When a building goes up, the contractor’s paperwork organizes costs by trade: concrete, electrical, doors and windows, HVAC. It is a practical way to manage a construction project. According to CostSegRx, an engineering-based cost segregation firm, it is also a weak foundation for a cost segregation study, because depreciation depends on what an asset does, not on which trade installed it.
Investors reviewing a study, their own or one prepared by another provider, can often spot this issue early if they know what to look for.
What Classifying by Trade Looks Like
The problem usually appears when a study is built from actual construction cost data. To get paid, contractors submit AIA G702 and G703 forms to the lender. These documents list the divisions of work completed, such as the foundation, the doors and windows, and the electrical, and request the next portion of the draw schedule.
Those forms serve their purpose for the bank, but they do not tell the full story for depreciation. Take concrete. A single concrete line could include the building’s foundation, which is depreciated over 27.5 or 39 years, and site paving or sidewalks, which are generally 15-year assets. A study that classifies the whole line as one trade will get part of it wrong.
Detailed build data is often hard to get. Many clients do not have it, and general contractors frequently do not have it either, because they sub out the work and the subcontractors send general invoices. That makes it even more important for the cost segregation professional to look past the pay application.
When the Obvious Classification Is the Wrong One
HVAC is a good example. In most buildings, it is treated as a building system and recovered through straight-line depreciation. But the right answer depends on how a specific system is used, and that often only becomes clear during a site inspection.
Consider a restaurant with HVAC in the dining room, the kitchen, and other areas. If one system is installed in a dry storage room to keep food at the temperature it needs to maintain quality, CostSegRx would reclassify that system as a 5-year asset rather than a 39-year asset. “That HVAC system is serving the business directly,” said Brian Kiczula of CostSegRx.
How These Errors Come to Light
Misclassification tends to surface when a cost segregation study was not done at the outset. CostSegRx often finds it during look-back studies for owners who placed a property into service a few years earlier. The team reviews the fixed asset schedule, sees a line simply labeled HVAC, and asks what the equipment was actually used for.
Another warning sign is a building treated as a single whole, with no separate carve-out for specialty equipment tied to the owner’s business.
Questions to Ask a Cost Segregation Provider
For investors comparing firms, a few direct questions can show whether a provider is classifying assets by function or relying on trade-based shortcuts:
Are you doing a detailed engineering study on my property? Will an engineer review the study? How will you conduct the site inspection on my specific property? Will an accountant review the file before the report is finalized?
Investors should also ask whether there is a charge for revisions if something needs to be reclassified, and whether the provider will update the study for capital improvements made before the end of the tax year. That last point comes up often. An investor may acquire a property in August, place it into service, and then complete renovations in December. At that point, the provider will need to either revise the original study or prepare a separate capital expenditure study.
A provider’s answers to these questions say a lot about its process. CostSegRx outlines its own approach, including engineering analysis and accounting review, on its About page. Whichever firm an investor chooses, the study should be reviewed with a CPA before it is used on a return.
About CostSegRx: CostSegRx is an engineering-based cost segregation firm led by Brian Kiczula, a member of the American Society of Cost Segregation Professionals. The firm works with residential and commercial real estate investors nationwide. CostSegRx provides complimentary estimates of benefit and supports investors and their CPAs through the full reporting process. Learn more at costsegrx.com or call (888) 850-4155.
This article is based on information provided by the expert source cited above. It is intended for general informational purposes only and does not constitute legal, financial, or real estate advice. Readers should conduct their own research and consult qualified professionals before making any real estate or financial decisions.
Disclosure: Individuals or companies mentioned may have a commercial relationship with KeyCrew.