiners should closely scrutinize studies performed on contingency fees. Refer to Circular 230.

• Evaluate the Study with respect to its depth, accuracy and methodology and consider the following questions: What methodology was used (see

Chapter 3 – Cost Segregation Approaches)? How does the study and report compare to the quality elements described in Chapter 4 – Principal Elements of a Quality Cost Segregation Study and Report?

• Determine the Cost Allocation Process used in the Study and the Source of any Unit Costs. The following questions may assist in determining the Cost Allocation Process: How were costs allocated? Were actual costs or estimates used? How were unit costs determined?

• Request Contemporaneous Documentation to Substantiate and Verify the Cost Basis of Assets.

• Determine Whether Cost Basis was Properly Allocated to land, nondepreciable land improvements (clearing, grubbing, general land grading) and/or other property types aside from those considered by the study.

o Consider if any project costs were allocated to land or land

improvements. Many studies allocate almost all costs to building and

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personal property, instead of allocating appropriate amounts to land, land improvements or other long-lived assets. In the case of acquired property, it is often appropriate to assign a large portion of an acquisition price to land prior to allocating the remaining purchase price to other property. See “Allocating Purchase Price of Acquired Property” later in this chapter.

(3) Step 5: Interview the Cost Segregation Study Preparer

• An interview with the preparer of the cost segregation study is an efficient way to obtain detail regarding the methodology used for the study as well as answers on the classification of questionable assets and the reasoning behind those classifications.

o Schedule an Interview with the Preparer. If possible, this should be

completed before or contemporaneous with the on-site inspection. The interview should address the scope and assumptions of the study and any observations of the project or facilities. Possible interview questions include:

• Were the properties inspected at the time of the study?

• Were photographs and/or video media taken and/or relied upon in

classifying property?

• Were sampling techniques used?

• What cost estimating guides were used? Where are the guides

located (for purposes of verifying estimates)?

• What documentation was used to establish the cost basis and

particular use of a property item?

• How was the cost of each property item identified, segregated, and

classified?

• Where are the supporting workpapers located?

(4) Step 6: Inspect the Property

• In some instances, the only way to resolve a question regarding the proper classification of an asset is to actually inspect the asset as installed in the taxpayer’s facility. An inspection can provide information to the examiner on the purpose and use of an asset as well as details of the installation and construction of the asset.

• In general, the Service Engineer (if assigned) is responsible for arranging the on-site inspection, which provides the opportunity to view the assets in question. Inspections also help identify underground utilities, off-site improvements and general grading costs that may have been misclassified as § 1245 or § 1250 property. Overall, the inspection provides information to assist in determining classifications of § 1245 and § 1250 property.

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o Prior to Scheduling the Tour, Complete your Review of the Study

to identify specific assets and concerns that require inspection.

o Prepare a List of Assets/Items that Warrant Inspection and provide

it to the taxpayer beforehand. Ask additional questions and/or view additional property components during the tour as needed.

o Plan the Inspection to Minimize Time and Travel Costs. For cases

involving multiple properties of similar character, consider inspecting only a representative number of properties or facilities.

o Take a Camera or Video Recorder (Camcorder) to record the

condition of the property. Confirm beforehand that photography will be permitted.

o Request that the Property Manager/Maintenance Engineer be

Available During the Tour. It is important that someone familiar with the physical attributes and workings of the property be available to answer questions and provide access to non-public areas.

o Request that the Preparer Attend the Tour. The preparer should be

able to identify the physical attributes of specific assets and explain how they were classified.

o Request Access to Plans, Drawings and Contract Documents that are

located on-site.

o Prepare an IDR in duplicate so that any requested items received

during the inspection can be noted and an acknowledgement copy of the IDR can be left with the taxpayer.

o View the Project Site and Document Features that impact the cost

allocations and property classifications. Consider the following points:

• Location - Record the address and locate it on a map for future

reference. What is the character of the neighborhood and how does the location impact land value? Is there any other property for sale in the area? Note the real estate company name and the address of the property for future reference.

• Topography - Observe the topography and determine whether the

land was initially hilly or low-lying. Did the project include the general grading of the land? Were large amounts of fill required in order to build?

• Site Conditions - Determine whether the project included the

subdividing or rezoning of land. Did it require environmental or land use permits, or the construction of access roads? Were off-site improvements (e.g., streets, sidewalks, sewers, storm drains) constructed? Were any of these improvements dedicated to the local municipality?

• Condition of Property - Is the property new or old, worn or

renovated? Were the materials modern or old?

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• Project Records - Where are the original project records (e.g.,

drawing, plans, contracts, payment records) located? Ask for the names of the employees who may have particular knowledge of the construction. Request interviews with such individuals as needed.

• Individual Assets - View each challenged asset to gain a thorough

understanding of the facts and circumstances that affect its classification and cost. Ask the site manager how the facility is used and how individual assets operate.

Cost Data - Discuss the methodology that was used to

determine the cost of assets. Were standard cost guides used to estimate costs? Ask on-site maintenance and facility operations personnel about local construction and repair costs to verify the estimated costs in the study.

o Prepare Notes and Drawings for future reference.

• Obtain sufficient information to properly classify each challenged

asset.

• When possible, obtain local cost data to verify estimates and cost

allocations.

(5) Step 7: Review and Verify the Asset Classes and Recovery Periods of

Property

• A major goal of a Cost Segregation Study examination is to verify the proper classifications and recovery periods of the assets included in the study.

• Review the study again to determine whether the property classifications assigned to the assets in the study are correct. This review is done in greater detail than the initial review performed for risk analysis purposes. The goal is to verify the proper recovery period of all assets and to identify possible land or non-depreciable land improvements classified as depreciable property in the study. As in the initial risk analysis review, the property matrices in Chapter 7 can be of great assistance in this detailed review.

o Are Assets Classified into Proper Groups according to Asset

Class or Recovery Period? Consider the following assets:

• Land

• Non-Depreciable Land Improvements (i.e., non-recurring land

preparation costs such as general land shaping and grading)

• Depreciable Land Improvements

• Buildings, Structural Components and Other § 1250 Property

• Office Furniture, Fixtures and Equipment

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• Information Systems

  • Building Systems (e.g., mechanical, electrical, plumbing)

  • Process Systems (e.g., process piping)

  • Non-Residential Real Property

  • Other Miscellaneous Property

o Are Assets Assigned to the Proper Asset Class and Recovery

Period?

• The classification of assets as either § 1245 or § 1250 property is a

factually intensive determination with no bright line tests.

List Assets into the Proper Asset Class and Recovery Period. Refer to Chapter 2 – Legal Framework, and to Special Topics

Chapter 6.D. – Relevant Court Cases for a summary of the pertinent law and judicial precedent with respect to the classification of property. Recovery periods are either specifically assigned by statute (§

168 and the Regulations thereunder) or are determined pursuant to Rev. Proc. 87-56, 1987-2 C.B. 674. Refer to Special Topics Chapter 6.C. – Depreciation Overview, for further information on recovery periods.

• Common Audit Issues

o A common issue is the allocation of specific components or portions of

a building system to § 1245 property. The issue often arises as a result of poor documentation and/or improper legal support.

• Example 1: Some studies may include a specific component of a

building's electrical system (e.g., plug outlet, switch, branch circuit) as being allocable to the piece of tangible personal property that it supports (e.g., dishwasher, garbage disposal, etc.). Accordingly, the component item is treated as § 1245 property (e.g., 7-year MACRS). However, if that same electrical component item can be used for other pieces of equipment, the Service examiner may consider it to be part of the building’s general electrical system. Accordingly, it would then be classified as part of the building as § 1250 property (39-year MACRS).

• Example 2: Some studies allocate a portion of the primary

electrical feeder circuit that carries electricity to one specific item of equipment or machinery as § 1245 property. The use of a "standard" percentage of electrical costs is a common approach. However, in the Service’s view, these types of allocations should be based on usage or load studies designed to ascertain the percentage of electricity allocable to specific § 1245 property (as

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opposed to supporting the general function or maintenance of the building). Examiners can also check whether a company was reimbursed for the sales tax paid on electricity used in manufacturing; this information may provide insight as to the correct percentage. In summary, the examiner should conduct an in-depth analysis of the allocation and supporting documentation when a standard percentage is used. Refer to Chapter 8.A. for a discussion of the proper methodology for the functional allocation of an electrical distribution system.

• Example 3: Some taxpayers have filed claims based on cost

segregation studies of leased property. Typically, leases were assigned to 39-year recovery property on the originally filed tax returns. Subsequently, the taxpayer redetermines its allowable depreciation on the basis that the acquisition was for goodwill rather than for the lease. The benefit is a potential 15-year amortization of goodwill pursuant to § 197 (if the acquisition otherwise qualifies under § 197). Examiners should closely scrutinize allocations of this type.

(6) Step 8: Research the Law, the Regulations and Appropriate Rulings

• Before reaching a final conclusion on the classification of a specific asset, the examiner should have conducted all the necessary research and reviewed all the relevant court cases, rulings and regulations that relate to asset classification and the challenged asset. While some assets may, at first glance, appear to be building-related, there may be revenue rulings or court cases that have concluded that these assets are instead tangible personal property (e.g., electrical wiring, HVAC, decorative millwork).

• Special Topics Chapter 6.D. – Relevant Court Cases contains a summary of pertinent court cases that relate to the classification of property for depreciation purposes. The examiner should read and study these cases for guidance. An examiner must also recognize that the determination of class life for a particular asset is factually intensive, and that the determination may vary with a particular industry and/or with the specific use by the taxpayer.

• Industry-specific guidance is included in Chapter 7.E. Casinos, Chapter

7.C. Restaurants, Chapter 7.B. Retail, Chapter 7.D. Biotechnology and Pharmaceutical, Chapter 7.F Auto Dealerships, Chapter 7.G Auto Manufacturing, and Chapter 7.H Residential Rental Property. It is anticipated that specific guidance for additional industries will be developed in the future and will be added to Chapter & - Industry Specific Guidance as it becomes available.

(7) Step 9: Cost Analysis

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• Once the proper classifications and recovery periods for the assets have been established, the next step, if required, is to perform a Cost Analysis. In a Cost Analysis, the examiner considers how the study allocated the project construction costs to the individual assets, evaluates whether the allocation was performed properly, and determines whether the cost basis of the assets as shown in the study is correct.

• The methodology used for the Cost Analysis depends on whether the assets are part of a newly constructed facility or are part of an existing facility that was acquired by the taxpayer. The difference in Cost Analysis methodologies between these two situations is due to the different methods used to perform studies for these properties. Actual construction cost information is nearly always available for Newly Constructed properties; however, it is rarely available for acquired properties. Property appraisal approaches and construction cost estimating techniques are often used to determine the construction costs for acquired properties.

• To properly perform a Cost Analysis, knowledge of construction and construction estimation is required and will most often involve the assistance of a Service Engineer. Because performing a Cost Analysis is also very time consuming, they should only be completed if there are significant questions regarding the proper basis amounts assigned to the assets on the study.

• If a cost analysis is required, see Step 12 below.

(8) Step 10: Summarize the Findings and Discuss the Challenged Assets with

the Taxpayer

• If the preliminary conclusion is that the taxpayer has misclassified certain assets, the examiner should meet with the taxpayer as soon as practical to discuss his/her findings and the reasoning behind them. This discussion may clear up any misunderstandings and disagreements as to the facts and may provide an opportunity to resolve the issue. Scribe the issue, industry or entity and provides an overview and general information on unique business practices.

(9) Step 11: Prepare the Final Report or the Notice of Proposed Adjustments

• At the conclusion of the examination, the examiner (Revenue Agent and/or Specialist) should prepare and issue a final report. The regulations under § 1.168(i)-7 allow a taxpayer to account for its MACRS property by treating each asset as being in a Single Asset Account (SAA) or by combining two or more asset in a Multiple Asset Account (MAA). Make the necessary adjustments to the basis of each asset affected by the cost segregation study, or to the basis of each multiple asset account (MAA) affected in which the taxpayer established an MAA, rather than making adjustments in a contra account. The record keeping rules under Treas.

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Reg. § 1.167(a)-7(c) require the adjustment on an asset-by-asset (or MAA-by-MAA) basis. This is especially important since the issuance of the 2014 § 168 disposition regulations. See the Capitalization of Tangible Property Audit Techniques Guide for more information about accounting for, and dispositions of, MACRS property. Specialists should consider having the examiner calculate the depreciation or amortization adjustments to ensure that all pertinent factors are included in the computation. Adjustments to the construction period interest may also be applicable. Consider if proposed adjustments should be treated as a Service initiated change in accounting method and, if so, follow the guidance in Rev. Proc. 2002-18. The Methods of Accounting and Timing Practice Network is available to assist Examiners with the method changes.

(1) Depending on the methodology used for the cost segregation study, the type of

indirect costs that were part of the construction, and whether the study is changing the classification of existing assets, the following steps should be considered as part of the examination.

(2) Step 12: Perform a Cost Analysis

• Step 12a: Cost Analysis of Newly-Constructed Property

o Actual cost records should be available for Newly-Constructed

Properties. This information can most likely be obtained from the cost segregation study preparer, the taxpayer, the project Architect, the project construction manager, or the general contractor. Cost records should be requested for significant property items only. Significant in this situation is defined based on the materiality amounts of the specific examination.

• Gather Background Information.

Secure total project costs by requesting information related to

the construction project billings. Review construction drawings and specifications.

• Construction drawings and specifications identify property

items, construction methods and locations of items within the structure.

• Review the record drawings (often called “as-built” drawings)

if they are available. Record drawings are prepared at the end of the construction project and incorporate all changes to the original building design made during construction, so they represent a record of what was actually constructed.

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These drawings are generally available from the taxpayer, the project Architect, the project general contractor or the construction manager. Other possible sources include the local building department, local fire department or the taxpayer’s insurance carrier. Review the most “up-to-date” drawings as well. These drawings include the latest revisions made by the Architect and Engineers and are typically found in the taxpayer’s facilities engineering or maintenance departments or the property manager’s office depending on the type of facility.

• Request copies of the building permit and certificate of

occupancy (C of O), which can assist in establishing the construction start date and the placed in service date.

• Request photographs of the site showing the condition of the

property before the project began. This will help determine whether significant site preparation or general grading costs were incurred.

• Request Contemporaneous Records to Substantiate the Cost

Basis of Assets in the Study.

Contract documents specify how payments are made and

typically require payment requests to be broken down into individual items of property. Refer to Special Topics Chapter 6.F. on the Construction Process for a discussion of how payments to contractors and suppliers are made and documented in a typical building construction project. For purchases made outside the construction contract (i.e.

furniture or equipment) or for indirect costs (i.e. Architectural/Engineering fees, plan review fees, etc.), purchase orders and invoices are a good source of cost data.

• Analyze the Total Project Costs.

Review the General Contractor’s and major Subcontractor

Requests for Payment (i.e. AIA G702 and G703). Particular attention should be made to the final pay applications, as these should be more indicative of the final total construction cost. Review any construction costs that may not be shown on the

pay applications, including change orders, indirect costs, and out-of-pocket costs. Test for completeness by looking for any missing elements (e.g., land shaping costs may be in a separate contract). Review invoices for any pre-purchased or owner-furnished

equipment. On large construction projects, the taxpayer may

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separately pre-purchase items that have a long delivery time (e.g., large capacity electrical sub-stations or transformers) or may directly purchase large equipment items such as air handling units to avoid the contractor markup. The contractor may also install owner-furnished equipment. The examiner should verify if any pre-purchased owner-furnished equipment is included in the total project cost and that the cost of such equipment is treated appropriately.

• Reconcile Total Project Costs in the Taxpayer's Records with

the Total Project Costs in the Study.

Request a copy of the taxpayer's general ledger data to support

the fixed asset amounts on the depreciation schedule. How does it compare to the amounts shown in the study?

• Typically, the property unit numbers or reference numbers

found in a study do not track the taxpayer's accounting entries. Find out what sources the preparer used in preparing the study.

• Verify that the total project cost in the study reconciles to the

total cost basis of assets in the taxpayer's books and records. The Examiner is in the best position to do this since he/she is the most familiar with the taxpayer’s accounting methods. The Examiner will also know where to look for other costs that should be in the building account but may have been expensed or otherwise entered improperly into another account.

Compare all data with the contemporaneous cost records. List any unsupported basis for potential disallowance.

• Reconcile Detailed Cost Breakdowns to individual property

elements.

