Cost segregation studies are complex analyses typically used to accelerate depreciation of personal property, particularly in real estate. Competent professionals can add significant value by conducting these studies. However, some common pitfalls follow.
- Inaccurate Asset Classification
- Complexity of tax law – Even competent professionals can struggle with the nuances of tax law. Misclassification of assets (e.g. allocating personal property incorrectly or misinterpreting IRS guidelines) can lead to incorrect depreciation schedules, which may raise red flags during audits.
- Over-Aggressive Segregation
- Risk of audit – Overly aggressive attempts to accelerate depreciation, such as incorrectly assigning assets to shorter depreciation categories, may trigger an IRS audit. The professionals need to have experience in handling IRS audits and respect from the IRS.
- Inconsistent Documentation
- Lack of thorough reporting – Even competent professionals may fail to maintain comprehensive documentation. Cost segregation studies require extensive records, including engineering reports, detailed asset breakdowns and cost allocations. Poor documentation can jeopardize the validity of the study, especially during an audit.
- Failure to Revisit Studies
- Change in tax law – Tax laws are frequently updated, and failing to revisit or update a cost segregation study in light of new regulations or IRS guidance can lead to missed savings opportunities or non-compliance.
- Ongoing renovations and improvements – A competent professional should revisit a study after major property improvements, to segregate additional costs incurred after the initial study was completed.
- Inadequate Communication with Clients
- Failure to explain risks – Professionals may not adequately explain the risks of certain classifications or the potential consequences of an IRS audit, leaving the client unprepared for potential challenges down the line.
- State Tax Issues
- State-specific rules – Some professionals may overlook the fact that not all states follow federal depreciation rules. States may have different depreciation schedules or may not allow for the same level of accelerated depreciation. Failing to consider state tax implications can result in errors on state tax filings.
- Impact on Future Transactions
- Depreciation recaptures – Accelerating depreciation through a cost segregation study can result in higher depreciation recapture taxes when the property is sold. Competent professionals may fail to explain the potential tax hit at the time of a future sale.