Cost Segregation Audits & Rule 142: Burden of Proof Guide

When it comes to defending your tax positions before the IRS or Tax Court, knowledge of Rule 142 of the U.S. Tax Court Rules of Practice and Procedure is essential especially in the context of cost segregation studies. If you're leveraging accelerated depreciation to boost your cash flow, it's critical to understand how the burden of proof can affect your tax strategy and audit outcomes.

Core Highlights

• The taxpayer typically bears the burden of proof when defending cost segregation deductions unless specific conditions under IRC § 7491 are met.
• An engineering-based, well-documented cost segregation study is essential to withstand IRS scrutiny and potentially shift the burden of proof to the IRS.
• Courts evaluate asset classification based on facts and circumstances, including installation permanence, function, and removability so detailed evidence is critical.

Table of Content

• Core Highlights
• What Is Rule 142?
• Why This Matters for Cost Segregation
• What the IRS Is Looking For
• How to Shift the Burden to the IRS
• Real Case: Hospital Corporation of America v. Commissioner (2009)
• Best Practices for Cost Segregation Studies Under Rule 142
• Final Thoughts

What Is Rule 142?

Rule 142(a)(1) states that:

“The burden of proof shall be upon the petitioner, except as otherwise provided by statute or determined by the court.”

In simpler terms: if the IRS challenges your tax return, the burden is generally on you, the taxpayer to prove that your deductions are valid.

That includes depreciation deductions that arise from cost segregation studies.

Why This Matters for Cost Segregation

A cost segregation study allows you to reclassify components of a building such as flooring, electrical and landscaping into shorter recovery periods (5, 7, or 15 years) instead of the standard 27.5 or 39 years. This results in significant front-loaded depreciation and lower taxable income.

But if the IRS audits your return and disallows part of your depreciation deduction, you’ll need to prove that your study is accurate and defensible. That’s where Rule 142 comes into play.

What the IRS Is Looking For

In some cases, the IRS focuses on:

• Engineering-based justifications for reclassifications
• Accurate allocation of costs to personal property vs real property
• Consistency with IRS Audit Techniques Guides (ATGs)
• Proper substantiation and documentation

If your study is weak, generic, or based on “rule-of-thumb” estimates, the IRS may challenge it and you’ll bear the burden of proof.

How to Shift the Burden to the IRS

There are instances under the tax code (e.g., IRC §7491) where the burden of proof can shift to the IRS if:

1. You’ve complied with all IRS substantiation requirements,
2. You’ve maintained adequate records,
3. And you’ve cooperated with IRS requests.

But this rarely applies in cost segregation unless your study is meticulous, professional, and defensible. That's why hiring a qualified specialist is critical.

Real Case: Hospital Corporation of America v. Commissioner (2009)

In this landmark case, the Tax Court sided mostly with the taxpayer because they:

• Hired engineering experts
• Used cost estimation methods grounded in construction principles
• Thoroughly documented each asset’s function and classification

The IRS had their own estimates, but the Court found the taxpayer’s method more persuasive—thus meeting their burden under Rule 142.

Best Practices for Cost Segregation Studies Under Rule 142

1. Use an engineering-based approach
   Rule-of-thumb allocations are easy for the IRS to dismiss.
2. Document everything
   Maintain all blueprints, invoices, photos, and expert reports.
3. Be proactive
   Address IRS concerns before they arise by working with experienced tax professionals.
4. Know your numbers
   Be prepared to explain why an asset qualifies for 5-year vs 39-year treatment.

Final Thoughts

Tax Court Rule 142 reminds us that your tax position is only as strong as the evidence supporting it. In the world of cost segregation, this means having a detailed, well-supported, and professionally prepared study that can withstand IRS scrutiny.

If you're investing in real estate and not taking advantage of cost segregation, you're leaving cash on the table. But if you do it, do it right because the burden of proof is on you.

Ready to Bulletproof Your Depreciation Strategy?

At CostSegRx, we deliver audit-ready cost segregation studies that are fully compliant with IRS guidelines. Let’s put your depreciation on solid ground.