With the signing into law of the One Big Beautiful Bill Act, bonus depreciation is back to 100% for properties placed in service after January 19, 2025. This development is likely to drive strong interest in cost segregation tax strategies going forward.
However, to minimize audit risk, you must implement the strategies strictly in accordance with IRS guidelines. It requires leveraging competent professionals throughout the process, from property inspection and analysis to tax preparation.
This post will help you identify a professional who can perform a cost segregation study whose results can withstand IRS scrutiny.
Who Can Perform a Cost Segregation Study?
The IRS does not mandate a specific profession or methodology for cost segregation studies. Any competent professional who can execute defensible and documentation-backed asset classification and cost allocations can perform a cost segregation study.
Generally, the following providers can perform a cost segregation study:
- Specialist cost segregation firms: Specialist firms with in-house engineers are the industry standard, especially for larger properties with significant depreciable basis.
- Accounting firms: Some CPA and tax advisory firms offer cost segregation services as part of their tax planning solutions for real estate investors. The cost segregation is often CPA-led, but some firms have in-house engineers.
Essential Qualifications and Credentials to Look for
While the IRS does not mandate a specific profession or qualification for cost segregation, its Cost Segregation Audit Technique Guide lists “preparation by an individual with expertise and experience” as a key element of a quality cost segregation study.
Specifically, the IRS states the following:
- Cost segregation requires expertise in construction methods and tax legislation regarding how property is classified for depreciation purposes.
- Generally, a study conducted by an engineer is more reliable than one performed by an individual without a background in construction or engineering.
That’s why as far as qualifications and credentials go, we recommend the following:
- Get specialist engineers with construction experience for the asset classification and cost allocations.
- Leverage a cost segregation-minded CPA familiar with relevant legislation to prepare your taxes.
The CPA should have hands-on experience integrating cost segregation into tax returns.
More importantly, they should understand how to treat bonus depreciation, Section 179, and Partial Asset Dispositions (PAD). Additionally, they should have experience using IRS Form 3115 to implement cost segregation on properties placed in service in prior years without requiring amendments to previous tax returns.
Who Should Not Perform a Cost Segregation Study
A quality cost segregation study will have detailed asset-level breakdowns, carefully documented engineering “take-offs,” and audit-ready workpapers.
It’s unlikely that you’ll achieve these standards if you let the following perform the cost segregation study:
- A generalist CPA: While a CPA likely understands the relevant tax treatments, they often lack the expertise required to identify all shorter-lived assets within a building and how to allocate costs using engineering costing techniques.
- A “rule of thumb” provider: It’s unwise to rely on providers who use fixed percentages or industry averages to classify assets and allocate costs. The IRS explicitly advises its examiners to approach these studies with caution, as they lack sufficient documentation to support cost allocations.
- Appraisers and valuation professionals: An appraiser or valuer helps determine fair market value. Their expertise does not extend to allocating costs into defensible depreciation reclassifications that can withstand IRS scrutiny.
Also, we advise against using DIY software to do your own cost segregation study. A lack of engineering review significantly increases audit risk.
IRS Guidelines on Who Can Perform Cost Segregation Studies
The IRS Cost Segregation Audit Technique Guide (ATG) is the primary guideline you should abide by when looking to produce a quality cost segregation report. It does not mandate a specific profession or credential for cost segregation studies.
The focus is more on approach or methodology, with the IRS acknowledging the following approaches:
- Detailed engineering approach from actual cost records: This involves utilizing cost information from existing construction/renovation and accounting records. It’s also called the “direct cost method.”
- Detailed engineering estimate method: It applies when actual cost records aren’t readily available. While it uses estimation, the engineering method still relies on solid documentation and construction records, such as building plans, job reports, and invoices.
- Survey or letter approach: This involves estimating costs by contacting contractors and subcontractors to obtain information on the costs of various assets within the property.
- Residual estimation approach: The methodology estimates only the costs of the shorter-lived assets and subtracts them from the total project cost. The remaining/residual cost is allocated to longer-lived assets.
- Sampling or modeling approach: The methodology uses models/templates to analyze multiple similar properties (by construction, use, and appearance). It then develops a standard model based on percentages and applies it to all properties within that specific category.
While the IRS provides for flexibility in methodology, it requires your study to be done by a “qualified individual” or “professional firm” that can competently make estimations relating to building construction.
