IRS Pub. 5653, Ch. 3: The Six Cost Segregation Approaches

Audio summary

A short audio walkthrough of this rule: what it says and why it matters for your study.

What it holds

Chapter 3 of Publication 5653 ranks six ways to prepare a cost segregation study from most reliable to least. At the top is a detailed engineering study built from actual cost records. Second is a detailed engineering cost estimate using published cost data. Below those are three less precise methods and, at the bottom, the rule-of-thumb approach, which the IRS views with caution.

Where this comes from

After cost segregation studies became common following the Hospital Corporation of America decision in 1997, the IRS needed a way to train its examiners to review them consistently. The result was the Cost Segregation Audit Techniques Guide, now published as IRS Publication 5653.

Chapter 3 of that guide explains the six approaches the IRS recognizes and ranks them by reliability. The current version of Pub. 5653 was revised in February 2025.

What it says

The six approaches, from most reliable to least, are: (1) detailed engineering study from actual cost records, using invoices, change orders, and engineering take-offs tied to the actual construction; (2) detailed engineering cost estimate, using the same engineering discipline but relying on published cost databases like RSMeans when actual records are not available, which is common for acquired properties; (3) survey or letter approach; (4) residual estimation, which may not reconcile to actual costs; (5) sampling or modeling; and (6) the rule-of-thumb approach, which uses little or no documentation.

The guide notes that no IRS standards govern who can prepare a study. But the taxpayer must be able to substantiate every classification. Actual records beat estimates, and estimates beat rules of thumb.

How it shows up in a study

When we prepare an engineered study using actual cost records or detailed estimates, we are working at the top of the IRS reliability scale. The methodology section of your report cites Chapter 3 to show the examiner that the approach used is the highest quality the IRS recognizes.

A rule-of-thumb study, where someone assigns broad percentages without engineering support, sits at the opposite end. Chapter 3 gives an examiner the language to challenge it.

What it does not mean

Using the highest-reliability methodology does not guarantee the IRS will accept every classification. An examiner can still question individual asset classifications or cost allocations even in a top-tier study.

The IRS also has no formal certification for who prepares a study. The responsibility for accuracy falls on the taxpayer. The methodology ranking in Chapter 3 tells you how defensible the underlying approach is, not whether every number in the study is correct.

Category

Methodology & procedure

Applies to

All property types

Status

Vetted

This page explains a tax authority in plain words. It is not tax advice for your situation. The way this authority applies to your property is reviewed by a licensed tax professional. Citation is provided so you or your advisor can read the primary source.