Rule of Thumb Cost Segregation: What the ATG Says About Percentages

A percentage can make cost segregation look simple. If a preparer assumes that a certain percentage of a project represents § 1245 property, the allocation can be calculated quickly. The 2025 IRS Cost Segregation Audit Technique Guide identifies this as the “Rule of Thumb” Approach and says examiners should view it with caution because it generally relies on little or no documentation. But the ATG makes an important distinction. It does not say every study using a rule of thumb must automatically be rejected. Instead, the documentation and conclusions must be examined on their own merits to determine whether the property was accurately identified and placed into the proper recovery periods.

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Key Takeaways

• The Rule of Thumb Approach generally estimates § 1245 property as a fixed percentage of project cost using limited documentation and industry experience or averages.
• A rule-of-thumb allocation applies a predetermined percentage rather than developing costs from detailed property-specific analysis.
• The ATG says examiners should view this approach with caution because it can lack sufficient documentation to support the allocation.
• A percentage-based result does not eliminate the need to identify the actual property and support its classification.
• The strongest studies use appropriate documentation, explain the methodology, and substantiate asset costs and classifications.
• A fixed percentage can produce materially different results from a property-specific analysis even when the total project cost is known.
• A percentage can describe a result, but it does not explain the property.

What Is the Rule of Thumb Approach?

The “Rule of Thumb” Approach is one of the six common approaches identified by the 2025 ATG.

The ATG describes studies using this approach as generally relying on little or no documentation and on a preparer's experience with a particular industry or property type.

One example provided by the ATG is estimating the amount of § 1245 property as a fixed percentage of project cost based on previously determined industry averages.

The calculation can be extremely simple.

Assume a preparer applies a 40% allocation to a $10 million project.

The calculation would be:

$10,000,000 × 40% = $4,000,000

The $4 million becomes the estimated § 1245 property allocation.

What is missing from that calculation is the physical explanation.

Which assets make up the $4 million?

What quantities exist?

How were those assets installed?

What does each asset do?

What documentation supports the costs?

Why is 40% appropriate for this particular property?

A fixed percentage does not answer those questions by itself.

That is the fundamental distinction between a percentage allocation and an engineering-based analysis.

How Does a Rule-of-Thumb Allocation Work?

The basic process starts with a known project cost or property basis.

The preparer then applies a predetermined percentage to estimate the portion attributed to § 1245 property.

For example:

• Total project cost: $8,000,000
• Assumed § 1245 percentage: 25%
• Estimated § 1245 property: $2,000,000

The remaining $6 million is then associated with the other property categories.

The arithmetic is straightforward.

The engineering analysis is not.

The 2025 ATG emphasizes that the determination of § 1245 property is factually intensive and must be supported by corroborating evidence. It also states that taxpayers must substantiate depreciation deductions and property classifications.

That means the percentage cannot substitute for understanding the actual property.

CostSegRx engineers approach the problem differently.

They begin with the physical property, its function, construction, documentation, and installed systems.

That is consistent with the broader engineering cost segregation process, where the property itself provides the evidence needed to support classification and cost conclusions.

Why Does the ATG Say to Use Caution?

The ATG's concern is primarily documentation and support.

It states that the Rule of Thumb Approach generally uses little or no documentation and relies on a preparer's experience or industry averages. Because of that, an examiner should view the approach with caution because it lacks sufficient documentation to support the allocation of project costs.

This does not mean experience has no value.

An experienced engineer may recognize patterns in commercial construction.

An experienced contractor may understand how systems are typically installed.

An experienced tax professional may understand the relevant recovery-period framework.

But experience is not the same thing as property-specific evidence.

A manufacturing facility in one location may differ substantially from another manufacturing facility.

A residential rental property may contain different components, finishes, systems, and site improvements from another property that appears similar at first glance.

Even two buildings with the same gross square footage can contain materially different assets.

This is why the ATG says that the determination of § 1245 property is factually intensive.

The classification has to follow the facts.

The cost allocation has to follow the evidence.

Where Can a Percentage Allocation Go Wrong?

The biggest issue with a fixed percentage is that it can hide differences between properties.

Consider two commercial buildings.

Both cost $10 million to construct.

Both contain 100,000 square feet.

Both are used for commercial purposes.

But Building A may contain extensive specialized equipment and dedicated systems.

Building B may contain primarily conventional building systems with relatively little specialized equipment.

A fixed percentage would produce the same allocation for both properties.

An engineering analysis may not.

The difference matters because the classification of an asset depends on facts such as its function, installation, relationship to the building, documentation, and applicable tax treatment.

The ATG's broader quality-study guidance says a quality study should use the best available documentation to classify assets and determine costs. It also says contemporaneous documentation is the most reliable and trustworthy.

That evidence can include:

• Construction drawings
• Specifications
• Contracts
• Invoices
• Payment applications
• Change orders
• Job cost reports
• Field inspection information
• Engineering take-offs

A percentage may be useful as a reasonableness check.

It is much less useful when it becomes the entire methodology.

What Does a Better-Supported Study Look Like?

The ATG does not prescribe one mandatory cost segregation methodology.

In fact, it expressly states that the IRS has not established specific requirements or standards for preparing cost segregation studies.

But the absence of a prescribed format does not eliminate the need for substantiation.

The ATG says actual costs are more accurate than estimates when actual costs are available. When estimation is necessary, the methodology and source of cost data should be clearly documented.

The ATG's definition of a quality study is especially important.

A quality study should:

• Classify assets into appropriate property classes.
• Explain the rationale for § 1245 and § 1250 classifications.
• Substantiate the cost basis of each asset.
• Reconcile total allocated costs to total actual costs.

It also identifies engineering take-offs, appropriate documentation, legal analysis, asset organization, and a detailed explanation of methodology among the principal elements of a quality study.

That is why what defines a quality cost segregation study matters to investors.

The goal is not simply to produce a percentage.

The goal is to produce an allocation that another qualified reviewer can understand, test, and support.

How Can a Fixed Percentage Change the Result?

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 commercial property has $12 million of depreciable project cost.

A rule-of-thumb approach applies a 30% allocation to § 1245 property.

The estimated allocation would be:

$12,000,000 × 30% = $3,600,000

Now assume an engineering-based review identifies $2.4 million of supportable § 1245 property based on the actual assets, quantities, documentation, and cost analysis.

The difference is:

$3,600,000 − $2,400,000 = $1,200,000

The two approaches produce a $1.2 million difference in the allocated cost.

The point is not that the engineering result must always be lower.

The point is that the percentage itself does not establish which result is correct.

The property-specific evidence does.

A quality analysis would investigate the actual assets and supporting costs rather than selecting the result that produces the preferred percentage.

The ATG also cautions that estimates should be reconciled to an acquisition price or total project cost to support the accuracy of an allocation.

What Should Investors Remember About Rule-of-Thumb Studies?

The Rule of Thumb Approach is easy to understand because the calculation is simple.

But cost segregation is not simply a percentage exercise.

The 2025 ATG identifies the approach and tells examiners to view it with caution because it generally lacks sufficient documentation to support the allocation.

At the same time, the ATG does not say that every study involving a rule of thumb should automatically be rejected.

Its examination guidance says the documentation should be examined and verified on its own merits to determine whether the property was accurately identified and placed into the proper recovery periods.

That distinction is important.

The issue is not whether a percentage appears reasonable.

The issue is whether the study can explain why that percentage applies to the actual property.

A well-supported study should connect the classification to the physical asset, the function of the asset, the available documentation, the applicable tax treatment, and the cost evidence.

For CostSegRx engineers, the principle is straightforward:

A percentage can describe a result, but it does not explain the property.