Originally published on Forbes.com.
Boiling down one of the more exciting provisions of the Tax Cuts and Jobs Act for my friends in reals estate, I would say that the bill lets them immediately write off a substantial piece of an acquisition – twenty maybe thirty percent. The reason for this is if you want to go all tax tax nerdy is Code Section 168(k) which allows expensing of property with a recovery period of 20 years or less.
And the excitement is not just for real estate people. Think of a group of professionals. Maybe they can buy the building they are in and expense the down payment. But how can this be when the recovery period for commercial buildings is 39 years? It is the magic of cost segregation that makes it happen.
Typically when you buy a building you are buying more than a depreciable structure on some non-depreciable land. Think of things like counters, cabinets, walk-in freezers, and the paving of the surrounding parking lot. You have three items with a five year recovery period and one with fifteen years. And thanks to TCJA you can expense them.
So do you think that I am sitting down with my clients trying to sort out the five and fifteen-year gold from the thirty-nine year chaff? Well not so much. Because that is not something that an accountant is likely to be any good at. I mean you would have to practically be an engineer. And as it turns out, there are, in fact, engineers for that very purpose. I’m going to refer to them as cost segregation professionals. And let’s talk about when you need one and how you should find one.
How Can You Not Find One?
Cost segregation has its origin in a concept known as “component deprecation” in the days of yore when we had an investment tax credit. The Tax Reform Act of 1986 put an end to that, but by going back to a long depreciable life for buildings still left some room for cost segregation. If you want to study up on the field the Tax Court decision you want to look at is Hospital Corporation of America, which came out in 1997.
Originally, as far as I have been able to discern, the engineers were inside national accounting firms. Over time the field has developed as an independent specialty. National firms continue to have the capacity in-house as do some regional firms. I was part of a regional firm that built the capacity in-house and then spun it out.
Cost segregation professionals are often recommended by accounting firms. And here is the troubling part. How are you supposed to know who to recommend? Picking the one who comes up with the highest percentage of five-year property seems to be an exercise fraught with peril. There are the matters of price and service. Mainly what you want is a report that will stand up under audit scrutiny.
The reality is that cost segregation reports are like life insurance. They are sold not bought. At least superficially, what makes a cost segregation group successful, is strong marketing. Essentially they have salespeople calling on accountants and telling them that they better recommend cost segregation to their clients, because if they don’t somebody else will. So if you do tax work, a cost segregation firm will hunt you down before long.
But How Do You Decide?
This question came leaping out at me last week when I wrote about a cost segregation consultant who was subject to stiff penalties. Code Section 6701 charges a $1,000 penalty if you prepare a document that you know will be used as part of a tax return that you know or should know is wrong. The exercise was likely not a picnic for the client or the tax preparer either.
What was nasty about the ruling that I was discussing was the holding that a consultant who unreasonably moved property into the five-year category wasn’t just making one return wrong. There would be five wrong returns. (That’s what the ruling said. Actually, because of the half-year convention, I think there would be six). Ironically, the consultant would be in less trouble under current law, since expensing would mean only one return was wrong – really, really wrong, but still just one return.
Somebody set up a twitter account to scold me indicating that I was spreading unreasonable fear:
Except that you forgot to mention in your article that the consultant claimed structural components as 5 year property. This is someone who obviously does not understand cost segregation. Eliminating such key elements in your article does nothing but create fear among CPAs.
I never quite got his point, since ferreting five-year property out of what appears to the uninitiated to be a building is what cost segregation professionals do. This particular CSP (referred to as a “tax/consultant engineer”), at least in the IRS view, got a little carried away. The obviousness of this particular CSP not understanding cost segregation got by the client and the tax preparer, who may well have recommended the CSP.
I was kind of invited into a more interesting discussion as I was added to an email thread of CSPs discussing the ruling I had written about.
Inside The CSP World
The email thread was a group of CSPs trying to figure out who the penalized CSP was and what they should do about it. It starts with:
I think _______ may be the firm that might have had the “tax consultant/engineer” who overstated 5-year property. My colleague, _______, reviewed one of their studies and it’s terrible. For example, they had $92K for 12 6” Pipe Bollards as well as upper cabinets at $5.8K/SF and base cabinets at $6.6K/SF
“Base cabinets at $6.6K/SF” – the horror! What is the world coming to? Seriously, the comment drove home to me that when I get a cost segregation report, I can’t really tell whether it even makes good nonsense. All I do is extract the summary numbers and put them in the depreciation software. And this is what can create the race to the bottom in terms of technical quality that is reflected further on in the thread.
We have come up against this firm before. In fact, they performed a “peer review” on a limited service hotel we worked on. It had an underground garage so land improvements were less than 8% and Section 1245 property was 18%. _____ told the CPA that we left about 30% on the table. We lost the CPA relationship. I repeatedly asked for the credentials of the reviewer – they would never provide them.
Even I can understand that one. When the parking is underground, there is not going to be much in the way of a parking lot to carve out of the total cost. Of course, you only have a problem with that if you have somebody go out and look. If instead, you have a formula that says there must be 15% of the purchase price for parking, it is a lot more economical and gives the client more savings.
