It's the Support, Not the Report: What IRS Engineers Actually Examine in a Cost Segregation Audit

James C. Peacock spent 38.5 years as a General Engineer at the IRS. He was among the first IRS engineers to examine cost segregation studies. He contributed to the original Cost Segregation Audit Techniques Guide, published in 2004, and every major update since, including the February 2025 revision. He trained roughly 200 new-hire IRS engineers on cost segregation methodology before retiring in September 2025.

I sat down with him for 90 minutes to ask one question: what actually determines whether a cost segregation study survives an IRS examination?

His answer was a phrase a colleague used throughout his career:

"It's the support, not the report."

— James C. Peacock, former IRS Engineer SME

The report is the deliverable you get from your cost segregation firm. The support is everything that backs it up: contractor invoices, final applications for payment, plans and specifications, RS Means workpapers with 12 or 16-digit component codes. A polished report with no support documentation is an audit waiting to happen. A less formatted report with complete underlying support will survive nearly any examination.

Most investors who commission cost segregation studies never ask about the support. They ask about the reclassification percentage, the tax savings number, and the fee. Those are the wrong questions. Here is what actually matters.

How Cost Segregation Studies Get Into Audits

First, a clarification. Cost segregation studies do not trigger audits. The IRS selects returns using a computerized scoring system called DIF (Discriminant Information Function) and through targeted examination campaigns. A cost segregation study does not appear as a standalone audit flag.

What actually happens: a return gets selected for examination for another reason, and the examiner discovers the cost segregation study inside it. At that point, the IRS engineer is called in.

According to IRS Statistics of Income data, the average business audit rate is approximately 0.07%. For businesses with a cost segregation study, it is approximately 0.078%. James puts it plainly: "Two out of a thousand instead of one. It doubled! But it's still very, very, very low." For more on audit selection mechanics, see our article on cost segregation audit risk.

The point is this: you may never face an examination. But if you do, the outcome is determined entirely by your support documentation.

What the IRS Engineer Checks First

When an IRS engineer opens a cost segregation examination, the first step is an Information Document Request (IDR). An IDR is a formal document that requires the taxpayer to provide specific records. The first round typically asks for two things: the purchase agreement and the cost segregation study itself.

From there, what the engineer examines next depends on what they find. James told me his process was consistent across hundreds of examinations. Two checks happened immediately.

Check 1: Land Allocation

The first thing James checked in any study was the land allocation. Land is not depreciable. It must be separated from the depreciable building and improvements before any cost segregation analysis begins. If the numbers in the study add up to the total purchase price with no land carved out, that is an automatic adjustment.

James described it simply: "If a property is purchased for a million dollars and the study adds up to a million dollars, we go — where's the land?" No negotiation. No discussion. The IRS makes a correction based on assessor records or comparable land values.

This is one of the most common and most preventable errors in low-quality studies. For a full breakdown of land allocation standards, see our article on land allocation as an IRS red flag.

Check 2: RS Means Codes

After land allocation, James went to the back of the report and looked for RS Means codes. RS Means is the standard construction cost database engineers use to price individual building components. A proper engineering analysis assigns a specific 12 or 16-digit RS Means code to each component being classified.

What James looked for: vague descriptions like "RS Means mechanical" with no code attached. That tells him the engineer used broad averages rather than property-specific analysis.

"RS Means mechanical" with no code — that's an IDR right there. Vague codes tell me they used averages and didn't look at the property."

— James C. Peacock, former IRS Engineer SME

The same applies to square footage models. A study that estimates component costs by dividing total building cost by square footage is telling the IRS engineer the firm did not do property-specific analysis. That generates more IDRs. More IDRs mean a longer, harder examination.

The High-Rise Example: What Missing Structure Looks Like

James reviewed a cost segregation study on a high-rise building during his time at the IRS. The Section 1245 personal property classification looked reasonable on its face. The engineers had documented electrical, mechanical systems, and finishes with some specificity.

But when he reviewed the Section 1250 structural components, he found the study had omitted the steel framework and concrete slabs entirely. Tens of millions of dollars in 1250 property was simply missing from the analysis.

James called this an automatic adjustment. No analysis required. The structural components were not a matter of classification dispute — they existed in the building and were not in the study. The adjustment followed directly.

This is a different failure mode than aggressive classification. Aggressive classification means you claimed too much as personal property. Missing structure means your estimate is incomplete. Both generate adjustments. But missing structure is harder to defend because the physical evidence is the building itself.

There is also a related red flag James called the adjustment factor problem. If a firm estimated 1245 property using RS Means unit costs and then applied a 10x factor to scale up to the actual purchase price, that is a major red flag. A large adjustment factor usually means the estimate is missing components, not just inflation. As James put it: "There's usually something missing in the estimate if the factors are that bad."

What "Support" Actually Means

The support documentation that IRS engineers expect to see falls into a clear hierarchy. James described what he typically requested after the initial IDR:

• 1.
  Purchase agreement — establishes the total consideration, which anchors the land allocation and the depreciable basis
• 2.
  Contractor's final application for payment — the most important document for new construction and renovation. Shows what was actually built and at what cost by trade
• 3.
  Plans and specifications — the architectural and engineering drawings. Show component placement, materials, and specifications that underpin classification decisions
• 4.
  Itemized invoices — component-level cost records for equipment, finishes, and improvements installed outside the general contractor's scope
• 5.
  RS Means workpapers with 12 or 16-digit codes — the engineering workpapers showing exactly which RS Means items were used to price each component

The goal is to minimize IDRs. Each IDR the IRS issues because prior documentation was unclear extends the examination and signals to the engineer that the study may have other gaps. As James put it: "The least amount of IDRs, the easier the audit goes."

