What the New Audit Technique Guidelines Mean for Cost Segregation

RON WAINWRIGHT: Welcome to the Cherry Bekaert Tax Credits and Incentives Advisory Podcast. Today we'll be discussing the new Audit Technique Guide for cost segregation.

RON WAINWRIGHT: My name is Ron Wainwright. I'm a tax partner in the Strategic Tax practice of Cherry Bekaert, specifically in the Tax Credits and Incentives Advisory practice. Joining me today is one of my colleagues, Sean O'Leary.

SEAN O'LEARY: Hi. My name is Sean O'Leary. I'm a senior tax manager in our Charlotte, North Carolina office in Cherry Bekaert's Tax Credits and Incentives Advisory group. I have worked with Ron for over eight years on cost segregation, energy, and other tax incentive projects. I also have a degree in electrical engineering from a prior career, which is useful in working on cost segregation and other energy projects.

RON WAINWRIGHT: For our audience, on June 1, 2022, the Internal Revenue Service published the latest edition of the Cost Segregation Audit Technique Guide, often referred to as the ATG. The Cost Segregation ATG assists IRS examiners during audits by providing an understanding of technical information, examination techniques, and what to look for when reviewing cost segregation reports.

RON WAINWRIGHT: The IRS put out the original technique guide in 2004. The document has undergone various revisions through the years, with the latest being in 2017 and most recently updated on June 1, 2022.

RON WAINWRIGHT: Sean, can you give us a little background regarding the ATG and how the IRS uses an Audit Technique Guide in examinations?

SEAN O'LEARY: The ATG is a document the IRS produces to provide a roadmap for conducting an audit on virtually any tax topic. It gives the agent conducting the exam a summary of tax authority and history related to that specific topic and an outline of how to conduct an exam.

SEAN O'LEARY: It also provides taxpayers with a framework to understand the IRS position on various technical issues within that topic and an idea of what to expect during an audit in terms of information requested and topics to be addressed.

SEAN O'LEARY: One thing to point out is that the ATG is not the same as tax law—statutes passed by Congress, Treasury regulations, or federal court cases have priority in the hierarchy of tax law and take precedence over an IRS publication such as the ATG.

SEAN O'LEARY: The ATG is the IRS's interpretation or focus within an audit and provides both the government and taxpayers a roadmap of what to expect during the audit. A taxpayer is not bound by any position implied or referenced in the ATG, but should be aware of it and understand that it can have significant impact on an audit.

SEAN O'LEARY: A little more background on the ATG as it relates to cost segregation: the IRS released the updated version in June 2022, the prior version dated to 2017. The changes in the new version focus heavily on substantial law changes over the past few years, including the Tax Cuts and Jobs Act and other legislation that have brought about significant changes in how real property is depreciated, which affects cost segregation studies and how they are conducted.

RON WAINWRIGHT: Now that we've covered the basics of what the ATG is, can you take a deep dive into some of the new topics covered in the recently released guideline?

SEAN O'LEARY: The ATG is designed to provide guidance for IRS employees and is not authoritative. Tax professionals have used this document to guide correct methods for conducting cost segregation studies properly.

SEAN O'LEARY: The ATG has been updated with respect to changes in accounting method, depreciation, bonus depreciation, Section 179 expensing, Section 179D deductions—the energy-efficient commercial buildings deduction—and Section 263A, the Uniform Capitalization Rules. It also addresses Qualified Improvement Property, or QIP.

SEAN O'LEARY: There was an error in the Tax Cuts and Jobs Act of 2017 regarding QIP classification and class life, and the ATG reflects updates aligning IRS examining agents to the applicable law.

SEAN O'LEARY: The ATG also includes specifics around land and building depreciation basis allocations. Notably, there is a new Chapter 8 that provides specific guidance regarding electrical distribution systems.

RON WAINWRIGHT: In conclusion, comparing the prior version with the new version, there is a push to further educate regarding electrical distribution systems and how an electrical component should be classified as either a structural component or personal property.

RON WAINWRIGHT: We expect future audits to look at whether the amount of the electrical distribution system treated as personal property aligns with the correct electrical load analysis for the property. Listeners should look for engineering-based cost segregation providers who can correctly analyze not only overall methodology but, more specifically, the electrical loads of a property and each individual electrical component.

RON WAINWRIGHT: There is a lot of new guidance within the Audit Technique Guide. Sean, if a taxpayer is audited for cost segregation, what are some areas the IRS might focus on?

SEAN O'LEARY: If a taxpayer is audited, the single biggest consideration is the amount or percentage of the building reclassified into personal property and land improvements, and whether those amounts are reasonable.

SEAN O'LEARY: Excessively high reclassifications into five- or seven-year personal property or 15-year land improvements without a detailed breakdown based on actual costs are likely to raise red flags. The IRS and the cost segregation industry have years of data on cost segregation projects, and there are rule-of-thumb reclassification amounts to be expected for different building types.