This is the sort of thing that happened with appraisals of easement charitable deductions. Charitable deductions of 10% to 15% were being claimed on buildings in historic districts for easements that did not add any new restrictions on the use of the property. The easements were essentially worthless.
The discussion then moved on to whether they should consider kicking somebody who would do such a thing out of their club. So I decided to interview Alex Bagne, President of the American Society of Cost Segregation Professionals.
About ASCSP
You can get all this on the website, but here are some of the high points:
The American Society of Cost Segregation Professionals (ASCSP) has been established as a non-profit corporation in response to the growing need for education, credentials, technical standards and a Code of Ethics within the cost segregation industry.
There is a Code of Ethics. In talking with Mr. Bagne, I mentioned the drive to have tax engineering studies be valued billed, a concept beloved by accounting firm management which was always struggling to find ways to generate revenue not tied to the “tyranny of the billable hour”. He indicated that the Code of Ethics frowned on that sort of thing:
ASCSP Members will not request, propose, or accept professional fees on a contingent basis for Federal Income Tax Depreciation related services (i.e. a percentage of enhanced cash flow, net present value of the “tax savings”, fixed fee plus additional cost savings, etc);.or accept fees based on: The reporting of a predetermined result; or a direction in assignment conclusion that favors the cause of the client.
And there is a qualification exam. Here is a sample question:
A project has an electrical panel with 42 circuit breakers, each rated at 20A/1P. Through your detailed analysis you have identified 28 circuit breakers directly associated with assets deemed to be personal property in nature. What percentage of the panelboard, if any, would you classify as personal property?
Got that? Good. You can explain it to me some time.
Frankly, stuff like this bothers me. I sometimes think the world has too many credentials and here we are having a new one. Check out the Wikepedia entry for “Conspiracies against the laity”, a term coined by George Bernard Shaw.
Adam Smith had a similar sentiment when he wrote – “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. To be fair the ASCSP Code of ethics frowns on that sort of thing.
ASCSP Members shall not engage in collusion, price fixing or any other strategies whereby open-market principles are compromised.
Some Other Thoughts
Mr. Bagne agreed that there is a strong marketing piece to the cost segregation enterprise and joked about the way accountants are terrorized for failing to recommend cost segregation studies. I asked him how big ASCSP is and he indicated that there are about 40 certified members working in about 25 firms. We also discussed other areas where engineers interact with the Tax Code.
The research and development credit is pretty well known, but I embarrassed to say that I was unfamiliar with Section 179D which allows a $1.80 per square foot deduction for commercial buildings that meet energy efficiency standards. Mr. Bagne’s firm also does the studies for that and he cautioned me that I best tell my clients about it so they don’t go to somebody else.
He indicated that the standards haven’t changed so that much new construction will meet them. An interesting quirk of the deduction is that it applies to buildings owned by federal, state and local governments. They are of course tax indifferent entities, so the deduction is awarded to whoever had the most responsibility for the government building meeting the standards.
I also asked how the Big 4 is relating to his organization and he indicated that they are getting a lot of support from Deloitte. I was also pleased to find that the cost segregation professionals I have been working with are among the certified. Better to be lucky than good.
All in, I think that ASCSP has a long way to go until it becomes an ‘accept no substitutes’ type of brand. I’m convinced enough to go so far to say that if you are using a consultant rather than working with a national firm that has the capacity in house, it is worth inquiring whether the people doing the actual work are ASCSP certified.
If they are not you can judge from the story they tell you about why their qualifications are even better whether they can talk a good game. And talking a good game can be really important in IRS audits.
It Is Not A Free Lunch
The downside of carving things out of a building as five-year property is depreciation recapture on disposition. When I talked a bit with Professor Jay Soled who has written a bit about cost segregation but not currently, he pointed out that the new rules restricting Section 1031 like-kind exchanges to real estate might make cost segregation less attractive.
One thing that troubles me about these discussions is that the implication is that cost segregation is some sort of election. In principle, if there is all sorts of five-year property mixed in with your building, you really should break it out to file an accurate return. Also, in principle, the Cohan rule should apply, if you are too thrifty to hire an engineer.
I discussed the application of the Cohan rule (Named for the famous Broadway producer who was too much of a yankee-doodle dandy to keep track of his receipts) with Mr. Bagne. One of the things he admitted was that if somebody was knocking out multiple copies of the same sort of building, they should be entitled to a pretty deep discount on subsequent studies after the first one. Applying that logic I could see some developers taking the function in-house, although I suspect it might not be worth the trouble.
Bottom Line
My inclination would be to get pretty insistent that my client hire a cost segregation professional for any project north of two million dollars. I have seen people argue for a threshold as low as five hundred thousand, particularly for specialized buildings. I don’t think I am ready to insist on the ASCSP stamp of approval, but it is certainly worth asking about. And you know all these complaints people have about tax complexity. Speaking as the child of children of the Great Depression, at least it give people work.