Which construction costs belong in the California property tax base, and why is the cost segregation total the wrong number?

What the assessor enrolls: value, measured at completion

Section 110.1(a) defines the full cash value of real property as its fair market value under section 110, determined for newly constructed property as of "the date on which new construction is completed, and if uncompleted, on the lien date" (section 110.1(a)(2)(B)). Section 71 states the same rule from the assessor's side: construction in progress is appraised at full value on each lien date "until the date of completion, at which time the entire portion of property which is newly constructed shall be reappraised at its full value, and that value shall be the base year value." Rule 463(a) narrows the target to the construction itself: the new base year value is set "for only that portion of the property which is newly constructed," and "the full value of new construction is only that value resulting from the new construction and does not include value increases not associated with the new construction." The base year value of the remainder, the land included, "shall not be changed" (section 71).

Fair market value under section 110(a) is what the property would bring if exposed for sale in the open market between informed parties. Cost is evidence of that amount, not the amount itself. The handbook on newly constructed property says "the actual market value of new construction may vary widely from the cost to construct those improvements," and that cost approach values "should, whenever possible, be checked against values derived from the other approaches" (Assessors' Handbook Section 410, Assessment of Newly Constructed Property (May 2014), pp. 21 to 22). The legal staff of the Board of Equalization gave a county the same answer: "The costs of construction may not equal the fair market value of a new residence. Therefore, county assessors should employ the valuation approach(es) that best estimates the value of new construction, not merely its cost" (Property Tax Annotation 610.0115, C 7/05/2005). For an alteration the regulation is explicit that "only the value, not necessarily the cost, of the alteration shall be added" (Rule 463(b)(3)).

Two consequences follow. A cost the owner incurred that added no value is not in the base, and value the market attaches beyond cost can be. And the question is never which costs "are taxable." The definitions in sections 103 to 106 and the exemptions following section 201 decide what kind of property exists and whether it is taxable; which costs measure its value is answered by sections 110 and 110.1, Rule 6 and the handbooks.

What the cost approach counts

Rule 6(a) makes the cost approach the preferred approach when neither reliable sales data nor reliable income data are available, and calls it "particularly appropriate for construction work in progress" and for property with relatively little physical deterioration. Rule 6(b) allows two routes: adjusting the property's own original cost for price-level changes, or estimating reproduction cost by "applying current prices to the property's labor and material components, with appropriate additions for entrepreneurial services, interest on borrowed or owner-supplied funds, and other costs typically incurred in bringing the property to a finished state (or to a lesser state if unfinished on the lien date)" (Rule 6(b)(2)). Replacement cost follows the same method for a substitute of equal utility (Rule 6(d)).

The advanced appraisal handbook fills in the categories. "Full economic costs necessary to construct real property and ready it for its intended use include (1) direct costs, (2) indirect costs, and (3) entrepreneurial profit" (Assessors' Handbook Section 502, Advanced Appraisal (December 1998), p. 13). Direct costs, "also called hard costs," are the labor and materials, and they "would also include other items, such as fees for building permits, contractor's profit and overhead, and charges for equipment rentals, that relate directly to the physical aspects of a construction project." Indirect costs, "or soft costs," are "those expenditures for items other than labor and materials typically incurred in bringing the property to a finished state," and the handbook lists the developer's administrative expenses, architectural and engineering fees, environmental impact studies, construction insurance, property taxes during construction, and interest on borrowed or owner-supplied funds (AH 502, p. 13). Its quantity survey example adds the construction loan fee and interest, appraisals, legal, development consultants, and title and escrow before an entrepreneurial profit line (AH 502, Example 2-3, p. 19).

That list settles the point most often got backwards. Indirect costs are not excluded because they are indirect. Architecture, engineering, permits, construction-period interest and loan fees, builder's risk insurance, property taxes paid during construction and the developer's own project administration are, in the Board of Equalization's method, part of the cost of the improvement. A schedule that strips "support costs" or "services" from the base because they are not bricks and mortar has no authority behind it, and the assessor's own cost approach puts those items back.

