§ 263A and Cost Segregation: Which Costs Must Be Capitalized?

Cost segregation changes how project costs are classified for depreciation, but it does not operate independently from the capitalization rules. The 2025 IRS Cost Segregation Audit Technique Guide specifically identifies § 263A and § 263A(f) as related issues that can affect the allocation of project costs in cost segregation studies. For self-constructed assets and property built under contract, the UNICAP rules generally require capitalization of direct costs and certain indirect costs allocable to the property. The ATG also explains that capitalized interest can be affected when costs are reallocated between real and tangible personal property. For commercial real estate investors, the important lesson is that changing an asset's depreciation classification does not automatically change which production costs must be capitalized.

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Key Takeaways

• § 263A requires capitalization of direct costs and certain indirect costs allocable to property produced by the taxpayer.
• Self-constructed assets and property built under contract can fall within the UNICAP rules because they are treated as property produced by the taxpayer.
• A cost segregation reclassification can affect the allocation of project costs without eliminating costs that § 263A requires to be capitalized.
• Engineering, design, insurance, utilities, taxes, and other indirect costs may need to be considered when determining capitalized project costs.
• Investors and project teams should understand the relationship between construction accounting, cost segregation, and UNICAP before finalizing the study.
• Capitalized interest can change when project costs are reallocated because § 263A(f) applies based on the nature and classification of designated property.
• Classifying an asset does not erase the costs required to capitalize it.

What Is § 263A in a Cost Segregation Study?

Section 263A contains the Uniform Capitalization, or UNICAP, rules.

For cost segregation purposes, the key question is how those rules interact with the costs of producing property.

The ATG states that the UNICAP rules require capitalization of all direct costs and certain indirect costs allocable to real property and tangible personal property produced by the taxpayer.

The ATG uses "produce" broadly.

For purposes of § 263A, producing property includes activities such as:

• Constructing
• Building
• Installing
• Manufacturing
• Developing
• Improving
• Creating

Self-constructed assets and property built under contract are treated as property produced by the taxpayer.

That means a commercial real estate construction project can involve two related but distinct questions.

First: What property was produced and how should it be classified for depreciation?

Second: What costs must be capitalized under § 263A?

Those questions interact, but they are not interchangeable.

The depreciation classification might change through cost segregation.

The capitalization requirement still has to be analyzed under its own rules.

How Does UNICAP Interact With Cost Segregation?

Cost segregation starts with the project's property and costs.

The engineering analysis identifies individual assets and property groups and determines how the costs should be allocated among them.

Section 263A can affect what costs belong in that starting basis.

The ATG states that direct costs and all indirect costs properly allocable to property produced must be capitalized, except where an applicable exception applies.

Direct costs generally include items such as:

• Direct materials
• Direct labor

The ATG also lists numerous examples of indirect costs that may be required to be capitalized to the extent they are properly allocable.

Those examples include:

• Engineering and design costs
• Insurance
• Interest
• Licensing and franchise costs
• Officer compensation
• Purchasing costs
• Quality control
• Rent
• Repairs and maintenance
• Taxes
• Tools and equipment
• Utilities

The important point is not that every project has every one of these costs.

The point is that the capitalization analysis cannot simply stop at the contractor's direct construction invoices.

The full project cost may include other costs that are properly allocable to the property.

This is why a quality cost segregation study addresses related § 263A issues rather than treating the study as a classification exercise alone.

For a deeper discussion of indirect costs in cost segregation, see indirect costs in cost segregation.

Why Does § 263A Matter to Commercial Real Estate Investors?

The practical reason is basis.

Cost segregation reallocates costs among property categories.

If the underlying project cost is incomplete, the resulting asset allocations may also be incomplete.

The ATG specifically tells examiners to consider whether all appropriate costs, including § 263A expenses, have been associated with a particular asset.

This becomes especially important for development and construction projects where the cost records may be spread across multiple accounts.

For example, a developer may have:

• Construction contracts
• Architectural and engineering invoices
• Permit costs
• Construction management costs
• Insurance
• Utilities during construction
• Interest expense
• Other project-related costs

Some of those costs may need to be allocated among property categories.

Others may have a more specific relationship to a particular asset or class.

The ATG notes that indirect costs may sometimes be assigned to the property class to which they relate, while other costs such as building permits, general conditions, and contractor overhead and profit may be allocated on a pro-rata basis.

That makes the cost development methodology important.

The investor should be able to understand not just the final allocation, but how the study got there.