Actual cost records should be used whenever possible. Review the taxpayer's internal "Job Cost Reports." Typically, a

preparer relies on these documents to derive the unit costs (assuming that the cost and description of the assets in the Job Cost Reports are accurate).

• The study methodology should be disclosed in the

Assumptions and Limiting Conditions section of the report.

• A careful analysis of the Job Cost Reports may yield

significant audit adjustments. The following is an example

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illustrating how the taxpayer does not always properly classify items that are listed in this report.

• The Job Cost Report includes a code for Furniture and Fixtures. Within this code are multiple records of vendors from whom the taxpayer claimed to have purchased items, such as furniture and fixtures. The preparer included the total cost as § 1245 property and listed it in the study as "FF&E." However, upon requesting contracts for each of the vendors under this heading, the Service Examiner discovered that some of these assets were actually § 1250 property and, therefore, concluded that these costs were erroneously included in "FF&E." Therefore, it is important that the examiner review the vendor contracts in the Job Cost Reports, especially those that detail the “Description of Work”, to verify asset costs.

• Prepare a List of Items/Costs that are Not Properly

Substantiated.

• Compute the Correct Costs (as necessary) for individual items

or groups of property.

• Review the Cost Segregation Study Report Again.

Review the study for its style and order of presentation. The

narrative typically describes the order of the development of costs and the spreadsheets show the analysis and sequence. Review the study’s conclusions, recommendations, assumptions

and limiting conditions. Verify that the assumptions and limiting conditions are

consistent with the facts developed from the inspection and the review of the drawings and specifications.

• Analyze How the Detailed Cost Breakdown was Prepared.

Review Direct Costs.

• Confirm that the direct costs are properly classified as either

§ 1250 or § 1245 property, and identify any questionable items for further review.

Review Indirect Costs.

• Ensure that indirect costs are properly allocated to their

respective assets.

• Indirect costs generally relate to the land, certain land

improvements, and/or the building or other structures. Indirect costs generally do not relate to the placement of

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machinery or furniture and fixtures. However, there are exceptions, such as for the design of a manufacturing line. Refer to Chapter 4 – Principal Elements of a Qualified Cost Segregation Study and Report, for additional discussion of indirect costs.

• Studies often use large spreadsheets and sophisticated

formulas to compute the allocation of indirect costs (generally on a pro-rata basis). The examiner should verify any formula by testing the allocations of indirect costs to ensure they do not exceed the total indirect costs.

• Identify Potential Audit Issues.

Site Preparation, General Grading and Land Shaping Costs

• Building and facility projects often require general grading, site preparation and other costs to make the site suitable for a proposed use. These costs, along with costs for stripping existing forest and vegetation (called clearing and grubbing) in addition to grading and compaction to provide a level site, are generally non-depreciable costs allocable to the basis of the land. A study may exclude these costs as being outside the scope of its work. In other instances, a study may argue that none of these costs are allocable to non-depreciable land improvements. Whether these types of costs are included in the study or not, the examiner should determine all land preparation costs included in the project, analyze them, and allocate them to non-depreciable land improvements, building, and/or depreciable land improvements. Before-and-after photographs may help with this determination. Also, the examiner should inspect the taxpayer's books and records to determine how these items were treated for both financial and tax purposes.

§ 1245 Property – Did the Study Utilize Cost Estimates or Actual

Cost Records?

• Review the § 1245 and § 1250 property listings and identify

the most significant items. The examiner should check the contractor payment records (e.g., AIA Form G-702) to see if actual costs of these items were used in the study or whether these item costs were based on some sort of allocation or estimate.

• For example, if the Form G-702 shows $1.2 million for the

"electrical" division work and the study shows or allocates

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$1.8 million to specialized § 1245 electrical equipment, then there may be a problem with the study’s cost determination. In this case, the examiner should request additional information to determine the source of the $1.8 million allocation. Note that this is only a quick check since additional equipment or other property purchased by the taxpayer outside the construction contract may significantly affect this type of comparison.

Potential Problems with Residual Methods.

• When a residual approach has been used, the examiner must be especially careful when reviewing § 1245 property costs. In essence, this method estimates the § 1245 property costs and then simply assigns the remaining portion of the total cost to § 1250 property. In general, the § 1250 residual cost is neither estimated nor checked for reasonableness. All too often the result of this procedure is that the § 1245 property cost is too high and the § 1250 property cost is too low.

• Cost estimates can also be manipulated to produce unreasonably high estimates for § 1245 property. This is because there are a wide variety of cost data publications that may be used, and some of these have relatively high estimates for costs.

• Most data sources have a higher cost for installing only one unit (e.g., a single electrical outlet) as opposed to installing 10 or 100 units. Economies of scale, "Quantity discounts" and competitive bidding may significantly reduce the actual unit cost. Accordingly, estimates for multiple units based on a single unit cost may be incorrect. The following is an example of this problem.

• Assume that 500 of the 120-volt electrical outlets (duplex receptacle) in a particular building have been determined to qualify as § 1245 property. The R. S. Means DataBase, 2003 Edition, page 464, line 4015, lists a total price of $34.50 per 120-volt duplex receptacle. Based on this data, a study may estimate that the 500 outlets have a total installed cost of $17,250 (500 x $34.50). However, this estimate should be reviewed or compared with the contractor’s actual price to determine its validity. When the taxpayer awarded the contract, the contractor submitted a schedule of cost for each item of work, such as for plumbing, electrical, heating, and site work (Forms G-702 and G-703). The examiner

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should review Forms G-702 and G-703 to determine the cost that the contractor assigned to the electrical work. If the Form G-703 indicates that $120,000 was assigned to electrical receptacles and there were 5530 receptacles to install, then the actual unit cost to install each receptacle is only $ 21.70 per outlet. The total actual cost for the 500 outlets is therefore only $10,850 (500 x $21.70). The total actual cost compared to the estimated cost ($17,250) may result in a significant difference. Note that cost estimates based on either the R. S. Means data or on the contractor's actual costs would need to be increased by any applicable indirect costs.

Potential Problems with “Rule of Thumb” Methods

• While the documentation of costs drawn from the use of a

"rule of thumb" method is typically sketchy and inadequate, the examiner should not categorically reject a study involving the use of "rule of thumb." The documentation needs to be examined and verified on its own merits to determine if cost recovery properties are accurately identified and placed into proper recovery periods.

(3) Step 12b: Cost Analysis of Existing or Acquired Property

• Allocating Purchase Price of Acquired Property

o Cost segregation is applied both to determine the classification of

property and to allocate the cost basis of property. This section focuses on cost segregation studies involved in allocating cost basis when acquiring a group of assets. Such allocations generally must rely on determining the fair market values of the acquired assets.

o In this audit technique guide, new property and particularly new

building construction projects receive much attention in the chapters addressing cost segregation studies and reports. However, cost segregation is not limited to newly-constructed property. Cost segregation also applies to the acquisition of a group of assets often acquired for a lump sum, such as real estate or a trade or business. Approaches for segregating newly constructed property rely on contemporaneously billed and itemized costs, published costs of new property, or other estimated costs new. To determine the fair market values of the acquired assets, appraisal practices and procedures must be relied on to allocate/segregate a lump sum basis.

o In the case of an acquisition including a combination of depreciable

improvements and non-depreciable property for a lump sum (e.g., buildings, land improvements, § 1245 property, and land), the basis for

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depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time; Treas. Reg. § 1.167(a)–5, apportionment of basis. The relevant inquiry is the fair market values of the properties at the time of acquisition. Whether an opinion of value is provided in a report styled as a cost segregation study or an appraisal report, any opinion of value should be developed and reported by appropriate standards of the professional appraisal practice (typically USPAP, Uniform Standards of Professional Appraisal Practice).

o Examiners should consider seeking the expertise of IRS Engineers

and Appraisers when examining value and allocation issues.

• Real Estate Allocations

o In allocating a lump sum price paid for real estate, appropriate

appraisal practices and procedures must be applied to determine the fair market values of the non-depreciable land and each of the depreciable assets (buildings, land improvements and personal property). The cost segregation study should explain the standard of value that is applied. When performing a risk analysis of a cost segregation study, examiners should also consider whether value opinions were provided by a competent and qualified appraiser.

o The fair market value of land should be based on the highest and best

use of the land as though vacant, even if the land has improvements. The land value may equal the value of the total real estate even if the real estate has substantial improvements when such improvements do not contribute value to the property. Whereas land has value, improvements contribute value. The value of the total real estate, less the value of the land, results in the contributory value of the improvements. Accordingly, it is inappropriate to estimate the value of the land by subtracting the estimated value of the improvements from the lump real estate price. Basis assigned to land in this residual fashion may result in understating the appropriate basis in the land and overstating the appropriate basis in the depreciable improvements. Examiners should also be wary if a cost segregation study relies solely on local assessed values rather than appropriately determining fair market values.

• Section 1060 Allocations

o Section 1060 prescribes special allocation rules for determining a

transferee’s (buyer’s) basis and a transferor’s (seller’s) gain or loss in an applicable asset acquisition. An applicable asset acquisition is any transfer of assets (either directly or indirectly) that constitutes a trade

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or business and with respect to which the purchaser’s basis in such assets is determined wholly by reference to the consideration paid for them. See § 1060(c).

o A group of assets constitutes a trade or business if i) the use of the

assets would constitute an active trade or business under § 355 or, ii) its character is such that goodwill or going concern value could under any circumstances attach to such group of assets. See Treasury Regulation (Treas. Reg.) § 1.1060-1(b)(2).

o The Omnibus Budget Reconciliation Act of 1990 – P.L. 101-508,

amended § 1060(a) to provide that where the parties to an applicable asset acquisition agree in writing as to the allocation of any amount of consideration, or as to the fair market value of any of the assets transferred, that agreement is “binding” on the transferee and the transferor unless the Commissioner determines that the allocation (or fair market value) is not appropriate. See § 1060(a)(2). The House Report accompanying the amendment to § 1060(a) explained that:

• “A written agreement regarding the allocation of consideration to,

or the fair market value of, any of the assets in an applicable asset acquisition will be binding on both parties for tax purposes, unless the parties are able to refute the allocation or valuation under the standards set forth in the Danielson case. The parties are bound only with respect to the allocations or valuations actually provided in the agreement. * * *

• The committee does not intend to restrict in any way the ability of

the Internal Revenue Service to challenge the taxpayers’ allocation to any asset or to challenge the taxpayers’ determination of the fair market value of any asset by any appropriate method, particularly where there is a lack of adverse tax interests between the parties. See H. Rept. 101-881, at 351 (1990).”

o In Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967), the

Court of Appeals ruled that a taxpayer can challenge the tax consequences of a written agreement “as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.” The Court of Appeals for the Eleventh Circuit has expressly adopted the Danielson rule. See Peterson v. Commissioner, 827 F.3d 968 (11th Cir. 2016); Plante v. Commissioner, 168 F.3d 1279, 1280-1281 (11th Cir. 1999); Bradley v. United States, 730 F.2d 718, 720 (11th Cir. 1984); and North American Rayon Corp. v. Commissioner, 12 F.3d 583, 589 (6th Cir. 1993).

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o In Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-18, aff’d 522

Fed. Appx. 840 (11th Cir. 2013), the taxpayer purchased two poultry processing plants in applicable asset acquisitions under § 1060. As part of the acquisitions, Peco Foods entered into written agreements with the seller allocating the purchase price among the acquired assets. In addition, Peco Foods hired an outside consulting firm to perform a cost segregation study on the acquired plants, and subsequently filed a Form 3115 with its tax return to change its accounting method and reclassify certain property from nonresidential real property to tangible personal property. The IRS disputed these changes, arguing that the taxpayer could not modify the purchase price allocations and subdivide them into component assets in a manner at odds with the allocation schedules. The Tax Court held that Peco Foods was bound by the clear and unambiguous terms of the original allocation schedules and could not deviate from its characterization of those assets. Thus, the taxpayer was not allowed to change its method of accounting for the acquired assets pursuant to its cost segregation study. It is unclear whether the holding in Peco Foods would apply to acquisitions other than applicable asset acquisitions under § 1060.

o Where the parties to an applicable asset acquisition do not agree in

writing to the allocation of consideration of the assets, § 338(b)(5) applies. In general, sellers and purchasers must allocate the consideration under the residual method as described in Treas. Reg. §§ 1.338-6 and 1.338-7 to determine the transferee’s basis in, and the transferor’s gain or loss from, each of the assets transferred. See Treas. Reg. § 1.1060-1(a).

• In addition to the steps previously discussed for Newly-Constructed Property, the following audit steps for existing properties should be considered.

o Review the Acquisition Documents to determine the assets

purchased. Determine whether there was a written purchase price allocation agreed to by the buyer and seller (you may need to contact the seller). If there was an allocation between personal and real property, then the written purchase price allocation is binding on the taxpayer and cannot be changed by a taxpayer’s subsequent cost segregation study. Only the Service can challenge a contract allocation. See § 1060(a); Danielson, supra. If there was not a written price allocation, then the examiner should address the study and go to the next step. See Peco Foods, supra.

o Review the Escrow Documents and Payment Records to

substantiate the overall purchase price.

o Ensure that the Land has been Properly Valued.

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• Request a copy of the appraisal that provides the opinion of the fair

market value of the property. The appraisal should indicate the value of the land and improvements separately. Land included in the purchase price is valued first. The value of land should be determined at its “highest and best use.” Properties tend to appreciate based on the value of land.

• Land value should not be reduced for any pre-existing

environmental contamination because the prior owners are often held responsible for this and/or the property is generally insured for this situation.

o Ensure that Older Properties are Adjusted for Depreciation.

• Assets and asset groupings must be carefully reviewed and

scrutinized to determine their physical and economic condition.

• Older items may be physically deteriorated or functionally or

economically obsolete and should be assigned a value commensurate with their condition or use. For example, a building may have been pre-wired for telephones but, if it is a “non-digital” system, it may have a low value.

o Ensure that Replacement Cost Values are Properly Adjusted for

the actual condition and remaining economic useful life of the assets.

• The value of used components must be reduced from the

replacement cost new value in proportion to the observed economic obsolescence or physical depreciation as compared to similar new assets. This principle is discussed in regard to the “ Helipot Building” in Lesser v. Commissioner, 42 T.C. 688 (1964), aff’d, 352 F.2d 789 (9th Cir. 1965), acq., 1966-2 C.B. 5, cert. Denied, 384 U.S. 927 (1966).

o Review the Contract Files for information regarding the original

construction and any subsequent repairs or modifications. This information should be used when viewing the existing condition of the building to verify, if possible, that the original contract work was performed.

o Review the Construction Drawings. The existing structure should be

compared to the record drawings (commonly called “as-built” drawings) to help identify subsequent repairs and modifications. In many instances for an acquired property, full construction drawings are not available or are minimal.

o Consider Demolition Expenses.

• Assets scheduled to be demolished should have no basis or value

assigned to them.

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• § 280B provides that the demolition cost of any structure is a

capital cost chargeable to the land. Any abandonment losses incurred in connection with a demolition should also be considered for capitalization to the land. See TAM 9131005 (Apr. 25, 1991).

(4) In summary, the examiner should ensure that:

• The study methodology for the proper allocation of the purchase price between the non-depreciable land and depreciable building and personal property must be based upon their values as of the date of purchase.

• The value of property items must take into account the physical wear and tear of each property item and any economic or functional obsolescence.

(5) Step 13: Review Sampling Techniques (If Necessary)

• Taxpayers may utilize sampling techniques to minimize the time and costs associated with performing an analysis on all the properties (refer to the discussion in Chapter 4.C. on Cost Segregation Methodologies). Sampling may also be used with cost documents. The use of sampling adds another level of difficulty when examining these studies. The examiner should take the following steps in reviewing a taxpayer’s sampling technique.

• Request the Assistance of Engineers and Computer Audit Specialists.

o If the taxpayer has used any form of sampling in a study, it is

imperative that a CAS be consulted to review the sampling method. The CAS will use Rev. Proc. 2011-42, 2011-37 I.R.B. 318, as guidance in evaluating the adequacy of the statistical sampling program. If needed, the CAS will request that a statistical sampling coordinator be assigned to specifically review the sampling procedures used by the taxpayer. An engineer can also assist in the review of strata and property groups, and the cost allocations of property.

o Sampling techniques may also be a useful tool for examiners when

reviewing the adequacy and accuracy of a cost segregation study. Consultation and/or referral to a statistical sampling coordinator in the CAS Program is highly recommended to develop a reliable and supportable sample.

