Direct and Indirect Costs: What Belongs in the Cost Segregation Study

A cost segregation study is not just about deciding which assets belong in shorter recovery periods. It also has to determine which project costs belong with those assets. The 2025 IRS Cost Segregation Audit Technique Guide identifies explanation of the treatment of indirect costs as one of the 13 principal elements of a quality study. The ATG recognizes that some costs should be assigned directly to a particular property class, while others may be allocated across assets on a pro-rata basis. For investors, the important question is simple: where does each cost actually belong?

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Key Takeaways

• Direct costs can generally be traced to a specific asset or construction activity, while indirect costs may support multiple property classes or relate specifically to one class.
• A quality study identifies the purpose of each indirect cost and explains how that cost was allocated.
• Land-related costs, building costs, and personal property costs do not automatically receive the same treatment.
• Surveying, subdivision, general grading, building permits, general conditions, and contractor overhead and profit illustrate why the purpose of a cost matters.
• Investors should ask what created each significant cost and which property class actually benefited from it.
• A cost allocation can change materially when indirect costs are assigned based on the property they actually support rather than spread indiscriminately.
• An indirect cost belongs where the work that created the cost actually belongs.

What Are Direct and Indirect Costs?

Direct costs are costs that can be associated with a specific asset, system, or construction activity.

Examples might include the labor and materials used to install a particular system or the invoice for a specific piece of property.

Indirect costs are different.

They may support the overall project or multiple classes of property rather than one specific asset.

The distinction matters because a cost segregation study allocates the property's total basis among different property classes.

If an indirect cost benefits multiple classes, the study needs a reasonable method for determining how much belongs to each.

If the cost specifically relates to one property class, it may be assigned directly to that class instead.

The ATG specifically states that indirect costs can include expenditures that should not be allocated to the entire project but instead assigned to the property class to which they relate.

That is the central concept.

The purpose of the cost determines where the cost belongs.

How Does Cost Allocation Work?

CostSegRx engineers begin with the property and the work performed.

The basic questions are:

• What exists?
• Why does it exist?
• What work created it?
• What property does that work support?
• What documentation supports the cost?
• How should the cost reasonably be allocated?

This approach follows the CostSegRx engineering philosophy that engineering produces supportable conclusions and tax treatment follows those conclusions. Documentation such as construction drawings, specifications, contractor records, invoices, photographs, site observations, owner interviews, and cost reconciliation records supports the analysis.

For a broader discussion of study quality, see cost segregation audit readiness.

The result is not simply a percentage allocation.

It is a documented explanation of why each cost belongs where it was placed.

Why Does the ATG Treat Indirect Costs as a Separate Issue?

The ATG says the treatment of indirect costs is an area of frequent controversy.

That makes sense.

A direct cost may be relatively easy to trace.

An indirect cost can support several different activities at the same time.

Consider contractor overhead and profit.

The contractor may earn overhead and profit on the entire construction project.

That cost does not necessarily belong exclusively to the building.

It may need to be allocated among the relevant property classes.

Now consider general grading.

General grading may relate to the land itself rather than to a depreciable building component.

The two costs have very different relationships to the property.

The ATG therefore says a quality study should explain the purpose of each indirect cost and describe its allocation.

The question is not simply:

“What percentage should we use?”

The better question is:

“What property did this cost actually support?”

Land-Related Costs: Where Do They Belong?

The ATG provides specific examples of indirect costs that typically relate only to land.

These include:

• Costs to survey land
• Costs to subdivide land
• General grading

The ATG states that these costs are typically allocable only to land.

That distinction matters because land is not depreciable.

If a project contains both land and depreciable improvements, the study needs to identify costs that belong to the land rather than automatically treating all project costs as part of depreciable basis.

For example, suppose a developer incurs a cost to survey and subdivide a parcel before construction begins.

The fact that the cost was incurred during the overall development process does not automatically make it a building cost.

The purpose of the work points to the property it supports.

This is why CostSegRx engineers examine the actual project and its documentation rather than applying a standard allocation percentage.

What About Building Permits and General Conditions?

