Cost segregation is an engineering-based study that breaks a purchased or constructed building into components that depreciate at different speeds. By default, a residential rental depreciates over 27.5 years and commercial property over 39 years. A study reclassifies parts of the purchase price, such as flooring, cabinetry, specialty electrical, appliances, and land improvements like parking and landscaping, into 5-, 7-, and 15-year property. Because property in those shorter classes is eligible for bonus depreciation, a study frequently converts 20% to 35% of a building's cost into deductions available immediately, dramatically front-loading tax savings. The strategy pairs with material participation rules: the losses it creates are only usable against wages if the owner qualifies under REPS or the short-term rental rules. Recapture on sale and study cost mean it is best for owners who will hold the property and can use the losses.
Cost Segregation
Primary authority: IRC §168; Hospital Corp. of America v. Commissioner, 109 T.C. 21 (1997)
The authority behind it
IRC §168; Hospital Corp. of America v. Commissioner, 109 T.C. 21 (1997)
Every entry in this glossary cites the statute, regulation, or IRS guidance behind it.
Worked example
An investor buys a $1,000,000 short-term rental (building value $800,000). A cost segregation study allocates $240,000 to 5- and 15-year property. With 100% bonus depreciation, she deducts roughly $240,000 in year one instead of about $29,000 of straight-line depreciation.
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Related terms
Bonus Depreciation
Bonus depreciation under IRC Section 168k lets a business deduct the entire cost of qualifying equipment and other...
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MACRS (Modified Accelerated Cost Recovery System)
MACRS is the default depreciation system for tangible property placed in service after 1986.
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Short-Term Rental Loophole
The short-term rental "loophole" is a quirk in the passive activity regulations: a property whose average guest stay...
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Real Estate Professional Status (REPS)
Real estate professional status removes the automatic "passive" label that Section 469 puts on all rental...
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Depreciation Recapture
Depreciation recapture is the rule that claws back prior depreciation deductions when you sell a depreciated asset...
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