• Understand the Sampling Technique.

o In situations involving large numbers of substantially identical

properties, a study may use sampling or estimation techniques to select specific properties on which a “full” cost segregation study is performed. This approach, often referred to as “modeling,” is typical for retail or food chain operations, where a “cookie-cutter” type of structure is involved.

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o The taxpayer may have a limited number of “prototype” structures,

such as free-standing units, locations in strip/enclosed malls, fullservice locations, carryout units, leased properties. The population is stratified by prototype to form groups of similar structures.

o Sampling within each prototype group is then performed with the

results projected to the entire population within that prototype. The projection of sampling results is limited to items and years included in the original population. The results cannot be extrapolated to years outside this population. The application of “extrapolation with a haircut” to items or years not included in the sampled population is not allowed for cost segregation studies.

o Adjustments made by an examiner to the cost allocation performed on

a sampled item are projected to the overall population to determine the overall adjustment. Based on which strata the adjusted sample resides in, the adjustment to the overall population may be significantly more than the adjustment made to the sampled item. This should be considered when performing a risk analysis on cost segregation studies that use statistical sampling.

• Determine/Evaluate the Degree of Similarity Between Properties Within a Group

o The determination of the similarity between properties within a

prototype group is difficult and creates a potential area of dispute. The examiner should be aware that while the appearance of a particular structure may be very similar to the prototype, differences could exist.

o The rationale for stratifying properties is generally based on factors

such as the style of the structure (e.g., location in strip/enclosed mall as opposed to a free-standing location), geographical location, and total square footage, leased, or owned. A stratification that is based on relatively unimportant factors or irrelevant similarities, such as the total number of windows in a structure or the total square footage of the site, is highly suspect and generally warrants further analysis.

o Geographic variations due to physical site characteristics, climate,

building codes and union versus nonunion labor, may create a wide disparity in structure costs. Therefore, stratification of otherwise similar properties across wide geographical areas may not be an accurate approach. Accordingly, the methodology should be carefully reviewed, as the “sampled” property may not be relevant to the other properties within the strata or group.

o CAS and engineers should be involved to properly analyze and

evaluate the strata and groupings, as well as the sampling methodology.

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• Review the Sampling Methodology.

o When conducted properly, statistical sampling is a reliable technique

when the risk (sampling error) of not examining 100 percent of the properties can be accurately determined.

o The use of a modeling technique is a reliable technique, provided the

standard models or templates are properly analyzed and are similar to their respective groups (i.e., appropriate stratification into similar groups).

o Judgment sampling is another technique, but this technique does not

rely on statistical methodology and is highly subjective. Therefore, it warrants greater scrutiny by the examiner.

• Potential Issues.

o Improper sampling techniques (regardless of the methodology used)

that do not reflect a valid estimate.

o A relatively small number of units in the population (less than 100) can

yield a small sample size. However, small sample size can be overcome by the application of a proper statistical sampling methodology and the utilization of the least advantageous limit computed at a 95% one-sided confidence level.

• Simply stated, the least advantageous limit is computed as the

point estimate plus or minus the sampling error, where the result provides the least benefit to the taxpayer.

• Many taxpayers simply use the point estimate without regard to the

sampling error, thereby ignoring the risk of error inherently associated with sampling techniques.

o Missing records, substitution of missing items, missing documentation,

and the use of estimated costs.

o Properties that may not be appropriate for sampling (e.g., small

number of dissimilar properties).

o Inappropriate stratification of properties and faulty statistical sampling

within each stratum.

o Use of judgment sampling, which is highly subjective and thus may be

of limited value.

(6) Step 14: Consider § 263A.

• The uniform capitalization (UNICAP) rules of § 263A require the capitalization of all direct costs and certain indirect costs properly allocable to real property and tangible personal property produced by the taxpayer. Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer. Therefore, changes to the class life

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or basis of an asset may require a concurrent adjustment of UNICAP costs.

• Furthermore, § 263A(f) requires the capitalization of certain interest expenses incurred in connection with the production of property. The interest capitalization rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property and include inherently permanent structures in the definition of real property. In summary, all real property and certain tangible personal property are subject to the interest capitalization rules. Therefore, changes to real and tangible personal property costs may impact the amount of capitalized interest.

• Taxpayers may attempt to exclude all § 1245 property from interest capitalization by arguing that § 1245 property is tangible personal property that does not meet the classification thresholds of Treas. Reg. § 1.263A8(b)(1). However, § 1245 property that is an inherently permanent structure is subject to interest capitalization without any restrictions. In general, the standard for determining whether an item of property is inherently permanent for purposes of § 263A and § 199 is broader than the standard for cost recovery (depreciation). For more discussion and analysis used to determine whether an item is inherently permanent under various Code provisions, see Chapter 6.E. - Inherently Permanent

Standard.

• For tax years beginning after December 31, 2017, a small business taxpayer is not required to capitalize costs including interest under § 263A. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of not more than $25 million for the 3 prior tax years (adjusted annually for inflation), and (b) is not a tax shelter as defined in § 448(d)(3). If the taxpayer has not been in existence for the three-year period mentioned above, § 448(c)(3) provides rules for determining if the taxpayer has met the gross receipts test for the period.

• Ideally, a taxpayer’s books and records should consider and comment on the treatment of UNICAP when amounts are restated for prior tax years based on a cost segregation study. Refer to Special Topics Chapter 6.A. –

Uniform Capitalization for a summary of the major provisions of § 263A. Specific questions regarding § 263A can be referred to the Inventory & § 263A Practice Network.

(7) Step 15: Consider Change in Accounting Method

• In general, it is the position of the Service that a change in an adopted depreciation method, recovery period or convention for depreciable property resulting from the reclassification of property is a change in accounting method. Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file a Form 3115, Application for Change in Accounting Method) and the adjustment to

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taxable income is made pursuant to § 481(a). Accordingly, claims for adjustment to a taxpayer’s adopted depreciation method based on a cost segregation study performed after the original return was filed should not be allowed. Instead, the taxpayer should use the voluntary method change procedures provided in Rev. Proc. 2015-13, 2015-5 I.R.B. 419, (or successor) to change its depreciation method on a prospective basis by filing a Form 3115. See IRM 4.11.6.

• Some of the more common issues encountered in this area include:

o Use of incorrect revenue procedure for implementing change in

accounting method (i.e., use of automatic change procedures instead of non-automatic change procedures);

o Terms of applicable revenue procedure(s) not properly applied;

o Change is not made to a permissible method;

o Form 3115 is not filed;

o Taxpayers want to add items to the original Form 3115, as filed;

o Lack of records to substantiate the § 481(a) adjustment;

o Informal claims filed in lieu of Form 3115;

o Informal claims filed prior to preparation of cost segregation study; and

o Lack of detail to determine basis and recovery periods.

• Prior to the issuance of final regulations under § 446(e), the issue of whether a change in depreciation method, convention, or recovery period constitutes a change in accounting method was unsettled due to conflicting court opinions. However, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(2)(i) and Example 9 of Treas. Reg. § 1.446-1(e)(2)(iii), effective for taxable years ending on or after December 30, 2003, provide that each such change constitutes a change in accounting method. Refer to Special

Topics Chapter 6.B. for a more detailed discussion on Change in Accounting Methods. You can refer specific questions regarding change in accounting methods to the Methods of Accounting and Timing Practice Network.

(8) Step 16: Penalty for Cost Segregation Study Preparer:

• Chief Counsel Advice (CCA) 201805001 provides an example of when an engineer tax consultant was liable for the IRC 6701 penalty for aiding and abetting understatements of tax. The CCA concluded that the engineer prepared and furnished to each client a cost segregation report that mischaracterized components of a building that was nonresidential real property with a 39-year recovery period as tangible personal property with a shorter recovery period (e.g., 5-year property). The engineer knew that their taxpayer-clients would use the cost segregation reports in connection with the preparation of individual and corporate tax returns. Thus, the engineer knew or had reason to believe that those taxpayer-clients would

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use the reports as guidance to claim excessive depreciation deductions when filing their income tax returns. The CCA also concluded that the engineer knew the reports, if relied upon, would result in understatements of tax liability. Under § 6701, the penalty is $1,000 for each individual return and $10,000 for each corporate return.

(1) Using the steps outlined in this chapter, the Service examiner can evaluate the

adequacy and accuracy of a cost segregation study and determine the proper classification and cost of property. The need for a specialist, such as a CAS or an Engineer, should also be evaluated and determined as soon as possible. The guidance in this Audit Techniques Guide is designed to facilitate the audit process and minimize burden on taxpayers, practitioners, and examiners alike.

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(1) The allocation of project costs in cost segregation studies for self-constructed

assets may be impacted by the Uniform Capitalization (UNICAP) rules of IRC § 263A. In addition, the interest capitalization rules of § 263A(f) may also apply. A brief summary of these provisions is presented below.

(1) The UNICAP rules require the capitalization of all direct costs and certain

indirect costs allocable to real property and tangible personal property produced by the taxpayer. For purposes of the uniform capitalization rules, to “produce” means to construct, build, install, manufacture, develop, improve, create, raise, or grow (See § 263A(g)(1); Treas. Reg. § 1.263A-2(a)(1)(i)). Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer and the rules under § 263A govern.

(2) In addition, § 263A(f) requires the capitalization of interest expense when the

taxpayer produces certain property. The interest capitalization rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property and include inherently permanent structures in the definition of real property. In summary, all real property and certain tangible personal property are subject to the interest capitalization rules. Therefore, any change in the allocation of costs between real and tangible personal property may have an impact on the amount of capitalized interest. Many taxpayers attempt to exclude all § 1245 property from interest capitalization arguing that the § 1245 property is tangible personal property that does not meet the classification thresholds of Treas. Reg. § 1.263A-8(b)(1). Most of the § 1245 property in these situations are inherently permanent structures (real property) subject to interest capitalization without any restrictions.

(3) For tax years beginning after December 31, 2017, a small business taxpayer is

not required to capitalize costs including interest under § 263A. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of not more than $25 million for the 3 prior tax years (adjusted annually for inflation), and (b) is not a tax shelter as defined in § 448(d)(3). If the taxpayer has not been in existence for the three-year period mentioned above, § 448(c)(3) provides rules for determining if the taxpayer has met the gross receipts test for the period.

(4) The following text summarizes the capitalization rules of § 263A and the interest

capitalization rules of § 263A(f). Further detail and updates can be obtained from the Inventory and § 263A Practice Network (PN). Also, § 263A adjustments generally involve a change in accounting method. Refer to Special Topics Chapter 6.B. – Change in Accounting Method for more information.

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(1) How does § 263A identify the costs subject to capitalization? Any cost which

(but for § 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale. Thus, for example, any cost (or portion of cost) that is not deductible is not properly allocable to property produced or acquired for resale.

(2) In addition, any cost required to be capitalized under § 263A may not be

included in inventory or charged to capital accounts or included in basis any earlier than the taxable year during which the amount is incurred within the meaning of Treas. Reg. § 1.446 1(c)(1)(ii).

(3) What costs are capitalized under § 263A? Except as otherwise provided, direct

costs and all indirect costs that are properly allocable to property produced must be capitalized. Indirect costs are properly allocable to property produced when they directly benefit or are incurred by reason of the performance of production activities. For a producer, the direct costs generally include direct material and direct labor. The regulations include examples of indirect costs (See Treas. Reg. § 1.263A-1(e)(3)(ii)). Examples of indirect costs required to be capitalized to the extent they are properly allocable to property produced are:

• bidding costs

• capitalizable service costs (including capitalizable mixed service costs)

• cost recovery allowances (however, remember depletion is only allocated

to inventory produced and sold during the year)

• engineering and design costs

• employee benefit expenses

• handling costs

• indirect labor costs

• indirect material costs

• insurance

• interest (see special rules under § 263A(f))

• licensing and franchise costs

• officers' compensation

• pension and other related costs

• purchasing costs

• quality control

• rent

• repairs and maintenance

• spoilage

• storage costs

• taxes

• tools and equipment

• utilities

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(4) Producers must capitalize costs (other than interest) whether incurred before,

during, or after the production period of property. Interest is only capitalized during the production period of property. Pre-production costs are subject to capitalization if the property is held for future production or if it is reasonably likely that the property will be produced at a future date. Thus, costs of storing raw materials and property taxes for real property held for development are required to be capitalized. Some issues may arise in determining the taxpayer's intent and the taxpayer’s change in intent. Production period costs are costs incurred beginning on the date on which production of the property begins and ending on the date on which the property is ready to be placed in service or is ready to be held for sale. Post-production costs are costs incurred after the actual production and may include storage and handling costs incurred while holding the property produced for sale after production.

(5) Treas. Reg. § 1.263A-1(f) sets forth various detailed or specific cost allocation

methods that a taxpayer may use to allocate interest costs to property produced. Under Treas. Reg. § 1.263A-1(f) a taxpayer may use a specific identification method, burden rate method, standard cost method, or any other reasonable method to allocate costs. In addition, in lieu of these methods, producers may use the simplified production methods provided in Treas. Reg. §§ 1.263A-2(b) and (c).

(1) Treas. Reg. §§ 1.263A-8 through 1.263A-15 provides guidance with respect to

the capitalization of interest under § 263A(f). These regulations are effective for 1995 and after, or at taxpayer's election, 1994. For years prior to the final regulations, Notice 88-99, 1988-2 C.B. 422, and temporary regulations provide guidance with respect to the capitalization of interest.

(2) For tax years beginning after December 31, 2017, a small business taxpayer is

not required to capitalize costs including interest under § 263A. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of not more than $25 million for the 3 prior tax years (adjusted annually for inflation), and (b) is not a tax shelter as defined in § 448(d)(3). If the taxpayer has not been in existence for the three-year period mentioned above, § 448(c)(3) provides rules for determining if the taxpayer has met the gross receipts test for the period.

(3) Interest is capitalized with respect to each unit of designated property . Interest

is capitalized during each computation period; the amount of interest that is capitalized is a function of:

• the amount of accumulated production expenditures;

• the amount of outstanding debt(s) on each measurement date; and

• the interest rate of the outstanding debt(s).

(4) In determining the amount of outstanding debt, traced debt is considered first.

The excess expenditure amount is the amount (if any) by which the accumulated production expenditures exceed the amount of traced debt.

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Interest on non-traced debt, up to the excess expenditure amount, must be capitalized, based upon a weighted average interest rate. Pursuant to Treas. Reg. § 1.263A-9(d), taxpayers may elect not to trace debt. See Treas. Reg. § 1.263A-9.

(5) Designated property is defined in § 263A(f)(1) and Treas. Reg. § 1.263A 8(b)(1). In general, § 263A(f) applies to designated property. Designated property is any property that is produced and that is:

• Real property; or,

• Tangible personal property (as defined in Treas. Reg. § 1.263A-2(a)(2)) that meets any of the following classification thresholds:

o Property with a class life of 20 years or more that is not inventory in the

hands of the taxpayer or a related person;

o Property with an estimated production period (as defined in Treas.

Reg. § 1.263A-12) exceeding 2 years; or

o Property with an estimated production period exceeding 1 year and

estimated cost of production exceeding $1,000,000.

(6) Note: All real property is subject to the rules of § 263A(f); the classification

thresholds only apply to tangible personal property.

(7) The classification thresholds are applied individually to each unit of property.

(8) Treas. Reg. § 1.263A-8(c)(1) defines real property. Real property includes land,

unsevered natural products of land, buildings, and inherently permanent structures. Any interest in real property, including fee ownership, coownership, a leasehold, an option, or a similar interest is real property. Unsevered natural products of land include growing crops and plants (that have a pre-productive period more than 2 years), mines, wells, and other natural deposits. Real property includes the structural components of both buildings and inherently permanent structures.

(9) Inherently permanent structures include property that is affixed to real property

and that will ordinarily remain affixed for an indefinite time. Examples are swimming pools, roads, bridges, tunnels, paved parking areas and other pavements, special foundations, wharves and docks, fences, inherently permanent advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and signals, telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment, grain storage bins and silos. For purposes of this section, affixation to real property may be accomplished by weight alone. See Treas. Reg. § 1.263A-8(c)(3).

(10) Property may constitute an inherently permanent structure even though it is not

classified as a building for purposes of former § 48(a)(1)(B) and Treas. Reg. § 1.48-1. Any property not otherwise described in Treas. Reg. § 1.263A-8(c)(3) that constitutes other tangible property under the principles of former § 48(a)(1)(B) and Treas. Reg. § 1.48-1(d) is treated for the purposes of Treas.

