Cost Segregation and Bonus Depreciation

What is cost segregation?

Cost segregation is one of the simpler ways to improve the after-tax return on a property you already own. If you’ve ever played a racing game like Gran Turismo, it’s like the cheap chip upgrade that gives your car a bit more horsepower. For those of you who aren’t ex-gaming nerds like me, it’s low-hanging fruit.

A cost segregation study is done by an engineer or specialist who breaks a property down into its components. They tell your CPA which parts of the building can be depreciated faster than the building itself.

Depreciation basics

Depreciation is a deduction for the wear and tear on a property over time. The IRS gives buildings a set schedule: 27.5 years for residential rental property and 39 years for commercial property. Land is never depreciated.

Say you buy a rental for $1,000,000 and $200,000 of that is land. The building is $800,000. On a straight 27.5-year schedule you’d deduct about $29,000 a year.

What a cost seg study changes

A lot of what you bought isn’t really “building.” Carpet, appliances, cabinets, some electrical and plumbing are personal property on a 5- or 7-year schedule. Parking lots, landscaping, fencing and sidewalks are land improvements on a 15-year schedule. A study moves those pieces onto the shorter schedules, so more of the deduction lands in the early years.

On a typical apartment building, something like 20% to 35% of the building’s cost ends up in the shorter categories. The results vary a lot by property type and age, which is why you pay someone to do the study.

Bonus depreciation

Bonus depreciation lets you deduct the shorter-life pieces (anything with a life of 20 years or less) all in the first year instead of spreading them out. It was 100% from 2017 to 2022, then started phasing down: 80% in 2023, 60% in 2024 and 40% in 2025.

The 2025 tax law restored 100% bonus depreciation permanently for property acquired and placed in service after January 19, 2025. Property acquired before that date stays on the old phase-down schedule. Combined with a cost seg study, this lets an owner deduct a large share of a property’s cost in the first year.

Recapture: what happens when you sell

Depreciation isn’t free money. It lowers your cost basis, so when you sell, some of that benefit comes back as taxable gain. The building portion is taxed at up to 25% (unrecaptured Section 1250 gain). The personal property portion accelerated by cost seg can be taxed as ordinary income. Investors often defer this with a 1031 exchange or offset it with new depreciation, but you should plan for it rather than be surprised by it.

The real value of cost seg is timing. You get deductions now and pay some back later, and a dollar of tax saved today is worth more than a dollar paid years from now.

When a study makes sense

• The property’s building value is high enough to justify the fee. Studies often cost a few thousand dollars, so very small properties may not be worth it.
• You plan to hold it long enough to use the deductions.
• You have income the losses can offset. A big loss you can’t use just carries forward.
• You already own a property you never did a study on. A look-back study lets you catch up the missed depreciation in the current year without amending old returns. Your CPA files a change in accounting method (Form 3115).

What this means for passive investors

If you invest as an LP in a syndication, you don’t order the study. The sponsor does, and your share of the depreciation shows up on your K-1. For most investors with a W-2 job, these are passive losses. They can offset other passive income, such as distributions or gains from other deals, but generally not your salary. Unused losses carry forward and are freed up when the property sells. Real estate professionals and some short-term rental owners are treated differently. Ask your CPA how it applies to you before you count on it.

For the full do-it-yourself walkthrough, see TheWealthElevator.com/costseg.