Is cost segregation legal?

The short answer

• Is it legal? Yes. It applies the depreciation classes the tax code already has.
• Is it a loophole? No. It changes when depreciation is taken, not the total.
• Does it raise audit risk? Any large deduction can draw questions. What matters is whether the study is documented well enough to hold up.
• Does the IRS approve studies? No. There is no approval process. The taxpayer has to be able to support the depreciation.

Why it is legal

Tax law does not treat a building as one item. It gives different parts different lives:

• The structure: 27.5 years for residential rentals, 39 years for other buildings.
• Items such as appliances, carpet and dedicated wiring: 5 or 7 years.
• Work outside the walls, such as paving, site lighting, fencing and landscaping: 15 years.

A cost segregation study sorts what was spent on a building into those classes. It is not a special election or a gray area. It is the tax code’s own classes, applied to the actual parts of the building. Without a study, the whole cost generally stays on the longest life, because nothing shows which parts qualify for shorter ones.

Is it a loophole?

No. Cost segregation changes when depreciation is taken, not the total. Over the life of the building, the total is the same. Taking more of it in the early years means paying less tax sooner and more later.

When the building is sold, part of that depreciation can be taxed again, which is called depreciation recapture. How it plays out for you is a question for your accountant.

Cost segregation audit risk

Any large deduction can draw questions from the IRS, with or without a study. A study does not make a return improper. What matters, if the IRS asks, is whether the study holds up.

The IRS guide tells examiners what to look for. In plain terms:

• Real cost records beat estimates. The guide calls a detailed approach built from actual construction costs the most accurate method. It tells examiners to view “rule of thumb” allocations with caution, because they lack documentation.
• The numbers must add up. The costs in a study should reconcile to the total actually spent or paid.
• Each classification needs a reason. The guide expects the legal analysis behind each class to be explained, and the method to be described.
• The preparer should know the work. The guide lists expertise and experience first among the elements of a quality study.

A weak study is where owners get hurt. In AmeriSouth XXXII v. Commissioner (2012), a case about an apartment complex, the Tax Court held that most of the items a study had moved to shorter lives were part of the building, and it faulted the owner’s evidence on others. A study holds up only as well as its reasoning and documentation.

Background: the courts and the IRS

• The Tax Court, 1997. In Hospital Corporation of America v. Commissioner, the court held that the long standing tests for telling personal property apart from a building still apply under today’s depreciation system. That is the basis of cost segregation.
• The IRS, 1999. The IRS formally accepted that part of the decision (Action on Decision 1999-008), while keeping the right to disagree about how particular items are classified.
• The IRS guide. The IRS publishes the Cost Segregation Audit Techniques Guide (Publication 5653, last revised in February 2025) for its own examiners. It explains how to review a study and what separates a reliable one from a weak one.

The IRS has no approval process for studies or preparers, and it has not set a required standard for preparing one. What it asks is that the taxpayer be able to support the depreciation claimed.

How Highbridge Studies prepares a study

Every study is prepared to the IRS Cost Segregation Audit Techniques Guide. It starts from the building’s own records, the property is visited in person, each classification carries its citation, and the total is reconciled to what was spent. The study process page walks through each step.

Highbridge Studies prepares the study only. It does not represent clients before the IRS or a state tax department, and no preparer can promise that the IRS will agree with every classification. How the study is used on a return is for your accountant to decide.

Curious what a study could mean for a building of your own? The cost segregation calculator gives a rough federal estimate.

Sources

• IRS Publication 5653, Cost Segregation Audit Techniques Guide (revised February 2025). Discusses Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), Action on Decision 1999-008 and AmeriSouth XXXII v. Commissioner, T.C. Memo. 2012-67.
• IRS Publication 946, How to Depreciate Property, for the class lives.

Questions