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Reg. § 1.263A-8 as an inherently permanent structure. See Treas. Reg. § 1.263A-8(c)(3).

(11) A structure that is property in the nature of machinery or is essentially an item

of machinery or equipment is not an inherently permanent structure and is not real property. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. A structure may be an inherently permanent structure, and not property in the nature of machinery or essentially an item of machinery, even if the structure is necessary to operate or use, supports, or is otherwise associated with, machinery. See Treas. Reg. § 1.263A-8(c)(4).

(1) A taxpayer may conduct a cost segregation study on used or previously existing

property and then re-compute its depreciation deductions for prior years. The underlying incentive for preparing these studies for Federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions. Examiners need to be aware of the potential issues relating to these re-computations, including the need for taxpayers to notify the Internal Revenue Service (IRS or Service) that it intends to make a change in accounting method for those items identified in the cost segregation study. This chapter provides a brief overview of the applicable law in this area.

(1) It has been the long-standing position of the Service that a taxpayer adopts a

permissible method of accounting in the tax year a depreciable asset is placed in service, relative to the depreciation method, recovery period (but not useful life), or convention for the depreciable property. A taxpayer adopts an impermissible method of accounting relative to depreciable property when it is treated in the same way on two or more consecutively filed returns. Once a method is adopted, a change in depreciation method, recovery period (but not useful life), or convention resulting from a reclassification of such property, results in a change in method of accounting. Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file a Form 3115, Application for Change in Accounting Method), and the adjustment to taxable income is made pursuant to § 481(a). If a taxpayer has adopted a method of accounting, the taxpayer may not change the method by amending its prior income tax returns. See Rev. Rul. 90-38, 1990-1 C.B. 57. Accordingly, amended returns or claims for adjustment, based on a cost segregation study performed after the original return was filed for the placed-in-service year and the original return for the subsequent tax year, should generally be disallowed on the basis that the taxpayer is attempting to make a retroactive method change. See § 446(e) and IRM 4.11.6.7.5.

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(2) The Service's historical position is that a change in computing depreciation

under §§ 167, 168, or 197, or former §§ 168 (ACRS), 1400I, 1400L(b), or 1400L(c) generally is a change in method of accounting under § 446(e) for which the consent of the Commissioner is required. However, this position was successfully challenged by several taxpayers in litigation with respect to depreciable property subject to § 168 (MACRS property). See Brookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003), Green Forest Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75, and O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003); but contrast Kurzet v. Commissioner, 222 F.3d 830 (10th Cir. 2000). Because of these decisions, there was inconsistent treatment of taxpayers with respect to whether a change in computing depreciation under § 168 was a change in method of accounting under § 446(e).

(3) Final regulations under § 446(e), T.D. 9307, 71 F.R. 78066 (December 28,

2006. (final regulations), address the circumstances under which a change in calculating depreciation or amortization is a change in method of accounting under § 446(e). These regulations adopt, with modifications, temporary regulations published in the Federal Register on January 2, 2004. The final regulations provide that the following are changes in method of accounting under § 446(e):

• A change in the treatment of an asset from non-depreciable or nonamortizable to depreciable or amortizable, or vice versa, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(2);

• A correction to require depreciation in lieu of a deduction for the cost of depreciable or amortizable assets that had been consistently treated as an expense in the year of purchase, or vice versa, Treas. Reg. § 1.446 1(e)(2)(ii)(d)(2);

  • A change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset, Treas. Reg. § 1.446 1(e)(2)(ii)(d)(2)(i); and,

  • A change to or from claiming the additional first year depreciation deduction provided by, for example, § 168(k), former § 1400L(b), or former § 1400N(d) under certain circumstances, Treas. Reg. § 1.4461(e)(2)(ii)(d)(2)(ii).

(4) Treas. Reg. § 1.446-1(e)(2)(iii), Example 9, provides an illustration of a change

in accounting method due to changes in depreciation method, recovery period and convention, all resulting from a cost segregation study.

(5) The final regulations clarify that a change in depreciation due to a posting or

mathematical error, or a change in underlying facts, is not an accounting method change because the rules in Treas. Reg. § 1.446-1(e)(2)(ii)(a) and (b) also apply to a depreciation change.

(6) In addition, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(i) provides that an accounting

method change does not include an adjustment in the useful life of a

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depreciable or amortizable asset for which depreciation is determined under § 167 (other than under § 168, former § 1400I, former § 1400L(c), former § 168, or an additional first year depreciation deduction provision of the IRC). This rule does not apply if a taxpayer is changing to or from a useful life (or recovery period or amortization period) that is specifically assigned by the Code, regulations, or other guidance published in the Internal Revenue Bulletin.

(7) Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(iii) provides that the making of a late

depreciation or amortization election or the revocation of a timely valid depreciation or amortization election is not a change in method of accounting, except as otherwise expressly provided by the Code, regulations, or other guidance published in the Internal Revenue Bulletin.

(8) Finally, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(v) provides that any change in the

placed in-service date of a depreciable or amortizable asset is not treated as a change in accounting method.

(9) The final regulations under § 446(e) only apply to a change in depreciation

made by a taxpayer for a depreciable or amortizable asset placed in service by the taxpayer in a tax year ending on or after December 30, 2003, regardless of whether the change in depreciation is a change in method of accounting.

(1) On January 28, 2004, the Associate Chief Counsel (P&SI) issued a Change in

Litigating Position Notice (“Notice”) regarding the application of § 446(e) to changes in computing depreciation. See Notice CC-2004-007, as clarified by Notice CC-2004-024 (July 12, 2004).

(2) The Notice provides that the Service’s position continues to be that a change in

computing depreciation under §§ 167, 168, 197, former §§ 1400I, 1400L(b), or 1400L(c), or ACRS, is a change in method of accounting under § 446(e) for which the consent of the Commissioner is required. However, for depreciable or amortizable property that is treated as a capital asset and placed in service in taxable years ending before December 30, 2003, the Service will no longer litigate the issue of whether such a change in computing depreciation is a change in method of accounting under § 446(e).

(3) The change in the Service's litigating position does not apply to a change in the

treatment of property from a non-capital asset (for example, inventory, materials, and supplies) to a capital, depreciable or amortizable asset (or vice versa), or to a change from expensing the cost of depreciable or amortizable property to capitalizing and depreciating or amortizing such cost (or vice versa). These changes are a change in method of accounting under § 446(e). Accordingly, examiners should consult with their local Chief Counsel attorneys should a taxpayer assert that these changes are not a change in method of accounting.

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(1) In Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-018, aff’d 522 Fed.

Appx. 840 (11th Cir. 2013), the taxpayer purchased two poultry processing plants in applicable asset acquisitions under § 1060. As part of the acquisitions, Peco Foods entered into written agreements with the seller allocating the purchase price among the acquired assets. Peco Foods then hired an outside consulting firm to perform a cost segregation study on the plants and filed a Form 3115 with its return to change its accounting method and reclassify certain property from nonresidential real property to tangible property. Id. At *3. The IRS disputed these changes, arguing that the taxpayer could not modify the purchase price allocations and subdivide them into component assets in a manner at odds with those schedules. The Tax Court held that Peco Foods was bound by the clear and unambiguous terms of the original allocation schedules and could not deviate from its characterization of those assets. Id. At *12. Thus, the taxpayer was not allowed to change its method of accounting for the acquired assets pursuant to its cost segregation study. It is unclear whether the holding in Peco Foods would apply to acquisitions other than applicable asset acquisitions under § 1060.

(1) The final tangible property regulations under Treas. Reg. §§ 1.263(a)-1, -2, and

-3 (final regulations), published on September 19, 2013, are generally effective for taxable years beginning on or after January 1, 2014.

(2) Taxpayers have used cost segregation studies to determine what constitutes §

1245 (personal) or § 1250 (real) property for many years. Historically, these cost segregation studies have resulted in advantageous depreciation deductions for taxpayers. With the issuance of the final tangible property regulations, the demand for cost segregation studies is on the rise.

(3) In many cases, taxpayers who previously decided not to conduct cost

segregation studies for depreciation purposes are hiring specialists with engineering expertise to determine units of property for purposes of determining whether certain costs improve a unit of property under Treas. Reg. § 1.263(a)3. Even taxpayers that conducted these studies in the past are once again hiring specialty firms or CPAs to take another look at their units of property and associated costs.

(4) Cost segregation studies now serve additional purposes. For example, not only

do these studies reclassify a building’s components into assets with shorter class lives, but they also identify building systems for purposes of determining whether costs are for an improvement to the building structure or building systems under Treas. Reg. § 1.263(a)-3. These studies are also used to identify functionally interdependent plant property and to determine individual components or groups of components that perform a discrete and critical function under these final regulations. Such items may represent a change in accounting method in which the taxpayer must file a Form 3115 to request consent for the change.

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(5) The Examiner should request and review all cost segregation (or similar)

studies, past and present and may need to engage the services of an IRS Engineer to determine whether the study was conducted properly.

(6) The Examiner should also consider if the taxpayer’s adjustments due to a cost

segregation study represent a change in accounting method and if the changes were implemented properly following the appropriate revenue procedures. See Rev. Proc. 2015-13, 2015-5 I.R.B. 419, (or successor) and Rev. Proc. 2023-24, 2023-28 I.R.B. 1207, (or successor) for current guidance. See the Capitalization of Tangible Property Audit Technique Guide for additional guidance on Treas. Reg. §§ 1.263(a)-1 to -3.

(1) To file a Form 3115 with the Service, a taxpayer needs to follow the procedures

outlined in the applicable revenue procedure. Although taxpayers generally argue that they are simply reclassifying property placed in service in prior years to “correct” class lives, this reclassification results in a change in recovery period, depreciation method and/or convention.

(2) Taxpayers who have adopted an impermissible method of accounting for

depreciation (or amortization) and have either (1) claimed no depreciation, or (2) claimed less than or more than the allowable amount of depreciation and are making a change described in Treas. Reg. § 1.446-1(e)(2)(ii)(d), are generally required to file a Form 3115 under either the automatic change or non-automatic change procedures (i.e., the voluntary method change procedures) to change the method of accounting. A taxpayer cannot change an adopted accounting method by filing an amended return unless specific guidance allows for an exemption.

(3) The general voluntary method change procedures are found in Rev. Proc.

2015-13 (or successor) with the list of automatic changes found in Rev. Proc. 2023-24 (or successor). As provided in Rev. Proc. 2015-13, Section 6, for an automatic change, the original Form 3115 must be attached to the taxpayer’s timely filed (including extension) original federal income tax return implementing the change in method of accounting for the year of change. Also, a duplicate copy of the Form 3115 must be filed with the IRS office in Ogden, UT no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with the federal income tax return for the year of change. If the automatic change procedures of Rev. Proc. 2015-13 (or successor) do not apply to a taxpayer’s situation, the non-automatic change procedures should be followed.

(4) The following is a list of the more common compliance issues involving

accounting method changes:

• Compliance issues for non-automatic method changes:

o Was the ruling letter granting consent to the change followed?

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o Is the method the taxpayer implemented consistent with the facts

presented and the representations made in the consent agreement?

o Is the § 481(a) adjustment, correct?

o Exam may perfect the method change as an examination adjustment

when deemed appropriate.

o A TAM is required to revoke or modify the ruling letter.

• Compliance issues for automatic method changes:

o Did the taxpayer fully comply with the provisions in the voluntary

method change procedure (Rev. Proc. 2015-13 or successor)?

o Is the method the taxpayer implemented consistent with the automatic

method change provisions described in Rev. Proc. 2023-24 (or successor) for the designated change number?

o Is the § 481(a) adjustment, correct?

o Exam may perfect the method change as an examination adjustment

when deemed appropriate.

o A TAM is necessary if the taxpayer made the method change in

compliance with the applicable procedures, but the examiner wants to revoke or modify the method change.

(5) If after reviewing the taxpayer’s cost segregation study and its implementation,

the Examiner determines (1) the taxpayer is using an accounting method that does not clearly reflect income or is improper under § 446(b); or (2) the taxpayer changed its method of accounting without obtaining the consent of the Commissioner under § 446(e), the Examiner should use the involuntary method change procedures in Rev. Proc. 2002-18, 2002-1 I.R.B. 678, to resolve these accounting method issues. See IRM 4.11.6.7.

(1) A change in the recovery period, depreciation method, and/or convention for

depreciable property is a change in accounting method. Once a method of accounting is adopted, a taxpayer is required to obtain the consent of the Commissioner through the timely filing of a Form 3115 to change the accounting method. Pursuant to Rev. Proc. 2015-13, a taxpayer may request automatic or non-automatic consent for the change. Although a Form 3115 may be subject to National Office review, it is generally the responsibility of the examiner to verify the propriety of the revised method of accounting for depreciation and the accuracy of the § 481(a) adjustment at the time of the examination. The examiner should evaluate the need to review the cost segregation study that formed the basis for the depreciation re-computations and the resultant change in accounting method.

(2) The issue regarding a change in accounting method with respect to the re computation of depreciation (e.g., those based on cost segregation studies) can be quite complex. Examiners should consult Treas. Reg. § 1.446-1(e) for further guidance. Examiners should also contact the Methods of Accounting and

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Timing Practice Network for assistance regarding ongoing developments in this area, as well as determining the taxpayer’s compliance with the proper procedures for changing the accounting method and computing the adjustment pursuant to § 481(a).

(1) To compute depreciation for assets subject to a cost segregation study, one

must use the proper property classification. The property classes control the applicable recovery period for assets, which are determined by statute or by reference to class lives. To determine the proper class lives, assets must be categorized into their appropriate asset classes. Cost segregation studies generally produce listings or groups of assets, based on asset classes under the Modified Accelerated Cost Recovery System (MACRS). This chapter provides a summary of the applicable authorities and available guidelines for classifying property into their appropriate classes as well as guidelines for computing depreciation deductions by using the proper depreciation method, recovery period, and convention.

(1) IRC § 167(a) provides a depreciation allowance for the exhaustion, wear and

tear of property used in a trade or business or held for the production of income. The depreciation deduction provided by § 167(a) for tangible property placed in service after 1986 generally is determined under § 168, the Modified Accelerated Cost Recovery System. MACRS prescribes two methods for determining depreciation allowances: (1) the general depreciation system in § 168(a) (GDS); and (2) the alternative depreciation system in § 168(g) (ADS). A taxpayer generally must use GDS unless the taxpayer is specifically required to use ADS or the taxpayer elects to use ADS. Under either depreciation system, the depreciation deduction is computed by using a prescribed depreciation method, recovery period and convention.

(1) GDS contains ten property classes, based on the recovery period of an asset

(3, 5, 7, 10, 15, 20, 25, 27.5, 39, or 50 years). Applicable depreciation methods include the 200% declining balance method, 150% declining balance method, and straight-line method. The depreciation methods under GDS are generally not elective, but a taxpayer may make an irrevocable election to use a less accelerated method under certain circumstances. However, 27.5-year property (residential rental property), 39-year property (nonresidential real property and qualified improvement property), 50-year property (railroad grading or tunnel bore), and certain 15-year property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property placed in service before January 1, 2018) must be depreciated using straightline depreciation. Note – qualified improvement property placed in service

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before January 1, 2018, that also meets the definition of qualified leasehold improvement property, qualified restaurant property, or qualified retail improvement property is depreciable over 15 years using straight line depreciation as well.

(2) ADS must be used for the following property: 1) listed property used 50 percent

or less for business; 2) tangible property used predominantly outside the United States; 3) tax-exempt use property; 4) tax-exempt bond financed property; and 5) certain other finite categories of property that are not common. In addition, a taxpayer may make an irrevocable election to use ADS for any class of property eligible for depreciation under GDS and placed in service for a particular tax year. The recovery periods under ADS are generally longer than the recovery periods under GDS, and the straight-line method must be used.

• For purposes of either GDS or ADS, there are three possible conventions:

Half-year, mid-month, and mid-quarter conventions.

• The half-year convention applies to property other than residential rental

property, nonresidential real property, and railroad grading and tunnel bores. Under this convention, the recovery period begins or ends on the midpoint of the tax year that the property is placed in service or disposed of.

• The mid-month convention applies to residential rental property,

nonresidential real property, and railroad grading and tunnel bores. Under this convention, the recovery period begins on the midpoint of the month that the property is placed in service.