SEAN O'LEARY: For example, five-year property in a newly constructed warehouse is much different than that of a medical office building. Taxpayers should be aware of these norms and be prepared to justify allocations that fall outside them.

SEAN O'LEARY: Another focus is the type of cost segregation study performed and the level and detail of record-keeping the taxpayer will need to provide. The ATG lists six different methods of doing a cost segregation study, but emphasizes that the detailed engineering approach is the most accurate. That is the approach we use for our projects at Cherry Bekaert.

SEAN O'LEARY: Other approaches can be used but may be scrutinized more heavily. Many practitioners use a rule-of-thumb study, applying average results of prior studies to a new property without a site visit or close examination of actual costs. The IRS generally views this approach as sketchy and inadequate.

SEAN O'LEARY: Taxpayers should evaluate the type of study their practitioner performs and be aware of audit risks. Record-keeping is critical: studies should be based on actual costs incurred, and taxpayers should retain contractor AIA documents and significant receipts or payments.

SEAN O'LEARY: The ATG also points out other areas to watch, including the amount of purchase price allocated to land. The IRS instructs that land should be valued on its "highest and best use," but taxpayers should use approaches that are justifiable and documentable.

SEAN O'LEARY: Land values vary significantly by location. Standardized land values applied nationwide can be problematic; land values in Miami, Washington, D.C., or Austin, Texas, are often much higher than in smaller, less urban areas.

SEAN O'LEARY: Other concerns include whether demolition costs of an older structure should be capitalized into land or into the building for new construction projects, and whether indirect costs during construction—such as contractor overhead or certain labor costs—should be capitalized under Section 263A.

RON WAINWRIGHT: From a procedural standpoint, what will the IRS expect from a taxpayer during an audit examination? What kind of information will be requested, how long does an audit take, and what happens if there is an adjustment?

SEAN O'LEARY: Cost segregation studies have become more popular for accelerating depreciation by reclassifying building components from Section 1250 property to Section 1245 property, which can result in shorter recovery periods.

SEAN O'LEARY: The IRS has updated the ATG because they expect more examinations. The ATG highlights the complexity of cost segregation issues: studies not only identify assets like molding and flooring but also evaluate building systems—electrical, plumbing—and reclassify portions of those components.

SEAN O'LEARY: Reclassifications often require complex determinations, such as electrical load or water pressure. The ATG states the study must identify, for example, that a specific percentage of a building's electrical distribution system directly supports Section 1245 property, such as specialized kitchen equipment. Based on that conclusion, the study then treats that portion of the electrical distribution system cost as Section 1245 property.

SEAN O'LEARY: Allocation of building components to Section 1245 property versus Section 1250 property is often contentious in examinations because taxpayers have a strong incentive to classify as much property as possible as Section 1245 property to take advantage of shorter class lives and bonus depreciation under Section 168(k).

SEAN O'LEARY: This contention was central in the landmark case Hospital Corporation of America versus the IRS, which forms part of the legal basis for how cost segregation studies are applied in tax law today.

SEAN O'LEARY: When taxpayers are contacted for an examination, they should have engaged a professional to complete the cost segregation—ideally Cherry Bekaert. A quality deliverable should use a detailed engineering approach based on actual cost records.

SEAN O'LEARY: The ATG notes the detailed engineering approach is generally the most methodical and accurate, but it is not always possible to obtain detailed construction cost information for older buildings. Taxpayers often seek cost segregation studies on buildings that are years or decades old.

SEAN O'LEARY: When records are not real time, examinations are likely to be more contentious. There is an engineering-based alternative called the detailed engineering cost estimate approach, used when detailed cost records are unavailable. While less reliable than using actual costs, the ATG notes that reasonable, accurate cost allocations are possible with this method.

SEAN O'LEARY: In an examination, several points can be contentious regarding whether the detailed engineering approach or the engineering cost estimate approach was used.

SEAN O'LEARY: The ATG lists elements of a quality cost segregation study aligned with what the IRS will scrutinize. First, the IRS will evaluate the firm or individual's expertise and experience in completing cost segregation studies. Preparation requires expertise in both construction and tax law, and a report should include the credentials of the team that prepared the study.

SEAN O'LEARY: Second, the IRS will evaluate the methodology used. The ATG describes various methods—engineering-based, statistical, and less precise approaches such as the individual residual method. A quality study should describe the methodology used.

SEAN O'LEARY: Third, appropriate documentation is required. Documentation depends on whether the property is new construction or an acquisition, but the ATG recommends using the best available documentation and conducting a site visit to support allocations.

SEAN O'LEARY: Fourth, interviews: a quality study should include interviews with the property owner, property manager, and contractors involved in the project.

