Key takeaways
- A cost segregation study identifies building components that qualify for shorter depreciation lives (5, 7 or 15 years) instead of 27.5 or 39 years.
- The One Big Beautiful Bill Act (OBBBA), enacted in July 2025, permanently restored 100% bonus depreciation for qualifying property acquired and placed in service after January 19, 2025. That makes reclassified components potentially deductible in the first year.
- Studies can be done for new acquisitions, construction and renovations, and as “look-back” studies on buildings placed in service in prior years, often without amending returns.
- Cost segregation primarily accelerates deductions; it does not eliminate tax. Depreciation recapture may apply when the property is sold.
- The IRS favors detailed, engineering-based studies that tie component costs to documentation.
A commercial building is not a single asset. It is a collection of components: the structure, roof and HVAC, but also carpeting, specialty lighting, dedicated electrical for equipment, cabinetry, signage, parking lots, landscaping and site utilities. Tax law assigns different depreciation lives to these components.
By default, many owners depreciate the entire building over 39 years (nonresidential) or 27.5 years (residential rental). A cost segregation study separates the components that qualify for shorter lives, accelerating deductions and improving cash flow in the early years of ownership.
With 100% bonus depreciation now a permanent feature of the tax code, the value of that acceleration has grown significantly.
How depreciation works for real estate
Under the Modified Accelerated Cost Recovery System (MACRS):
| Property type | Typical recovery period | Bonus eligible? |
|---|---|---|
| Land | Not depreciable | No |
| Nonresidential real property (structure) | 39 years | No (except certain qualified production property) |
| Residential rental property (structure) | 27.5 years | No |
| Land improvements (paving, landscaping, fencing, site utilities) | 15 years | Yes |
| Qualified improvement property (certain interior improvements to nonresidential buildings) | 15 years | Yes |
| Personal property (certain flooring, specialty electrical and plumbing, cabinetry, fixtures, equipment) | 5 or 7 years | Yes |
Bonus depreciation under Section 168(k) allows an immediate deduction of a percentage of the cost of qualifying property with a recovery period of 20 years or less. Under the Tax Cuts and Jobs Act of 2017, the bonus rate was 100% but was scheduled to phase down to 40% in 2025, 20% in 2026 and zero after that. The OBBBA reversed that phase-down and made 100% bonus permanent for qualifying property acquired and placed in service after January 19, 2025. The IRS has issued interim guidance on applying the new rules, including Notice 2026-11.
The OBBBA also created a temporary 100% allowance for certain qualified production property, nonresidential real property used in manufacturing, production or refining, subject to specific requirements. Owners of manufacturing facilities should evaluate this separately with their tax advisors.
What a cost segregation study does
A cost segregation study:
- Allocates the purchase price among land, building and other components (often relying on an appraisal; see our commercial real estate appraisal guide);
- Identifies components that qualify as 5-, 7- or 15-year property, based on tax law, case law and IRS guidance;
- Estimates the cost of each component using construction documents, cost data and engineering methods; and
- Produces a report with the analysis, support and fixed asset schedules for the tax return.
The IRS Cost Segregation Audit Techniques Guide describes the characteristics of quality studies. A detailed engineering approach, using actual construction cost records or detailed cost estimates, is generally regarded as the most reliable. Studies based on rules of thumb or percentages without support are more vulnerable on examination.
A worked example
An investor acquires a commercial building in 2026. After allocating value to land, the depreciable basis of the building is $3,000,000. A cost segregation study reclassifies 25% of the basis:
- 5- and 7-year personal property: $450,000
- 15-year land improvements: $300,000
- 39-year building: $2,250,000
First-year depreciation (simplified, ignoring mid-month convention):
| Without study | With study | |
|---|---|---|
| Bonus depreciation on 5-, 7- and 15-year property | $0 | 750,00039−yearbuilding( ÷ 39) |
| Total year-one depreciation | $76,923 | $807,692 |
| Additional year-one deduction | $730,769 |
At a 37% marginal federal rate, the additional deduction could defer roughly $270,000 of federal income tax in year one, subject to passive activity rules and other limitations.