The ATG gives different treatment to certain project-wide costs.

Building permits, general conditions, and contractor overhead and profit are typically allocated to assets on a pro-rata basis.

Why?

Because these costs can support multiple property classes across the project.

A building permit may relate to the overall construction authorization.

General conditions may support the entire construction operation.

Contractor overhead and profit may apply across the work performed.

These costs therefore cannot automatically be assigned to one asset simply because they appear in the construction records as one line item.

Instead, the study needs to determine an appropriate allocation based on the property costs or other relevant facts.

This is where the engineering analysis and cost records work together.

Do Indirect Costs Belong on § 1245 Property?

Not necessarily.

The ATG says indirect costs generally do not relate to the placement of business machinery or furniture and fixtures because these assets are typically purchased and installed under separate contracts.

That means an item such as separately purchased furniture may not receive an allocation of construction indirect costs.

The same concept can apply to equipment purchased outside the construction contract.

But the ATG also recognizes an important exception.

Indirect costs that specifically relate to components of personal property may be assigned to § 1245 property.

The ATG gives examples such as:

• Special consultants for computer wiring
• Process engineering
• Costs to design a computer system

These costs may be assigned directly to the system they support.

That distinction prevents an overly simplistic rule.

The correct question is not:

“Is this an indirect cost?”

It is:

“What does this indirect cost relate to?”

When Is a Pro-Rata Allocation Appropriate?

The ATG recognizes that certain indirect costs may reasonably be allocated across property classes.

Examples include:

• Liability insurance
• Bonds
• Overhead
• Profit

The ATG says it may be reasonable to allocate certain indirect costs where the total amount of the cost is based upon the pro-rata cost of each class of property.

Suppose a contractor's overhead is calculated as a percentage of the contractor's total direct construction costs.

If the project contains building property, land improvements, and qualifying personal property, the overhead may need to be distributed across those categories based on the underlying cost relationship.

The exact treatment depends on the facts and the cost structure.

The important point is that the allocation should have a reason.

Pro-rata does not mean arbitrary.

What Documentation Supports Indirect Costs?

Indirect cost analysis depends heavily on the quality of the underlying records.

Useful documentation can include:

• Construction contracts
• Architect and engineering invoices
• Permit records
• Contractor pay applications
• General conditions schedules
• Change orders
• Consultant invoices
• Insurance records
• Bond costs
• Contractor overhead and profit information
• Project accounting records

The ATG emphasizes the use of the best available documentation in a quality study and identifies contemporaneous documentation as the most reliable and trustworthy.

This matters because the same cost description can have different implications depending on what the supporting record shows.

“Engineering” is not enough.

The study should determine what engineering work was performed and what property it supported.

Why Does Engineering Matter to Indirect Cost Allocation?

At first glance, indirect costs may seem like an accounting issue.

But the allocation often depends on understanding the physical property.

Consider process engineering.

The invoice may simply say:

Engineering services: $100,000

That description does not tell the study where the cost belongs.

The engineer needs to understand what the consultant designed.

Did the work relate to the building?

Did it relate to a specialized production system?

Did it support computer infrastructure?

Did it support multiple property classes?

The answer determines the appropriate treatment.

The CostSegRx engineering approach begins with:

What exists?

Why does it exist?

What business activity does it support?

How is it installed?

What documentation supports it?

How should its costs be reasonably allocated?

That same framework applies to indirect costs.

How Do Indirect Costs Affect Different Property Classes?

The treatment can differ depending on the property class involved.

For example, a project may contain:

• Land
• 15-year land improvements
• 39-year nonresidential real property
• 5-year property
• QIP 15-year property, when applicable

A project-wide cost does not automatically receive the same treatment across all five categories.

A land-related cost may belong to land.

A site improvement cost may follow the specific land improvement it created.

A building permit may be allocated across relevant assets.

A consultant's cost may belong directly to a specific § 1245 system if the consultant's work was dedicated to that system.

The engineering analysis determines the relationship.

The tax treatment follows that documented relationship.

How Should Investors Evaluate Indirect Cost Treatment?

Investors reviewing a cost segregation study should ask several practical questions.