Entrepreneurial profit is a different kind of entry: "a market-derived estimate of what the entrepreneur expects to receive for his/her contribution," not a measure of money spent (AH 502, pp. 13 to 14). Rule 6(b)(2) authorizes the addition, so a cost approach value can exceed the ledger even when every dollar on it is accepted. The statutory limit is narrow: for special use property, "the assessor shall not add a component for entrepreneurial profit unless he or she has market-derived evidence that entrepreneurial profit exists and has not been fully offset by physical deterioration or economic obsolescence," and special use property is "a limited market property with a unique physical design, special construction materials, or a layout that restricts its utility to the use for which it was built" (Rev. and Tax. Code section 401.6(a), (b)(3)). A general-purpose office and retail building does not fit that definition, so whether a profit component is supported is argued on sales and income evidence.

Three groups of cost fall outside the approach even on this broad reading. The first is cost that is not a cost of the property valued. "Off-site improvements, impact fees, and certain development fees when not directly associated with new construction of a particular property are considered nonassessable enhancements of land value, rather than assessable new construction" (AH 410, p. 25), and "costs related to such off-site construction should not be used as an indicator of the added 'new construction' value to the subject property" (Property Tax Annotation 610.0063, C 5/12/2000). The project's own permit fees are a direct cost; a traffic mitigation fee that funds an intersection elsewhere is not a cost of the building. The second is cost that is not a cost of bringing the improvement to a finished state: start-up payroll, utilities before occupancy, moving expense and consumable supplies are operating costs of the owner's business. Leasing commissions and marketing sit at the edge. The basic appraisal handbook counts "lease-up or absorption costs necessary to reach normal occupancy (e.g., marketing expenses, leasing commissions, or expenditures made by the property owner for tenant improvements)" among indirect costs (Assessors' Handbook Section 501, Basic Appraisal (January 2002)), while Rule 6(b)(2) and the AH 502 list name only costs of reaching a finished state, and the finished state of an improvement is the date it "is available for use" (Rule 463(e)). The textual argument for leaving post-completion leasing costs out is available but unsettled, since the Board of Equalization's basic handbook counts them and no annotation resolves the point; the owner's schedule carries them as their own line so the point is argued as a line, not buried in a total. The third is demolition. The taxable value of the total property is the full value of the new construction added "to the taxable value of preexisting property reduced to account for the taxable value of property removed during construction" (Rule 463(a)). The removed improvements leave the roll; the cost of removing them is not an addition to anything.

Real property, fixtures, personal property, and what never enters the roll

The base year value belongs to real property. Real property is the right to land, the mines, minerals, quarries and timber in or on it, and "improvements" (section 104); improvements are "all buildings, structures, fixtures, and fences erected on or affixed to the land" (section 105(a)(1)); personal property is "all property except real estate" (section 106(a)). New construction "means" any addition to real property, "whether land or improvements, including fixtures" (section 70(a)(1)), and Rule 463(b)(1) reaches "any substantial addition to land or improvements, including fixtures, such as adding land fill, retaining walls, curbs, gutters or sewers to land, or constructing a new building." Personal property is never new construction. It has no base year value, because section 110.1 speaks only of real property, and it is assessed every year at full value as of the lien date (sections 401 and 110) from the owner's property statement.

Within real property the line that matters runs between structure items and fixtures. A fixture is "an item of tangible property, the nature of which was originally personalty, but which is classified as realty for property tax purposes because it is physically or constructively annexed to realty with the intent that it remain annexed indefinitely" (Cal. Code Regs., tit. 18, section 122.5(a)(1)). Physical annexation means property "attached to, imbedded in, or permanently resting upon land or improvements" or not removable "without substantially damaging it" (Rule 122.5(b)(1)); constructive annexation reaches unattached property that is "a necessary, integral, or working part of the realty" (Rule 122.5(c)(1)); "intent is the primary test of classification," judged by what is "reasonably manifested by outward appearance," and a contract between the parties is "not binding" on the assessor (Rule 122.5(d)(1), (d)(2)). For new construction, a fixture is "an improvement whose use or purpose directly applies to or augments the process or function of a trade, industry, or profession" (Rule 463(c)), and the property statement defines a structure item as an improvement whose "primary use or purpose is for housing or accommodation of personnel, personalty, or fixtures" (BOE-571-L, Schedule B instructions).