This is a timing benefit. Total depreciation over the life of the property is the same; the study moves deductions forward. But because a dollar saved today is worth more than a dollar saved later, the present value benefit can be substantial.
Look-back studies: catching up on missed depreciation
If you placed a building in service in a prior year and depreciated it entirely as 27.5- or 39-year property, you may be able to perform a look-back study. Generally:
- the change is made through an automatic change in accounting method by filing Form 3115;
- the cumulative missed depreciation is deducted in the current year as a Section 481(a) adjustment; and
- you generally don’t need to amend prior returns.
Whether bonus depreciation applies to look-back property depends on when it was acquired and placed in service and the bonus rate in effect at that time. Property placed in service before January 20, 2025 is generally subject to the bonus rules in effect when it was placed in service.
Who benefits most
Cost segregation tends to make sense for:
- commercial property owners with buildings costing roughly $750,000 or more (smaller properties can benefit, but study costs weigh more heavily);
- recent acquisitions, new construction and major renovations;
- property types with significant personal property and site work, such as medical offices, restaurants, hotels, retail, auto dealerships, self-storage, manufacturing and multifamily properties;
- owners with taxable income to offset, or who qualify as real estate professionals or otherwise can use the losses; and
- owners planning to hold the property for several years.
It may make less sense when: – the owner cannot use the deductions due to passive activity loss limits; – the property will be sold soon, triggering recapture; or – the owner is in a low tax bracket now but expects a higher one later.
Risks and trade-offs
Depreciation recapture
When the property is sold, gain attributable to depreciation on Section 1245 property (personal property) is generally recaptured as ordinary income. Depreciation on the building structure (Section 1250) is generally taxed at a maximum 25% rate as unrecaptured Section 1250 gain. A 1031 exchange or holding until death (with a basis step-up under current law) can change the analysis.
Passive activity limits
Rental real estate losses are generally passive. Unless you qualify as a real estate professional, materially participate in certain short-term rentals, or have passive income to offset, accelerated deductions may be suspended and carried forward.
State conformity
Not all states follow federal bonus depreciation. Many require add-backs, which reduce the state tax benefit.
Audit exposure
Poorly supported studies invite challenges. Use qualified professionals and keep documentation.
Purchase price allocation
In an acquisition, the allocation of price among land, building and personal property affects the study. Allocations in purchase agreements should be reasonable and supportable. See our article on purchase price allocation in asset and stock sales.
How to prepare for a study
Gather: – closing statement and purchase agreement; – appraisal, if available; – construction contracts, draw requests and change orders; – architectural and engineering drawings; – fixed asset ledgers and depreciation schedules; – invoices for renovations and improvements; and – site plans and property photos.
Frequently asked questions
Yes. It applies long-standing tax rules and IRS guidance. Quality and documentation are what matter.
The IRS Audit Techniques Guide favors studies prepared by individuals with knowledge of construction and tax law. Engineering-based methods are generally considered the most reliable.
Yes. Multifamily and other residential rental properties often have significant 5-, 7- and 15-year components.
It applies to qualifying property with a recovery period of 20 years or less, acquired and placed in service after January 19, 2025, subject to the statute’s rules. Buildings themselves (27.5 and 39 years) generally do not qualify, except for certain qualified production property.
The bottom line
With 100% bonus depreciation restored permanently, cost segregation has returned as one of the most powerful cash-flow tools available to real estate owners. But it is a timing strategy with trade-offs, and its value depends on quality, documentation and your overall tax picture.
Foxboro Consulting Group, Inc. provides real estate valuation and appraisal services and cost segregation support, including purchase price allocations and component analyses. Contact us to discuss whether a study makes sense for your property.
This article is for general informational purposes and does not constitute tax, legal or accounting advice. Tax rules change and their application depends on individual facts; consult a qualified tax advisor.
