How to Read a Cost Segregation Report Against the IRS Quality Checklist

Key Takeaways

• IRS Publication 5653, the Cost Segregation Audit Techniques Guide (rev. 2-6-2025), lists 13 principal elements of a quality study and report in Chapter 4.
• The elements cover who prepared the study, how it was done, what documents support it, and whether the numbers tie back to actual costs.
• A sample report is the easiest way to check a firm before hiring it. Most of the 13 elements are visible on the page.
• Reconciliation to actual costs, a clear methodology and a documented site visit are three of the most useful items to check.
• A report that skips several elements is not automatically wrong, but it gives an examiner more to question.

Cost segregation studies can produce large first-year deductions, and that is exactly why the IRS pays attention to them. When an examiner reviews a study, the starting point is the agency’s own audit guide, Publication 5653. Chapter 4 of that guide lists 13 elements the IRS associates with a quality study and report.

Most owners never read that list. They see the final number and the firm’s summary, and they rely on the provider for the rest. That works until the study is examined. The Ambrose Group’s checklist for evaluating cost segregation companies recommends a simple habit instead: ask any firm for a sample report and compare it with the IRS list before signing. This article explains how to do that.

What a cost segregation report is supposed to do

A cost segregation study breaks a building’s cost into components and assigns each one a recovery period. Some parts, such as certain electrical work, specialty plumbing, finishes and site improvements, can qualify for 5-, 7- or 15-year lives instead of the standard 39 years for commercial buildings. The report supports those classifications. For a full explanation of how a study is built from start to finish, see this cost segregation study guide.

The report has two jobs. It must support the deduction on the owner’s return, and it must hold up if the IRS asks how the numbers were reached. The 13 elements in Chapter 4 describe what a report needs to do to do the second job well.

The 13 elements, grouped by what they show

The list in Publication 5653 reads like a technical outline. It is easier to use when the items are grouped by the question each one answers.

Who did the work

1. Preparation by an individual with expertise and experience. The IRS expects a study to be prepared by someone with real knowledge of construction, engineering or cost estimating, and of the tax rules involved. The report should name the people who did the work and state their qualifications. Owners comparing firms can ask what credentials stand behind the study, whether that is an engineering background, cost estimating experience or an appraisal designation such as the MAI designation.

How the work was done

2. Detailed description of the methodology. The report should explain the approach used, step by step. The IRS describes several methods in Publication 5653, ranging from detailed engineering approaches to less precise estimates. A report that never says which method was used is hard to defend.
3. Use of appropriate documentation. This includes construction drawings, specifications, invoices and cost records. It also covers the site visit. According to Publication 5653, “A quality study includes a site visit to gain a better perspective and understanding of the design and purpose” of the property. A report should say when the inspection took place and who performed it.
4. Interviews conducted with appropriate parties. Owners, property managers, architects and contractors often know how a space is actually used, which affects how components are classified. The report should note who was interviewed.

How the report is organized

5. Use of a common nomenclature. Components should be described with consistent, recognizable terms so an examiner can follow them.
6. Use of a standard numbering system. A recognized numbering structure makes it easier to trace each line item from the cost records to the final classification.
7. Explanation of the legal analysis. Classification decisions rest on tax law and court cases. The report should explain the legal reasoning behind them rather than simply listing results.

How the numbers were built

8. Determination of unit costs and engineering “take-off.” This includes detailed quantity measurements and the costs applied to them. A strong report shows this work rather than presenting only totals.
9. Organization of assets into lists or groups. Assets should be grouped in a way that matches the recovery periods and makes review practical.
10. Reconciliation of total allocated costs to total actual costs. This is one of the most important checks. Costs assigned across all categories should add up to the property’s actual cost basis. If they do not reconcile, the study has a basic problem.
11. Explanation of the treatment of indirect costs. Items such as architect fees, permits and contractor overhead have to be allocated in a reasonable, documented way.

What the report classifies and considers

12. Identification and listing of Section 1245 property. The report should clearly list the components treated as shorter-life personal property, since these drive most of the tax benefit.
13. Consideration of related aspects. Publication 5653 gives examples such as Section 263A, changes in accounting method and sampling techniques. A careful report addresses the issues that apply to the specific property instead of ignoring them.

How to use the list with a sample report

Owners do not need to become engineers to use this checklist. A sample report from the firm, with client details removed, is usually enough to see whether most of the elements are present.

A practical review can follow a few steps:

1. Check the front of the report for the names and qualifications of the people who prepared it.
2. Look for a methodology section that states which approach was used and why.
3. Find the site visit. The report should give a date and name the person who inspected the property.
4. Look for a reconciliation schedule that ties the allocated costs back to the total cost basis.
5. Scan the asset listings. They should be organized, numbered and described in consistent terms.
6. Look for an explanation of the legal basis for the classifications, not only a table of results.

If a firm will not provide a sample report, or the sample is mostly marketing material with a summary table, that tells an owner something about the work product. Firms offering cost segregation consulting services should be able to explain how their reports address each element.

Warning signs in a report

Some patterns suggest a study may have trouble under examination:

• No documented site visit, especially when construction drawings are incomplete.
• No reconciliation of allocated costs to actual costs.
• Classifications presented without any explanation of the legal reasoning.
• A study prepared from a general percentage or rule of thumb rather than property-specific data.
• Vague descriptions of who prepared the work.

One area deserves special attention: land. Land cannot be depreciated, so its value has to be separated from the building’s basis before any components are classified. A report that uses a default percentage or takes the figure from the appraisal district without support may overstate the depreciable basis. A well-supported land allocation is one of the details that separates a careful study from a quick one.

What the checklist does not cover

The 13 elements describe the report’s quality, not whether a study makes financial sense. A well-built study on the wrong property can still be a poor decision. Owners should also consider building basis, how long they plan to hold the property and how depreciation recapture could affect a future sale. These questions belong in a conversation with the owner’s CPA, who will use the report to support the tax return.

Coordination with that CPA matters for another reason. The CPA is the person who will rely on the study, so the CPA should be comfortable with how it was prepared and documented. A firm that works directly with the owner’s accountant makes that review easier.

A simple habit that protects the deduction

The IRS has published its own standard for a quality study. Owners can use that same standard when choosing a provider. Asking for a sample report and checking it against the 13 elements takes less than an hour, and it shows how a firm documents its work before any money changes hands. A report built with those elements in mind is far better prepared for the day an examiner asks how the numbers were reached.

About the author: Daniel Ambrose, MAI, is Executive Vice President of Tax Services at The Ambrose Group in Jersey Village, Texas, where he leads property tax consulting and cost segregation for commercial owners across the state. The Ambrose Group has served Texas property owners since 1994.

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