Cost-Segregation: Mitigating Taxes & More

Are you purchasing an investment property? How about considering constructing a new rental property? One of the advantages of real estate investments is the ability to claim business expenses to offset your rental income. However, unlike other business equipment and assets, the IRS has stringent rules on when you can deduct the purchase price.  

This can cause delayed depreciation deductions, which can lead to higher taxable income. There is a loophole to these provisions, known as a cost segregation study. In this article, we'll cover the fundamentals of cost segregation studies, including how they can help you expedite your depreciation deductions to mitigate taxes.  

For tax purposes, residential real estate is depreciated over 27.5 years and commercial real estate is depreciated over 39 years. These depreciation conventions apply to the building being purchased. Let's say you purchase a commercial building for $500,000 and the land value is $100,000. The $100,000 land value is not depreciated, leaving the remaining $400,000 to be depreciated over 39 years or about $10,250 per year.  

However, within the depreciable building price of $400,000 are components that have a quicker depreciable life. For example, kitchen appliances are depreciated over 5 years, while furniture and fixtures have a 7-year depreciable life. A cost segregation study breaks your purchase price down into each class of property. For example, after a cost segregation study, your 39-year building base might only be $200,000, while you have $100,000 in 5-year property and $100,000 in 7-year property. This allows you to expedite your depreciation deduction.  

The main goal of a cost segregation study is to frontload your depreciation deduction to earlier years. First, this is done by identifying each type of asset in the building component and assigning a useful life. Examples of assets that will be included in a cost segregation study include electrical, plumbing, HVAC, fixtures, furniture, finishes, cabinets, the roof, siding, windows, and the driveway. Every identifiable asset will be listed with a useful life.  

After you've received your cost segregation study, your accountant will use the information to leverage faster depreciable lives and take advantage of special depreciation options. There are two types of special depreciation options: Section 179 and Bonus Depreciation. Unlike traditional depreciation rules that require you to depreciate an asset over its useful life, special depreciation options give you the ability to deduct all or a portion of the asset in the year placed in service. Let's break down each of these items in more detail.  

Section 179  

Section 179 gives real estate investors the ability to deduct 100% of certain assets in the year placed in service. This deduction applies to most classes of property besides the structural building (27.5 or 39-year property). Section 179 also applies to qualified improvement property, such as HVAC units, alarm systems, and security systems.  

One of the caveats of Section 179 is that it cannot create a loss. This means that if you have $10,000 of taxable income, your maximum Section 179 deduction is $10,000. Section 179 also begins to phase out dollar-for-dollar once $3,130,000 of assets are placed in service during the year. The maximum Section 179 deduction is $1,250,000 for the 2025 tax year. Not all states allow Section 179, making it important to consult with your tax advisor.  

Bonus Depreciation 

Bonus Depreciation went into law under the 2017 Tax Cuts and Jobs Act. However, this deduction has begun to phase out. For the 2025 tax year, Bonus Depreciation allows 40% of an asset's cost basis to be deducted in the first year. This percentage drops to 20% in 2026 and 0% beginning in 2027. 

Bonus Depreciation generally applies to items that Section 179 does not cover, such as driveway improvements, fences, and swimming pools. Unlike Section 179, Bonus Depreciation can create a net loss. If you're a real estate professional, using Bonus Depreciation to generate a loss from your rental activities could be helpful to offset other active income sources, such as a W-2 job or 1099 income. It's also important to note that not all states allow Bonus Depreciation, resulting in a state depreciation difference.  

There are a few other cost segregation considerations to keep in mind. Let's explore these items in more detail.  

Depreciation Differences are Temporary  

The first consideration is that depreciation differences are temporary. When you eventually sell a property, your taxable gain is determined by your basis in the property. Your basis in a property is the purchase price plus improvements minus depreciation. Expediting depreciation through a cost segregation study lowers your basis, creating a larger gain upon sale.  

Let's say you bought a property for $500,000 and claimed $200,000 in depreciation through a cost segregation study in the first year. If you were to sell the property for $700,000 the next year, you would generate a taxable gain of $400,000. Real estate investors need to determine if the upfront depreciation deduction is worth the lower basis. 

A Professional Study is Required  

Cost segregation studies are regulated by the IRS, with specific guidelines that govern the process. This means that a professional study is required. Due to the complexity, cost segregation studies can be expensive, especially depending on the size of the property. Real estate investors should determine if the price of a cost segregation study is justified. For example, if you only plan on holding a property for one year, paying for a professional study might not be worthwhile.  

Study Timing Matters 

The timing of your study also matters. Cost segregation studies should be completed in the year placed in service. For example, if you purchase and place a property in service during 2025, your cost segregation study should be completed and ready to go for your 2025 tax return. Switching your asset depreciation on your tax return can raise red flags.  

Does it sound like your next real estate purchase could benefit from a cost segregation study? If so, it's important to work with both a cost segregation study expert and a tax professional right away. For more information about claiming your cost segregation study on your tax return to mitigate taxes, reach out to KDG's expert tax team today.