DIY Cost Segregation Study Tips/Tools/Templates?

34 Replies

Greetings BP'ers...

As part of a 1031 exchange, I have purchased a handful of short term rental properties in the last few mos.  I have about 1 week left on my initial 45 day period to put properties under contract to avoid the tax implications from my sale of the commercial real estate.  There is a real  likelihood that I won't find another property that I feel is worth buying in the next week or so.

I am planning to perform a cost segregation study on the STR's I have purchased to take advantage of the bonus depreciation rules currently in effect to offset the tax consequences of leaving some $$ on the table coming out of my 1031 exchange. I could hire a firm to do this, but they run at around $5K on the low end. I don't think the complexity of what I need to analyze really requires that level of horse-power. I am looking to perform this myself.

Has anyone out there ever taken the DIY approach? Do you have any examples and spreadsheets you could share?

Thanks in advance!

Karen

There are a number of guidelines the IRS has for performing a proper cost segregation study (which will pass in the event of an audit) Here is the link to that list on the IRS website:

Cost Segregation Audit Technique Guide - Chapter 4 - Principal Elements of a Quality Cost Segregation Study and Report

I have never seen a DIY before, but I'm sure people do it.

Depending on the size and type of your property the fee for engaging a qualified engineer-based firm to conduct the study can be as low as $3,000 (lower in certain cases), and the significant benefit created well outweighs the minimal costs.

Thanks a million for sending me that guideline! Another reason I am looking to DIY this is for the learning experience as well. Knowledge is power. This seems like a fairly easy exercise in comparison to a large multi-unit property with land and lots of improvements. I have studio, 1, and 2 bedroom condos.

Couple things to consider - small SF houses and condos don't take a lot of time.  You could hire a cost-seg pro, have them look at several of your properties, you will get a professional opinion and you will gain some experience.  Then you will have a leg to stand on during audit.

You can do it yourself but the time involvement in reading the depreciation sections and understanding detailed construction costs will likely outweigh the benefit.  Unless you don't value your time at all.  Many CPAs do not do not provide this service at their practice so that may give you an indication on what it takes to do it correctly.  There are different levels of a cost seg study and there are residual methods to cut some corners but you will never come to a correct answer.  You will either take too much depreciation or leave too much on the table.

Last - if you determine the benefit isn't worth hiring an expert I would talk to your tax preparer about your properties and see what they have to say.  Hopefully with your potential 1031 you have gotten some tax advice on how to defer or plan for a gain...

Hi Folks!

Thanks for the guidance. It was initially my CPA that suggested I consider the DIY approach. I will definitely be contacting a pro to see if I would be better served by a professional analysis. 

Thanks so much for sharing your collective wisdom on this topic...

Karen

@Karen Chenaille There are definitely people out there who will try the DIY approach with cost seg. The thing is you need to cross your fingers and hope you don't get audited. If the IRS actually looks at a DIY cost seg they'll immediately throw it out without any further review. Thing is reviewing depreciation is about at the bottom of the IRS priorities, so improper cost seg generally flies under the radar. 

The IRS Chief Counsel released a memo stating that to perform cost segregation properly one must have knowledge of construction, construction techniques, design, auditing and estimation procedures. That means generally the only people truly qualified to do cost segregation are construction engineers or architects who have been trained in cost segregation and the pertinent tax code. That's why the first element in a quality study is preparation by an individual with expertise and experience. So a DIY method is not recommended unless you're actually qualified. 

On the surface cost seg can seem simple enough to DIY. Say you remodeled a rental condo and have all the invoices for the rehab. It makes sense that you'd just need to figure out what qualifies for 5, 7 or 15 year depreciation from the rehab, keep the rest of the property on a 27.5 year schedule, setup a depreciation schedule and call it a day right? The problem with that is two-fold: first there are likely existing assets that are not replaced that qualify for shorter asset lives so you're leaving money on the table, and second you have no cost basis for the removed assets replaced in the remodel as they're intertwined with the initial building cost basis so you'd technically still be depreciating retired assets which is tax fraud. 