• The mid-quarter convention applies to property (other than residential

rental property, nonresidential real property, and railroad grading and tunnel bores) if more than 40% of the aggregate bases of such property is placed in service during the last three months of the tax year. Under this convention, the recovery periods for all property placed in service, or disposed of, during any quarter of a tax year begin on the midpoint of the quarter.

(1) For purposes of either GDS or ADS, the applicable recovery period is

determined by statute or by reference to class life.

(2) The recovery period of residential rental property, nonresidential real property,

and railroad grading and tunnel bore, are established by statute. See §§ 168(c) and 168(g)(2)(c).

• Residential rental property has a recovery period of 27.5 years for

purposes of GDS and 40 years for purposes of ADS (30 years for purposes of ADS for residential rental property placed in service after December 31, 2017).

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o § 168(e)(2)(A) defines "residential rental property" as any building or

structure if 80 percent or more of the gross rental income is rental income from dwelling units.

• Nonresidential real property has a recovery period of 39 years (or 31.5 years if the property was placed in service before May 13, 1993) for purposes of GDS and 40 years for purposes of ADS.

o § 168(e)(2)(B) defines "nonresidential real property" as § 1250

property which is not residential rental property or property with a class life of less than 27.5 years.

• Railroad grading and tunnel bore have a recovery period of 50 years for purposes of both GDS and ADS. §§ 168(c) and 168(g)(2)(c).

• 15-Year Real Property: Under MACRS, while real property generally has a recovery period of 39 years (nonresidential real property or 27.5 years (residential rental property), the following designated real property is 15year property:

o Qualified leasehold improvement property (QLIP), defined in former §

168(e)(6) circa 2005, placed in service between 10/22/2004 and 12/31/17. Qualified restaurant property (QRP), defined in IRC former § 168(e)(7) circa 2005, placed in service between 10/22/2004 and 12/31/17. Qualified retail improvement property (QRIP), defined in IRC former § 168(e)(8) circa 2009, placed in service between 12/31/2008 and 12/31/17.

o These properties have a recovery period of 15 years and must be

depreciated by the straight-line method and half-year convention (unless the mid-quarter convention applies). Under the alternative depreciation system (ADS) these properties have a recovery period of 39 years. See Chapter 6.H. for the § 179 and bonus depreciation treatment of QLIP, QRP, and QRIP.

• Qualified Improvement Property (QIP)

o Placed in service after 12/31/2015 and prior to 1/1/2018 was defined in

§ 168(k)(3), Protecting Americans from Tax Hikes Act – P.L. 114-113 (PATH Act of 2015), and has a recovery period of 39 years for GDS and 40 years for ADS. QIP was created to make it eligible for bonus depreciation. QIP placed in service after 12/31/2015 and before 1/1/2018 has a recovery period of 15 years for GDS and 39 years for ADS if it also meets the definition of QLIP, QRP, or QRIP.

o QIP placed in service after 12/31/2017 is defined in § 168(e)(6), Tax

Cuts and Jobs Act of 2017 – P.L. 115-97 (TCJA), and, as originally enacted, had a recovery period of 39 years for GDS and 40 years for ADS (and thus was not eligible for bonus depreciation). However, in

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2020, the recovery period was retroactively changed with the addition of § 168(e)(3)(E)(vii), Coronavirus Aid, Relief, and Economic Security Act – P.L. 116-136 (CARES Act), from 39 years to 15 years for GDS and from 40 years to 20 years for ADS, which also meant that QIP could be eligible for bonus depreciation.

o QIP is defined as any improvement to an interior portion of a building if

the improvement is placed in service after the date the building was first placed in service. However, QIP does not include any improvement attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. The CARES Act also clarified the definition of QIP in § 168(e)(6)(A) to include only those improvements "made by the taxpayer" to an interior of the building…"

(3) Recovery Period for Qualified Real Property Table showing Placed in

Service Date Range and depreciable period for GDS and ADS purposes.

SL (GDS), and 39-Yr SL (ADS).

** Initially, QLIP, QRP, and QRIP applied only to new improvements to the interior of the building. After 2008 QRP applies to the entire building for both new and purchased property and the 3-year rule was eliminated.

*** For property placed in service after 12/31/17, QIP replaces QLIP, QRP, and QRIP. QIP was retroactively given a GDS 15-year recovery period and ADS 20-year recovery period pursuant to the CARES Act.

(4) Section 168(i)(12) provides that the terms “§ 1245 property” and “§ 1250

property” have the meanings given such terms by § 1245(a)(3) and § 1250(c), respectively.

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(5) Section 1245(a)(3) provides that "§ 1245 property" is any property which is or

has been subject to depreciation under § 167 and which is either personal property or other tangible property (not including a building or its structural components) that was used as an integral part of certain activities.

(6) Section 1250(c) defines "§ 1250 property" as any real property, other than §

1245 property, which is or has been subject to an allowance for depreciation. In other words, § 1250 property encompasses all depreciable property that is not § 1245 property.

(7) Section 1245(a)(3) provides that "§ 1245 property" is any property which is or

has been subject to depreciation under § 167 and which is either personal property or other tangible property (not including a building or its structural components) that was used as an integral part of certain activities. Such activities include manufacturing, production, or extraction, furnishing transportation, communication, electrical energy, gas, water, or sewage disposal services. Certain other "special use" property also qualifies as § 1245 property but is not relevant to this discussion. It is important to note that a building or its structural components is specifically excluded from the definition of § 1245 property.

(8) Treas. Reg. § 1.1245-3 defines "tangible personal property," "other tangible

property," "building," and "structural component" by reference to Treas. Reg.§ 1.48-1. This regulation relates to former § 48, which was enacted in 1962 along with §§ 1245 and 1250. Section 48 allowed an investment tax credit (ITC) based on the "applicable percentage" of the investment in tangible depreciable property placed in service during the taxable year. The ITC (§ 48) was later repealed in 1986. See the previous chapter, Chapter 2 - Legal Framework, for a description of the provisions set forth in Treas. Reg. § 1.48-1.

(1) Section 168(i)(1) provides that the term “class life” means the class life (if any)

that would be applicable with respect to any property as of January 1, 1986, under former § 167(m) as if it were in effect and the taxpayer were an elector. Prior to its revocation, former § 167(m) provided that in the case of a taxpayer who elected the asset depreciation range system of depreciation, the depreciation deduction would be computed based on the class life prescribed by the Secretary of the Treasury which reasonably reflects the anticipated useful life, and the anticipated decline in value over time, of the property to the industry or other group.

(2) Treas. Reg. § 1.167(a)-11(b)(4)(iii)(b) sets out the method for asset

classification under former § 167(m). Property is included in the asset guideline class for the activity in which the property is primarily used, regardless of whether the activity is insubstantial in relation to all the taxpayer's activities. Thus, for depreciation purposes, a taxpayer may be engaged in more than one activity. If a taxpayer uses assets in more than one activity, the cost of the asset is not allocated between the two activities; rather, the total cost of the asset will be classified for depreciation purposes according to the activity in which the

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asset is primarily used. This determination may be made in any reasonable manner. In Rev. Proc. 97-10, 1997-1 C.B. 628, either a gross receipts test or a square footage test was used to determine whether a building was primarily used as a retail motor fuels outlet.

(3) For example, assume that a taxpayer owns and operates a hotel/casino

complex. The taxpayer is engaged in two business activities: casino operations and hotel operations. Assets used by the taxpayer in its casino operations are includible in the activity category that includes casino operations (asset class 79.0 Recreation of Rev. Proc. 87-56, 1987-2 C.B. 674). Assets used in hotel operations are includible in the activity category that includes hotel operations (asset class 57.0 Distributive Trades and Services of Rev. Proc. 87-56). If a particular asset is used in both activities, the total cost of the asset will be classified for depreciation purposes according to the activity in which the asset is primarily used; the cost of the asset is not allocated between the two activities. The determination of primary use may be made in any reasonable manner. For additional information, see IRS FSA 200203009.

(4) Asset classifications are based on how the asset is primarily used. In the case

of a lessor of property, the asset class for such property is determined as if the property were owned by the lessee. See Treas. Reg. § 1.167(a)-11(e)(3)(iii) and the following court cases for additional information and consideration.

• Clajon Gas Co. L.P. v. Commissioner, 354 F.3d 786 (8th Cir. 2004), rev’g

119 T.C. 197 (2002): Pipelines leased to producers to transport natural gas fell under the asset class for producing natural gas regardless of ownership.

• Saginaw Bay Pipeline Co. v. United States, 338 F.3d 600 (6th Cir.2003), rev’g 124 F.Supp.2d 465 (E.D. Mich. 2001): Every natural gas carriage pipeline which functions as a gathering pipeline is in the methane gas production process irrespective of the primary business of the owner of that pipeline.

  • Duke Energy Natural Gas Corp. v. Commissioner, 172 F.3d 1255 (10th Cir.1999), rev’g 109 T.C. 416 (1997): Based on the asset's primary use, the classification of natural gas gathering systems constituted as assets used in the production of natural gas.

(5) As stated earlier, GDS contains ten property classes, based on the recovery

period of an asset. For those classes of property not established by statute, the applicable recovery period is determined by reference to class life. See § 168(e)(1). It is also worth noting that qualified Indian reservation property, generally have shorter applicable recovery periods. See § 168(j)(1) and (2).

(1) Revenue Procedure 87-56, 1987-2 C.B. 674, sets forth the class lives of

property that are necessary to compute the depreciation allowances under §

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168 (MACRS). The revenue procedure establishes two broad categories of depreciable assets:

• Asset classes 00.11 through 00.4 that consist of specific assets used in all business activities.

• Asset classes 01.1 through 80.0 that consist of assets used in specific business activities.

(2) The same item of depreciable property can be described in both an asset

category (asset classes 00.11 through 00.4) and an activity category (asset classes 01.1 through 80.0). In this situation, the item is classified to the asset category unless it is specifically excluded from the asset category or specifically included in the activity category. For additional guidance see below:

• Norwest Corporation & Subsidiaries v. Commissioner, 111 T.C. 105 (1998) (item described in both an asset and an activity category (furniture and fixtures) should be placed in the asset category)

• Rev. Rul. 2003-81, 2003-2 C.B. 126 (an asset included in both an asset category and an activity category is placed in the asset category, unless it is specifically excluded from the asset category or specifically included in the activity category).

(3) Revenue Procedure 87-56 contains tables of class lives and recovery periods.

To properly utilize Rev. Proc. 87-56, the following steps are suggested:

• Check Asset Classes 00.11 through 00.4 that consist of specific assets used in all business activities to see if it contains a description of the asset in question.

o Refer below to Step 2 (if the asset is described in an asset category) or

to Step 3 (if the asset is not listed in an asset category).

• If the subject asset is described in one of the asset categories, then check asset classes 01.1 through 80.0 that consist of assets used in specific business activities to find the activity to which the property relates or in which it is primarily being used.

o If the activity is described in one of the activity categories, read the text

(if any) under the title to determine if the property is specifically included in the activity category.

o If it is, then use the recovery period shown for the activity category

following the description of that activity.

o If the property is not specifically included in the activity category, or if

the property is specifically excluded from the activity category, then use the recovery period shown in the appropriate asset category.

• If the asset is not listed in an asset category, then find the activity to which the property relates or in which the property is primarily being used and

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use the recovery period shown in the appropriate column following the activity category description.

o If the property is not listed in an asset category and the activity to

which it relates is not included in one of the activity categories, then the property should be categorized as “Certain Property for which Recovery Periods assigned (Personal Property/§ 1245 Real Property with No Class Life).” Property in this category generally has a recovery period of 7 years for GDS or 12 years for ADS. Very few assets fall under this default category.

(1) The following examples illustrate the use of Rev. Proc. 87-56 for determining

the proper asset recovery period. See also Appendix B of IRS Publication 946.

(2) Example 1: Richard Green is a paper manufacturer. During the year, he made

substantial improvements to the land on which his paper plant is located. Assume that these land improvements are depreciable property. He checks the asset categories and finds land improvements under Asset Class 00.3 Land Improvements. He then checks the activity categories and finds his activity, paper manufacturing, under Asset Class 26.1, Manufacture of Pulp and Paper.

• If Richard had only looked at the asset categories, he would have

erroneously selected Asset Class 00.3, Land Improvements, and would have incorrectly used a recovery period of 15 years for GDS or 20 years for ADS. However, Richard uses the recovery period under Asset Class 26.1 Manufacture of Pulp and Paper, because it specifically includes land improvements. Thus, the land improvements have a 13-year class life and a 7-year recovery period for GDS. If he elects to use ADS, the recovery period is 13 years.

• Note: It is presumed in this example that the subject land improvements

are directly associated with the factory site or production process, for example, effluent ponds or canals necessitated by the production process, or parking lots utilized by employees directly involved with the production process. However, those land improvements that are more closely associated with non-production activities, such as administrative or retail activities of the taxpayer, would be categorized in Asset Class 00.3 Land Improvements and have a 15-year recovery period under GDS. See Rev. Rul. 2003-81.

(3) Example 2: Sam Plower produces rubber products. During the year, he made

substantial improvements to the land on which his rubber plants are located. Assume that these land improvements are depreciable property. He checks the asset categories and finds land improvements under Asset Class 00.3. He then checks the activity categories and finds his activity, producing rubber products, under Asset Class 30.1, Manufacture of Rubber Products. Reading the

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headlines and descriptions under Asset Class 30.1, Sam finds that it does not specifically include land improvements. Therefore, Sam uses the recovery period for Asset Class 00.3 Land Improvements. Thus, the land improvements have a 20-year class life and a 15-year recovery period for GDS. If he elects to use ADS, the recovery period is 20 years.

(4) Example 3: Pam Martin owns a retail-clothing store. During the year, she

purchased a desk and a cash register for use in her business. She checks the asset categories and finds office furniture under Asset Class 00.11 Office Furniture, Fixtures, and Equipment. Cash registers are not specifically listed in any of the asset categories. She then checks the activity categories and finds her activity, retail store, under Asset Class 57.0 Distributive Trades and Services, which includes assets used in wholesale and retail trade. The description for this asset class does not specifically list office furniture or a cash register.

• She looks back at the asset categories and uses Asset Class 00.11 for the

desk, since it constitutes office furniture. Thus, the desk has a 10-year class life and a 7- year recovery period for GDS. If she elects to use ADS, the recovery period is 10 years. For the cash register, Pam uses Asset Class 57.0 Distributive Trades and Services, because cash registers are not specifically listed in one of the asset categories but are assets used in retail business. Accordingly, the cash register has a 9-year class life and a 5-year recovery period for GDS. If she elects to use the ADS method, the recovery period is 9 years.

(1) The Standard Industrial Classification Manual (SIC) published by the Office of

Management and Budget can provide insight into the content of the asset classes described in Rev. Proc. 87-56. Care must be exercised because SIC does not make use of the same classification techniques and depreciation concepts of Rev. Proc. 87-56. While SIC has precise categorization by primary business activity using language very similar to that found in Rev. Proc. 87-56, the revenue procedure departs dramatically from the categorization scheme of SIC by establishing two broad categories of depreciable assets: (1) asset classes 00.11 through 00.4 that consist of specific assets used in all business activities; and (2) asset classes 01.1 through 80.0 that consist of assets used in specific business activities. However, the asset class numbers for the specific business activities described in Rev. Proc. 87-56 are largely taken from SIC.

(2) Additionally, it may be helpful to look at the North American Industry

Classification System (NAICS). NAICS was introduced in 1997 to replace the SIC system and more closely reflects the many new industries that have propagated since the establishment of the SIC system in 1937, including many service industries currently under-represented in the SIC system. Although the manner of categorization is similar under both SIC and NAICS, the category

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codes are vastly different, which is why the Service generally does not look to NAICS for insight purposes. However, NAICS can be helpful (because of its expanded description of service industries) in determining in which one of two activity categories, a particular asset should be categorized.

(1) In addition to the legal framework presented earlier in Chapter 2, the court

cases listed below provide further guidance as to whether a particular asset constitutes § 1245 property or § 1250 property. Although the issue in many of the cases below relates to whether property is eligible for the now-expired investment tax credit (ITC), the precedent that was developed to ascertain whether property constituted eligible property for purposes of ITC is equally applicable to ascertain whether property constitutes as § 1245 property for purposes of ACRS/MACRS.

