Cost Segregation and IRS Audit Triggers
Understanding what actually triggers IRS examination of cost segregation positions is important for property owners and their advisors. The IRS does not publish its selection algorithms, but the patterns that attract attention are fairly well understood from ATG guidance, practitioner experience, and examination history. Cost segregation audit triggers are specific and manageable, not a reason to avoid the practice.
This article identifies the real audit red flags in cost segregation, distinguishes them from factors that are commonly but incorrectly viewed as triggers, and explains what properties are more likely to face review. For context on how examinations are actually conducted, see the IRS audit and compliance guide.
TL;DR - Key Takeaway
How the IRS Selects Returns for Cost Segregation Examination
IRS return selection is not primarily driven by manual review of individual depreciation schedules. The IRS uses computerized scoring systems, including the Discriminant Information Function (DIF), to compare returns to statistical norms for similar taxpayers. Returns that score significantly above the norm in specific categories may be selected for review.
Returns are also selected through information matching, referrals from other examinations, and industry-specific enforcement initiatives. The IRS periodically focuses examination resources on specific industries or practices that it has identified as sources of compliance risk. Cost segregation has been the subject of targeted guidance rather than targeted enforcement, which reflects the IRS's position that the practice is acceptable when done correctly.
Real Cost Segregation Audit Triggers
The factors that genuinely increase cost segregation examination risk are specific and well-documented:
- Use of deficient methodology: Studies using the residual method or rule-of-thumb percentages without engineering analysis are more likely to contain errors that an IRS agent can identify.
- Inconsistent Form 4562 reporting: If the depreciation schedule does not reconcile to the study, the discrepancy may attract computational review.
- Unusually high personal property percentages: Allocations that are significantly higher than typical for the property type may attract review, even if they are technically correct.
- Missing documentation: A study without adequate construction records or site documentation is more vulnerable to adjustments if selected.
- Unqualified provider history: If the IRS has encountered deficient studies from the same provider in prior examinations, returns prepared by that provider may face elevated scrutiny.
Depreciation Audit Triggers Specific to Real Estate
Several depreciation-specific patterns attract IRS attention in real estate returns. These include: applying bonus depreciation to assets that do not clearly qualify as personal property or 15-year land improvements, inconsistent treatment of similar assets across different properties on the same return, and claiming depreciation on assets that may be non-depreciable (such as land improvements that are actually land).
The irs audit triggers real estate category also includes changes in depreciation method that are not accompanied by a proper Form 3115 filing. Switching from one depreciation treatment to another without following the applicable change in accounting method procedures creates a compliance issue independent of the cost segregation question.
What Triggers a Cost Segregation Audit in Practice
In practice, the cost segregation studies most likely to face examination are those with: very large Section 481(a) adjustments from retroactive studies, high reclassification percentages on properties where the property type does not typically support such percentages, or studies prepared by providers with a history of examination issues.
Studies on large commercial properties with complex asset mixes may face examination simply because the magnitude of the deductions involved justifies the IRS resource allocation. This is not a sign that the study is deficient, but it makes quality preparation more important.
Form 3115 and Cost Segregation Audit Exposure
Retroactive cost segregation studies implemented via Form 3115 are a common source of large Section 481(a) adjustments. The IRS National Office must consent to certain automatic change in accounting method requests, and the IRS reviews Form 3115 filings as part of its normal process.
A Form 3115 filing does not by itself trigger examination. However, a very large negative 481(a) adjustment on a return may attract computational review. The most effective way to manage this is to ensure the underlying retroactive study is well-documented and meets ATG quality standards.
Audit Triggers by Property Type
The IRS has accumulated data on typical reclassification percentages by property type from prior examinations. Returns that deviate significantly from these norms may face additional scrutiny. For example, a simple single-tenant commercial building reporting a very high personal property percentage without specialized systems or improvements may invite questions.
Properties with specialized uses, such as hospitality, healthcare, manufacturing, or food service, have legitimate reasons for higher personal property allocations due to specialized equipment, process systems, and distinctive interior improvements. These classifications should be supported by property-specific documentation.