A study that comes with complete support documentation — purchase agreement, contractor pay applications, plans, RS Means workpapers at code level — often resolves with only the initial IDR. The engineer reviews the documents, verifies the methodology, and closes the case. That is the outcome a properly documented study produces.

LUQ: The IRS Framework for Flagging Unusual Items

IRS examiners use a framework called LUQ — Large, Unusual, Questionable — to identify items that warrant additional scrutiny. Any cost segregation result that looks disproportionate relative to the property type or use gets classified as LUQ.

James gave a concrete example. A standard warehouse where 50% of total cost is allocated to HVAC systems (in a non-refrigerated building) would immediately flag as LUQ. HVAC in a standard warehouse is a relatively modest share of total cost. A 50% allocation suggests either the estimate is wrong or the documentation is missing.

The IRS intentionally never published percentage thresholds for LUQ classifications. James explained why: "The IRS deliberately never published thresholds because as soon as we say X percent is acceptable, everyone's going to claim X minus 1 percent."

The practical implication for investors: there is no safe number. What matters is whether the classification is supported by documentation. A 40% 1245 allocation that is fully backed by plans, invoices, and 16-digit RS Means codes is more defensible than a 20% allocation supported by nothing.

For a detailed breakdown of what IRS engineers examine during the full audit process, see what an IRS engineer looks for in a cost segregation audit.

Classification Disputes: When the Law Governs

Not all examination disputes are about documentation quality. Some come down to how courts have defined personal property versus structural components. James walked me through two examples that come up regularly.

Kitchen Cabinets: Amerisouth v. Commissioner (2012)

The Tax Court ruled in Amerisouth that kitchen cabinets, countertops, and sinks in residential rental properties are 1250 property — they are for the "operation and maintenance of the building" and depreciate over 27.5 years.

To classify these items as 1245 personal property (5-year), a taxpayer must document two specific things: (a) the items were actually removed and (b) they were actually reused or disposed of. "Theoretically removable" is not enough. The White Coat test — personal property must be movable AND in fact moved — applies. The White Coat case involved roadside billboards that were physically dismantled and relocated.

Self-storage metal partitions screwed into walls can qualify as 1245 if the owner can prove they have been removed and moved to other locations. The key word is "prove." Documentation of the removal and relocation is required.

For the full history of court cases that define these classification standards, see our article on significant court cases in cost segregation.

Dedicated Electrical Panels: Scott Paper

The Scott Paper case established that a dedicated electrical panel serving specific equipment — an electric dryer, a stove, industrial machinery — can be allocated to 1245 property if the taxpayer proves the panel is exclusively used for that equipment. This is covered in Chapter 8 of the IRS Audit Techniques Guide.

The word "exclusively" matters. A panel serving both general lighting and a specific machine does not qualify. A panel running only to the dryer does. The distinction requires documentation: as-built electrical drawings showing circuit routing are the standard support.

A Note on AI-Generated Studies

James raised one concern about the direction of the industry unprompted. Firms are beginning to market AI-generated cost segregation studies. He was direct about the problem: "It goes against every IRS rule" because these approaches skip the physical inspection the IRS expects.

That said, he saw a legitimate role for AI as a completeness check tool. One pattern he observed in IRS examinations was studies where engineers were so focused on identifying 1245 personal property that 1250 structural components became an afterthought. The 1250 section was rushed, incomplete, or internally inconsistent. AI tools that flag gaps in 1250 coverage before the report is finalized could genuinely improve study quality.

The distinction: AI as a classification engine (replacing the engineer's analysis) goes against IRS standards. AI as a review tool (ensuring the engineer did not forget structural categories) could improve studies. No AI tool replaces the property inspection requirement.

What a Defensible Documentation Package Looks Like

James summarized the standard a properly documented study should meet. It is not complicated, but it is specific.

The contingency fee item deserves a note. The IRS Audit Techniques Guide states that examiners "should closely scrutinize" cost segregation studies prepared on contingency. The engagement agreement becomes part of the first IDR. This does not make contingency-fee studies invalid, but it does mean the IRS looks harder at them. James said he never directly encountered a contingency-fee study that he thought was deliberately manipulated, but the arrangement creates incentive problems the IRS was aware of.

The IDR Minimization Thesis

James's framing for what good documentation accomplishes is practical: the goal is to minimize IDRs. Every IDR the IRS issues represents a gap in the documentation that the examiner needs to fill. Fewer IDRs mean the examiner has what they need. The examination moves faster, costs less, and is less likely to escalate.

"The least amount of IDRs, the easier the audit goes."

— James C. Peacock, former IRS Engineer SME

A study that arrives at examination with the purchase agreement, contractor pay applications, plans, and RS Means workpapers already organized answers the first IDR completely. The engineer reviews them, confirms the methodology is sound, and either closes the case or issues a narrow follow-up on a specific item.

A study with a polished PDF report and no underlying workpapers answers the first IDR with the report alone. The examiner issues a second IDR for the contractor invoices. The taxpayer scrambles to find records from a construction project that may have been years ago. The contractor may not respond promptly. The examination drags. New IDRs arrive. The IRS engineer, facing unclear answers, broadens the scope.

The report gets you through the door. The support determines whether you stay in the room.

For a broader look at how the IRS examination process unfolds from initial notice through resolution, see our article on the cost segregation IRS audit process. For an overview of what qualifies as a legitimate study versus one that will fail examination, see what cost segregation is and what it requires.