(2) Unfortunately, there are no bright-line tests for distinguishing § 1245 property

from § 1250 property. Each of the cases below is factually intensive. Additionally, opinions by different courts sometimes conflict; therefore, an ultimate determination of the categorization of an asset generally cannot be based upon reading merely one case. In addition to reading all of the cases on point, one must also consider whether the Service has acquiesced to a particular position or case. Advice should be sought where the asset at issue is not specifically discussed in any of the below opinions, if one is not sure of how to categorize a specific asset, or if the opinions are vague or conflicting.

(1) This chapter contains two tables to assist examiners in locating pertinent cases

that address specific assets:

(2) Table 1: Case Law by Case Name (in reverse chronological order)

(3) Table 2: Case Law listed by CSI MasterFormat Division (both 2020 (50

divisions) and 1995 (16 divisions))

(4) NOTE : Cost Segregation studies are often organized following the Construction

Specifications Institute (CSI) MasterFormat Division system. The CSI MasterFormat system is a master list of numbers and titles classified by construction trades (concrete, electrical, plumbing, mechanical, carpentry, masonry, steel, etc.) that was developed to simplify and facilitate communication within the construction industry. From 2004 through 2020 the system uses 50 divisions with 35 being active divisions and 15 reserved for future expansion. The inclusion of the CSI MasterFormat Divisions in these tables is for informational purposes only and is not an endorsement of either the Construction Specifications Institute or the MasterFormat system.

(5) For reference purposes, this chapter also contains a third table listing all the

CSI MasterFormat Divisions for both the 2020 and 1995 editions:

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(6) Table 3: Listing of CSI MasterFormat Divisions (both 2020 (50 divisions) and

1995 (16 divisions))

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

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• Division 12 — Furnishings

• Division 13 — Special Construction

• Division 14 — Conveying Systems

• Division 15 — Plumbing & Mechanical

• Division 16 — Electrical

(1) In determining whether a structure, or component of a structure, is inherently

permanent, one must consider the governing code section defining the scope and nature of the structure. Chapter 2.L. – Inherently Permanent Test of this Audit Techniques Guide (ATG) discusses whether a structure is inherently permanent for cost recovery purposes under § 168. The analysis used for inherent permanency for cost recovery purposes under § 168 is not the same as for other code sections that use the “inherently permanent” concept. This includes the Uniform Capitalization (UNICAP) rules of § 263A (discussed in Chapter 6.A. of this ATG) and the Domestic Production Deduction (DPD) rules of § 199. The “inherently permanent” rules for each of these other code sections are markedly different from those for cost recovery. Care should be taken when evaluating a cost segregation study that the correct “inherently permanent” rules are applied. To assist the examiner to recognize the differences between each code section, a brief summary of these provisions is presented below.

(1) The primary issue in cost segregation studies is the proper classification of

assets as either § 1245 or § 1250 property. The definitions of property for purposes of §§ 1245 and 1250 are essential for determining eligibility for a number of other IRC provisions (including §§ 167, 168, 179, and former § 48). Treas. Reg. § 1.1245-3 defines "tangible personal property," "other tangible property," "building," and "structural component" by reference to Treas. Reg. § 1.48-1. This regulation relates to former § 48 which was enacted in 1962 along with §§ 1245 and 1250. Former § 48 allowed an investment tax credit (ITC) based on the "applicable percentage" of the investment in eligible property placed in service during the taxable year. Eligible property included tangible personal property (other than heating or air conditioning units) and other tangible property (primarily machinery and equipment used in specific business activities) that was closely integrated into the taxpayer's trade or business. Land, buildings, structural components contained in or attached to buildings, and other inherently permanent structures generally were not eligible for ITC.

(2) Treas. Reg. § 1.48-1(c) defines “tangible personal property” as any tangible

property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures). Thus, buildings, swimming pools, paved parking areas, wharves and docks, bridges, and fences are not tangible

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personal property. Tangible personal property includes all property (other than structural components) which is contained in or attached to a building. Thus, such property as production machinery, printing presses, transportation and office equipment, refrigerators, grocery counters, testing equipment, display racks and shelves, and neon and other signs, which is contained in or attached to a building constitutes tangible personal property for purposes of the ITC. Further, all property that is in the nature of machinery (other than structural components of the building or other inherently permanent structure) is considered tangible personal property even though located outside a building. Thus, for example, a gasoline pump, hydraulic car lift or automatic vending machine, although annexed to the ground, is considered tangible personal property.

(3) Treas. Reg. § 1.48-1(c) also provides that local law is not controlling for

purposes of determining whether property is or is not “tangible” or “personal.” Thus, the fact that under local law property is held to be personal property or tangible property is not controlling. Conversely, property may be personal property for purposes of the ITC even though under local law the property is considered to be a fixture and therefore real property.

(4) Treas. Reg. § 1.48-1(d) provides that in addition to tangible personal property,

any other tangible property (but not including a building and its structural components) used as an integral part of manufacturing, production, or extraction, or as an integral part of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services by a person engaged in a trade or business of furnishing any such service, or which constitutes a research or storage facility used in connection with any of the foregoing activities, may qualify for the ITC. This regulation essentially provides that inherently permanent structures (but not a building and its structural components) used in certain business activities will be deemed eligible for the ITC.

(5) Treas. Reg. § 1.48-1(e)(1) defines a “building” as any structure or edifice

enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. The term includes, for example, structures such as apartment houses, factory and office buildings, warehouses, barns, garages, railway or bus stations, and stores. Such term includes any such structure constructed by, or for, a lessee even if such structure must be removed, or ownership of such structure reverts to the lessor, at the termination of the lease.

(6) Specifically excluded from the definition of the term “building” are: (i) a structure

that is essentially an item of machinery or equipment, or (ii) a structure that houses property used as an integral part of an activity specified in former § 48(a)(1)(B)(i) if the use of the structure is so closely related to the use of such property that the structure clearly can be expected to be replaced when the property it initially houses is replaced. Factors which indicate that a structure is closely related to the use of the property it houses include the fact that the

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structure is specifically designated to provide for the stress and other demands of such property and the fact that the structure could not be economically used for other purposes. Thus, the term “building” does not include such structures as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns, and coal tipples.

(7) Treas. Reg. § 1.48-1(e)(2) provides that "structural components" includes such

parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.

(8) In Revenue Ruling 75-178, 1975-1 C.B. 9, the Service stated, “the problem of

classification of property as ‘personal’ or ‘inherently permanent’ should be made on the basis of the manner of attachment to the land or the structure and how permanently the property is designed to remain in place.” Thus, the test to be used to determine whether an asset is tangible personal property is the inherently permanent test.

(9) The seminal case involving the determination of whether an asset is inherently

permanent for purposes of § 168 and former § 48 is Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975). The Tax Court noted that “tangible personal property” is not intended to be defined narrowly nor to follow the rules of State law where fixation to the land is a basis for distinguishing personal property from other property. Based on an analysis of prior case law, the Tax Court put forth six questions designed to ascertain whether a particular asset qualifies as tangible personal property. These questions, also referred to as the "Whiteco factors," are:

• Is the property capable of being moved, and has it in fact been moved?

• Is the property designed or constructed to remain permanently in place?

• Are there circumstances which tend to show the expected or intended length of affixation, i.e., are there circumstances which show that the property may or will have to be moved?

• How substantial a job is removal of the property and how time-consuming is it? Is it “readily removable”?

• How much damage will the property sustain upon its removal?

• What is the manner of affixation of the property to the land?

(10) Movability itself is not determinative in measuring permanence. The Whiteco

court held that affixation to land does not per se exclude the property from the category of tangible personal property. Inversely, in L.L. Bean, Inc. v. Commissioner, T.C. Memo. 1997-175, aff'd, 145 F.3d 53 (1st Cir. 1998), the

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court held that the mere fact that a structure is theoretically capable of being moved does not conclusively establish that it is not inherently permanent.

(11) Examiners should also consider the following additional factors when

addressing permanency (some of which may overlap with the Whiteco factors):

• The history of the item or similar items being moved;

• The manner in which an item is attached to a building or to the land;

• The weight and size of the item;

• The function and design of the item;

• The intent of the taxpayer in installing the item;

• The time, cost, manpower, and equipment required to move the

components;

• The time, cost, manpower, and equipment required to reconfigure the

existing space if the item is removed;

• The effect of the item’s removal on the building; and

• The extent the item can be reused after removal.

(12) See AmeriSouth XXXII, Ltd. V. Commissioner, T.C. Memo. 2012-67; Trentadue

v. Commissioner, 128 T.C. 91 (2007); PDV America, Inc. and Subs. v. Commissioner, T.C. Memo. 2004-118; Hospital Corp. of America and Subs. v. Commissioner, 109 T.C. 21 (1997).

(13) Further detail and updates can be obtained from the Depreciable and Capital

Expenditures Practice Network.

(1) The uniform capitalization (UNICAP) rules require the capitalization of all direct

costs and certain indirect costs properly allocable to real property and tangible personal property produced by the taxpayer. Included in this is the capitalization of interest expense when the taxpayer produces certain property. See § 263A(f) and Treas. Reg. § 1.263A-8. For tax years beginning after December 31, 2017, small business taxpayers (previously defined in Chapter 6.A.2.) are not required to capitalize costs including interest under § 263A.

(2) Producers must capitalize costs (other than interest) whether incurred before,

during, or after the production period of property. Pre-production costs are subject to capitalization if the property is held for future production or if it is reasonably likely that the property will be produced at a future date. Thus, costs of storing raw materials and carrying costs of realty held for development are required to be capitalized. Production period costs are costs incurred beginning on the date on which production of the property begins and ending on the date on which the property is ready to be placed in service or is ready to be held for sale. Post-production costs are costs incurred after the actual production and may include costs of storage, warehousing, insurance, materials, and handling.

(3) In contrast, interest is only capitalized during the production period of property.

Treas. Reg. §§ 1.263A-8 through 1.263A-15 provide guidance with respect to

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the capitalization of interest under § 263A(f). These regulations are effective for 1995 and after, or at taxpayer's election, 1994. For years prior to the effective date of these regulations, see Notice 88-99, 1988-2 C.B. 422, as well as the prior temporary regulations, which provide guidance with respect to the capitalization of interest.

(4) For purposes of UNICAP, interest is capitalized with respect to each unit of

designated property. Designated property is defined in § 263A(f)(1) and Treas. Reg. § 1.263A-8(b)(1). Designated property is any property that is produced that constitutes: i) real property; or ii) tangible personal property which meets any of the following criteria: A) property with a class life of 20 years or more that is not inventory in the hands of the taxpayer or a related person; B) property with an estimated production period exceeding 2 years; or C) property with an estimated production period exceeding 1 year and an estimated cost of production exceeding $1,000,000. Note that all real property is subject to the rules of § 263A(f); the listed criteria only apply to tangible personal property. The criteria are applied individually to each unit of property.

(5) Treas. Reg. § 1.263A-8(c)(1) defines real property. Real property includes land,

un-severed natural products of land, buildings, and inherently permanent structures. Any interest in real property, including fee ownership, co-ownership, a leasehold, an option, or a similar interest is real property. Real property includes the structural components of both buildings and inherently permanent structures, such as walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property. Tenant improvements to a building that are inherently permanent are real property.

(6) Treas. Reg. § 1.263A-8(c)(3) provides that inherently permanent structures

include property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Examples include swimming pools, roads, bridges, tunnels, paved parking areas and other pavements, special foundations, wharves and docks, fences, inherently permanent advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and signals, telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment, grain storage bins and silos. For purposes of this section, affixation to real property may be accomplished by weight alone.

(7) Treas. Reg. § 1.263A-8(c)(3) further provides that property may constitute an

inherently permanent structure even though it is not classified as a building for purposes of Treas. Reg. § 1.48-1(e). Additionally, any property that constitutes “other tangible property” under the principles of Treas. Reg. § 1.48-1(d) is treated as an inherently permanent structure.

(8) Treas. Reg. § 1.263A-8(c)(4) provides that a structure that is property in the

nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property. In the case,

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however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. A structure may be an inherently permanent structure, and not property in the nature of machinery or essentially an item of machinery, even if the structure is necessary to operate or use, supports, or is otherwise associated with, machinery. The purpose of this regulation is to prevent the definition of “property in the nature of machinery” from including inherently permanent structures that support or are otherwise necessary to the operation of that machinery such as ski lift towers and offshore oil platforms.

(9) Treas. Reg. § 1.263A-10(b) provides that real property includes any

components of real property owned by the taxpayer that are functionally interdependent. Components of real property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component by the taxpayer or a related person.

(1) The principles and tests used to determine whether an item of property is

tangible personal property under Treas. Reg. § 1.48-1(c) (and thus to determine whether the item qualifies as § 1245 property) do not apply in determining whether such item of property is tangible personal property or real property for purposes of § 263A(f). Chief Counsel Advice (CCA) 200648026. Accordingly, property classified as depreciable tangible personal property for purposes of § 168 can be either real property or tangible personal property for purposes of the “avoided cost” interest capitalization calculation under § 263A(f). A determination of whether interest is capitalized with respect to a unit of designated property is made under the principles of § 263A(f) and the regulations thereunder and is not controlled by the characterization of property for purposes of § 168.

(2) Similarly, the classification of the property for purposes of § 263A(f) does not

control its classification for purposes of cost recovery under § 168. Id. Interest capitalized under § 263A(f) is treated as a cost of the designated property produced; cost recovery is determined by the applicable IRC and regulatory provisions relating to the use, sale, or disposition of property.

(3) There are five primary aspects to how the definition of inherently permanent

differs between §§ 168 and 263A.

(4) First, whereas Treas. Reg. § 1.48-1(c) contains the principle that the

classification of property under local law is irrelevant to the classification of property for purposes of the ITC (and § 1245 property), the local law characterization of an item of property can be a relevant consideration in the classification of property as either tangible personal property or real property for purposes of § 263A(f). CCA 200648026.

(5) Second, whereas the legislative intent regarding the ITC favors a broad

construction of “tangible personal property,” the legislative history of § 263A(f)

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contains nothing to indicate that Congress intended the broad construction of tangible personal property under the ITC to apply to interest capitalization under § 263A(f). CCA 201211011.

(6) Third, an item of property that does not qualify as a structural component under

the ITC scheme because it does not relate to the operation or maintenance of a building, may constitute a structural component of the building (and thus real property) for purposes of § 263A since there is no requirement under Treas. Reg. § 1.263A-8(c) that the item of property relate to the operation and maintenance of a building. The property, however, still must otherwise possess sufficient indicia of being a structural component to be classified as such. CCA 200648026.

(7) Fourth, although the definition of inherently permanent structures in Treas.

Reg. § 1.263A-8(c)(3) references “other tangible property” under Treas. Reg. § 1.48-1(d) as a type of inherently permanent structure, an item of property may be an inherently permanent structure for purposes of UNICAP even though it would not have been an inherently permanent structure (and thus not “other tangible property”) for purposes of the ITC. CCA 201211011.

(8) Fifth, the specific nature of the limitations on the machinery exclusion in Treas.

Reg. § 1.263A-8(c)(4) (as well as language in the preamble to the regulation) indicates that the provision was intended to reject a specific line of ITC cases and rulings that greatly expanded the definition of what constitutes property in the nature of machinery under Treas. Reg. § 1.48-1(c). Thus, inherently permanent structures that support or are otherwise necessary to the operation of that machinery are inherently permanent for purposes of UNICAP. CCA 201211011.

(9) Within the context of a cost segregation study, sometimes building systems

such as electrical distribution and plumbing systems are deemed to be “dual purpose” for cost recovery purposes. Thus, for purposes of § 168, the portion of the cost of the building system corresponding to the percentage allocable to equipment constitutes tangible personal property (§ 1245 property) whereas the portion corresponding to building operation and maintenance constitutes structural components (§ 1250 property). As stated above, however, the fact that costs are characterized as tangible personal property for purposes of § 168 is not sufficient in itself to establish that these costs do not constitute real property for purposes of capitalizing interest under § 263A(f). Building systems are functionally interdependent with the building in which they are installed such that a building and its building systems are part of the same unit of real property for purposes of Treas. Reg. § 1.263A-10. Splitting a building system into two units of property for purposes of § 263A(f) would be contrary to the functional interdependence test underlying the concept of unit of property in the avoided cost regulations. Moreover, no provision is made for real property components and tangible personal property components combining into a single property unit; a unit of property under Treas. Reg. § 1.263A-10 must either be a real property unit (consisting entirely of real property components) or a tangible personal property unit (consisting entirely of tangible personal property

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components). Accordingly, allocating the cost of a building system such as an electrical distribution or plumbing system between real property and tangible personal property is inconsistent with § 263A(f).

