Cost segregation pitfalls: what the IRS audit guide looks for

Facts checked 2026-10-20. Related: Accelerated Depreciation.

A cost segregation study splits a building's cost into shorter-lived parts so that depreciation comes sooner. Bonus depreciation is back at 100% for qualified property acquired after January 19, 2025, so studies are being heavily marketed.¹ The IRS has published exactly how its examiners judge them.²

Pitfall 1: "rule of thumb" studies

The IRS Cost Segregation Audit Techniques Guide describes studies that are "merely based on a 'rule of thumb' approach", meaning they use "little or no documentation". For example, a preparer will "estimate the amount of § 1245 property as a fixed percentage of project cost by relying on previously determined 'industry averages' (e.g., 40% for a manufacturing facility)." Its instruction to examiners: "An examiner should view this approach with caution."²

Pitfall 2: missing the elements of a quality study

The guide lists 13 "Principal Elements of a Quality Cost Segregation Study":²

Preparation by an individual with expertise and experience
Detailed description of the methodology
Use of appropriate documentation
Interviews conducted with appropriate parties
Use of common nomenclature
Use of a standard numbering system
Explanation of the legal analysis
Determination of unit costs and engineering "take-off"
Organization of assets into lists or groups
Reconciliation of total allocated costs to total actual costs
Explanation of the treatment of indirect costs
Identification and listing of § 1245 property
Consideration of related issues (§ 263A, change in accounting method, and sampling techniques)

Under documentation, the guide says "A quality study includes a site visit". It also says "A field inspection is recommended for all quality studies", and that this is critical for used or acquired property, where drawings are often missing.² A study that cannot show its work is hard to defend.

Pitfall 3: assuming the deduction offsets your salary

Faster depreciation does not override the passive activity rules. For most rental owners who are not real-estate professionals and do not materially participate, the extra losses generally offset only passive income.³ The at-risk rules and the excess business loss limit can also apply.⁵⁶ A large first-year loss that cannot be used yet is a timing benefit at best.

Pitfall 4: forgetting recapture

When you sell, gain on components treated as Section 1245 property is generally taxed as ordinary income up to the depreciation taken.⁴ Cost segregation mostly moves deductions earlier. Whether it saves money overall depends on how long you hold the property and on your tax rates when you sell.

Pitfall 5: purchase-price allocations

The guide discusses Peco Foods. There the taxpayer had agreed purchase-price allocation schedules, then used a later study to reclassify assets. The Tax Court held the taxpayer "was bound by the clear and unambiguous terms of the original allocation schedules."² Allocations in a purchase contract matter.

Questions to ask a provider

Will someone with engineering or construction cost expertise inspect the property?
Will the report reconcile allocated costs to the actual purchase or construction cost?
How does it apply the legal tests for separating §1245 from §1250 property?
Has anyone modeled the passive-loss limits and recapture for my situation?

To see which strategies fit your situation, try the Tax Savings Finder. It asks a few anonymous questions to help you figure out how you might save on taxes.

Education only; not tax, legal or investment advice.

Sources

IRS Notice 2026-11 (100% bonus depreciation, property acquired after Jan. 19, 2025), https://www.irs.gov/pub/irs-drop/n-26-11.pdf
IRS Publication 5653, Cost Segregation Audit Techniques Guide, https://www.irs.gov/pub/irs-pdf/p5653.pdf
26 U.S.C. §469, https://www.law.cornell.edu/uscode/text/26/469
26 U.S.C. §1245(a)(1), https://www.law.cornell.edu/uscode/text/26/1245
26 U.S.C. §465, https://www.law.cornell.edu/uscode/text/26/465
26 U.S.C. §461(l), https://www.law.cornell.edu/uscode/text/26/461