A cost segregation study breaks a building purchase or construction cost into components with different recovery periods. Items classified as five-, seven- or 15-year property depreciate faster than the building shell, which is 27.5 years for residential rental property or 39 years for nonresidential real property under Publication 946. With bonus depreciation, reclassified components can produce a large first-year deduction. The CPA firm that signs the return owns the position, so it should be able to review the study the way an IRS examiner will.
The examiner's yardstick
IRS Publication 5653, the Cost Segregation Audit Technique Guide, describes a study as a way to "segregate" or "allocate" costs among land, land improvements, buildings, equipment, and furniture and fixtures. It states that it is not an official pronouncement and cannot be cited as authority, but it shows what an examiner looks for. Chapter 4 lists 13 principal elements of a quality study:
- Preparation by an individual with expertise and experience.
- A detailed description of the methodology.
- Use of appropriate documentation.
- Interviews with appropriate parties.
- Use of a common nomenclature.
- Use of a standard numbering system.
- An explanation of the legal analysis.
- Determination of unit costs and engineering take-offs.
- Organization of assets into lists or groups.
- Reconciliation of total allocated costs to total actual costs.
- An explanation of the treatment of indirect costs.
- Identification and listing of section 1245 property.
- Consideration of related aspects, such as section 263A, a change in accounting method and sampling.
Read the study against that list. A report with a table of percentages and no unit costs, interview notes or reconciliation will not survive a request for support.
Test the numbers
- Reconciliation. The total allocated to all components must equal the total actual cost, including land. Agree it to the closing statement or the construction cost ledger.
- Land. Land is not depreciable. The guide expects a quality study to explain how land and land development costs were treated, and those costs generally go to non-depreciable land accounts. Check that the study used the same land allocation as the return.
- Indirect costs. The guide says indirect costs must be allocated proportionately to the basis of the assets they relate to. Costs to survey and subdivide land and general grading are typically allocable only to land, while building permits, general conditions and contractor overhead and profit are typically spread pro rata.
- Furniture and equipment. Costs belong in the study only if the furniture, fixtures and equipment were included in the total project cost. If they were bought separately, the study should not assign project cost to them.
- Method used. The guide lists six approaches: detailed engineering from actual cost records, detailed engineering cost estimate, survey or letter, residual estimation, sampling or modeling, and "rule of thumb." It says an examiner should view a rule-of-thumb study with caution because of thin documentation, but should not reject it categorically; the documentation is examined on its own merits.
- Prior-year property. The guide states the Service's position that reclassifying property already on a filed return is a change in accounting method. It requires consent, generally through Form 3115, with the adjustment under section 481(a), and says claims based on a study done after the original return was filed should not be allowed as amended returns. Confirm the return preparer has handled it.
Worked example one: a warehouse
A client buys a warehouse for $2,000,000. Land is $400,000, leaving $1,600,000 depreciable. A study reclassifies 20 percent of the depreciable cost, or $320,000, to five-, seven- and 15-year property. Assume 100 percent bonus depreciation applies to the reclassified property and approximate year one with a full-year amount.
- Without a study: $1,600,000 divided by 39 is $41,026.
- With a study: bonus on $320,000 is $320,000, plus $1,280,000 divided by 39, which is $32,821. Total $352,821.
- Increase in first-year deduction: $352,821 minus $41,026, or $311,795.
Notice 2026-11 describes the 100 percent additional first year depreciation deduction for qualified property acquired after January 19, 2025, and states that property is not treated as acquired after the date a written binding contract for its acquisition is entered into. Check the contract date before assuming the percentage.
Worked example two: an apartment building
A client buys an apartment building for $3,000,000. Land is $600,000, leaving $2,400,000 depreciable as residential rental property over 27.5 years. A study reclassifies 25 percent, or $600,000, to shorter-lived property, and the same bonus assumption applies.
- Without a study: $2,400,000 divided by 27.5 is $87,273.
- With a study: $600,000 of bonus, plus $1,800,000 divided by 27.5, which is $65,455. Total $665,455.
- Increase in first-year deduction: $665,455 minus $87,273, or $578,182.
Both examples ignore the mid-month convention, so the first-year building amount is smaller in practice. The deduction is a timing benefit. The five- and seven-year components are section 1245 property, so a later sale recaptures the depreciation on them as ordinary income, as described in depreciation recapture under sections 1245 and 1250. For the bonus rules, see section 179 and bonus depreciation after the 2025 legislation.
Common errors to catch
- A table of percentages with no unit costs, take-offs or interview notes.
- A reclassified total that does not reconcile to actual cost.
- Land allocated differently in the study and on the return.
- A study applied to a filed year through an amended return instead of a method change.
- No preparer credentials in the report.
- Rule-of-thumb percentages applied to a building they were not drawn from.
Review steps
- Obtain the study and the preparer's credentials and experience.
- Agree total cost and the land allocation to the closing statement or cost ledger.
- Check the report against the 13 elements and note any missing.
- Test the reclassified groups to the fixed asset register, with recovery period and in-service date for each.
- Recompute year-one depreciation and agree it to the return.
- If the property was placed in service in an earlier year, confirm the method-change filing.
What to keep in the file
- The study and the engineer or preparer's credentials.
- The reconciliation to actual cost and the land allocation support.
- The fixed asset register showing each reclassified group, recovery period and date.
- The client's loss-use analysis: passive loss limits, basis and the effect on the real estate professional test.
- The sale plan, if any, because recapture changes the economics.
Sources
- Internal Revenue Service, Publication 5653, Cost Segregation Audit Technique Guide (revised June 2022): https://www.irs.gov/pub/irs-access/p5653_accessible.pdf
- Internal Revenue Service, Publication 946, How To Depreciate Property (27.5-year and 39-year recovery periods): https://www.irs.gov/publications/p946
- Internal Revenue Service, Notice 2026-11, Interim Guidance on Additional First Year Depreciation Deduction under Section 168(k): https://www.irs.gov/pub/irs-drop/n-26-11.pdf
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error