It's also quite a bit more complicated than "this qualifies for 5 year and this doesn't qualify" since there isn't really a "list of every possible asset and it's depreciation life" most assets that qualify for 5 year fall under asset class 57.0 assets used in distributive trades and services. There are 6 tests called the WhiteCo factors (named after a tax court case on the subject) designed to figure out the permanence of individual assets to see if they qualify for short life treatment. You can even have the exact same asset and in one case it qualifies for 5 year and in another case it doesn't. A simple example is baseboards: if they're considered permanently attached to the wall like being glued on they're treated as a long life asset, it would damage the wall to remove it so it's like part of the wall; on the other hand if it's easily removable like being tacked or nailed onto the wall it qualifies for 5 year. That's just one out of a thousand different nuances that makes cost seg so complex. 

Even among professional cost segregation firms there are huge differences in methodology and accuracy. The IRS describes 6 different methods with varying levels of accuracy. Many cost seg firms use a statistical sampling or computer generated modeling approach which is a bit cheaper since it's less work, but it's inherently inaccurate so it generally leaves money on the table or worse overstates qualifying assets. If that's what you're looking for it may be better to save the money and do it yourself since your guess may be as good as theirs. Accuracy is important so the detailed engineering from actual cost records and detailed engineering using cost estimation methods are the preferred approaches. 

So you can DIY and realistically chances are quite low that you'd have any issues, but if the IRS reviews it the fines and penalties will significantly outweigh saving some money by not having it done professionally plus you're either gonna leave a lot on the table or overstate which is a surefire way to get audited. Having it done right gives you peace of mind on the audit front, you're not leaving money on the table, and the benefits will significantly outweigh the costs usually at least 3 to 1 but oftentimes it's 5 to 1 or 10 to 1 depending on the property. 

I'm also looking into a DIY cost segregation approach for 3 duplex properties that I will be closing on in the next 45 days. As a licensed CPA I know enough to understand that cost segregation studies are a very specialized product that require, at a minimum, industry specific cost and engineering data support which can only be acquired through experience and a history of completing such studies. This has led me to search for firms specializing in the niche area of cost segregation for lower value rental properties, and what I found was firms who are using internally developed software which allows for such cost/engineering data to applied to basic parameters of a specific rental property to come up with a lite cost segregation report for lower value properties (depreciable basis >$500k).  So far I have found 2 firms that provide such a service, 1) KBKG and 2) TitanEcho. Both of these firms offer cost segregation reports, generated from proprietary software, for $400 apiece, however KBKG offers complementary audit defense while Titan audit defense is extra. The return on such a relatively small investment is a no-brainer because of bonus depreciation, however I am curious to see if anyone else has tried or heard of these firms or others providing similar services. 

I second KBKG - fairly easy to use their software to generate CS reports once you watch their tutorial video. I used them for two of my SFRs rentals.

@Matt Jones I'd be weary of a $400 computer generated report. It'll likely not stand up to audit, and on TitanEcho's website it even says their E5S modeling does not meet IRS audit requirements for cost seg. 

I think this type of thing will disappear fairly soon since the IRS Chief Counsel recently released a memorandum on the topic of penalties for aiding and abetting understatement of income tax as it relates to cost seg. Put simply the cost seg provider as well as the CPA who signed off on the report will be liable for hefty penalties for any overstatement of depreciation that results in understatement of tax liability. 

That being said the only way these low cost providers could protect themselves would be to write their programs in such a way that the benefit their work provides is so low compared to the reality of what is allowable that there isn't any chance of overstatement of depreciation, which means it would be understated and you're leaving money on the table. 

Just like everything else, with cost seg you get what you pay for, and $400 doesn't pay for much.

Point well taken Paul, thank you for your input! KBKR has free webinars covering their cost segregation tools that I am going to check out (free CPE!). I will report back when I find out more from their webinar. 

Separate but related question, do you know if the cost of a cost segregation report  is deductible or must be amortized? Just curious....

