Cost
Segregation

What gets reclassified

• 5-year property. Carpet, decorative lighting, window treatments, appliances, specialty plumbing and electrical (fountains, specialty wiring).
• 7-year property. Office furniture, non-residential personal property. Less common in real estate.
• 15-year property. Site improvements (paving, fencing, landscaping, sidewalks, signage, exterior lighting), land improvements. Significant portion of industrial and retail.
• 27.5-year (residential) or 39-year (commercial). Building structure, roof, HVAC, plumbing, electrical, windows, walls. What remains after reclassification.
• Land. Not depreciable. Typically 15–25% of purchase basis.

Typical reclassification: 20–35% of depreciable basis moves to accelerated schedules. Higher on amenity-heavy properties (multifamily 25–35%, industrial with site improvements 30–40%, hotels/STR 30–45%).

Bonus depreciation schedule

TCJA 2017 allowed 100% bonus depreciation on qualifying property through 2022. Phase-out:

• 2017 − Sept 27: 50% bonus on some categories
• Sept 28, 2017 – 2022: 100% bonus
• 2023: 80% bonus
• 2024: 60% bonus
• 2025: 40% bonus
• 2026: 20% bonus
• 2027+: 0% (revert to MACRS only)

Political note: proposals to restore 100% bonus depreciation have cycled through Congress for years. Current 2026 law assumes the 20% rate unless legislation changes. Plan for current law.

The cost-seg math

$1M multifamily acquisition (2026):

  Land (20%):             $200,000
  Depreciable basis:      $800,000

Without cost seg:
  27.5-year straight-line: $29,091/year

With cost seg (30% reclassified):
  5/15-year property:      $240,000
  Bonus 20% of $240k:       $48,000 year-1 immediate
  Remaining $192k depreciates via MACRS:
    Year 1:  $48,000 (bonus)
              + $38,400 (MACRS 5-year first-year, half-convention)
              + $14,884 (27.5-yr on $560k)
              = $101,284 year-1 depreciation

  vs $29,091 without cost seg — 3.5x acceleration

On a $100k taxable income reduction at 37% federal:
  $101,284 − $29,091 = $72,193 additional deduction
  Tax savings: ~$26,700 cash

Study cost: $5,000-$10,000
Payback: immediate first year

§469 passive activity loss rules

Cost-seg creates paper losses. The ability to use those losses against W-2 and ordinary income depends on §469 passive activity loss rules:

• Passive rental. Default classification. Losses only offset other passive income (not W-2). Excess suspended, carried forward.
• $25,000 exception. Active participation (not just passive ownership) allows up to $25k loss against non-passive income, phased out at MAGI $100k–150k.
• Real Estate Professional Status (REPS). §469(c)(7) — 750+ hours in real estate trade/business AND more than 50% of total personal services AND material participation in rental activities = full loss deduction against all income.
• Spouse REPS. One spouse qualifies on their time; both benefit on joint return.
• STR material participation. Average guest stay ≤ 7 days = not a "rental activity" under §469(c)(7)(B)(ii). Material participation (100+ hours AND more than any other person) unlocks loss deductibility without needing REPS. The "STR loophole."

Study mechanics

• Engineering-based study. Provider conducts site visit, inventories building components, uses IRS Audit Techniques Guide standards. Documented and defensible. $5k–25k cost.
• Chief counsel advice / residual. Lower-cost approximation. Less defensible in audit. Often insufficient for aggressive reclassification.
• Providers. CSSI, Engineered Tax Services, CBRE Tax, KBKG, Cost Segregation Authority.
• Catch-up studies. Performed years after acquisition via Form 3115 (change in accounting method) to catch up on missed depreciation. §481(a) adjustment claims prior years’ missed depreciation in current year.

Recapture at sale

What goes up must come down. At sale:

• §1250 (real property). Gain up to accumulated depreciation taxed at max 25% (unrecaptured §1250 gain).
• §1245 (personal property). Gain up to accumulated depreciation on 5/7/15-year assets taxed at ordinary income rates (up to 37%).
• Remainder. Gain above accumulated depreciation taxed at long-term capital gains rate (0/15/20%).

Mitigation strategies:

• §1031 exchange defers recapture
• Installment sale §453 spreads recapture over years
• Death and step-up basis eliminates all deferred tax
• Charitable remainder trust (CRT) on substantial gain

§179 expensing

§179 allows immediate expensing of certain qualifying property up to $1.22M (2024 limit, indexed annually). Applies to tangible personal property and certain real property improvements. Less relevant for large real estate since bonus depreciation covers the same categories with higher limits, but useful for smaller properties or when bonus phases out.

When cost seg pays off

Rule of thumb: cost-seg pays off if:

• Purchase basis > $500k (residential) or $400k (commercial)
• Holding period > 3 years
• Investor has offsetting income to use the depreciation
• Property has meaningful 5/15-year content (amenity-heavy, industrial, STR, hotel, MOB)
• Tax bracket is high enough to benefit (33%+ federal+state)

Common pitfalls

• Aggressive 15-year allocation. Provider pushes 40% 15-year reclassification. Auditor disagrees. Deductions clawed back + penalties.
• REPS hours undocumented. Claiming REPS without contemporaneous time log. IRS audit denies REPS, converts losses to passive suspended.
• STR material participation failed. Used property >14 days personally. §280A disallows losses. STR loophole lost.
• Recapture surprise at sale. Cost-seg creates phantom income at sale. Must plan 1031 or installment sale to defer.
• No Form 3115 for catch-up. Late cost-seg requires Form 3115, not amended return. Filing wrong form misses deduction.
• Bonus phaseout timing. Acquiring in 2026 gets only 20% bonus. Acquiring in 2024 got 60%. Timing materially affects year-1 benefit.
• AMT complications. Alternative Minimum Tax can disallow some accelerated depreciation benefits for high-income taxpayers. Modeling required.
• State non-conformity. California doesn’t conform to bonus depreciation. Separate state schedule required. Same for several other states.