The majority of cost segregation providers are conducting studies using the “Residual” method. Yet, it is difficult to find a single cost segregation provider advertising that they provide “Residual” Cost Segregation Studies. Why do you think that is? Perhaps it is because the IRS states that Residual studies are, “simpler and less time consuming” and “can also be less accurate”. The IRS further states that the Residual method, “generally does not reconcile project costs” and “can produce a skewed in result in favor of s1245 property”. Once you truly understand what a Residual Study is, you start to get a sense of why providers are not advertising that they use this abbreviated method.
In fact, the majority of cost segregation firms claim to be providing some form of engineering studies when in reality they are providing Residual studies. How can they do this? We believe it has to do with the fact that many of these providers are actually providing an engineering/residual hybrid type of study. While they may use some engineering methods for the short life assets, they are still simply lumping the residual amount into one or several real property categories. Even though they may use some engineering methods, the residual nature of these studies still contain the weaknesses inherent in the residual method. In addition, they do not provide a complete reconciliation of project costs at the component level and they do not provide the detail necessary to retire structural components that are removed from service such as roof, hvac, doors, windows, etc.
How does a building owner support a $5M single line item described as Real Property? This is no joke. We recently had an opportunity to review a competitor’s study for a hotel. The cost segregation firm provided a breakdown of most of the short life components (several items were incorrectly classified as personal property by the way) and then lumped the remaining $5M into one line item to be depreciated over 39 years. How do you explain to the IRS that the allocations made to short life property are accurate when you can’t even identify what makes up the $5M balance? Worse yet, how do you retire assets within the $5M line item when they are replaced/removed from service? The answer to both questions is simply – you can’t.
If you previously purchased a residual study and subsequently removed structural components, you likely have ghost assets on the books (i.e., you are still depreciating the old assets that have been removed service). To make matters worse you are also depreciating the new asset. The good news is that the IRS issued temporary regs in December 2011, giving property owners a two year period to clean up their depreciation schedules and write off structural components previously disposed of. Unfortunately, the typical residual study does not contain the detail necessary to allow you to do this. Click here to learn how we can assist you.
Residual Cost Segregation Studies are a Disservice to CPA’s and Building Owners. Unfortunately, they can be somewhat difficult to identify. So how do you spot a residual provider/study? The easiest way to identify a residual provider is to ask to see a sample of their final deliverable. Check to see how many components are detailed for the Real Property category. Is there only one 39 year category? Maybe several? The better residual providers might provide a dozen or two.
It is up to you to identify the level of service you will be getting. The answer is in the details.