IRS Cost Segregation Audit Techniques Simplified

In traditional depreciation, you allocate your property’s entire cost basis linearly over 27.5 years (residential) or 39 years (commercial). The approach can be pretty inefficient, as some building components won’t last that long.

To solve this problem, the IRS allows you to separate your shorter-lived building components from the real property, a process referred to as cost segregation. You can then subject the building components to depreciation schedules consistent with their actual useful lives.

However, cost segregation can be complicated, and the IRS frequently scrutinizes the reports to ensure the cost allocations are reasonable. As such, you must strictly follow the IRS Cost Segregation Audit Techniques Guide to avoid audits, lost deductions, or penalties.

In this post, we’ll explore the IRS cost segregation guide, covering its key components and accepted study methodologies. We’ll also cover audit-readiness, which is essential for real estate professionals and large-scale property owners.

What’s New in the IRS Cost Segregation Audit Techniques Guide

The IRS Cost Segregation Audit Technique Guide (ATG) is updated regularly to reflect changes in tax procedures and legislation. At the time of writing this post, the most recent changes relate to the 2017 Tax Cuts and Jobs Act (TCJA).

One of the key focuses of the guide is the utilization of bonus depreciation for accelerated depreciation and the eligibility criteria. The 2017 TCJA allowed for 100% bonus depreciation through 2022, with a phase-out schedule that saw the rate fall to 60% in 2024.

Notably, the One Big Beautiful Bill Act reversed the phase-out and restored bonus depreciation to 100% for properties placed in service after January 19, 2025. However, the ATG hasn’t captured the change as of this writing.

Here are other key details new in the ATG that you should pay attention to:

• Qualified Improvement Property: TCJA consolidated Qualified Leasehold Improvement Property, Qualified Restaurant Property, and Qualified Retail Improvement Property into a single category, Qualified Improvement Property (QIP).
• A key correction in the CARES Act of 2020: The legislation assigned a 15-year recovery period to QIP for the General Depreciation System and a 20-year recovery period for the Alternative Depreciation System.
• A new chapter 8: The new section addresses the need to correctly classify electrical distribution systems based on an electrical load analysis. The classification could result in either shorter-lived personal property or 39-year property.
• Land valuation: Updated guidance on land values stresses the need to accurately determine a property’s depreciable basis.
• Changes in accounting method: ATG references Revenue Procedure 2022-14, which updated procedures for taxpayers looking to change their accounting method.
• Residential rental property: The ATG now provides industry-specific guidance for this type of property.

Key Components of an Audit-Ready Cost Segregation Study

The IRS doesn’t mandate a specific method for conducting cost segregation studies. However, the ATG has guidance on what the IRS would consider a defensible cost segregation study.

Here are the key elements to ensure your study is defensible and audit-ready:

• Qualification of the preparer: The IRS states that a study conducted by someone with an engineering or construction background is more reliable.
• Description of the methodology: You must detail the rationale and methodology you used to arrive at various cost allocations. Chapter 3 of ATG discusses six methodologies/approaches and states that the detailed engineering approach from actual cost records is the most methodological and accurate.
• Detailed documentation: You should rely more on solid documentation of the construction costs and less on estimations. Back up the study with documentation such as construction drawings, blueprints, specifications, job reports, supplier invoices, contracts, change orders, and payment requests.
• Legal analysis: The ATG states that a quality study must provide a thorough legal analysis, including citations to support property classification decisions.
• Reconciliation: You must reconcile the segregated costs with the original tax basis.

IRS Examination Procedures and What to Expect

The IRS requires an examiner to conduct a risk analysis to determine whether the potential benefits of the examination outweigh the resources required to execute it.

If the examiner decides to proceed with the examination after the initial risk analysis, the process will proceed as follows:

• The examiner will request copies of the cost segregation study report and the letter of engagement to determine the study’s scope and evaluate its depth and accuracy.
• The examiner will interview the preparer of the cost segregation report to understand the reasoning behind the classifications.
• In some instances, the examiner may choose to inspect the property in person.
• The examiner then verifies the asset classes and recovery periods of the properties.
• The IRS requires the examiner to research the law and relevant rulings before establishing asset classifications.
• Once the examiner establishes the proper asset classifications, they perform a cost analysis to determine whether the allocations were performed properly and whether the cost basis assigned is correct.
• The examiner summarizes their findings and discusses the challenged assets with the taxpayer.
• The examiner prepares a final report or notice of proposed adjustments.

Audit Red Flags in Cost Segregation Studies

The ATG spells out what a quality study looks like. You want to avoid the following red flags that are typical of low-quality studies:

• Using rule-of-thumb estimates instead of a detailed, engineering-based analysis
• Overly aggressive classifications that could misclassify longer-life real property
• Unreasonable land valuations to increase the depreciable basis
• Missing or incomplete documentation

Also, using a preparer who lacks the requisite professional experience or background is a significant cause of concern.