Rule 124 lists classifications the assessor follows "unless there are persuasive distinguishing facts," on a list that "is not intended to be inclusive of all items of property required to be classified" and that relates "solely to classification of property and not to evaluation thereof" (Cal. Code Regs., tit. 18, section 124). Its improvements include wall-to-wall carpets, hard-surface floor coverings, lighting fixtures, signs attached to buildings and on separate supports, built-in kitchen appliances, built-in cabinets and furnishings, built-in air conditioners, elevators with the computer components that operate them, affixed partitions, awnings, paved roads, concrete flatwork, fences, sprinkler systems and on-site utilities (Rule 124(b)(2)); shrubs, bushes and perennial grasses are land (Rule 124(b)(1)). The list sorts realty into land and improvements; furniture that is not built in, movable equipment, computers that do not operate an improvement, and artwork hung on a wall are outside it and are personal property under Rule 123.

Two further rules take whole categories off the real property roll. Storage media are valued "as if there were no computer program on such media except basic operational programs," and "otherwise, computer programs shall not be valued for purpose of property taxation" (Rev. and Tax. Code section 995), a rule the property statement repeats in its instruction not to include application software costs. And fixtures "that are normally valued as a separate appraisal unit from a structure" are outside the definition of "property" for supplemental assessment purposes (section 75.5(a)): they acquire a base year value as new construction but are not billed on the supplemental roll, and they reach the regular roll through Schedule B of the BOE-571-L, which reports fixtures in a column separate from structure items, land improvements, and land and land development, at original or allocated cost by year of acquisition. Fixtures and other machinery and equipment classified as improvements also "constitute a separate appraisal unit" when declines in value are measured (Rule 461(e)). The practical consequence is a reconciliation the owner must do itself: the built-in items the real property appraiser counted inside the building's cost approach and the fixtures the business property division enrolls from Schedule B are the same dollars, and an owner who reports them on Schedule B without showing that they already sit in the new construction value invites an assessment of them twice.

What a cost segregation study is, and what it is not

A cost segregation study answers a federal question. Nonresidential real property is recovered over 39 years (IRC section 168(c), (e)(2)(B)); property with a shorter class life is 5-year, 7-year or 15-year property (section 168(e)(1), (i)(1)); and a study's purpose, in the IRS's description, is "the allocation or reallocation of building costs to tangible personal property," because section 1245 property "has a shorter recovery period (e.g., 5 or 7 years)" (IRS Publication 5653, Cost Segregation Audit Technique Guide (February 2025)). The guide tells examiners that a study should "allocate indirect costs to the appropriate assets," normally pro rata, and "reconcile total allocated costs to total actual costs." Each feature makes the study's total the wrong starting number, for three separate reasons.

The study's classes are depreciation classes, not property tax classes. The federal line runs between section 1245 and section 1250 property; the California line runs between land, structure, fixtures and personal property, drawn by annexation and intent under Rule 122.5 and the Rule 124 list. The lines cross constantly. Wall-to-wall carpet, decorative lighting, millwork, wall coverings, built-in cabinets, signage, canopies, built-in appliances and the dedicated electrical and plumbing serving tenant equipment are commonly 5-year or 7-year property in a study and are improvements under Rule 124 or fixtures under Rule 122.5. Paving, curbs, site lighting, landscaping and storm drains are 15-year property federally and are improvements or land development for property tax (Rule 124(b)(2); Rule 463(b)(1); AH 410, Table 2-2, p. 12, listing grading, paving, curbs, gutters, sidewalks, drains and utilities among site improvements). Data cabling embedded in walls and ceilings is physically annexed (Rule 122.5(b)(1)) whatever recovery period it carries. The 39-year class is therefore not the real property base, and the shorter classes are not personal property.

The study reconciles to total project cost, so it includes whatever the owner capitalized: the land allocation, owner-furnished furniture and equipment, computers and audiovisual systems, application software, artwork, start-up expense, each assigned a class so the total ties. The personal property among them goes on Schedule A of the property statement and is assessed annually; the software is not assessed; the operating expense is not property; the land allocation measures nothing, because the land's base year value does not change on completion (section 71). None is new construction.