Further, the guide explicitly states that a study done by an engineer is more reliable than one conducted by someone without an engineering or construction background.
That’s why we recommend you only consider engineering-based cost segregation studies, i.e., either of the first two approaches we discussed.
At Seneca Cost Segregation, we only do engineering-based studies. Also, we go above and beyond to provide the following:
- CPA-ready documentation: We provide a comprehensive cost segregation report that your CPA can easily use to prepare your taxes.
- Implementation support: Should you and your CPA require guidance on how to implement our findings effectively, we’ll be available post-study to provide the necessary support.
- Audit defense: We stand behind every report we create. Every study is backed by our iron-clad Seneca AuditDefense guarantee.
Ready to maximize your tax savings with an IRS-compliant cost segregation study?
Contact our team today for an engineering-based study that can turn 20-40% of your property cost into immediate tax savings.
Risks of Using an Unqualified Cost Segregation Provider
You must use a qualified provider for your cost segregation study to eliminate or minimize the following risks:
- Missed tax savings: An unqualified provider may fail to identify all shorter-lived assets in your property, resulting in lower front-loaded depreciation.
- Audit risk: An unqualified provider may use improper estimation techniques and fail to back up their claims with sufficient documentation, significantly increasing audit risk.
- Section 6662 penalties: If the incorrectly done cost segregation study leads to a substantial understatement of your income tax, the IRS may impose an accuracy-related penalty equal to 20% of the underpayment.
- Additional study costs: If the IRS rejects your asset classifications and cost allocations, you may have to undertake a corrective study, which will come with extra costs. It’s best to do everything correctly the first time.
Further, an unqualified provider may compromise your exit strategy. Often, you have to deal with depreciation recapture if you sell a property soon after front-loading depreciation.
If the assets weren’t appropriately classified during cost segregation, it will undermine asset tracing, complicating the use of exit strategies like 1031 exchanges.
How to Choose the Right Cost Segregation Specialist
Technical expertise and professional credentials are only the baseline requirements to evaluate when choosing a cost segregation specialist.
For an excellent outcome, you must also consider the following factors:
- An in-house engineering team: Firms without engineers, e.g., accounting firms, typically outsource the actual cost segregation analysis. It leads to inflated costs because the contracted team has its own markup to cover.
- Verifiable industry experience: Like any other professional services field, cost segregation benefits from having extensive industry experience. It increases the likelihood that you make the proper judgment in grey areas, which is valuable because IRS cost segregation guidelines leave room for professional interpretation.
- Audit defense guarantee: While a properly done study is unlikely to cause an audit, the firm should be ready to defend its report in the event of an IRS audit. Also, the audit protection should be accompanied by a money-back guarantee.
Additionally, you should only work with a firm that’s comfortable doing a complimentary preliminary analysis on your property to help you ascertain your potential tax savings before you commit to a full study.
It will help you determine if the cost segregation study is worth it.
Frequently Asked Questions (FAQs)
Here are answers to some of the commonly asked questions about cost segregation:
Is Cost Segregation Allowed for Mixed-Use Properties?
Yes, mixed-use properties are eligible for cost segregation.
We recommend using an experienced cost segregation firm because of the complexities associated with shared infrastructure and leasehold improvements.
How Long Does a Cost Segregation Study Take?
The duration depends on the size of the property and the firm’s capacity.
At Seneca Cost Segregation, we typically complete studies within 2 to 4 weeks.
Can I Do My Own Cost Segregation Study?
Yes, you can do your own cost segregation study if you have the construction and engineering expertise to classify assets and allocate costs correctly.
Without the expertise, we strongly advise against it due to the heightened audit risk.
Conclusion
A comprehensive cost segregation tax strategy should employ engineering expertise, complete documentation, and expertise in accounting/tax legislation.
It’s best to rely on an experienced engineering team for the asset classification and cost allocation side of the project and a knowledgeable cost segregation-minded CPA for tax preparation.
At Seneca Cost Segregation, we have an experienced engineering team that has completed over 10,200 studies nationwide. We know what it takes to produce a defensible IRS-compliant study.
Also, you can tap into our network of reliable cost segregation-minded professionals, such as CPAs and tax advisors, should you need them.
Contact us today for a free proposal and a complimentary preliminary analysis of your property to see how much you can save with a cost segregation study.
