Your Cost Segregation Will Fail Audit If You Miss These 5 Elements
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In this episode, Toby Mathis, Esq., interviews Chris Streit from CSA Partners about the five critical elements that cause cost segregation studies to fail under IRS audit. Chris, whose firm has completed tens of thousands of cost seg reports, reveals that 80% of studies contain fatal flaws that will not survive scrutiny. The conversation covers the importance of establishing proper real estate professional status or short-term rental qualification before taking accelerated depreciation.
Chris explains why land value allocation is the first thing the IRS examines and how it must use county valuation at time of purchase—not rule-of-thumb percentages. They discuss the non-negotiable requirement for physical site visits with video documentation, the necessity of using current RSMeans software with local jurisdiction pricing (not outdated books or averages), and why having accessible audit support is crucial when the IRS comes calling. Chris emphasizes that the burden of proof is on the taxpayer, making professional documentation and expert backup essential. Tune in to learn how to protect your cost segregation deductions and avoid costly audit failures!
Highlights/Topics:
(00:00) – Introduction: Why Your Cost Seg Will Fail
(00:54) – Element #1: Real Estate Professional Status
(02:46) – Element #2: Land Value Allocation
(09:06) – Element #3: Engineered Study & Site Visits
(12:38) – Element #4: RSMeans Cost Data Requirements
(15:39) – Element #5: Audit Support & Accessibility
[00:00:00] Intro.
[00:00:11] Toby: Hey, guys. Toby Mathis here. Here’s the fact, your cost segregation study, the one you really thought about, you sought on TikTok, or you talk to your accountant, is going to fail unless you do these five things. I brought the head of a cost seg company, CSA Partners, Chris Streit, in to tell us what is killing these reports, what he’s seeing. By the way, they’ve done tens of thousands of reports, so welcome Chris.
[00:00:41] Chris: Thank you, Toby. Always a pleasure, especially on this topic. I know sometimes it can be a wet blanket, but as long as you’ve done it, then you’re safe.
[00:00:51] Toby: All right, five. Let’s nail them. Number one.
[00:00:55] Chris: To start, there’s one that overarches all, and I would say this isn’t even counted because it’s table stakes, you got to have a report. You can’t just take a deduction for a property that you have. A report is going to be critical. It’s going to be your main source of evidence. The five things you’re going to dive into, okay, what does that report consist of.
[00:01:13] With that report, the first thing that you want to make sure of is your status as a real estate professional or somebody who has short term rentals and is using the short term rental loophole, which we’ve done videos on before. It’s imperative that you make sure that status is ironclad and you have documentation necessary, because those are things the IRS is going to look at, disallow any excess depreciations taken, and apply it against your active income. That’s number one.
[00:01:40] Toby: Let’s dive into that just for a second because I always say there are two lanes. Lane one is what’s the deduction that you could, and that’s what the cost seg report’s going to tell us is how much I could get lost. Lane two is, how do I use it. What you’re saying is the thing that’s going to get you crushed is if you think you can use it, but you can’t because you don’t actually qualify under whatever you’re trying to do. If you’re trying to do the short-term rental loophole, you’re trying to do the real estate professional status, you’re an active participant in real estate, maybe your income goes up too high, or maybe you just want the loss because you have a whole bunch of other passive income, make sure you nail that down.
[00:02:18] Chris: That’s key. We’ve seen that pop up a lot. That is a big element between the tax preparer and their client, you. They need to know that you actually are somebody who materially participates in this, and you’re not saying executive at some other company, not doing real estate. If they can sniff that and they ask you to prove it and you can’t, then it does nullify a lot of this depreciation.
[00:02:43] Toby: That’s a good number one. What’s number two?
[00:02:46] Chris: Number two, this one starts to get easier. When doing that report, the land value. Land value, we have found, and this has been a recent surge from the IRS, is one of the key things and first things they look at. I have my theories as to why and the main ones are is that it’s an easy test. You can say, hey, there’s a very specific guidance on how to approach taking the land value out to determine your depreciable basis. It is using the time of purchase, using the county valuation, and applying that apportionment. If that’s not done right, then that’s a failure very quickly.
