Cost Segregation - A Red Flag For the IRS??

Question

I have been investigating having cost segregation studies done to two STR investments I own. I'm getting some pushback from my CPA of several years. He is a former IRS auditor, before going out on his own. He is definitely more conservative in his advisement, but seems willing to go along with defensible positions that fall within the tax code. We are taking advantage of two new tax saving opportunities that require some additional research and paperwork on our end. We provided that and he was happy to get on board with those strategies. But, he seems very concerned about the prospect of doing Cost Segregation for the depreciation on these two properties. Our original and adjusted basis on each property falls in the $400s and the Cost Seg studies are being quoted in the mid-$2,000 range per property. Our CPA has suggested that Cost Seg is for investors with millions invested in real estate, and more predominately on the commercial RE side. He has suggested that this may be more of a red flag to the IRS. Furthermore his point is that regardless that this is likely defensible, that IF there is an audit the cost (and/or time) of an audit defense may outweigh the benefit of the cost seg. However, with the bonus depreciation (maybe not the correct terminology) it appears to accelerate the depreciation and make the up front savings very significant.

And additional detail that is important / relevant is that I am a full-time licensed real estate broker. I have a hard time imagining that I would not meet the qualification of "Material Participation in Real Estate" as a real estate professional, which would allow me to apply the bonus deprecation toward my earned income as a real estate professional. I still need to look up the IRS guidelines around the qualifying real estate professional. But, part of his point is that IF I do not qualify, it may be a long time before I can take advantage of those losses from the bonus depreciation anyways. Overall, he seems to want to do a basic cost seg for me on the FF&E and Capital Improvements and leave the original basis of the property on the conventional depreciation schedule.

I would love some feedback, personal experience, thoughts on this matter. I need to decide pretty quickly to file for 2023 or file extension and order these cost seg studies.

Kory Reynolds · Answer

I don't think I would advise anyone do something or not do something because it might be a "red flag" - yes the IRS has plenty of red flags, but the audit rate on most of these issues is so comically low, that as long as you have a legitimate position - take it, don't not do it just because it might slightly increase your chances of an audit.  I have heard people say similar things about the home office deduction, or vehicle expenses - if it's valid, I'll take it every time.  That said, no CPA worth their salt would take a wrong position just because they think the chances of it being audited are slim.

Interesting nugget - the IRS even has a form for disclosing to them in the event that you think you are taking a position that is contrary to IRS guidance - Form 8275 - and if you validly disclose your position on this form you can avoid penalties if the position is overturned.  The standard of needing to file this form...isn't at least "more likely than not" (50/50) it would be overturned, and position has a "reasonable basis"  - which is interpreted as greater than a 10% chance of success of being upheld in a challenge.  10%!!!!  And....The IRS still only looks at a small fraction of these.  There are a pair of attorneys on the CPE circuit that always talk about these, and talk about in all their years of being involved with these...only a couple have ever been selected for audit.

Costin I. · Answer

@Dan Lucchesi - Here is a CSS Decision Diagram flowchart intended to bring together all the various questions when assessing the benefits of a CSS (via a professional or DIY). Hope it will give you some guidance in your quest.

[Past performance is no guarantee for future results, but if you liked this post, don't forget to vote]

Dan Lucchesi · Answer

Thanks Zach. That is good perspective.

Julio Gonzalez · Answer

If you have the cost segregation done by a reputable company then even if you get audited, you'll have proper support to back up your deductions.

Now whether it's worth it - A cost segregation study can be extremely beneficial but its a case by case basis that depends on a multitude of factors. Most cost segregation study companies will provide a free cost/benefit analysis quote to tell you how much the study would cost and how much you could potentially benefit from the study. For me, it's helpful to see the actual numbers to decide if the cost is worth the benefit.

Dan Lucchesi · Answer

HAHA. I've always tried to avoid the many ways that cause the public to hate us. I would welcome a much higher barrier to entry for our industry. What other industry dealing with hundreds of thousands of dollars of people's money lets people become licensed in three weeks and no formal education?

Account Closed · Answer

Happy to share!

Account Closed · Answer

cost seg and REPS usually increase odds for audit, but please keep in mind Today, an American's overall chances of being audited are about 1 in 200. Moreover, three-quarters of all audits are correspondence audits in which the IRS sends the taxpayer a letter in the mail asking about one or two issues.

Cost Segregation - A Red Flag For the IRS??

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