Pushing Your DIY Cost Seg Envelope

By Jason Watson, CPA
Posted Sunday, May 25, 2025

It is not surprising that many rental property owners who use a do-it-yourself cost segregation tool such as CostSegEZ.com want to push down land values which inherently increases the building value. This in turn pushes up the value of the property that can be accelerated.

As mentioned previously, the easiest way to determine this is using the county assessor’s ratio. Let’s say you purchase a rental property for $500,000, and according to the assessor’s data the parcel is assessed at $45,000 land and $180,000 building for a total of $225,000. In this example, land is 20% and using this ratio, you could assume that land is $100,000 on your $500,000 purchase leaving $400,000 as building.

The Internal Revenue Manual, Part 4. Examining Process, Chapter 48. Engineering Program, Section 6. Real Property Valuation Guidelines, and specifically under 4.48.6.3 Documenting subparagraph 2, states “assessment and tax data” should be considered when determining value. Ok, that is quite the mouthful.

How about a tax court case? In Nielson v. Commissioner, Tax Court Summary Opinion 2017-31, the court concluded that a county assessor’s allocation to land and improvement values were more reliable than the taxpayers’ proposed values. The tax court also noted they could not find any authority that suggests a taxpayer is qualified to allocate the value of the property between land and improvements. Boom!

If you disagree with the county assessor ratio method, then spend the money on an appraisal- the opinion of a disinterested third-party will usually be viewed favorably if challenged.

Another consideration is the average cost per square foot building costs. If you purchase a lovely short-term rental property in Malibu, and want to claim that $1.8 million of the $2.5 million purchase price is the building allocation for an 1,800 square foot property, you might be pushing it. This would be $1,000 per square foot construction costs. Location, location, location, right? Sure, building costs can easily exceed $500 a foot and even $1,000 a foot depending on finishes and construction complexity, but you need to be careful.

Yet another consideration is the discussion and application of replacement cost found in the Cost Segregation Audit Techniques Guide. Here is a blurb-

When construction cost information for the acquired property is not available, it must be estimated using the construction cost data, methods, and techniques normally employed for a property appraisal. These estimated property costs (replacement cost new (RCN)), which include indirect costs, are then adjusted for the asset’s age and condition at the acquisition date, including physical depreciation, functional obsolescence, and economic obsolescence. These adjustments are generally expected to be different among the various items of acquired property (e.g., a building and its structural components, land improvements, and personal property), given that each of these items of property have varying expected useful lives, levels of use, and may have been constructed and/or installed on different dates. The total replacement cost new less depreciation (RCNLD) of the acquired items of property, along with the fair market value (FMV) of the land, should reasonably approximate the total purchase price of the acquired property.

Ok, neat. Later on, in the ATG, the IRS issues this guidance for examination-

Ensure that Replacement Cost Values are Properly Adjusted
for the actual condition and remaining economic useful life of the assets.

The value of used components must be reduced from the replacement cost new value in proportion to the observed economic obsolescence or physical depreciation as compared to similar new assets. This principle is discussed in regard to the “Helipot Building” in Lesser v. Commissioner, 42 T.C. 688 (1964), aff’d, 352 F.2d 789 (9th Cir. 1965), acq., 1966-2 C.B. 5, cert. Denied, 384 U.S. 927 (1966).

And they pile on with this-

Real Estate Allocations
The fair market value of land should be based on the highest and best use of the land as though vacant, even if the land has improvements. The land value may equal the value of the total real estate even if the real estate has substantial improvements when such improvements do not contribute value to the property. Whereas land has value, improvements contribute value. The value of the total real estate, less the value of the land, results in the contributory value of the improvements. Accordingly, it is inappropriate to estimate the value of the land by subtracting the estimated value of the improvements from the lump real estate price. Basis assigned to land in this residual fashion may result in understating the appropriate basis in the land and overstating the appropriate basis in the depreciable improvements. Examiners should also be wary if a cost segregation study relies solely on local assessed values rather than appropriately determining fair market values.

Yuck. The bottom line to all this- use the county assessor ratio method supported by the Nielson tax court case, and apply some common sense with building and replacement costs as compared to the age of the purchased building.