[00:03:23] Oftentimes it is done wrong. When I say often, 80% plus. While that report is a prerequisite to at least start with these five things, that report isn’t worth the paper that it’s written on if the land value was not done the right way.
[00:03:35] Toby: All right, let’s go over this real quick so people understand. You can only depreciate the improvement on a piece of property. If you have a chunk of land and you build a building on it, the only thing that’s depreciated is the building, not the land. We have to back out the land value when you purchase a property so that we can figure out what’s the depreciable basis. You get a company like CSA partners to go out there, do their study, and say, here’s how each of these components, what its useful life is, so we can accelerate that depreciation.
[00:04:04] The two ways that I’ve always looked at is, you’re either using the county assessor and the ratio of what it’s being assessed at. If it’s 20% land, 80% improvement, then I’m going to say, oh, I bought a building for, I don’t care what its assessment says. It’s those ratios. If I bought it for considerably more, I’m still saying 20% of that purchase price is land. Or I do an appraisal and I get the land value from an appraiser. Is that correct thinking, or am I off?
[00:04:34] Chris: No, that’s the correct way of thinking. Even when getting that appraisal though, you still want to apply the apportionment method. When you look at the guidance, the apportionment is the direction it goes. Even getting that valuation, applying that against the apportionment towards an apportionment number is how the IRS is going to judge that as a pass fail because it’s public information.
[00:04:55] We’ve seen what’s happening from a staffing perspective in the IRS. They still have a requirement to generate revenue for the treasury. This is one of those things that doesn’t require a lot of excess thought. You can just look at it and say, did it follow. Yes or no? The two things you mentioned are spot on, Toby.
[00:05:14] Toby: Interesting. What about a condominium? I’ve seen this, where you have no land value. Literally, it’s the condo and they say, hey, there’s no land value in this thing, and you’re writing off the whole thing. Is that a thing?
[00:05:24] Chris: Yeah. There are some properties where there is no land value at all. Think of some of those high rises. You’re in the 14th story, and you don’t actually own the land. That’s the main building owner who still has that that is out there, that is available. Those of course usually generate a lot of depreciable basis.
[00:05:43] I think the key thing folks need to look out there for is there’s a lot of providers out there that are intriguing and draw you in with the promise of savings and dollar bills right now, which they’re right, but also they don’t have the resources to adequately go through these steps to get the land value. They might just apply 80/20, and you might happen to be in Southern California where land value is exceptionally high. That exposes you to audit.
[00:06:10] The key thing is if you see things that are happening that are just quick, easy, they’re almost not even whole numbers, you know it was just pasted on there, and they’re selling that to somebody else to solve the problem in the future.
[00:06:24] Toby: Give people an idea of the breadth of experience you guys have. You guys do this as a living for accounting firms. The big accounting firms are going to come to CSA Partners and say, can you do this study for us. How many of these have you been involved with? How many studies, how many audits, and things like that?
[00:06:42] Chris: We’ve done now over the last five years, we’re over. 30,000-35,000 studies, somewhere in that range over the last five years, so a pretty large amount. We saw the audit environment swing. When you looked in Q4 of 2024, audits were surging up. You might see seven to eight in a year out of the volume that we’re dealing with. It’s roughly 1% to 2% of returns out there being audited. It’s not a huge number.
[00:07:10] In Q1 with the Department of Government Efficiency, we saw those audits get slashed quickly. We also saw there be furloughs and impacts to the staffing within the IRS, but there is still a preponderance of these audits happening specifically for people in real estate who are claiming bonus depreciation and any type of accelerated depreciation.
[00:07:33] Where we’ve put a lot into this to make sure it works is we actually pay for an API for every single benefit analysis, not even engagement, to get the actual land value from the county immediately sent over, so we can get the right data and give it to people quick to help inform the decision if this is a good investment for them or not.