(10) Further detail and updates can be obtained from the Inventory and § 263A PN.

(1) The Domestic Production Deduction (DPD) was enacted effective for taxable

years beginning after December 31, 2004, and was intended to motivate domestic economic growth. The DPD was repealed by the Tax Cuts and Jobs Act – P.L. 115-97 (as amended by the Consolidated Appropriations Act, 2018, Public Law 115-141, § 101(c), 132 Stat. 348, 1151, 1156) for taxable years beginning after December 31, 2017. The DPD is determined by applying a percentage to the lesser of a taxpayer’s qualified production activities income (QPAI) or taxable income. The applicable percentage is 3 percent for taxable years 2005 and 2006, 6 percent for taxable years 2007 through 2009, and 9 percent for taxable years beginning after 2009. § 199(a).

(2) QPAI is determined by taking domestic production gross receipts (DPGR) less

cost of goods sold (COGS) and other expenses allocable to such DPGR. DPGR includes gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. § 199(c)(4)(A)(i)(l). QPP means tangible personal property, computer software and sound recordings. § 199(c)(5). DPGR also includes gross receipts from the construction of real property in the United States by a taxpayer in the normal course of a construction trade or business. § 199(c)(4)(A)(ii). DPGR also includes gross receipts from engineering or architectural services performed in the United States with respect to the construction of real property. § 199(c)(4)(A)(iii) and Treas. Reg. § 1.199-3(n). Treas. Reg. § 1.199-3(j)(2) defines tangible personal property as any tangible property other than land, real property described in Treas. Reg. § 1.199-3(m)(3), and property described in other sections of the regulation (computer software, sound recordings, qualified films, electricity, natural gas, and potable water). Property such as machinery, printing presses, transportation and office equipment, refrigerators, grocery counters, testing equipment, display racks and shelves, and neon and other signs that are contained in or attached to a building constitutes tangible personal property for purposes of § 199. In determining whether property is tangible personal property, local law is not controlling.

(3) Treas. Reg. § 1.199-3(m)(3) defines real property as buildings (including items

that are structural components of such buildings), inherently permanent structures (as defined in Treas. Reg. § 1.263A-8(c)(3)) other than machinery (as defined in Treas. Reg. § 1.263A-8(c)(4)) (including items that are structural components of such inherently permanent structures), inherently permanent land improvements, oil and gas wells, and infrastructure. Treas. Reg. § 1.1993(m)(4) defines the term infrastructure to include roads, power lines, water

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systems, railroad spurs, communications facilities, sewers, sidewalks, cable, wiring, and inherently permanent oil and gas platforms. For purposes of § 199, structural components of building and inherently permanent structures include property such as walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property. Treas. Reg. § 1.199-3(m)(3).

(4) Accordingly, the definition of an inherently permanent structure is the same for

§ 199 as it is for § 263A(f). In other words, the same rules that determine what constitutes an inherently permanent structure for UNICAP purposes described above also apply to determine whether property qualifies as QPP. The result of using these rules is that if property is determined to be an inherently permanent structure under Treas. Reg. § 1.263A-8(c)(3), it is real property for purposes of § 199 and Treas. Reg. § 1.199-3(m)(3), is not QPP, and the gross receipts and allocable expenses derived from the property can only be used to determine DPGR and QPAI if the taxpayer meets the rules in Treas. Reg. § 1.199-3(m)(6) related to deriving gross receipts from the construction of real property performed in the United States, or the rules in Treas. Reg. § 1.199-3(n) related to engineering or architectural services. Note that, per Treas. Reg. § 1.1993(m)(6)(iii), DPGR derived from the construction of real property performed in the United States does not include gross receipts derived from the sale, exchange, or other disposition of real property acquired by the taxpayer even if the taxpayer originally constructed the property. In addition, DPGR derived from the construction of real property does not include gross receipts from the lease or rental of real property constructed by the taxpayer.

(1) In CCA 201302017, the Service considered whether a variety of outdoor

advertising displays constituted inherently permanent structures and were therefore real property when determining QPP for purposes of § 199. It noted that the definition of an inherently permanent structure in Treas. Reg. § 1.263A8(c)(3) establishes two basic criteria for an inherently permanent structure: first, it is affixed to real property; second, it will ordinarily remain affixed for an indefinite period of time.

(2) The term “affixed to real property” under Treas. Reg. § 1.263A-8(c)(3) is

understood pursuant to its ordinary and common-sense meaning, that is, physically connected or attached. Affixation to real property may be accomplished by weight alone. Embedding a structure in the ground can establish attachment to real property. Mounting a structure to a foundation also can accomplish adequate connection to real property. Similarly, affixation may be achieved when the means of connection secure a structure to real property to withstand severe weather conditions. If installation of the structure involves the use of construction machinery and equipment, attachment to real property may be indicated.

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(3) The term “ordinarily remain affixed for an indefinite period of time” under Treas.

Reg. § 1.263A-8(c)(3) means that the structure will typically remain affixed to real property for the period during which the structure is expected to remain in operating condition and serve a useful function, in other words, the useful life inherent in the structure. In general, the structure is attached without any fixed plan to remove it at a particular date in the future, and the exact date when the structure will be removed is neither known nor knowable when it is affixed. Additionally, the possibility or occurrence of temporary or permanent removal from real property (such as from hurricane force winds) does not transform the intrinsically permanent nature of a structure.

(4) Practices of an industry or taxpayer also may be instructive as to whether a

particular structure or type of structure is inherently permanent. Therefore, a definite lease term may be ignored if it is customary for the industry to renew the lease until the structure’s inherent useful life is exhausted or the structure is no longer profitable. Lastly, the amount of time and expense involved in affixing the structure to be able to function also should be considered.

(5) Unlike the Whiteco factors for determining whether an item of property is an

inherently permanent structure for cost recovery purposes, for purposes of § 199 it is irrelevant that the means of connection permit removal without damage to the structure. For example, a structure attached by weight alone is likely removable without damage. Similarly, a structure bolted to a cement foundation that is embedded in the ground is likely removable without damage but nevertheless is connected to real property. Note, however, that the manner of affixation should sufficiently secure the structure so that it will remain in place to be able to perform its intended function.

(6) In short, an item is an inherently permanent structure for purposes of § 199

“when it is attached to real property and will ordinarily remain connected to real property to be able to perform its intended function.” CCA 201302017.

(7) Further detail and updates concerning using the Inherently Permanent rules

within § 199 can be obtained from the Corporate Income and Losses PN.

(1) In determining whether a structure, or component of a structure, is inherently

permanent, one must consider the context and governing code section. The analysis used to determine whether an item is inherently permanent for cost recovery purposes under § 168 (or for ITC purposes under former § 48) is not the same as the analysis for UNICAP purposes under § 263A and DPD purposes under § 199. As a consequence, the “inherently permanent” rules for cost recovery are markedly different from those for the other code sections.

(2) For cost recovery purposes, the Whiteco factors were designed in light of

legislative history indicating that “tangible personal property” was intended to be broadly defined and that the rules of State law where fixation to the land is a basis for distinguishing personal property from other property were not to be followed. Thus, the standard for determining whether an item of property is

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inherently permanent for purposes of cost recovery is relatively narrow. In contrast, the standard for whether an item is inherently permanent for purposes of UNICAP and DPD follows its ordinary and common-sense meaning, namely that fixation to the land is sufficient provided the item of property will remain in operating condition and serve a useful function over the useful life inherent in the structure. Hence, the standard for determining whether an item of property is inherently permanent for purposes of UNICAP and DPD is broader than the standard for cost recovery. Care should be taken when evaluating a cost segregation study that the correct “inherently permanent” rules are applied.

(1) A cost segregation study is typically completed using information that was

developed for the construction process. This information includes drawings, specifications, and supplier and contractor payment documents. To better understand how a cost segregation study is conducted, it is helpful to understand this process. The following discussion provides a general overview of this process, from the conceptual stage through the bidding, construction, payment, and completion stage of a project. Although there may be certain facts and circumstances in specific geographic locales that vary from what is presented here, the basic construction concepts are similar in all locales. For purposes of this discussion, it is assumed that a fee contractor, rather than an in-house labor force, performs the construction. For additional information and a glossary of construction terms, refer to the LB&I Construction Industry or the Construction Industry Audit Techniques Guide.

(1) The Construction Process is composed of six distinct stages; each of these

stages is discussed below in more detail.

• Stage 1: Concept

o All construction projects begin with planning and design, also referred

to as "architectural programming." Numerous overlapping steps occur during this conceptual or design phase, prior to actual construction of the project.

o An architect is the primary designer of a building or project and

controls the overall design, specifications, finished materials (e.g., brick, paint, carpet, wall covering, etc.), and other architectural features of the building. In addition, the architect supervises the engineers responsible for the structural, mechanical, electrical, lighting, plumbing and communications system design of the building. Engineers must always conform to the design requirements of the architect. Each member of the design team must also be licensed with the proper state licensing authorities where the facility is located.

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o Planning & Architectural Programming

• During the initial stages of the design process, the architect(s) and

engineer(s) have a number of client meetings to determine the purpose and objective of the proposed construction. The primary activities, for which the project is being constructed, as well as the relationships between spaces, are reviewed. Consideration is also given to how well the completed project relates to adjacent buildings (if any) and its surroundings. The preliminary programming produces a list of solutions, alternatives, feasibility studies and costs estimates. After a review of the programming statement, schematic plans are prepared.

o Schematic Plans

• Schematic plans are the first plans of a facility and show the

interrelationship between spaces and activities. All of the parties (architects, engineers, and the client) review the schematic plans and make recommendations, as necessary. Any changes are then incorporated into the final schematic plans. Revised schematic plans are also known as "preliminary plans," and provide a graphic view of the project, the refined details of how the project will look, and the relationship of all spaces.

• Once the preliminary planning phase is complete, the project then

enters a stage involving the preparation of contract bid documents and working drawings.

• Stage 2: Contracts and Bid Documents

o The construction contractor(s) are normally selected through a

competitive bidding process but may also be selected via negotiation. To solicit construction bids, the builder must provide potential bidders with: a) Working drawings and plans for the proposed structure, as well as b) Project specifications. These are called the “construction documents” and offer a complete and detailed set of information to communicate all the required items within a building project.

o Stage 2a: Working Drawings

• Contract/Working Drawings/Plans

All projects, whether they involve new construction or the

expansion of an existing structure, require the preparation of contract documents. The contract working drawings and plans provide a pictorial representation of the construction work and specify or lay out the designer’s intentions for the facility. The drawings illustrate, among other things, the appearance, layout,

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equipment, and amenities of the project. These drawings show the architect’s plan/design for the building’s overall appearance, such as finish materials, floor plans, sizes, and use of each building area. In contrast, engineers design the building’s structural, mechanical, electrical, plumbing and communication systems. The architect also begins to gather project data to deal with

problems or situations that are expected to arise during the construction process, such as local zoning requirements, local infrastructure, traffic, environmental and population impact, acoustic, energy, lighting, and aesthetic considerations. Various consulting engineers may also be used to solve specific project problems. The following are examples of the numerous drawing plans that

may be involved in a construction project.

• Architectural Drawings

The architectural drawings (or “Plans”) indicate the layout of the

project, such as floor plans, elevations, sections, and details of the construction and architectural finishes. These plans are typically numbered sequentially with the prefix "A" for "architectural." The most common type of an architectural plan is an overhead view of the spaces on a specific floor. These plans also indicate the length, width and various heights of the structure and floor elevations. Plans may show notes of specific construction information and may contain details on a specific portion of work. Exterior elevations show the exterior and the exterior finishes

and are similar to photographs of the exterior. Architectural schedules on the plans indicate the door types, windows, hardware, plumbing, and light fixtures in each room. In preparing the plans, the architect utilizes graphic symbols,

instead of words, to indicate various facility conditions. These symbols indicate the various types of material, sizes, and room finishes to be used. Symbols may be shown on the plans themselves or in the legends of the plans. [A list of general symbols is shown in the Appendix of Plan Reading and Material Takeoff, by Wayne J. DelPico, published by R. S. Means Company.]

• Site Plans

A civil engineer is responsible for the proper drainage of a site,

as well as the design of land improvements, such as paving,

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curb and gutter design, retaining walls, and drainage culverts. Site plans prepared by the civil engineer indicate the existing and proposed grades of the land and the specific location of the facility on the land.

• Structural Plans

The structural plans are prepared by structural engineers and

show the structural design of a building. These plans incorporate foundation planning with considerations for rain, snow, wind, earthquakes, and other natural phenomena. Structural engineers design the facility for both “live” and “dead” loads of the building. Live loads consist of the people, furniture and other items that are not part of the building but are supported by the building. Dead load is simply the weight of the building or structure itself.

• Mechanical Plans

Mechanical plans are prepared by a mechanical engineer to

show the design of the various mechanical systems in the building. These systems must be designed to incorporate the proper air conditioning, heating, and ventilation equipment, as well as adequate plumbing, to meet the needs for all of the building’s designated activities. Like the structural engineer, the mechanical engineer must

design the mechanical building systems to meet building “loads.” For example, office work produces a certain level of heat load, whereas cooking in a commercial kitchen may produce greater heat loads. The energy use of the air conditioning, heating, pumps, and other building equipment are monitored by the mechanical engineer and are considered when specifying building equipment for an efficiently designed building system. Mechanical plans are numbered with the prefixes “P” for “plumbing” and “H” for “heating, ventilating and air conditioning.”

• Electrical Plans

An electrical engineer prepares electrical plans to show the

electrical distribution system for the efficient distribution of power in a building. The plan design includes the distribution of electrical power from the utility company and the distribution to power-specific equipment. Engineering design factors for the overall electrical “load” of a building must also be considered (e.g., proper sizing and arrangement of transformers, panel

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boards, circuits, wires, conduits and power to the various machines, equipment, and activities in the building). Electrical engineers may also handle the lighting design requirements of the building, as well as specialty areas such as a central security monitoring system, a computerized control system, and fire and smoke management systems. Electrical plans are numbered with the prefix “E” for “electrical.”

• Communications

There may be several other sets of plans that detail the layout of

special communications systems. For instance, the fire and security systems, network computers system, telephone and communications systems, media and entertainment systems could be shown on a separate set of plans. All of these plans could be included with the bid documents or be a separate contract all together. If there is a specific issue that arises during your examination of a cost segregation study that concerns one of these communications systems, be sure to ask for them in addition to the other sets of plans of your subject building.

• Stage 2b. Specifications and Other Written Construction Documents

o Contract Specifications

• The second part of the contracts and bid documents stage is the

preparation of project specifications, also known as “specs.” Specs instruct the contractor on how to build the project, and consist of contract documents, the technical specifications of the materials and the quality of the materials to be installed, and the workmanship for installation of the materials. Given the amount of information that is required to be included, specs have to be organized in a coherent manner. The most widely accepted system for arranging construction specifications is the “CSI MasterFormat.” The CSI format, developed by the Construction Specification Institute, requires four categories of information: bidding requirements, contract forms, contract conditions, and technical specifications.

o Bidding requirements

• Bidding requirements describe the conditions of the bid to the

owner, and encompass the Invitation to Bid, the Instructions to Bidders, the Information Available to Bidders, the Bid Forms and Attachments, and the Bid Security Forms. The type of contract

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between an owner and a contractor dictates the form of the bidding conditions.

o Contract Form

• Contract forms are divided into sections, including the Agreement,

the Performance and Payment Bonds, and the Certificates.

o Contract Conditions

• The contract conditions include the General Conditions and

Supplementary Conditions.

o Technical Specifications

• Technical specs are generally prepared for each specific project in

the CSI MasterFormat (see below) and these include hundreds, perhaps thousands of individual items that will be installed in a project. The CSI MasterFormat has been modified (through 2020) to include many more divisions included for electrical and communication systems to accommodate current trades and systems now included in most buildings.

o 2b(i). Construction Specifications Institute (CSI) MasterFormat

• The Construction Specifications Institute (CSI) is a national

organization dedicated to the standardization and improvement of construction specifications. The CSI MasterFormat is a master list of numbers and titles classified by construction work results to standardize and facilitate communication within the construction industry. The MasterFormat system is widely used in the construction industry by architects, engineers, estimators, and contractors to organize detailed construction cost information.

