Is Bonus Depreciation Worth the Audit Risk?

Question

For 2022, my husband met Real Estate Professional status.  I am a high income W2 earner.  We filed an extension for 2022 taxes and are just finalizing them now.

Our CPA says that if I cost segregate and bonus depreciate two assets we bought, that it increases my audit risk since I have a higher W2.

Is that true?  I don't want to be audited.  But, I also think that we're doing everything according to the law.  He mets REPS, and we are allowed to bonus depreciate.  So, why not do it?

Any thoughts/experience?

Thanks in advance!  Debby

Michael Plaks · Answer

@Deborah R.

Yes, it increases your audit risk. Especially due to your husband qualifying for REP status. The IRS actually has a targeted audit program against REP status.

So what? If you actually qualify for the REP status and have good records, you don't have much to worry about. Yes, you can get audited. You can also get audited even if you don't employ these strategies.

@Scott E. - I'm pretty sure you misunderstand how your CPA's audit insurance works. He cannot "assume all liability" from an audit. That would mean paying your taxes and interest+penalties for you. He won't do it. What audit insurance normally does is protects you from paying him additional money for defending you in case of an audit. But not from an adverse result of an audit, should it happen. Just like the best lawyers can lose a case, we can lose an audit. In this situation, you still have to pay the IRS additional taxes, interest and penalties.

Eric Williams · Answer

@Michael Plaks

Where did you hear about this targeted program?

I'm not denying it I would just like to read up on it. I Googled all over but could only find audit campaigns for LB&I (Large Business and International).

Ashish Acharya · Answer

That is not correct!

Scott E. · Answer

My CPA told me the same thing. But if you're doing everything by the books, getting audited shouldn't be a big concern.

Also... my CPA offers an 'audit insurance' (can't remember if it's called exactly that). For a small fee every year, he signs something that assumes all liability in the event of an audit. Does your CPA offer something similar?

John Malone · Answer

@Lawrence Porter sounds about right! Bonus depreciation has no bearing on audits. Its part of the law. I hate when fellow tax advisors spread bonus depreciation fear…

Eric Williams · Answer

You will not convince me that bonus depreciation by itself increases audit risk.

Why? Because bonus depreciation is the required, default treatment for qualified property defined in 168(k).

You literally have to elect out of bonus depreciation via the 4562.

However, other additional factors may work to increase audit risk.

From the instruction of 4562:

"If you timely filed your return without making an election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Enter “Filed pursuant to section 301.9100-2” on the amended return"

This is basically saying that without an election out of bonus depreciation, bonus depreciation is the default.

This is further evidence in the regs of 168:

(f) Elections under section 168(k)—(1) Election not to deduct additional first year depreciation—(i) In general. A taxpayer may make an election not to deduct the additional first year depreciation for any class of property that is qualified property placed in service during the taxable year.

(iv) Failure to make election. If a taxpayer does not make the election specified in paragraph (f)(1)(i) of this section within the time and in the manner prescribed in paragraph (f)(1)(iii) of this section, the amount of depreciation allowable for that property under section 167 or 168, as applicable, must be determined for the placed-in-service year and for all subsequent taxable years by taking into account the additional first year depreciation deduction.

Eric Williams · Answer

Right but I didn't see any details of that specific campaign in there.

I guess I was trying to figure out if there were specific transactions they look at that would be reported.

Often times you can anticipate by reviewing an IRM which is an audit playbook but I didn't see any for REP.

Maybe an example would be what transactions has the IRS gone after in determining inflated COGS in LB&I campaigns.LB&I Active Campaigns | Internal Revenue Service (irs.gov)

Michael Plaks · Answer

Yes, it is part of the law. And yes, it does have bearing on the audit probability. These two statements are perfectly compatible.The IRS computer assigns a DIF score to each tax return. It is similar to the credit score: good points for desirable behavior and bad points for undesirable behavior. The undesirable behaviors include large business losses compared to business income and losses used against high W2 income. This is EXACTLY what we accomplish with cost segregation/bonus depreciation! So, a higher DIF score and a higher chance of an audit comes with the territory.What Lawrence said is true: the IRS will not challenge the cost segregation study itself, as long as it is performed by credentialed professionals such as the engineers employed by cost seg firms. But it does not mean that you will not get audited. You quite likely will!

Once again. When you claim high losses resulting from cost segregation and bonus depreciation - your chances of an IRS audit do go up. However, if you do get audited, your professionally done cost segregation study should stand without any problem.

John Malone · Answer

@Scott E. Audit insurance is offered by some. Read the fine print though! Also, there should never be a fear of an audit if you follow the regulations as you said

Lawrence Porter · Answer

In 23 years, we have never had a cost seg study challenged.

Is Bonus Depreciation Worth the Audit Risk?

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