[00:07:52] Toby: Yeah. Again, for folks out there, if your assessment is, hey, my building is worth a million dollars and the land value is $200,000, okay, that’s 20%. If you bought your building for $3 million because it has nothing to do with the assessed value, we know that, and you use 20%, you have $600,000, so you have $2.4 million of depreciable basis, you’re going to be okay. You should have somebody who actually knows what they’re doing, look at it, then it needs to be documented, and you need to actually have a report. You should have somebody actually walk in there looking through the property to ascertain here’s what things the values are.
[00:08:25] You do that, you don’t need to be nervous. You’ve covered your bases and you’re great. If you aren’t doing that, then your risk goes up. You should be a little nervous because if somebody calls you on it and then, hey, if you’re a real estate professional and you’re taking this big deduction, and you’re like, yes, I’ve offset a whole bunch of my tax, and then you get that audit notice, you’re going to feel a little nauseous when you go back and that report was done incorrectly. Penalties and interest, and I have to pay the tax. It’s worse than just having it done right in the beginning. What I always say is do it right in the beginning, then you don’t have to worry. All right. What number was that? Was that two?
[00:09:03] Chris: That’s two.
[00:09:04] Toby: Yeah. We need to get to three.
[00:09:07] Chris: Three is ensuring that it is an engineered study. One of the key variables to observe if you are going down this route is, is there a site visit. The site visit doesn’t need to be physical with an actual body there on the site. It could be a remote site visit, but that site visit is a key element to ensure that it’s going in the path of engineered studies.
[00:09:30] What I found is if you’re looking at the engineering element and you see a site visit, you’re moving to a very high probability that you’re going to be in the engineered study. The reason why a lot of folks don’t do that is it’s expensive. It requires people to do that. It requires training. It requires a technology if they are going to be remote. That engineered component is what helps uphold the report that is put forward in the deduction taken.
[00:09:58] Right now, the IRS asks these two questions to start. Substantiate your basis, which is basically asking you to prove the land value, and they say, did you do a site visit? Doing one is one thing, proving you did one. Toby, you’re a lawyer, you know this. Proving you did one is a completely other thing. That’s what an engineering study is, and that is critical in maintaining your deduction.
[00:10:21] Toby: Document the heck out of everything when you do it, and then you don’t have to come back three years later and try to recreate something. I go, I think we walked it. Didn’t we do this? You’re like, where’s the study? Yeah, get it done ahead of time, and then you can sleep at night. All right. You’ve hit three really good ones. I’m interested in what’s number four.
[00:10:42] Chris: We saw this to be a relative uptick too. Going back to the site visit, the data, and the substantiation that you have for this, we’ve spent millions in capitalized expenses and technology to make sure we could have that data, captured videos of this. That data that you get on that site corresponds to one other thing. How do you determine the cost of these assets when you’re doing cost segregation? You are saying, I have physically identified this crown molding here. I can see it, here’s a video of it. I have that video, I have proof.
[00:11:15] What’s the cost that you use to determine that crown molding based on the length of it, based on the type of it? Usually firms like us and others use the IRS recommended method of RSMeans, which is a construction software. It’s used to determine what it would cost to replace, to build out this type of property.
[00:11:35] RSMeans updates every single year. It is incredibly expensive. It also has 970 different local jurisdictions accounted for based on the cost to do certain things. Specifically, an electrician in Phoenix is not the same as an electrician in New York City, completely different. RSMeans does all that. The next thing is making sure you have, or the provider you’re using has that data somewhere. It’s being sent into the report and it is up to date, meaning the most recent version, and it is accounting for the local differences.
[00:12:11] We have seen IDRs, which is an information data request, which comes from the IRS asking people to prove they use the most recent version of RSMeans. Not a book. It has to be a software embedded into your system and to unlock all the Excel files to show that you use the vial corresponding to the data source of RSMeans. It’s an easy check and it’s a quick pass fail if done wrong.
[00:12:38] Toby: These software programs that are out there, I’ve seen it, people are just using rule of thumb, or they use this as what other properties in the area? That means that all of those are going to fail under audit, right?
