Setting the Record Straight

Recently I came across an article regarding cost segregation that immediately got my attention. There were two misleading assertions that I could not let pass. It is important to set the record straight so that taxpayers do not miss a perfectly legitimate opportunity to save money with a cost segregations study.

The first misguided assertion was that cost segregation and component depreciation are the same. Quite frankly, they are not even close. Component depreciation became popular way back in the 1940s after the Shainberg1 decision in favor of the taxpayers in 1942. Component depreciation was the practice of taking a building and breaking out the component parts into their estimated useful lives. The actual structures were taken at 40 years; the wiring was depreciated at 15 years; the plumbing was depreciated over 15 years; the asphalt tile floor was depreciated over 10 years; etc. This was allowed at the time by Regs. § 1.167(a)-7. A little history lesson, in 1942, the IRS could not justify any reason as to why the component method was invalid. However, with the advent of § 168 the IRS considered component depreciation to be illegal in 1981. The final death blow to component depreciation was delivered by statute in 1986.

Cost segregation does not focus on a component of a building but rather on specific items that are broken out based primarily on their function. The wiring in the previous example was given a life based on an estimate of its useful life. Since 1981 the life of an asset has been specified by § 168 (old and new). A building, including the wiring, is currently assigned a 39-year life assuming it is nonresidential realty. The wiring can be broken out by function i.e. does it serve equipment or does it serve a base building function. In a cost segregation study, the breakout is accomplished by examining electrical blueprints in a “load analysis” as was sanctioned in the Scott Paper case.2 Properly done, one would take the portion of the wiring that serves equipment over the shorter life of the equipment and the portion that serves the building over the longer life of the building. This is considerably different than component depreciation.

Secondly, the authors of the article badly misinterpreted like-kind regulations in their example. They were cautioning against having a cost segregation study done before doing a like-kind exchange because of potential recapture issues. In the article they pointed out that if you had excess basis in your 15 and 5-year classes, you had exposure to depreciation recapture. The regulations3 they quoted clearly state that the only time the gain is recognized is when there is an exchange group deficiency, not a surplus. A deficiency is where you do not have enough basis in the acquired property to cover the carry over basis required by the like-kind exchange code and regulations. Therefore, the problem will be in the class that has a deficiency, not a surplus. To the contrary, their example insisted that an excess basis caused the problem, whereas the issue was in the 39-year class where they had a deficiency, not in the 5-year or 15-year assets.

Unmistakably, this is a lesson in knowing when to turn to knowledgeable tax professionals specializing in cost segregation. Bedford Cost Segregation is always available to provide information on cost segregation studies whether related to like-kind exchanges or any other issue.


1 Shainberg v. Commissioner, 33 T.C. 241 (1959)
2 Scott Paper Co. v. Commissioner, 74 T.C. 137 (1980)
3 Regs. § 1.1031(j)-1