When conducting a cost segregation study, one essential consideration is the IRC Section 263A adjustment. While cost segregation focuses on accelerating depreciation by reclassifying building components into shorter recovery periods, Section 263A, often called the “uniform capitalization rules,” requires certain costs to be capitalized to property. Understanding how the 263A adjustment works is key to ensuring compliance while still maximizing tax savings.
Why Is the 263A Adjustment Required?
The IRS mandates the 263A adjustment to prevent businesses from deducting expenses that should be included in the cost basis of a building or improvement. Section 263A ensures that both direct and indirect costs related to property acquisition, construction, or improvement are properly capitalized rather than immediately deducted.
Without applying the adjustment, taxpayers might understate their building’s cost basis, leading to inaccurate depreciation schedules and potential audit risk.
How 263A Impacts Cost Allocation in a Cost Segregation Study
In a cost segregation study, engineers and tax professionals break down construction or acquisition costs into asset categories with different depreciation lives. The 263A adjustment modifies this allocation by requiring that certain indirect costs be added to these asset categories.
This adjustment ensures that each asset class, whether 5-year, 7-year, 15-year, or 39-year property, carries its fair share of required indirect costs. By applying the adjustment properly, the study maintains IRS compliance while preserving the benefits of accelerated depreciation.
Direct vs. Indirect Costs: What Must Be Capitalized?
- Direct Costs: These include materials, labor, and contractor expenses directly tied to the construction or improvement of a property. They are always capitalized.
- Indirect Costs: Section 263A requires certain indirect expenses to also be capitalized, such as design fees, engineering costs, construction supervision, purchasing, and certain overhead expenses.
Not all indirect costs qualify. General business expenses; like marketing, selling, or unrelated administrative costs; are excluded.
Treatment of Self-Constructed and Improved Assets
Section 263A rules apply not only to purchased buildings but also to self-constructed property and capital improvements. For self-constructed assets, taxpayers must capitalize a portion of indirect labor, overhead, and even interest during the construction period.
When improvements are made, such as renovations or expansions, the same capitalization rules apply. In both cases, a cost segregation study incorporates the 263A adjustment to ensure these additional costs are appropriately allocated.
Steps for Calculating and Applying the 263A Adjustment
- Identify Costs Subject to Capitalization – Determine which indirect costs must be allocated under Section 263A.
- Select a Reasonable Allocation Method – Common methods include square footage, labor hours, or cost percentage approaches.
- Allocate Costs to Property Classes – Spread the indirect costs across each property category identified in the cost segregation study.
- Adjust the Depreciation Schedules – Incorporate the allocated costs into the reclassified property basis to calculate depreciation accurately.
- Document the Process – Maintain detailed support for calculations, methodology, and allocations to withstand IRS review.
Conclusion
The 263A adjustment is a critical component of a compliant cost segregation study. While its rules can seem complex, they ultimately ensure that property costs are allocated fairly and depreciation schedules are accurate. By properly applying Section 263A, property owners benefit from accelerated depreciation while staying aligned with IRS requirements.
At CSSI, our engineering-based studies account for 263A adjustments, giving property owners peace of mind that their tax strategies maximize savings without added risk.
