Cost Segregation and the IRS: Is It Legal? Does It Raise Audit Risk?

This content is not tax or financial advice for you. Please talk with a CPA to find what's right for your situation.

Does the IRS allow cost segregation?

Yes. The tax code itself sets different depreciation lives for different kinds of property. Cost segregation is simply the process of identifying which parts of a building fall into which category.

The turning point came in 1997, when the U.S. Tax Court decided Hospital Corporation of America v. Commissioner. The court agreed that certain building components could be treated as personal property with shorter lives. The IRS later accepted this approach and in 2004 released its first audit guide for cost segregation studies.

What the IRS actually cares about

The IRS doesn't object to cost segregation. It objects to poor cost segregation. Its audit guide tells examiners to look for:

• Who prepared the study and whether they have relevant expertise
• Whether the method used is reliable and clearly explained
• Whether costs are supported by real documents, not guesses
• Whether the allocated costs add up to the actual purchase or construction cost
• Whether the legal reasoning for each classification is explained

In its guide, the IRS ranks study methods. A detailed engineering approach based on actual cost records is considered the most reliable. "Rule of thumb" approaches are considered the least reliable.

Does cost segregation trigger an audit?

There's no rule that says a cost segregation study triggers an audit. But a few things can draw attention:

• A very large loss compared to your income
• Claiming real estate professional status to use those losses
• Unusually high reclassification percentages for the property type
• Missing or sloppy Form 3115 filings on look-back studies

The IRS has received more funding for enforcement in recent years. That makes documentation more important than ever.

How to keep your study audit-ready

• Hire qualified people. Look for engineering credentials or certified cost segregation professionals.
• Get a detailed report. It should include methods, photos, asset lists, cost sources, and a reconciliation.
• Avoid contingent fees. A fee tied to your tax savings can look like an incentive to inflate results.
• Keep your records. Store the study with your tax files for as long as you own the property, plus at least three years after you sell.
• File paperwork correctly. For look-back studies, file Form 3115 with your timely filed return and send the required copy to the IRS.

What happens if the IRS challenges a study?

An examiner may reclassify some assets back into 27.5- or 39-year property. That would reduce your deductions and could lead to tax, interest, and possibly penalties. A strong report with clear support is your best defense. Many providers include audit support in their fee. Ask before you sign.

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This content is not tax or financial advice for you. Please talk with a CPA to find what's right for your situation.