Table 1: Relative Audit Trigger Likelihood by Allocation Pattern
| Pattern | Trigger Likelihood | Mitigation |
|---|---|---|
| Allocation consistent with property type norms | Low | Standard documentation is sufficient |
| High allocation with specialized property support | Low to moderate | Property-specific engineering documentation essential |
| High allocation without specialized property context | Elevated | Thorough asset-by-asset documentation required |
| Large 481(a) adjustment via Form 3115 | Moderate | Complete retroactive study documentation |
| Study from provider with prior IRS issues | Elevated | Use qualified credentialed provider |
Triggers Reference Table
| Trigger Factor | Real Trigger? | Notes |
|---|---|---|
| Performing a cost segregation study | No | IRS accepts the practice; not a red flag |
| Deficient methodology (residual method) | Yes | ATG-flagged; creates systematic error risk |
| Form 3115 filing with large adjustment | Partial | IRS-approved procedure but large adjustments attract review |
| Missing site inspection documentation | Yes | Reduces defensibility; ATG quality element missing |
| Using an engineering-based provider | No | Reduces risk; ATG-aligned methodology |
Managing Cost Segregation Trigger Exposure
The most effective way to manage audit trigger exposure is to control the factors that are within the taxpayer's control. Engaging a qualified provider, conducting a physical site inspection, maintaining complete documentation, and reconciling the study to the filed return addresses every known trigger factor.
For the full suite of mistakes that create examination exposure, see common cost segregation mistakes and how to avoid them. For specific misclassification risks that attract scrutiny, see common misclassifications in cost segregation studies.
True Audit Red Flags vs Common Misconceptions
The most common misconception about audit red flags cost segregation is that the practice itself is aggressive. Cost segregation is established, accepted, and explicitly addressed by IRS guidance. The real red flags are methodological and documentary, not strategic.
A property owner who performs a cost segregation study using a qualified provider, maintains complete documentation, and files a return consistent with the study conclusions has done everything that can reasonably be done to manage audit exposure. The residual risk is the normal audit risk that applies to any tax position.
Frequently Asked Questions
What triggers a cost segregation audit?
No single factor automatically triggers a cost segregation audit. Examination selection is driven by statistical algorithms, information return matching, and referrals. Factors that increase selection likelihood include large unexplained deductions, unusual year-over-year depreciation changes, and patterns the IRS has observed in prior examinations of similar returns.
Does a large depreciation deduction automatically trigger IRS scrutiny?
A large depreciation deduction alone does not automatically trigger IRS review. The IRS uses statistical methods to compare a return to similar returns. A deduction that is proportionate to the property basis and consistent with the property type is less likely to attract attention than one that is outlier relative to comparable returns.
Are Form 3115 filings a cost segregation audit trigger?
Form 3115 filings for a change in accounting method are reviewed by the IRS, but they are an IRS-approved procedure and are not inherently a red flag. However, because they produce a Section 481(a) adjustment that can be large, they may attract computational review to verify the adjustment was calculated correctly.
What depreciation audit triggers apply specifically to real estate?
Real estate depreciation audit triggers include: inconsistent asset class lives across years, switching from one depreciation method to another without a Form 3115, claiming bonus depreciation on assets that may not qualify, and reporting land improvements as 15-year property without adequate documentation.
Does cost segregation with bonus depreciation face more scrutiny?
The combination of cost segregation and bonus depreciation can produce a large first-year deduction that stands out on a return. While this is not an IRS red flag by itself, it may increase computational review. The underlying classification methodology and documentation standards are the same regardless of whether bonus is claimed.
What is cost segregation scrutiny by property type?
The IRS pays attention to allocation percentages relative to property type norms. If a simple commercial building reports an unusually high percentage of personal property compared to similar properties, the classification may face additional scrutiny. This does not mean the classification is wrong, but the documentation must be proportionately thorough.
Can a prior audit increase cost segregation examination likelihood for future years?
If a prior year examination resulted in adjustments to cost segregation positions, the IRS may flag subsequent years with similar positions for review. A prior audit that was resolved without adjustments does not generally increase future examination risk.
What red flags do unqualified providers create in cost segregation?
Studies prepared by unqualified providers may contain systematic errors in classification that are identifiable by IRS agents familiar with the Audit Techniques Guide. Providers that the IRS has encountered in prior examinations with poor-quality work may also elevate scrutiny for taxpayers who use them.
Does retroactive cost segregation using Form 3115 increase audit risk?
Retroactive cost segregation filed via Form 3115 is an IRS-approved change in accounting method. It does not create special audit risk beyond the normal review applied to any Form 3115 filing. However, the retroactive study must still meet all quality standards and documentation requirements.
How does consistent documentation reduce cost segregation scrutiny?
Complete, well-organized documentation reduces scrutiny by making the IRS review process more efficient. When an agent can verify all classifications quickly from the study report and supporting documents, they are less likely to expand the examination scope or request additional information.
To understand how to defend a study if examination occurs, see how to defend a cost segregation study in an audit. For the broader compliance framework, see the IRS Audit and Compliance guide.