SEAN O'LEARY: Fifth, use of common nomenclature: the ATG recommends using clear, commonly understood terms and a standard numbering system. Allocations in the study should remain consistent with construction documents—cut sheets and drawings—to create a nexus between documents and cost allocations.

SEAN O'LEARY: Sixth, a legal analysis: the ATG suggests that a legal analysis should support classifications made in the study based on property specifics.

SEAN O'LEARY: Seventh, determination of unit cost and engineering takeoffs: a quality study should thoroughly explain how a property class is broken down, consistent with blueprints, photographs, and other construction documentation.

SEAN O'LEARY: Eighth, organization of assets into lists or groups: a quality study should list assets by recovery period in a way that generally ties back to the taxpayer's fixed asset ledger.

SEAN O'LEARY: Ninth, reconciliation of total allocated cost to total actual cost: the ATG warns that estimating techniques should be used consistently throughout the study, and quality studies should avoid duplication by reviewing property already classified as Section 1245 property.

SEAN O'LEARY: Tenth, explanation of treatment of indirect costs: methods for allocating indirect or soft costs, such as permitting and contractor overhead, should be clearly explained in the report. This is a common audit focus.

SEAN O'LEARY: Eleventh, identification and listing of Section 1245 property: a quality study should list all Section 1245 property identified and show any Section 1250 property reclassified by the study.

SEAN O'LEARY: Twelfth, accounting method changes: a change in depreciation method is considered a change in accounting method by the IRS. A quality study will take this into account, and where applicable, a Form 3115 may be required to effect an automatic accounting method change and catch up depreciation.

SEAN O'LEARY: Thirteenth, consistency and avoidance of duplication in estimating and allocation methods across the study and in any supporting examination.

RON WAINWRIGHT: How long does a typical cost segregation examination take?

SEAN O'LEARY: Our experience is that an examination can take between 90 and 120 days because of the depth the IRS examining agent may pursue. However, we have had examinations conclude in less than two weeks when the taxpayer delivers a comprehensive cost-seg-plus deliverable that addresses ATG concerns and questions proactively.

RON WAINWRIGHT: Moving on to a broader concept: what is the impact of cost segregation on taxpayers, and what aspects might taxpayers be unaware of?

SEAN O'LEARY: One important item is the statute of limitations. Under Section 6501, the statute is generally three years for most taxpayers. However, cost segregation catch-up opportunities often allow taxpayers to go back five, ten, or even 15 years to capture missed depreciation without filing amended returns.

SEAN O'LEARY: This catch-up is often accomplished through Form 3115, an automatic accounting method change filed with the current tax return, which allows taxpayers to take cumulative depreciation adjustments in the current year.

SEAN O'LEARY: Many taxpayers know that accelerating depreciation reduces current-year tax liability. What is less understood is the lifetime benefit of a cost segregation study and the impact of compounding. By reclassifying portions of a building from longer-lived property to shorter-lived property, taxpayers accelerate deductions many years, producing significant lifetime tax savings.

SEAN O'LEARY: For example, a nonresidential building with a 39-year life or a residential rental property with a 27.5-year life can have portions reclassified to shorter lives, accelerating deductions and creating permanent lifetime tax savings when viewed on a present-value basis.

RON WAINWRIGHT: Sean, any final comments on the ATG discussion?

SEAN O'LEARY: We focused on the IRS ATG revised in June 2022, the nuances and technical aspects it covers, and what to be aware of if audited. We want to emphasize the powerful benefits of cost segregation.

SEAN O'LEARY: Nearly any dollars invested in real estate—construction of a new building, purchase of an older building, renovation or expansion—will typically generate significant tax benefits in the form of accelerated depreciation. That drives higher depreciation expense in earlier years and reduces tax liability, producing cash savings that can be reinvested.

SEAN O'LEARY: The bottom line is that taxpayers should look for opportunities to take advantage of tax benefits related to investments in real property and use cost segregation as a tool to drive those results.

RON WAINWRIGHT: I would add that we are often involved in 1031 exchanges, or like-kind exchanges. Cost segregation studies can be utilized in a like-kind exchange, and we will publish a thought leadership article and another podcast on that topic.

RON WAINWRIGHT: When considering cost segregation studies, consider both positive and potential negative impacts on a long-term basis. Positive impacts include present-value catch-up adjustments versus gain in a later year, focus on Section 1245 property, like-kind exchange benefits, increased bonus depreciation through componentization, potential influence on the taxpayer's alternative minimum tax position, and implications for allocations of gross receipts such as those relevant to Section 199A.

RON WAINWRIGHT: We hope this discussion on the Audit Technique Guide for cost segregation has been informative. Check out Cherry Bekaert's website, cbh.com, for the latest guidance and resources on federal and state credits and other tax and business topics.

RON WAINWRIGHT: This concludes today's podcast. Please like, share, and subscribe, and thank you for listening.