Overview of Depreciation Compliance and IRS Audit Risk

The IRS Cost Segregation Audit Technique Guide (ATG) is a 120+ page manual used by examiners. Key areas of focus include: (1) Whether the study was performed by qualified professionals with engineering expertise. (2) Whether a physical inspection was conducted. (3) Whether the component classifications are supported by the MACRS property class tables and relevant court cases. (4) Whether the study uses a recognized methodology (detailed engineering approach, residual estimation, or sampling/modeling). (5) Whether personal property classifications are supported by the six-factor test from Whiteco Industries v. Commissioner (permanent attachment, manner of attachment, design, relationship to other property, intent of parties, and local law). Examiners are trained to be skeptical of studies with unusually high reclassification percentages, round-number allocations, and desktop-only methodologies.

An audit-resilient cost segregation file includes: the complete study report (with engineering analysis, component-by-component breakdown, and legal citations), photographs from the physical inspection, the engagement letter with the cost seg firm specifying the scope of work, the CPA's Form 3115 (if look-back) and revised Form 4562 depreciation schedules, the property appraisal or purchase price allocation supporting the building/land split, and construction documents or blueprints (if available). The study should be stored permanently—it will be relevant at every future audit and at disposition (when recapture is calculated). If the property is exchanged via 1031, the study transfers to the replacement property's file.

Audit risk for cost segregation depends on several factors. Lower risk: study performed by a reputable engineering firm with a physical inspection, reclassification percentage within typical ranges (15-30% for residential, 20-40% for commercial), and the investor has a CPA who regularly handles cost segregation returns. Higher risk: desktop study without site visit, reclassification above 40% for simple residential properties, study performed by a firm with no engineering credentials, or first-year depreciation deduction creates a disproportionately large loss relative to income. The IRS does not audit cost segregation studies as a category—they audit tax returns. A large loss on Schedule E, REPS claims, or significant changes from prior-year depreciation amounts may trigger examination, at which point the cost segregation study will be reviewed.