The landmark decision Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997) ("HCA"), was the legal support for property owners to use what is known as Cost Segregation. Prior to this historic ruling, the IRS treated every part of a commercial property as “real” property (section 1250) with 39-year life expectancy. Of course not every part of a building lasts 39 years. And this was precisely HCA’s claim in its challenge; namely that the then-current code was unfair and unrealistic. The Tax Court ruled against the IRS, requiring it to rewrite the code allowing some elements of every commercial building to be reclassified as “personal” property (section 1245) and be given far shorter life expectancies of 3, 5, 7, 10 and 15 years. Those “personal” components with shorter lives allow property owners to increase their tax deductions and their cash flows.

Eligible Entities to Perform Cost Segregation Studies

In 1999, the IRS issued Chief Counsel Advice (CCA) # 199921045, requiring that a valid cost segregation study had to be performed by a “contemporaneous and independent” building or construction engineering entity. It must conduct a physical inspection of the property, and record items to be reclassified as “personal” property. Engineers are required by law to evaluate the entire real estate property and the manner in which it was constructed and finished. Entities related to the building owner, such as the CPA, the real estate broker, the appraiser and financial advisor, are not considered “contemporaneous and independent” and therefore unqualified to perform this Study; violation of this requirement may subject taxpayer to IRS audits.

What is the Process?

Property owners are first provided a free Base Study showing the estimate of the benefits and the cost of the Study. Next engineers visit the property and work from building plans and cost documents. Engineers will use an IRS-required 140-point checklist to reclassify eligible building elements to “personal” property designation (section 1245) with short-term life expectancies of 3, 5, 7, 10 and 15 years. As required by the IRS, engineers will also take pictures of the reclassified items to be included in the Study. An average Study takes 4 to 6 weeks to complete.

Increased Cash Flow for Property Owners

Cost segregation provides property owners an accurate and substantially decreased tax basis and substantial tax benefits resulting in greater cash flow. Cost segregation can not only bolster the property’s financial bottom line, but also put spent tax dollars back into the property owner’s wallet.
For example, a property owner acquires a building for $5   million and spends an additional $500,000 for its rehab for a final cost of $5,500,000 (assuming the cost of the underlying land has been deducted). An engineering-based cost segregation study may enable the property owner to realize tax benefits of approximately $385,000 to $550,000.