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Cost Segregation Studies: Understanding the Application of Income Tax Analysis to Property Tax and Sales Tax Reporting

May 23, 2017

Many companies have cost segregation studies performed when they have new construction projects. These studies are valuable because they segregate costs into shorter depreciable lives to maximize income tax depreciation deductions in the early years. 

However, to get the most state-tax-favorable treatment for your construction project, it is important to understand the potential integration between the cost segregation study and sales and property taxes. Understanding your study will ensure that your company will use the information from the study to properly report both sales/use and property taxes. Used properly, the cost segregation study may also provide valuable substantiation for property and sales tax opportunities available to your organization.

Property Tax
There are many building components, like carpeting and cabinetry, which are placed into five- or seven-year class lives. While acceptable for income tax purposes, this may not be appropriate for property tax reporting. For property tax purposes, these costs still retain their character as real property. In states that impose personal property taxes, care should be taken that these assets are not self-reported by the owner as furniture and fixtures. This would likely result in double taxation because those items are usually factored into the value of the real estate.

Another building cost that is often segregated is electrical requirements for specific processing equipment. Again, while acceptable for income tax purposes, the treatment of electrical requirements may vary depending on whether the components are exclusive to the specific equipment and whether the equipment is hard wired or connected via junction boxes or outlets. If an allocation of the building service panel is made, these costs may qualify under the manufacturing exemption or may still be properly included as part of the real estate value. Proper understanding and use of the cost segregation study can both prevent double assessments and provide the added value of third-party documentation of the cost of items that should be “carved out” and treated as exempt from property taxation.

Generally the IRS has strict rules related to heating and ventilation systems, so those components may usually remain as 39-year property. Depending on the manufacturing exemption qualifications, these assets may be integral to and necessary for the manufacturing process.

Sales Tax 
In most sales tax audits, the auditors tie assets from the depreciation schedules to invoices to verify that sales tax was properly paid. Since indirect costs (contractor profit, project incidentals, and engineering/design costs) are allocated to the various tangible assets, the acquisition costs on the depreciation schedule will not tie to any invoice. If auditors can’t match the acquisition to a specific invoice, they will likely include that item as an error. 

In addition, an auditor may treat assets with a seven-year class life as personal property and potentially subject them to sales tax unless further information is provided. For example, carpeting may remain personal property if it is not attached to the floor. However, if it is tacked or glued to the floor, then many states will treat the carpeting as a real property improvement.

To thwart these potential issues, there are a few alternatives. Many fixed asset software programs allow you to utilize special field codes to sort assets. As a result, a seven-year class life asset may be flagged as real property in a field that tracks non-income tax treatment. A depreciation schedule sorted by this special field can eliminate some of these issues. Company personnel responsible for maintaining fixed asset schedules may wish to consider utilizing descriptions other than “seven-year property” or “personal property” that cause auditors to immediately question the potential taxability of the items in question.

Alternatively, a company should consider providing a copy of all or a portion of the cost segregation allocations to assist the sales tax auditor in tying construction costs/invoice amounts to the depreciation schedule.

The tax treatment of various building components varies by tax type and by state. Since both of those taxes are generally self-reported by taxpayers, some auditors and assessors are often reluctant to alter the treatment that was initially reported. Therefore, it is important to make the needed alterations to the cost segregation report before the initial filings. 

Cost segregation studies are critical to successfully document and sustain cash flow savings from shorter depreciation lives for federal and state income tax purposes. They can also be used to successfully document the cost of exempt property both from the property and sales tax perspectives. Wipfli has assisted numerous building owners in analyzing cost segregation reports to determine proper reporting for sales tax and property taxes. We have also worked as a liaison between companies and state taxing officials to ensure that double taxation is avoided, available exemptions are secured, and erroneous audit adjustments are not made by auditors applying income tax law instead of sales tax law.