Cost segregation has undoubtedly developed over the last few years as tax court cases transform the way companies use cost segregation to reduce their tax burden. Cost segregation is the study performed by engineers, contractors, or others to review assets and split them into different categories to provide appropriate tax life to each asset and allow purchasers to benefit from the accelerated depreciation timeline for many building components. Cost segregation is usually done before finalizing the sale of a property or shortly after.

The AmeriSouth case is one of the few defining cases of how cost segregation is navigated for taxpayers. It explored the extent of the allowable cost segregation in a depreciable rental real estate that went to tax court.

The Background of the AmeriSouth Case

In 2003, AmeriSouth purchased an apartment building for $10.25 million. After the purchase, AmeriSouth used a cost segregation survey in an attempt to break down a single apartment building into over 1,000 assets. The assets were classified across several categories of short-life depreciable assets over 5 to 15 years instead of using the modified accelerated cost recovery system or MACRS stand of 27.5 years applicable to rental real estate. With this cost segregation method, AmeriSouth deducted over $3 million for depreciation from 2003 to 2005.

The IRS initiated an audit under TEFRA and subsequently reviewed the cost segregation study and disagreed with many items listed. Due to the IRS audit, AmeriSouth was denied $1,079,751 in those deductions. The case ended up in tax court to dispute the items and further argue that AmeriSouth was attempting to depreciate assets it did not own.

The AmeriSouth case introduced a stricter definition of structural components, where an asset is considered structural if it is essential to the operation and maintenance of the building, rather than just essential to the operation of a generic shell building. This new definition potentially limits the scope of assets that can be depreciated over shorter periods.

In the case of AmeriSouth, the Tax Court defined structural components differently than it had in previous cases. The AmeriSouth case held that each asset is a structural component when it is integral to the operation and maintenance of the real estate building. In previous cases, a component would be structural if it was essential to the generic shell building.

Once the case had reached the tax court, AmeriSouth stopped responding to communications from the court, their attorneys, and the IRS. The court, at that point, allowed the attorneys to withdraw from the case, leaving AmeriSouth to defend themselves. Instead of dismissing the case entirely, it deemed any factual matters not contested to be conceded by AmeriSouth. The court sided with the IRS for most of the items listed, holding that the components were indeed structural components and subjected to the 27.5-year depreciation value.

Following the AmeriSouth decision, the IRS has shown increased scrutiny of cost segregation studies. Taxpayers and practitioners must ensure thorough documentation and justification for the classification of assets to withstand IRS examination. The case also underscores the importance of engaging experienced professionals for conducting cost segregation studies, as poor preparation and documentation can lead to disallowed deductions and increased tax liabilities.

How the AmeriSouth Case Impacted Cost Segregation

The AmeriSouth case redefined structural components, making it harder to classify certain building parts as personal property for shorter depreciation periods. The IRS's stance on cost segregation studies has become more stringent as well, requiring better documentation and justification for the classification of assets. By introducing a stricter definition of structural components and prompting closer IRS examination, the AmeriSouth case has increased the complexity and scrutiny involved in the cost segregation process. Careful planning, thorough documentation, and professional expertise are now crucial to conducting a sound cost segregation study and realizing tax savings.