@Matt Jones Thanks for the shout out, happy to put in my two cents. I can't speak for other firms or using software for cost seg, but I'd assume that their fees just like ours are fully deductible as a business expense for professional services. It's a nice bonus that the true cost of a cost segregation study is the after tax cost. So if a client is at the 37% rate a $10,000 study would only really cost $6,300, and that doesn't even include the state tax deduction if applicable. 

I'd be interested to check out that webinar. I'm curious as to what they do since it just doesn't seem possible for a computer generated report to meet the standards for a quality cost segregation study.

@Paul Caputo how much to you charge for a Cost Seg study on a SFR?

Keep in mind KBKG calculator is only for SFR with a value under 500K, so we are not talking expensive SFR, nor MF or other types.

@Costin I. We quote each project based on the specific details of the property so it varies. That being said if we're just looking at one SFR it's generally $2,500. If we're looking at a portfolio of multiple SFR's there's some cost sharing so the per property cost goes down depending on how many properties. We can generally make the numbers work down to about $100k less land value, and lower if we're looking at a portfolio of 6 or more properties.

There's a big difference between plugging some numbers into an online calculator that generates a report instantly based on statistics and a forensic detailed cost segregation study. A qualified engineer does a site survey to fully document the assets then a team of engineers does a 100% property breakdown using all 32 primary divisions of the building code to produce an accurate report that includes all elements of a quality cost segregation study per the IRS Cost Segregation Audit Techniques Guide with a ready to File Form 3115 if needed. There are no statistics or computer models used. Each asset is looked at individually, costs are adjusted and then rectified with the total property cost. That process takes a lot of time, and qualified engineers don't work for peanuts. 

There's no doubt that this calculator is cheaper than an actual study, but again you get what you pay for. Statistics are inherently inaccurate to the reality of the property, so they've either overstated or understated the allowable assets. If it's overstated you're exposed to fines and penalties. If it's understated you've left money on the table. 

Most people are fine with this since it's such a low cost and the chance of audit is very low. My guess is they limit this to SFR's under $500k and they err on the side of understating by at least 5%-10% to limit exposure. We could put together the same calculator, but we don't because it'll be inaccurate.

@Paul Caputo While I don't disagree with your points, at the same it doesn't make you an uninterested party in evaluating KBKG calculator. Given the difference from your $2,500 to theirs $400, that 5%-10% understating makes it good enough in my book for an average SFR.

But I wouldn't worry too much, I doubt you are capturing that many SFR investors to do Cost Seg studies for them for $2500 a piece. KBKG found a way to serve an underserved market. Especially when we are talking only acceleration of depreciation, not actual savings - that $2,100 cost difference can be a big one for the small investor.

@Costin I. Absolutely I totally agree with you. I run into a lot of small investors that our service just doesn't make sense due to the cost vs the benefits especially if they're in a lower tax bracket. Different products serve different needs and this is a good example of that. Just pointing out there's a significant difference between the two.

While we do have a lot of clients who invest in SFR's we're usually looking at a portfolio of SFR's in that case, and the majority of properties we look at are larger commercial properties. We just offer the same service to everyone regardless of property size. Some smaller investors want a forensic detailed report and some are fine with a computer generated report. All depends on the individual and the situation.

Late to the party here, but doing a cost seg on your own is playing with fire.  The IRS has so many guidelines that unless you keep up with them on a regular basis it is very difficult.  Also they even discourage cpa's from doing studies because the large majority of them don't have the construction knowledge necessary to do the proper break downs of costs. Though a cost seg study doesn't increase your chance of audit, if you happen to go to audit it would be very tough to defend as a lay person.  I have been working in the cost seg industry for over 15 years and have successfully defended numerous studies at audit.

@Karen Chenaille

I really like doing the algorithm based cost segs for under 1M rental properties. The company I use sells an additional audit guarantee where they will do a fully engineered study if you get audited. I think these are great for small rental properties and for anything placed into service starting first of the year 2018 gets awesome additional bonus depreciation. So I'm not scared of doing the algorithm based ones for smaller properties.