In broad terms, cost segregation allows a taxpayer to separate the components of a property that depreciate faster. This can reduce tax liability and increase cash flow in many cases.

It is common for taxpayers to engage tax professionals, often working with architects, builders or engineers, to (1) distinguish the items of property treated as structural components of a building for tax purposes from items of property (personal property) closely associated with the building and (2) allocate costs between the building components and personal property (and among the various classes of personal property). This process is referred to, by both tax professionals and IRS, as cost segregation. Cost segregation studies are not binding on the IRS.

It is possible, where the cost of appraisals, accounting, and tax preparation fees warrant, to retroactively segregate a building’s property into its Sec 1250 and Sec 1245 components, thus allowing a shorter depreciable life (generally 7 years for commercial property and 5 years for residential rental property) for the Sec 1245 components. Amending prior returns is not required if the automatic IRS consent to a change in accounting for depreciation is used. However, retroactive change should be approached with caution.

IRS stated that appliances, carpets, furniture, etc., used in a rental real estate activity are 5-year MACRS class property (Ann 99-82). The IRS has also indicated that such property used in a residential rental real estate activity is 5-year MACRS class property (IRS Pub 527, (2024), page 13). As with most things in taxes there is no all-encompassing list of items that can or cannot be treated as Sec 1245 property. Each item must be looked at on a one-by-one basis. Consider for example kitchen cabinets; most are easily removable and replaceable and might be considered Sec 1245 property. But here are some issues to consider:

The language of the final regulations clarifies that the 15% limitation is calculated by comparing the value of all the incidental properties to the value of all of the replacement real properties acquired in the same exchange.

Nonetheless, under section 1031(b), a taxpayer must recognize gain on the receipt of the incidental personal property, which is not like kind property. (Final Reg. §1.1031(k)-1(g)(7)(iii)). See the Tax Deferred Exchanges chapter for further discussion on these regulations.

Most recent cases and rulings related to cost segregation refer to HCA v. Commissioner discussed below.

The Tax Court found that a taxpayer’s cost segregation study that broke down the cost of a residential apartment complex into over 1,000 parts was overly aggressive and agreed with the IRS that most of the components were structural components, integral to the buildings’ operations and maintenance, and were depreciable over 27.5 years rather than the 5 to 15 years used by the taxpayer. Only the following components were reclassified as personal property depreciable at lesser lives: clothes dryer vents; outlets and timers related to watering of the grounds; surveillance components (TV and camera); gate components; outlets for refrigerators, stoves, and washer/dryer machines; and cable, telephone and data outlets. (AmeriSouth XXXII, Ltd., T.C. Memo 2012-67)

The Tax Court ruled that a taxpayer could not modify purchase price allocations that had been agreed to when two processing plants were acquired. After the purchase, the taxpayer had a cost segregation study done which separated the assets into various subcomponents and reclassified them for depreciation purposes as 7-year or 15-year property instead of the 39-year class applicable to commercial buildings and their structural components. The taxpayer applied for a change in accounting method and claimed a Sec. 481(a) adjustment. The IRS took the position that the taxpayer could not modify the purchase price allocations under Sec. 1060, which provides that in connection with an applicable asset acquisition, the parties to a written agreement as to purchase price allocation are bound by the agreement. The Court agreed with the IRS. (Peco Foods Inc. et al., T.C. Memo 2012-18)

Therefore, taxpayers who anticipate purchasing the assets of a business should consider having a cost segregation analysis completed before the purchase agreement is written.

The court ruled that the enactment of ACRS did not redefine § 1250 property to include property that had been § 1245 property for purposes of ITC (investment tax credit). Accordingly, the court determined that §168(f)(1), prohibiting component depreciation, applied only to §1250 property. The HCA ruling effectively reinstated a form of component depreciation for certain building support systems, such as the electrical and plumbing systems that directly serve tangible personal property. Therefore, cost segregation methodologies previously used to allocate the cost of a building between structural components and ITC property can now be used for § 1250 and § 1245 property.

In an Action on Decision (AOD CC-1999-008), the Service acquiesced to the validity of the method approved by the court (i.e., pre-1981 ITC tests remained applicable for determining tangible personal property under both ACRS and MACRS). However, the Service non-acquiesced to the court’s findings as to which specific assets qualified as tangible personal property. Two cases, LaPetite Academy and Boddie-Noell, were specifically referenced in the AOD with respect to the determination of structural components and tangible personal property.

Additional information related to the IRS’ view related to cost segregation can be obtained from the IRS’ Audit Technique Guide on Cost Segregation. The most recent revision (June 1, 2022) is available at: Publication 5653 (6-2022) (irs.gov). There are a few industry-specific tables that break down (at least in IRS’ view) what is 1245 and 1250 property.

The IRS Audit Technique Guide used to assist examining agents evaluate the validity of cost segregation studies submitted by taxpayers to substantiate accelerated depreciation deductions.