• The CSI Format (1995 and prior) consists of 16 “Divisions of the

Work,” which are:

Division 1 - General Requirements Division 2 - Site Work Division 3 - Concrete Division 4 - Masonry Division 5 - Metals Division 6 - Wood & Plastics Division 7 - Thermal & Moisture Division 8 - Doors & Windows Division 9 - Finishes Division 10 - Specialties Division 11 - Equipment

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Division 12 - Furnishings Division 13 - Special Construction Division 14 - Conveying Systems Division 15 - Mechanical Division 16 - Electrical

• Each CSI Division is further sub-divided into three additional parts

called General, Products, and Execution (Installation).

General - explains the scope or the limits of work for a particular

CSI Division and makes a correlation between the technical specifications and the general and supplementary conditions of the contract. The administrative portion for any trade (e.g., shop drawings) would also be found in this section. Products - lists the materials to be used, by name and model

number, and explains the quality of materials and the basis for any substitution. Execution - explains the method of material installation,

techniques to be used, and workmanship quality.

• In 2004, the MasterFormat expanded from 16 Divisions to 50

Divisions, reflecting innovations in the construction industry. The 16 Division CSI MasterFormat was modified to include many more divisions and provide greater detail for work results to accommodate current trades and systems now included in most buildings. An example of the modification from 2004 includes a division for communication systems separate from the electrical division. The new CSI MasterFormat numbers and titles are intentionally structured for anticipated growth and expansion in the future, and some are reserved for future expansion.

• The 2020 Divisions are:

PROCUREMENT AND CONTRACTING REQUIREMENTS

GROUP:

• Division 00 — Procurement and Contracting Requirements

SPECIFICATIONS GROUP

• General Requirements Subgroup

• Division 01 — General Requirements

• Facility Construction Subgroup

• Division 02 — Existing Conditions (natural conditions)

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• Division 03 — Concrete (footing)

• Division 04 — Masonry (concrete block/brick)

• Division 05 — Metals (beams)

• Division 06 — Wood, Plastics, and Composites (framing)

• Division 07 — Thermal and Moisture Protection (insulation water barrier)

• Division 08 — Openings (doorways)

• Division 09 — Finishes

• Division 10 — Specialties

• Division 11 — Equipment

• Division 12 — Furnishings

• Division 13 — Special Construction

• Division 14 — Conveying Equipment

• Division 15 to 19 — RESERVED FOR FUTURE EXPANSION

Services Subgroup:

• Division 20 — RESERVED FOR FUTURE EXPANSION

• Division 21 — Fire Suppression

• Division 22 — Plumbing

• Division 23 — Heating Ventilating and Air Conditioning

• Division 24 — RESERVED FOR FUTURE EXPANSION

• Division 25 — Integrated Automation

• Division 26 — Electrical

• Division 27 — Communications

• Division 28 — Electronic Safety and Security

• Division 29 — RESERVED FOR FUTURE EXPANSION

Site and Infrastructure Subgroup:

• Division 30 — RESERVED FOR FUTURE EXPANSION

• Division 31 — Earthwork

• Division 32 — Exterior Improvements

• Division 33 — Utilities

• Division 34 — Transportation

• Division 35 — Waterway and Marine

• Division 36 to 39 — RESERVED FOR FUTURE EXPANSION

Process Equipment Subgroup:

• Division 40 — Process Interconnections

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• Division 41 — Material Processing and Handling Equipment

• Division 42 — Process Heating, Cooling, and Drying

Equipment

• Division 43 — Process Gas and Liquid Handling, Purification

and Storage Equipment

• Division 44 — Pollution Control Equipment

• Division 45 — Industry-Specific Manufacturing Equipment

  • Division 46 — Water and Wastewater Equipment

  • Division 47 — RESERVED FOR FUTURE EXPANSION

  • Division 48 — Electrical Power Generation

  • Division 49 — RESERVED FOR FUTURE EXPANSION

As cost segregation professionals convert to this newer system,

the IRS will see more studies incorporating the 50 Divisions. No matter which system is used in the cost segregation study, remember that this is just one method of organizing the abundance of information (labor and materials) needed in a construction project. The examiner should always look at the underlying information to verify the accuracy of the cost segregation study.

o 2b(ii). AIA Construction Documents

o The American Institute of Architects (AIA) is a nationally recognized

professional organization of architects. AIA has developed standardized contract documents for building design and construction that are universally accepted in the building design and construction industry. These AIA Contract Documents are organized by the following series:

• A-Series – Owner/Contractor Agreements

• B-Series – Owner/Architect Agreements

• C-Series – Other Agreements

• D-Series – Miscellaneous Documents

• E-Series – Exhibits

• F-Series – Reserved

• G-Series – Contract Administration and Project Management

Forms

• AIA Document A201, General Conditions of the Contract for

Construction

o The general conditions establish the legal terms and conditions that

will govern the construction of the project and address everything involved in the project from minor items to critical items. The general conditions include a number of provisions that determine the respective rights and responsibilities of the owner and contractor. AIA

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Document A201 is a standardized document that provides the legal basis and description of the following contract items:

• General Provisions

• Owner

• Contractor

• Administration of the Contract

• Subcontractors

• Construction by the Owner or by separate Contractors

• Changes in the Work

• Time

• Payments and Completion

• Protection of Persons and Property

• Insurance and Bonds

• Uncovering and Correction of Work

• Miscellaneous Provisions

• Termination and Suspension of the Contract

o Document A201 provides legal definitions of the elements in the

construction process, the items that will be provided by the contractor, and details how to prepare material submittals, shop drawings, and progress payment requests.

• Stage 3: Bidding

o The third stage of the construction process is bidding. Once an owner

determines that a project is feasible and that construction financing is available, the owner will solicit bids or proposals from general contractors and/or specialty contractors. Owners generally use trade publications and newspapers to invite contractors to bid on a construction job. A copy of “The Notice to Contractors” will be shown in the project’s specifications, providing contractors with the bidding procedures.

o The following is the sequence of events to prepare a contract bid:

• The contractor obtains a copy of the plans and specifications from

the owner to prepare a formal estimate of the construction cost or bid (experienced construction personnel prepare the bids).

• The contractor reviews the contract plans and specifications to

determine how to build the project and to consider all the limitations or conditions the owner requires for the project.

• The contractor solicits bids from subcontractors, estimates their

direct material and labor costs, and evaluates the ultimate profit potential of the contract. The amount of the bid covers the estimated costs and a profit for the construction project.

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• The owner evaluates all of the submitted bids and then awards the

contract.

• The contract document and specs contain the project start and

completion dates, the progress billing procedures, the insurance requirements, and other pertinent information.

o The preparation of a bid is the first step in the cost control system of a

construction project. The agreed-upon bid price then becomes the budget by which the actual expenditures are measured and drawn against. The object of a cost control system is to provide the general contractor and/or owner with information regarding actual project costs versus the anticipated or budgeted costs. These cost comparisons become essential for internal control purposes.

o Standard cost manuals, such as the "R.S. Means Building Construction

Cost Data," are used by a general contractor to compute a bid. These guides contain a compilation of cost data for each phase of construction. There are also construction cost data guides for both union and non-union wage rates. If the IRS examiner needs to estimate construction costs as part of the analysis of a study, it is important to use the proper wage rates.

o Subcontractors bid jobs in much the same way that a general

contractor does. A subcontractor may also solicit bids from subsubcontractors for specialty construction.

o Working drawings and specifications provide information to allow

general contractors to estimate the project’s construction costs. Along with using their own estimators, a contractor usually has the subcontractor’s and the material supplier’s information readily available. If necessary, a general contractor can perform the preliminary details and/or shop to estimate the proper costs to construct various parts of a building. The general contractor gathers all the information from his estimators and subcontractors and then adds in an amount for overhead and profit. This final cost estimate is used in the competitive bidding for the construction of a project.

o The cost estimate of a building or project is broken down and

organized by the construction divisions shown in the specifications. The cost estimate is further detailed by trade and by item. The general contractor may also have a bank of information to estimate labor and material costs. Otherwise, the contractor will rely on any of several cost estimating manuals (e.g., R. S. Means Building Construction Cost Data (highly detailed), Marshall Valuation Services, etc.).

o While bidding is the most common method used to select a general

contractor, negotiation may also be used, especially in a situation where an owner has worked with a contractor in the past and a relationship of trust has been established. In a negotiated situation, the

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profit of the contractor is often a percentage of the total construction cost, and this percentage is agreed to with the owner.

• Stage 4: Construction (Field Work)

o The fourth stage of the construction process, called fieldwork, is the

actual construction of the project. Fieldwork is broken down into building permits, subcontractors, scheduling subcontractors, shop drawings, project submissions, and change orders.

• Building Permits

Before construction can begin, the appropriate municipality must

issue a building permit. Specifications and blueprints must be provided to the municipality's building department, along with the application for a permit. The period of time for a permit to be approved can be lengthy, especially in the case of new construction. The general contractor or owner may also be required to submit results of soil testing, environmental impact studies, and any other necessary testing or studies. Sometimes, a public hearing is mandated if there is opposition to the project. In most cases, a permit is issued within a few months. The cost of the permit and any related studies may be the responsibility of either the owner or the general contractor. Construction projects must also follow the standards of the

applicable building code. A building inspector will be involved at various construction stages to verify that the project is being constructed according to municipal code.

• Subcontractors

Subcontractors range from a one-person operation to

nationwide, publicly traded corporations, or divisions of larger corporations. Subcontractors are distinguished from general contractors by their limited scope of work, which usually involves specialized skills, knowledge, or ability. Subcontractors, which include plumbers, electricians, framers, and concrete workers, generally enter into contracts with the general contractor and may provide the raw materials used in their specialty areas. The general contractor, not the owner of the property, pays the subcontractors. Materials purchased by the subcontractors are generally delivered directly to the job site. The subcontractors’ work may either be completed in stages or continuously.

• Scheduling of Subcontractors

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The general contractor schedules the subcontractor's work so

that the construction runs smoothly and is completed on schedule. The general contractor is also responsible for scheduling the subcontractor in such a way that one subcontractor does not hold up another. This order on subcontractor sequencing is known as the "critical path." The following is an example of the sequence in scheduling

subcontractors for a small project: Clear the land (which may include demolition of existing

structures)

• Excavate the land (which may include digging holes and

leveling)

• Pour the foundation

• Frame steel and/or concrete

• Rough framing

• Rough electrical

• Concrete flooring

• Roofing

• Heating and air conditioning

• Ductwork for heating and air conditioning

• Elevators and/or escalators

• Sprinklers and other safety equipment

• Install electrical fixtures

• Insulate and weather strip

• Frame windows and door sashes

• Install tile and marble

• Install suspended acoustical ceilings

• Install toilets, sinks and other plumbing fixtures

• Paint walls (inside and out)

• Shop Drawings

Working drawings only include enough detail to show the

general contractor the overall layout of the building. The individual specialty trades and suppliers use working drawings to produce shop drawings for items such as granite finishing, cabinets and countertops, structural steel, etc. Shop drawings detail the specific building components and are usually produced after the final design phase but before the beginning of the construction phase. Drawings are prepared in accordance with the instructions on Document A201. The architect/engineer will also check each shop drawing for precise measurements and for compliance with the intended building design.

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• Project Submissions

Project submissions are an important part of the construction

process. Each installed building item must receive the architect’s approval to ensure that the item or product is in conformance with technical specifications. Project submissions illustrate each item's intended use, function, method of attachment or installation requirements, and placed-in-service date. When the project starts, the architect and /or engineer monitors the contractor’s progress and often approves the progress payments made to the contractors. The architect/engineer may also make modifications to the building plans as needed.

• Change Orders

Change orders are the written contract revisions that increase or

decrease the total contract price. Change order documents contain the change order number, change order date, a description of the change, and the amount of the change order. Contractors, based on the terms of the contract, may also issue orders.

• Stage 5: Construction Payments

o The fifth stage of the construction process is the construction

payments stage. When a contractor completes a prescribed amount of work, the owner pays the contractor for the completed work, and records the payments on their books (CIP or WIP accounts).

o Specifications for Payment

• The following AIA Documents are normally used in the contractor

progress payment process:

AIA Form G701 – Change Order AIA Form G702 – Application and Certificate for Payment AIA Form G703 – Continuation Sheet

• The specifications for contract payments are shown in Document

A201, under the “General Conditions for Construction Contracts,” and contain AIA Forms G701 (utilized for change orders) and G702. Form G702 requires that the contractor break down the bid into various parts of work. The project designer (architect or engineer) critically reviews Form G702 schedule of values prepared by the contractor and either accepts or rejects them. The close scrutiny of this form is due to the future release of funds that will be used to pay for the progress (and ultimately the completion)

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of construction. This Form also provides the first basis for the construction cost control on a project. The architect and/or engineer have a legal and fiduciary responsibility for the accuracy of the cost allocations. The architect and the owner also want an adequate and timely distribution of funds to ensure smooth progress payments and to ensure that there will be the necessary funds to pay for the completion of the last portion of the project.

• It is also to the contractor’s benefit that items of construction be

broken into as many parts as possible. The more individual items of work the contractor can identify and complete, the more items of work will be entitled for billing and request of payment. Typical schedules of values on Form G702 may be 15 to 20 pages long and may contain hundreds, if not thousands, of individual cost items.

• The contractor submits Form G702 to request payment on a

regular basis. The contractor completes Form G702 by listing the total construction cost for each item of work completed to date. The amount previously paid for the work and the amount accomplished in the current billing period are subtracted from the total amount to arrive at the amount of money remaining, minus a retainage for the completion of the work.

• It is extremely important for the IRS examiner to analyze the G702

and G703 documents. These documents are prepared by a third party (which provides an element of objectivity) and includes a detailed breakdown and analysis of the construction costs.

o Change Orders

• The architect/engineer may make modifications or change orders

to the construction plans as needed. Change orders should be reviewed for any agreed changes to the payment schedule.

o Unit Costs

• In some contracts, there is a schedule of unit costs or prices used

in the construction of the building. CSI MasterFormat Division 01 in the 16 Division format or Division 00 in the new 50 Division format typically provides for unit prices to be revealed in the bidding documents. The IRS examiner should verify that there is a schedule of Unit Prices in the contract documents and request a copy.

o Owner’s Records

• Most corporate taxpayers must keep records of their payments in a

subledger for construction-in-process (CIP) or work-in-process

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(WIP) type costs to comply with GAAP requirements. All payments made by a company are recorded on their general ledger (GL). The payment records are transferred and held to the appropriate subledger until the project is completed. When the building project is placed in service, the taxpayer moves or transfers the costs to their fixed asset or depreciation schedule and begins cost recovery for the project for both book and tax purposes. The IRS examiner should request all relevant costs in these accounts for the cost segregation project under examination.

• Stage 6: Completion

o The final phase of the construction process is known as the completion

stage, and it readies the building for occupancy.

• Record Drawings (previously called As-Built’s)

After a facility or project is completed, the architect and

contractor prepare a set of plans known as record drawings. These drawings represent exactly how the facility was constructed and they also incorporate all the changes to the original construction drawings. It is very important that the IRS examiner reviews these record drawings; these drawings represent the actual construction of the project.

• Notice of Partial Completion

In some instances, the owner may desire to occupy a portion of

the completed building. In that case, local building officials conduct an inspection to determine if that portion of the facility meets all building codes and is safe to be occupied. If approval is granted, a "Certificate/Notice of Partial Occupancy" is issued.

• Notice of Substantial Completion

Local building officials issue this notice when 95 % of the

construction is complete. Another document, AIA G704 Certificate of Substantial Completion is signed by the architect and allows the building owner to occupy/utilize the completed portion.

• Notice of Completion/Certificate of Occupancy

A "Notice of Completion" is requested by the contractor/owner

when the building is 100% complete. The project must pass a final inspection by local building officials for the "Notice of Completion" and the "Certificate of Occupancy" to be issued.

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These documents are recorded at the office of the local recorder and the property will be then appraised for property tax purposes.

• Taxpayer Places the Asset in Service – Begins Depreciation

The costs for the project are recorded in the taxpayer’s CIP or

WIP subledger and held in this suspense account until the costs can be recovered. Once the project is placed in service, depreciation can begin. For the taxpayer’s recordation of the project, in their books and records, depreciation begins when the costs in the CIP are transferred into a fixed asset account or to a depreciation schedule (See CCA 20140202F). The IRS examiner should request these records from the taxpayer.