Has Anyone Been Audited for Cost Segregation?

The method is not the question anymore

Owners ask this because "cost segregation sounds too good to be true" is a natural reaction to seeing carpet, cabinetry, and a parking lot reclassified out of a 39-year schedule and into 5-, 7-, and 15-year schedules. It is a fair question. The honest answer is that the technique was tested in court decades ago and it held.

In Hospital Corporation of America v. Commissioner (109 T.C. 21, 1997), the Tax Court ruled against the IRS and confirmed that a building's components can be classified separately for depreciation purposes when the underlying facts support it. That case, and the ones that followed it, is why a cost segregation study today is not an aggressive position. It is a documented application of a method the IRS itself lost the fight over and then formalized.

Decades of subsequent practice have not reopened that question. What has developed since is a body of practical standards, formalized in the IRS's own guidance, for how a study should be built so its conclusions hold up. Owners searching this question are usually really asking about that second thing: not whether the method survives scrutiny, but what makes one specific report survive it.

What the IRS actually publishes on this

The IRS does not treat cost segregation as a gray area. It publishes the Audit Techniques Guide (Pub 5653), a document written for its own examiners that walks through how a defensible study is built: site-specific engineering, cost detail tied back to actual construction or purchase records, and a reconciliation that accounts for every dollar of the purchase price or construction cost.

That guide is effectively the IRS handing every taxpayer the rubric its own examiners grade against. A study built to that standard is not exploiting a loophole. It is following the playbook the IRS wrote.

What an exam outcome actually turns on

When a return with a cost segregation study is selected for examination, and any return with any large deduction can be, the examiner is not re-litigating whether component-level depreciation is allowed. They are checking whether the specific study in front of them meets the standard. That means:

• Was the classification done by an engineer with site-specific documentation, or estimated with a rule-of-thumb percentage?
• Does the cost detail reconcile to the actual purchase price or construction cost, with nothing double-counted and nothing left over?
• Are the class-life assignments (5-year, 7-year, 15-year, and the 39-year or 27.5-year structural shell) supported by the underlying tax law, not just asserted?
• Is there a paper trail: the report itself, the closing statement or cost records, and photographs?

A study that answers those questions cleanly holds up. A study that guessed at percentages without engineering behind them is the one that has trouble, and that risk lives in how the study was built, not in the fact that a study exists at all.

An example of what a documented study looks like

To make this concrete, one recently delivered study on an office and warehouse building carried a $1,911,675 building basis (land excluded) and identified $330,674 of first-year increased deductions against a $9,900 fee, a 33.4 to 1 ratio. The number itself is not what an examiner cares about. What matters is that every dollar of that $330,674 traces back to a specific component, a specific cost, and a specific class life in the engineering file behind it.

What an examiner is trained to check

The Audit Techniques Guide is not a vague set of principles. It walks an examiner through a specific checklist: whether the engineer who performed the classification documented the building's construction type and use, whether the cost assigned to each reclassified component ties back to an identifiable line item in the purchase price or construction contract, and whether indirect costs like design fees, permits, and general overhead were allocated consistently across every component instead of loaded disproportionately onto the ones being moved to shorter schedules.

An examiner working through that checklist against a report that already answers each point in writing has very little left to argue about. That is the practical value of building a study to the IRS's own standard instead of to a lower one: it is not persuasion, it is simply having already shown the work the examiner is trained to look for.

This is also the reason a flat percentage estimate, one that assigns a round 20% or 25% of basis to short-life property without site-specific engineering behind it, is a different animal from an engineered study, even though both might be marketed under the same name. The guide draws that distinction directly, and it is why engineering-based classification matters more than the label "cost segregation study" on its own.

Who stands behind the report if it is questioned

Basis Property Group's studies are produced by our engineering team, with technical work run in partnership with one of the largest accounting firms in the country. If an examiner questions the methodology, our team provides full audit defense of the report itself, meaning the engineers who built the classification respond to the examiner's technical questions about how components were classified and costed.

That is defense of the report, not representation of the taxpayer. The owner's own CPA still represents the owner in the exam and still signs and files the return. Our job is to make sure the engineering underneath that return can answer any question an examiner asks about it.

That division of labor is deliberate. The people who built the classification are the ones best positioned to explain it years later, line by line, if a question ever comes up. The owner's CPA is not left trying to reconstruct an engineer's reasoning from a summary page; the engineers who did the work are still available to answer for it.

Frequently asked questions

Does doing a cost segregation study make my return more likely to be examined?

There is no published IRS data tying cost segregation itself to a higher audit selection rate. The method is settled law, described in the IRS's own Audit Techniques Guide. Returns get selected for many reasons unrelated to a single depreciation study, and the guide exists because the IRS expects to see these studies regularly, not because it treats them as suspicious.

What is Hospital Corporation of America v. Commissioner?

It is the 1997 Tax Court case (109 T.C. 21) where the IRS argued against component-level depreciation and lost. The ruling confirmed that building components can be classified into shorter recovery periods when the classification is supported by the facts. It is the legal foundation the entire cost segregation industry has built on since.

Can the IRS disallow a cost segregation study?

An examiner can challenge specific classifications within a study if the underlying engineering or documentation is weak. Whether a challenge holds up depends on the quality of the report, not on cost segregation as a concept. A well-documented, engineer-built study aligned with the IRS's own Audit Techniques Guide is built to withstand that kind of review.

Who deals with the IRS if my study gets questioned?

The team that produced the engineering report handles technical questions about how the study classified and costed components, that is audit defense of the report. The taxpayer's own CPA continues to represent the taxpayer and handle the exam itself. The two roles are separate and both matter.