[00:12:50] Chris: They will certainly fail for a couple of reasons. Most of those ones that are producing a report for you almost instantaneously, usually they’re having you self-select land value, or they’re using some type of automatic percentage, not accounting for anything about your specific property. The second is there’s no site visit because it happens instantaneously. Second, it’s not actually plugged into a tool like an RSMeans, which requires a lot of money upfront, but also an integration that is not necessarily built in, it’s just based on a simple average.
[00:13:19] Using all of that, you’re either going to be giving up a lot of potential deduction because they’re playing the odds and short cutting it. If they do get audited, then they’ll go do a site visit because it would fail. All three of these tests would be fail, fail, fail.
[00:13:32] Toby: I would say this that if you’re building, you have invoices, you’re probably going to be fine because you could say, here’s what the actual cost was. This would really be for people that are doing a cost seg study that have purchased a property, and now they want to accelerate the depreciation on the property they purchased. Not because they’re building, not because they did a big remodel, but because I got a million dollar property, I want to figure out what the land value is, and then accelerate depreciation on that improvement value. I didn’t build it, so I have no idea. Is that correct thinking?
[00:14:06] Chris: That’s a great distinction. Those things will be primarily applicable to those not new construction type of things, which you have to go in and identify. The thing I will say for new construction is the actual cost are known because you do have a detailed budget of that construction. The things that could still be out there for you and a risk element would be some of those first things. Is there a site visit? Some people might say, I already had the budget, why do you do a site visit? Because when you go to the site visit, you found that not in the budget is a fountain that was put right in the lobby of this condominium. That is not accounted for in this budget.
[00:14:39] Site visit still has to occur for it to be fully engineered. The land value has a little bit more nuance to it because think about what it as county appraiser might be if there’s no improvement, and this is the first improvement on there. There needs to be a little bit more scrutiny that goes into that land value allocation. You’re absolutely spot on.
[00:14:58] Toby: It keeps coming back to this, just make sure you work with a professional. I know that sounds like a broken record, but that’s because these facts actually matter. If you get under audit and you don’t have something, they are using the audit guide. You’re using a pass fail and you’re just going to be denied. You’re going to say, wait a second, but I have all these things.
[00:15:18] The last thing is if you are doing building, keep track of all that stuff. Put it aside, make sure it’s in a cost seg file. Make sure that your cost seg provider has it so it’s part of the report, so that if you’re asked to conjure it up three or four years later, you have it at your fingertips. All right, so that’s four. What’s number five?
[00:15:39] Chris: The fifth one is the most important one, where I think a lot of people don’t think about it because they say, you know what, there’s a 99% chance I’m never going to be audited. I’ve never been audited before, so it’s probably not going to happen to me again. When it does happen, that’s when you feel very vulnerable. Your back’s against the wall.
[00:15:59] The fifth thing that you need to have is accessibility. You need someone there, someone to talk to, not a bot, not ChatGPT even. You could ask it, how do I handle this audit with the IRS? Hey, you should probably have done this study is what it’s going to say. I will say this one thing, Toby, because you said it as well. Having done all this right, make sure that the audit goes swimmingly well. That’s so incredibly true, but the reason we’re doing this video is because I have found that nine times out of 10, one, if not all of those things are not done. The IRS knows it, so they’re asking these questions.
[00:16:35] Accessibility is key. When you get audited, the moment you get that information data request from the IRS asking for information, or sometimes we’ve found that they’ve even gone over that step, they just issue a determination, the thing about tax, and this is true at the federal level, the state, and local level, the burden of proof is not on the IRS. The burden of proof is on you, the taxpayer. They can claim something and they say, you prove us wrong.
[00:17:00] Determinations are being issued without that, and you need somebody in your corner to help you the moment that happens because from the time you start, it is like playing a game of Texas Hold’em almost is the way I look at it. If you’re going and bluffing at the start, you’re going to make it worse, you want to make sure you have pocket aces. When you go into that first conversation, you have guardrails around it.
