EXPLAINED: "Real" cost segregation vs. DIY cost segregation

[Michael Plaks]

When your property is relatively inexpensive, say $200k, and you want cost segregation applied to it - is it worth it to hire a cost segregation firm and pay their fee? 

Before we explore this question, an important reminder: make sure that you can benefit from cost segregation, to begin with. I discussed this at length here: https://www.biggerpockets.com/forums/51/topics/1075919-five-...

Now, back to the "is it worth it?" Assume the cost segregation firm identifies $50k worth of quick depreciation in your $200k property. With the current 80% bonus depreciation, it translates into a $40k deduction and $10k in tax savings, give or take. The firm's fee will probably eat 1/4 to 1/3 of your savings. Does not sound too great, right?

In this situation a DIY cost segregation option sounds appealing. You only pay around $500, but you have to make your own estimates for everything inside your property and enter these numbers into their software. What software? There are at least two companies that offer this service via their websites: KBKG and DIYCostSeg. Easy to find them with Google.

Should you or should you not?

1. Is DIY cost segregation allowed? The tax law does NOT define specific requirements or standards for cost segregation studies, and neither does the IRS. The IRS expects your cost seg report to be "factually intensive", "supported by corroborating evidence" and performed by a "qualified individual.” So, the answer is: there is nothing that clearly prohibits DIY cost segregation reports.

2. Is DIY cost segregation reliable? Well, what is it based on? Your own estimates. Are they reliable? If you consider yourself a "qualified individual" to make such estimates - maybe. After all, you work in real estate, right? Just remember that all software, including cost segregation software, works on the GIGO principle: garbage in - garbage out.

3. Is DIY cost segregation audit-proof? First, let's define "audit-proof." If you think of audit-proof as avoiding an audit - then no. There is no way to prevent an IRS audit from happening, despite the hyped-up claims of some tax firms. You can minimize your chances, but the chance is never zero. In fact, using cost segregation results in an unusually high depreciation deduction, which IS an IRS audit flag. Cost segregation DOES make an IRS audit more likely.

The real question is: if you happen to get audited, will your cost segregation survive such an audit? With a "real" cost segregation study, it is signed by a licensed engineer who absolutely is a "qualified individual." I have not heard of the IRS challenging, much less overturning a professionally done cost segregation study. 

Not so with DIY cost segregation. Here the IRS has a reason to challenge your credibility and the credibility of your self-produced numbers. Be prepared to defend it if the stuff hits the fan.

4. But they offer audit insurance! They do. And I highly recommend paying an extra $200 or so for it. However, it does not mean they will defend your numbers. What they will do if your DIY-ed cost segregation is audited is they will send you an engineer (you pay travel costs) to conduct a "real" cost segregation study and present it to the IRS instead of yours.

5. Then what's the reason to have a "real" study if it exists as a backup option anyway? Ahh. There is a critical one. An engineer sent by a cost segregation firm can find a lot MORE components to bonus-depreciate than you can estimate yourself. It's quite possible that they can find enough additional deductions to pay for the additional cost of their service and sometimes a lot more. The more expensive your property is - the more likely this to be the case.

Conclusion.

DIY is an option. Just like it is an option with almost anything. You have to make your personal decision, considering the time and effort it will take you to DIY it; the risk of it being done wrong, and the potential opportunities you might miss by not letting the pros handle it for you.

The more expensive your property is - the more reasons you have to hire professionals.