The study allocates indirect costs pro rata across every asset, the opposite of what a property tax schedule needs. Pro rata allocation spreads design fees, permits and interest across furniture and software as well as the building. The property tax schedule assigns indirect costs to the improvement they brought to a finished state and leaves personal property at its own acquisition cost, which for reporting includes "excise, sales, and use taxes, freight-in, installation charges, and all other relevant costs" (BOE-571-L, Part II instructions). A study's per-asset figures are therefore wrong on both sides: indirect cost has been shifted off the building and onto the furniture.

Building the schedule: an example

A developer's wholly owned LLC completes a mid-size office and retail building in the spring of the completion year on land it has owned for years. Its construction account closes at $60 million: $48 million of hard costs under the general contract and owner-let subcontracts, including built-in fixtures; $9 million of soft costs (architecture and engineering $3 million, permits and plan check $1.5 million, construction loan interest and fees $2.5 million, builder's risk insurance and property taxes during construction $0.6 million, the developer's project staff $0.9 million, legal, title and consultants $0.5 million); $1 million of traffic and park impact fees that fund improvements elsewhere in the city; $0.5 million to demolish a small structure on part of the site; and $1.5 million of tenant improvement allowances paid to the first retail tenants. The cost segregation study totals $64 million because it also carries $2.9 million of owner-furnished furniture, computers and audiovisual equipment, $0.2 million of application software, and $0.9 million of start-up expense and leasing commissions, and it assigns about $16 million to the 5-, 7- and 15-year classes.

The property tax schedule sorts the same ledger into five classes. Non-assessable cost comes out first: the software ($0.2 million, section 995), the start-up expense and, on the textual argument above, the leasing commissions ($0.9 million, shown as a separate line), and the impact fees ($1 million, AH 410, p. 25, and Annotation 610.0063). Personal property comes out next and goes to Schedule A at its own cost: $2.9 million of furniture, computers and audiovisual equipment, assessed each year at market value and never part of the base year value. The demolition ($0.5 million) is not an addition; the removed structure's value leaves the roll under Rule 463(a). What remains is the cost of the new construction: $48 million of hard cost, $9 million of soft cost, and $1.5 million of tenant improvements, which are new construction enrolled at full cash value on completion (Property Tax Annotation 610.0105, C 11/30/1990), or $58.5 million. Inside that figure the owner separates, from the contractor's schedule of values, the built-in items the county will treat as fixtures, say $4 million of tenant kitchen exhaust and refrigeration, security and access systems, and dedicated process electrical, because those dollars go on Schedule B in the fixtures column, are outside the supplemental roll if the county normally values them as a separate unit (section 75.5(a)), and must be shown to the real property appraiser as already inside the $58.5 million.

The $58.5 million is a cost indicator, not the assessment. The assessor may add entrepreneurial services under Rule 6(b)(2) and test the result against sales of comparable new buildings and the building's income; the owner may show that part of the cost added no value or that vacancy at completion depresses what a buyer would pay. The study's $64 million was never in the analysis, and no percentage of it is.

Practice notes

The sound sequence for an owner approaching completion is to build the property tax schedule from the cost ledger before the supplemental notice arrives, in the five classes above, with each soft cost line kept visible rather than netted into a hard cost total, and with a fixture schedule tied to the contractor's schedule of values and reconciled to Schedule B of the property statement. The cost segregation study is read for its asset inventory, which is useful, and set aside for its totals and allocations, which are not. The enrolled value is then compared to the schedule's cost indicator: a value materially above cost signals an entrepreneurial profit addition or a market adjustment the owner can test, and a value materially below cost usually means the assessor's cost tables, not the ledger, drove the number. Where the county's new construction appraisal and its business property enrollment both reach the same built-in items, the owner raises the overlap in writing in the year of completion, since an appeal of the supplemental assessment is the vehicle for value and the property statement is the vehicle for fixtures and personal property. G&G State Tax Group provides new construction cost reconciliation, fixture and personal property classification, and supplemental assessment review and appeal support alongside its state and local tax practice.