IRS Pub. 5653, Ch. 5: How the IRS Reviews a Study

Where this comes from

Publication 5653 is the IRS's training guide for examiners who audit cost segregation studies. Chapter 4 sets the quality standard for what a good study looks like. Chapter 5 explains how an examiner uses that standard when a return is selected for review.

Chapter 5 is the IRS's own audit roadmap. Reading it tells you how to build a study that passes.

The three phases

The first phase is an initial risk analysis. The examiner compares the report to the Chapter 4 quality standards, checks the asset classifications against Revenue Procedure 87-56 (the IRS's master list of MACRS asset class lives), and identifies any red flags. Studies that satisfy Chapter 4 are described here as lower risk and draw a narrower initial review. Studies with missing elements or unexplained deviations from Rev. Proc. 87-56 get more attention.

The second phase is the full examination. This can include reviewing original construction documents, requesting a site visit, checking the engineering take-off quantity by quantity, and verifying that indirect costs like overhead and fees were handled correctly.

The third phase covers related considerations: whether a required Form 3115 was filed for any accounting method change, whether the Section 263A cost capitalization rules were followed, and whether the study's sampling approach (if any) was statistically valid.

How it shows up in a study

Every study we prepare is built to pass the initial risk analysis in phase one. That means hitting all 13 study elements and all 9 report elements from Chapter 4, reconciling to actual costs, and following Rev. Proc. 87-56 for each asset class.

We also address the phase-three considerations proactively. The legal analysis section of your report flags whether Form 3115 is needed for a look-back study and whether Section 263A applies to any of the costs. A study that addresses these issues up front gives the examiner nothing to pursue in phase three.

What it does not mean

A study built to Chapter 4 passes the initial risk screen. That does not mean it will never be examined further. A return can be selected for audit for reasons unrelated to the study, and if the examiner looks at the study at all, they will follow the Chapter 5 process.

The guide also does not bind examiners to a specific outcome. The phases describe the process, not the result. A well-documented study in a full examination may still face questions about specific classifications, especially for contested items like electrical systems, HVAC, or land improvements.