Where Does § 263A Show Up in Real Estate Projects?

The most obvious application is new construction.

Suppose an investor develops a commercial property from the ground up.

The project may include a building, land improvements, equipment, specialized systems, and other property.

The contractor invoices may capture a substantial portion of the direct construction costs.

But the total capitalized basis can involve more than those invoices.

The ATG's cost analysis guidance directs examiners to review project costs that may not appear on contractor pay applications, including change orders, indirect costs, and out-of-pocket costs.

This is where engineering and accounting records need to work together.

An engineer may identify a specialized electrical system as supporting a particular asset.

The accounting records may show the total cost of the electrical work.

Section 263A may affect which additional project costs belong in the capitalized basis.

The final cost segregation allocation needs to reflect the appropriate starting cost.

Self-Constructed Property

Self-constructed property is directly within the ATG's discussion of § 263A.

The taxpayer may be constructing, improving, or developing its own property rather than purchasing a completed asset.

In that situation, the UNICAP rules apply to the costs properly allocable to the property produced.

Property Built Under Contract

The ATG also treats property built under contract as property produced by the taxpayer for purposes of § 263A.

That means an investor should not assume that using a general contractor removes the project from the capitalization rules.

The focus remains on the costs properly allocable to the property.

How Should Investors Approach § 263A Before Cost Segregation?

The best time to consider § 263A is before the project records become difficult to reconstruct.

Investors, developers, accounting teams, and project managers can create a stronger record by tracking the project costs from the beginning.

Useful practices include:

• Maintain project-specific accounting records
• Separate construction costs from unrelated operating expenses
• Track change orders
• Preserve architectural and engineering invoices
• Track owner-furnished equipment
• Document construction-period interest
• Maintain contractor pay applications
• Preserve general ledger detail
• Document the placed-in-service date

The ATG's quality-study guidance says a quality study should explain the treatment of related issues, including § 263A.

That means the cost segregation engineer should understand the cost structure of the project rather than simply applying percentages to a final total.

At CostSegRx, our engineers focus on the property's physical systems, the available project documentation, and the cost records supporting the engineering conclusions.

The engineering question is:

What was built, what does it do, and what costs belong to that property?

The tax analysis then determines how those costs are treated under the applicable rules.

For a broader look at engineering methodology and documentation, see how engineers approach cost segregation.

Illustrative § 263A Example

Illustrative example only. Figures shown are estimated for demonstrative purposes only. Actual capitalized costs, asset classifications, depreciation, and tax results depend on the specific property, supporting documentation, engineering analysis, applicable capitalization rules, and taxpayer circumstances.

Assume an investor constructs a commercial property with $10 million of direct construction costs.

During the project, the investor also incurs $600,000 of other project-related costs that must be evaluated under the capitalization rules.

Assume, for illustration, that the applicable analysis results in the full $600,000 being included in capitalized project costs.

The resulting project basis being analyzed for cost segregation would therefore be:

• $10 million direct construction costs
• $600,000 additional capitalized costs
• $10.6 million total capitalized project cost

Now suppose the engineering study identifies a portion of the property as 5-year property and another portion as 39-year nonresidential real property.

The study must allocate the appropriate capitalized project costs among those assets.

The additional $600,000 does not disappear simply because the engineering study changes the depreciation classification of portions of the project.

That is the lesson.

Cost segregation changes the classification of property. It does not automatically remove capitalizable costs from the property's basis.

Engineering Principle

Classifying an Asset Does Not Erase the Costs Required to Capitalize It.

Section 263A adds an important layer to cost segregation.

The engineer is determining what property exists and how the costs should be allocated among those property elements.

The capitalization rules determine which direct and indirect production costs must be included in the property's capitalized cost.

Then § 263A(f) can create another consideration for capitalized interest.

The ATG explains that changes in the allocation between real and tangible personal property can affect the amount of capitalized interest.

This is especially important because the § 263A(f) definition of designated property is not simply a mirror of the depreciation classification under § 168.

The ATG specifically warns that some property treated as § 1245 property for depreciation can still be treated as real property for purposes of interest capitalization when it is an inherently permanent structure.

That distinction is easy to miss.

But it reinforces the central engineering lesson.

The property needs to be understood before the tax treatment can be applied correctly.

Classify the asset.

Trace the cost.

Apply the capitalization rules.

Then determine the appropriate depreciation treatment.

Classifying an asset does not erase the costs required to capitalize it.