Accepted Methodologies in Cost Segregation Studies

The IRS Cost Segregation Audit Techniques Guide discusses the following six common approaches for conducting cost segregation studies:

• Detailed engineering approach from actual cost records: Also referred to as the “direct cost method” or “detailed cost approach,” this methodology requires you to rely on detailed direct cost information (from vendors, suppliers, contractors, etc.) and indirect cost information (from consultants, local government departments, etc.). It’s ideal for new constructions where records are available.
• Detailed engineering cost estimate approach: This methodology is similar to the detailed cost approach, except it estimates some costs. However, you must ground the estimates on solid documentation and construction-based documents. It’s used primarily on acquired properties where detailed cost records are unavailable.
• Survey or letter approach: In this methodology, you’ll contact the contractors and subcontractors via survey or letter and request information on the costs of the assets they installed on the property. You’ll then reconcile further estimates with the actual costs.
• Residual estimation method: In this approach, you’ll determine the costs of the short-lived assets and deduct them from the total project cost to establish the value of the long-lived real property.
• Sampling or modeling approach: This approach requires you to analyze properties identical to yours in terms of use, appearance, and construction, then model costs based on pre-established cost data. For instance, the model may show that 10% of the costs are allocable to personal property.
• “Rule of thumb” approach: This methodology uses little or no documentation and estimates costs based on rules of thumb. It generally relies on the preparer’s experience and industry averages.

Evidently, the best approach is to do a detailed, engineering-based cost segregation study.

At Seneca Cost Segregation, we only conduct engineering-based studies, leveraging our experienced team of engineers who have completed over 10,000 studies nationwide.

Moreover, each study is backed by Seneca AuditDefense, giving you peace of mind that we’ll help you defend our asset classifications and cost allocations in the unlikely event of an audit.

Request a free proposal today to see how much you can save in taxes with an IRS-compliant engineering-based cost segregation study.

Importance of Documentation for IRS Compliance

Detailed documentation is a principal element of a quality segregation study and report. You want to use the best available documentation to classify and determine the costs of all short- and long-lived assets.

Here’s why documentation is necessary:

• Supporting asset classification: The primary goal of a cost segregation study is to identify shorter-lived assets for purposes of accelerated depreciation. You should address the IRS’s fears that you may over-allocate costs to shorter-lived assets. Provide construction documentation such as drawings, blueprints, and specifications.
• To substantiate costs: You want to assure the examiner that the allocated costs are grounded in facts, not guesswork. You can provide purchase/closing documents, change orders, payment requests, and vendor/supplier invoices.

Additionally, the preparer’s credentials and documentation quality will likely determine the IRS’s decision to challenge the study.

For instance, in the case of the “rule of thumb” approach that utilizes minimal documentation, the IRS cost segregation guide explicitly instructs examiners to view such studies with caution.

Best Practices to Prepare for an IRS Audit

A cost segregation study conducted strictly according to IRS guidelines is the best audit defense.

Here are the three IRS recommendations that we believe will enhance your audit readiness:

• Take the engineering-based approach: The IRS states that a study done by someone with a construction or engineering background is more reliable. Use the IRS-preferred approach and avoid accounting-based, “rule of thumb”, and residual estimation methodologies.
• Partner with a qualified professional: The cost segregation report must detail the preparer’s qualifications. As such, it helps to use only the best cost segregation company.
• Provide detailed documentation: The more supporting documents you provide to substantiate property classifications and cost allocations, the better. You should offer source records and reconcile costs.

Frequently Asked Questions (FAQs)

Let’s answer some of the common questions we get about cost segregation:

What is the Difference Between a Cost Segregation Audit and a Tax Court Case?

An audit is an administrative process that helps the IRS verify the claims you’ve made in your cost segregation report. The IRS may arrive at a determination different from your original claims.

If you disagree with the IRS’s determination, a court case (a judicial process determining the correct tax liability) may ensue.

Can the IRS Reopen a Previously Audited Cost Segregation Study?

Yes, the IRS can reopen such a case, but it’s uncommon because taxpayers have a right to finality.

How Does Bonus Depreciation Impact an IRS Cost Segregation Audit?

Cost segregation and bonus depreciation help you frontload the depreciation of personal property and site improvements. It’s a substantial deduction.

Therefore, the IRS will be particularly interested in the accuracy of your cost allocations.

What Penalties Can Arise from a Failed Cost Segregation Audit?

The primary result of a failed audit is often disallowed deductions, back taxes, and interest.

However, some accuracy-related penalties, such as those under the Internal Revenue Code (IRC) §§ 6662 (20% of the underpayment or 40% in egregious cases), may also apply.

How Long Does an IRS Cost Segregation Audit Usually Take?

Depending on the property, the cost segregation methodology, and the taxpayer’s status, a cost segregation audit could last months or more than a year.

Conclusion

A cost segregation tax strategy is an excellent way to free up cash to grow your portfolio faster. However, it demands technical competence and strict adherence to IRS guidelines.

Don’t let an undocumented study expose you to audit risk. At Seneca Cost Segregation, we use an IRS-preferred engineering-based methodology to deliver studies designed to withstand the highest levels of IRS scrutiny.

Contact us today to take the guesswork out of IRS compliance, bake audit-readiness into your cost segregation study, and convert 20-40% of your property costs into immediate tax savings.