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Fundamentals
What cost segregation is, how a study is built, and the MACRS classes it uses. Educational, not advice.
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- FundamentalsCompany educational explanation
What Is Cost Segregation?
Cost segregation separates the cost of a building into components with different tax recovery periods, so parts of the property can be depreciated faster than the building itself. Land stays out of depreciation. The study prices each component and documents the class it belongs in.
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How a Cost Segregation Study Works
The steps of a typical study, from gathering cost records and inspecting the property to classifying components, reconciling costs, and handing a report to your CPA. Publication 5653 describes six approaches; using actual cost records is the most accurate. The guide is examiner guidance, not a required format.
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Why Depreciation Matters
Depreciation lets property owners deduct the cost of buildings and equipment over time. The timing of those deductions affects cash flow, which is why recovery periods matter. Land is never depreciable. Section 167 allows the deduction; section 168 computes it.
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Cost Segregation vs. Standard Depreciation
How depreciation differs when a property is treated as one building versus separated into components, and what changes — and what does not — when you use a study. Total depreciable basis stays the same. Timing, method, and recapture character can change.
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Personal Property vs. Real Property
The line between tangible personal property (§1245) and real property (§1250) decides most cost segregation outcomes. Treasury Regulation §1.48-1 and the cases that apply it draw that line. Local fixture law does not. Permanence and function are tested together, item by item.
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Land, Building, and Site Improvements
Every property splits into land, which is not depreciable, the building, and land improvements such as paving and landscaping, which are generally 15-year property. General site grading is usually treated as part of the land. Activity classes can override class 00.3.
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MACRS Explained
The Modified Accelerated Cost Recovery System sets the depreciation method, recovery period, and convention for most business property. Class lives and a few statutory assignments produce the periods. Salvage value is treated as zero. Buildings use statutory 27.5- or 39-year lives.
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5-Year Property Explained
Five-year property includes computers, many assets used in retail and service businesses, and personal property in rental housing such as appliances and carpet. The class comes from a class life of more than 4 but less than 10 years, not from a rule that every fixture in a building is 5-year property.
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7-Year Property Explained
Seven-year property covers office furniture and fixtures, assets in several industry activity classes, and any personal property that has no assigned class life. The class comes from a class life of 10 to under 16 years. It is not a default for building components or structural finishes.
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15-Year Property Explained
Fifteen-year property is mostly land improvements — paving, sidewalks, fencing, landscaping — plus qualified improvement property and certain retail motor fuels outlets. The class life band is 20 to under 25 years, with a few statutory additions. Buildings and parking garages stay out of class 00.3.
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27.5-Year Residential Rental Property
Residential rental buildings are depreciated over 27.5 years if at least 80% of their gross rental income comes from dwelling units. Hotels and similar transient lodging do not count. The test is applied building by building, and owner-occupied portions count at rental value.
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39-Year Nonresidential Real Property
Commercial buildings — offices, stores, warehouses, hotels — are generally depreciated over 39 years, straight-line, using the mid-month convention. Structural components stay with that building class unless the regulations and facts place them elsewhere. The building itself is not bonus-eligible.
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Depreciable Basis Explained
Depreciable basis is the amount you can depreciate: generally your cost for the property, minus land, adjusted for improvements and prior depreciation. A cost segregation study allocates that number. It does not increase it. Gift, inheritance, and exchange basis rules can change the starting figure.
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Placed-in-Service Date Explained
Depreciation starts when property is placed in service — ready and available for its intended use — not when you buy it or first collect rent. The date sets the first-year convention, which law applies, and, together with the acquisition date, the bonus percentage. Components of one project can have different dates.
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Purchase Price Allocation
When you buy a property, the price must be split between land and building, and a study then divides the building portion further. How that split is made affects every later number. A written allocation in an applicable asset acquisition can bind the parties.
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New Construction Studies
For new buildings, a study can use actual construction cost records — the approach the IRS audit guide calls the most methodical and accurate. Indirect costs are allocated across components. Self-constructed property has its own bonus acquisition-date rules, including a 10% cost safe harbor.
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Acquisition Studies
When you buy an existing building, construction records are usually unavailable, so a study relies on inspection, drawings, and documented cost estimates reconciled to the purchase price. Land is valued first. Used property can still qualify for bonus depreciation if the acquisition tests are met.
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Renovation and Improvement Studies
Renovations raise two questions: how to classify the new work, and what to do with the basis of the components that were removed. The tangible property regulations decide what must be capitalized. A study can then classify the capitalized cost and support a partial disposition election.
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Look-Back Studies
A look-back study applies cost segregation to a property already in service in an earlier year. Missed depreciation is usually claimed through an accounting method change, not by amending old returns. Bonus rates follow the original acquisition and placed-in-service dates, not the year the study is written.
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Form 3115 and Accounting Method Changes
Form 3115 is how a taxpayer asks to change an accounting method, including how property is depreciated. Many depreciation changes qualify for automatic consent under the current list. The form instructions in force are the December 2022 revision. A current-year study usually does not need the form.
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Engineering-Based Cost Estimation
When actual costs are not available, studies estimate component costs from drawings, quantities, and published cost data. The IRS audit guide sets out what makes those estimates reliable. Published databases are estimating tools, not tax authority, and a uniform step-up to the purchase price is not an acceptable method.
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Site Inspections and Documentation
A site inspection records what is actually installed, how it is attached, and what it serves. The IRS audit guide recommends one for every quality study. Photographs, notes, and interviews create the evidence a reviewer will ask for. Drawings show design; the visit shows what was built.
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Study Reports Explained
What a cost segregation report usually contains, section by section, based on the elements the IRS audit guide lists for a quality report. The asset schedule is what your CPA posts. The narrative and exhibits are what support it. The guide is not a required format and is not legal authority.
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Working With Your CPA
A cost segregation study classifies and prices components. Your CPA or tax adviser decides how to use it on your return. Bring the CPA in before the study starts so basis, dates, elections, and any prior filings are settled. Educational information, not tax advice.
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Cost Segregation Terminology Glossary
Plain-language definitions of the terms that appear most often in cost segregation studies and reports. The cited Code sections and regulations control. These summaries are for reading a study, not for taking a return position. Educational information, not tax advice.
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