What are the major indirect costs in the project?

What work created each cost?

What property benefited from that work?

Was the cost allocated directly or pro-rata?

Why was that method selected?

What documentation supports the allocation?

Were separately purchased assets kept separate from construction costs?

These questions can reveal whether the study is treating indirect costs systematically or simply spreading them across the project.

For another discussion of indirect costs and related soft-cost issues, see indirect costs and impact fees in cost segregation studies.

Investors can also review detailed engineering cost estimates when actual cost records are unavailable.

Illustrative Example

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

Assume a hypothetical commercial construction project has:

$10 million of direct construction costs

and:

$1 million of indirect project costs.

Assume the indirect costs include building permits, general conditions, contractor overhead, and contractor profit.

A simplified allocation might look like this:

Property Class	Direct Cost	Allocated Indirect Cost	Total
5-year property	$1,000,000	$100,000	$1,100,000
15-year land improvements	$1,000,000	$100,000	$1,100,000
39-year nonresidential real property	$8,000,000	$800,000	$8,800,000
Total	$10,000,000	$1,000,000	$11,000,000

This is a simplified illustration of a pro-rata approach.

But the ATG also provides for situations where an indirect cost should be assigned differently because its purpose is specific to a property class.

For example, if a $100,000 consultant fee was specifically for designing a computer system, treating that fee as a general project cost could fail to reflect what the work actually supported.

The engineering question changes the allocation.

The example therefore illustrates the core principle:

The correct allocation depends on the purpose and relationship of the cost.

Why Can Indirect Costs Become an Audit Issue?

The ATG specifically identifies indirect cost treatment as an area of frequent controversy.

That makes indirect costs an important examination issue.

The IRS may ask:

• What was the cost?
• What did the cost pay for?
• Which property benefited?
• What allocation method was used?
• Why was that method appropriate?
• What documentation supports the conclusion?

The ATG's examination guidance also tells examiners to analyze total project costs and consider whether project costs were properly allocated to land, non-depreciable land improvements, and other property types.

That means the issue is not simply whether the study included indirect costs.

The issue is whether the study treated them correctly.

What Does the ATG Require From a Quality Study?

The ATG lists “Explanation of the Treatment of Indirect Costs” as one of the 13 principal elements of a quality cost segregation study.

A quality study should therefore explain:

• The purpose of each significant indirect cost
• The property or property classes it relates to
• Whether the cost was allocated directly or indirectly
• The methodology used for the allocation
• The supporting documentation

This is consistent with the ATG's broader definition of a quality study as accurate and well documented.

The goal is not to produce a complicated cost schedule.

The goal is to make the cost allocation understandable.

How Does This Fit Into the ATG Encyclopedia?

This article is the fourth article in the Quality of Study / Cost Development section.

The sequence is intentional:

Quality Study

What does the ATG expect from a quality study?

↓

Cost Reconciliation

How do the study's allocations tie back to actual costs?

↓

Engineering Take-Offs

How are individual property costs developed?

↓

Direct and Indirect Costs

How are project costs assigned across property categories?

↓

Acquired Property

How is cost reconstructed when original records are unavailable?

The progression matters.

The study first establishes what quality means.

Then it reconciles the total.

Then it develops individual property costs.

Then it explains how the costs surrounding those property units are allocated.

That creates a connected engineering and cost-development framework.

Engineering Principle

An Indirect Cost Belongs Where the Work That Created the Cost Actually Belongs.

The 2025 ATG does not treat indirect costs as a bucket that should automatically be spread across every asset.

Some costs are typically associated with land.

Some are allocated across assets on a pro-rata basis.

Some can be assigned directly to a specific property class.

The difference comes from purpose.

That is why the ATG requires a quality study to explain the purpose of each indirect cost and describe its allocation.

For investors, the lesson is straightforward.

Do not ask only:

“How much indirect cost was allocated?”

Ask:

“What work created that cost, and what property did that work actually support?”

That question leads back to the engineering evidence.

And the engineering evidence is what makes the allocation understandable and supportable.

An indirect cost belongs where the work that created the cost actually belongs.