[00:17:22] From a firm standpoint, whatever report we do, we stand by it all the way through there and don’t charge our clients a dime. We will attend every single call. That’s not somebody overseas, that’s somebody sitting here in America that’s going to be jumping on the call with the IRS, your lawyer, and your CPA.
[00:17:41] Toby: I’m just going to say as a caveat too, is when you’re doing cost seg studies, there’s a difference between price and value. Price. Hey, I could get a report done for free. I could just pick a number, pull it out of a hat, and throw it on a return, not even do a report. There’s that range versus, hey, I pay someone to do a professional report. The value difference is, hey, if I’m just picking numbers out of the sky, I’m going to be leaving money on the table.
[00:18:08] What I’ve found is that people that use the software or use people that are the deep discount, they don’t get the deductions that an actual cost seg study and somebody who does it day in and day out can say definitively, here’s the numbers we’re going to use. We can back it up, and we want 40%. Put it into 5, 15, 7-year property, and we’re going to get a massive deduction as opposed to, hey, it’s 25% ballpark. That extra 15% cost you a ton. The price might’ve been cheaper, but the cost to you was significantly higher. The value wasn’t there.
[00:18:43] There is a value proposition when you’re using somebody who knows what they’re doing. By the way, using somebody who knows what they’re doing, CSA Partners, I’ll put their link in the show notes, these guys do a great job doing a free analysis of your property. You give them the basic information, and they’ll be able to tell you what pretty darn good ballpark of exactly what you’d receive and what the tax savings are. That’s why we use them, and that’s why I suggest that you reach out to them as well.
[00:19:12] They’ve done tens of thousands of studies over the years. Again, we do about 10,000 returns here at our shop a year for our clients. We don’t pretend like we’re doing the cost seg studies. We use an outside firm that’s a professional audit, and you should too if that’s something that you’re doing. These cost seg studies are very potent. It can give you huge benefit, but don’t go on the cheap, guys. Chris, anything else you want to hit?
[00:19:39] Chris: One thing on that benefit analysis piece that we do for free, for people who are interested in cost seg. Step number two in this to make sure you do, to protect yourself from audit is the land value allocation. We actually do all of that well before an engagement. If you want a free land value allocation that’s defensible by the IRS, not just a benefit analysis, we have that for you at the website. Toby’s going to include a link too. If you’re curious about that, please feel free to input that. We’d be happy to supply you with that, but also hope we can help you with cost segregation as well and help you with whatever happens.
[00:20:13] Toby: All right. I’m going to put other videos we’ve done with Chris in the past. I’ll put links to those. I’ll put them here at the end. Go watch one of those. In the meantime, and subscribe. It helps our algorithm. Thank you, Chris. Put your comments down below if you have questions of Chris. We’ll look at it. We’ll make sure you get some, and then we’ll answer your questions. If you have comments, again, put them down below. Like and subscribe, and I’ll see you guys later.
[00:20:36] Chris: Thanks, Toby.
[00:20:40] Outro.
Toby Mathis, Esq. is the ForbesBooks author of Infinity Investing: How the Rich Get Richer And How You Can Do The Same. Toby is a tax attorney and founded Anderson Business Advisors, one of the most successful law, tax, and estate planning companies in the United States. Toby’s businesses have been featured on the Inc. list of fastest-growing US companies on 5 different occasions, have been voted as national and local “Best Places to Work”, have received numerous awards including business of the year and a “Firm of the Future” by Intuit – makers of QuickBooks. Toby is a US tax expert and successful investor with several hundred individual pieces of real estate located throughout the US.
As a result of Anderson’s tax work with tens of thousands of successful investors including preparing over 100,000 investor tax returns, Toby has seen which strategies stand the test of time and which do not. He bases his opinions on personal experience and that of his clients and does not agree with most of what is taught by the so-called “gurus” of our time. Toby believes investors achieve the greatest success by focusing on tax advantages and purchasing cash-flow assets rather than trying to profit on short-term trends.
