Cost Seg Audits Are Heating Up: What Real Estate Investors Need to Know

At the start of the episode, Thomas announces that Hall CPA has officially brought cost segregation services in-house. For now, the service is being offered exclusively to current clients, though that may expand in the future.

This shift comes at a time when cost segregation is drawing more attention from IRS examiners, making study quality and defensibility more important than ever.

What the IRS Is Challenging in Cost Seg Audits

According to Justin, one of the biggest trends in recent audits is that many examiners still seem unfamiliar with how cost segregation studies actually work. In some cases, the first hurdle is simply walking the examiner through the basic purpose of the study and explaining how the depreciation numbers were calculated.

Nathan adds that every audit is different. Some agents ask for the full cost segregation study, while others only want to see the depreciation report or supporting schedules. But one thing has shown up consistently across nearly every audit: material participation logs.

Even when the audit doesn’t seem directly tied to participation issues, the IRS often asks for those logs before closing things out. For short-term rental investors in particular, keeping those records current is critical.

Increased IRS Focus on Five-Year Property

One of the more significant developments the team has seen is an increase in IRS scrutiny around five-year property, also known as Section 1245 property.

Nathan explains that the IRS appears to be pushing back more aggressively on whether certain components really qualify for shorter depreciable lives. For example, assets like cabinets, flooring, and lighting may have previously been classified as personal property eligible for bonus depreciation, but examiners are increasingly arguing that some of those items are actually structural components of the building and should be depreciated over 27.5 or 39 years instead.

That distinction matters a lot. When an item is reclassified out of five-year property, it can no longer qualify for the same front-loaded depreciation benefits, which can significantly reduce the taxpayer’s deduction.

Why Photos Are Becoming More Important

A recurring theme in these audits is the IRS asking for photographic evidence.

Justin says that when examiners dig into a cost segregation study, they often want photos of the actual property components being classified. That makes sense from the IRS’s perspective. The examiner is sitting behind a desk, often reviewing returns from prior years, and likely has no practical way to visit the property in person.

Photos can help substantiate whether specific assets truly qualify for shorter recovery periods. They also become especially important when the property has already been sold by the time the audit begins, which is often the case given that audits frequently examine returns filed 18 to 24 months earlier.

This is one reason more detailed studies that include visual documentation can be much easier to defend.

Why Software Studies Are Becoming Riskier

When Thomas asks how this trend affects software studies, both Justin and Nathan are clear: software-based cost segregation studies are becoming a much higher-risk option.

The main problem is that software studies typically do not involve a site visit, photographic documentation, or detailed property-level substantiation. So when an auditor asks for support, there may be little available beyond the output of the software itself.

Nathan points out that if a taxpayer didn’t also pay for audit support through the provider, they may be left without meaningful backup when the IRS starts asking questions. That can put taxpayers in a vulnerable position, especially as audit activity expands into 2022 and 2023 returns and sometimes into additional years when multiple properties are involved.

In his view, this is a very recent shift, but it’s becoming a meaningful one. What may have once been seen as a lower-cost shortcut is now carrying a lot more audit exposure.

The 2025 IRS Audit Technique Guide Matters

A major part of this discussion centers around the IRS’s updated Audit Technique Guide, released in February 2025.

Justin describes the guide as essentially a field manual for IRS examiners. It outlines how they should approach cost segregation issues, what questions to ask, and what areas deserve closer scrutiny.

One of the key takeaways from the guide is that field inspections are recommended for “all quality studies.” While that language does not outright ban software studies, it clearly signals that the IRS places greater value on studies backed by onsite inspection and more robust support.

At the same time, Justin emphasizes an important nuance: the IRS still has not issued a strict, prescribed set of standards that all cost segregation studies must follow. That means there is still ambiguity in the space, and that ambiguity is part of why different firms may approach studies differently.

So the issue is not that software studies are automatically invalid. The issue is that the lack of hard-line standards, combined with the IRS’s growing preference for site visits and supporting documentation, makes software studies more vulnerable under examination.

The Tradeoff: Lower Cost vs. Higher Risk

Nathan frames the decision clearly.

Software studies are usually cheaper upfront, which is why many investors choose them. But that lower cost can come with a higher risk of disallowed deductions later if the IRS challenges the classifications and the taxpayer lacks sufficient support.

By contrast, engineering-based studies with site visits may cost more initially, but they generally offer:

• stronger documentation
• lower audit risk
• more accurate classifications
• better potential deductions

That means the taxpayer may actually come out ahead not only from a defense standpoint, but from a tax savings standpoint as well.

More Detail Can Lead to Better Tax Results

Justin explains that software studies are not only less defensible in many cases, but they also tend to be more conservative.

Because they lack the granular detail of an on-site engineering study, they often produce lower amounts of five-year and 15-year property.

That translates to less bonus depreciation and fewer immediate tax savings.

In other words, a site visit doesn’t just help with audit protection. It can also improve the actual tax outcome.

Better Studies Create Better Tax Planning Opportunities

Toward the end of the episode, the conversation shifts from audit defense to tax planning.

Justin notes that one of the overlooked advantages of a more detailed cost segregation study is that it creates more planning flexibility.

For example, depending on the client’s broader tax situation, it may make sense to:

• elect out of bonus depreciation on certain classes of property
• evaluate whether Section 179 is more beneficial than bonus depreciation
• consider state-specific treatment of depreciation deductions
• time deductions more intentionally across tax years

This is where detailed reporting becomes especially valuable. The more precise the breakdown, the more opportunities a tax advisor has to model options and tailor the strategy to the client’s circumstances.

Final Thoughts

Cost segregation is still a powerful tax tool, but the environment around it is changing. Investors who want to maximize deductions and minimize audit risk need to think carefully about how their studies are prepared, documented, and implemented on the tax return.

As this episode makes clear, the cheapest option is not always the smartest one.

Disclaimer: This podcast summary was generated from the transcript and may contain some errors or miss key points from the audio recording.