Did you know your building could be putting more money in your pocket—right now?
If you’re a real estate investor or property owner, you might be sitting on a legal tax strategy that could significantly boost your cash flow in the early years of ownership. It’s called cost segregation, and it’s one of the most underused tactics in real estate tax planning.
In this article, we will explain what cost segregation is, how to make the most of it, and its cons that you should be aware of.
What Is Cost Segregation?
Cost segregation is a method that lets you break down your property into parts, such as roofs and the HVAC unit—and then depreciate (or write off) those parts faster on your taxes.
Usually, the IRS treats a building like one big thing you have to depreciate slowly:
- 27.5 years for residential rentals
- 39 years for commercial buildings
But in reality, your building is full of things that wear out way faster—carpets, lights, appliances, cabinets, even sidewalks and parking lots. With cost segregation, you can tell the IRS: “Hey, these parts won’t last 30 years. Let me write them off faster.” And the IRS says, “Okay!”
How Does Cost Segregation Work
When a property is purchased, it includes not only the building structure, but also includes everything inside and outside—like flooring, lighting, cabinets, appliances, parking lots, and landscaping. On average, about 30% of these components fall into tax categories that can be written off much quicker than the building itself.
A Cost Segregation study takes a closer look at the total purchase price or construction cost of the property—costs that would normally be depreciated over 27.5 years for residential or 39 years for commercial buildings. Instead of lumping everything into one long depreciation schedule, the study separates out components that qualify for faster write-offs.
The main goal is to identify and reclassify parts of the property that can be depreciated over 5, 7, or 15 years instead of the full 27.5 or 39 years. For example, special-use electrical outlets—like those powering computers or appliances—can be classified as 5-year property, allowing the owner to deduct their value much sooner and reduce taxable income significantly in the early years of ownership.
Example: Before vs. After Cost Segregation
Imagine an investor purchases a multifamily residential property for $1.5 million. Under the standard depreciation schedule, the building would be depreciated evenly over 27.5 years, resulting in approximately $54,545 per year in depreciation deductions.
However, with a cost segregation study, let’s say 30% of the property’s cost ($450,000) is reclassified as personal property with 5, 7, or 15-year lifespans. That means instead of spreading that $450,000 over 27.5 years, the investor can now accelerate depreciation—deducting up to $90,000 per year for the first five years.
In addition to that, the remaining $1.05 million is still depreciated over 27.5 years. This strategy significantly increases depreciation deductions in the early years, reducing taxable income, boosting cash flow, and improving the property’s overall investment performance.
How Does a Cost Segregation Study Work?
When we talk about cost segregation, we’re really referring to the process of identifying and reclassifying parts of a building that can be depreciated faster for tax purposes. This is done through a cost segregation study—a detailed analysis that breaks the property into its individual components, like flooring, electrical systems, and landscaping, so that the eligible parts can be written off.
The study typically begins with a feasibility analysis to see if the property qualifies and would actually benefit from cost segregation. Specialists look at the structure and features of the property to identify components that wear out faster than the building itself.
Next, they move into the information-gathering phase, collecting documents like closing statements, appraisals, blueprints, and inspection reports to get a full picture of the property’s layout and costs.
Then comes the property analysis, where engineers and tax experts review every part of the building—using site visits or construction documents—to separate out qualifying short-life assets such as carpeting, cabinets, or paving.
The final step is the delivery of a comprehensive report. This outlines what portions of the property have been reclassified, how much can be depreciated sooner, and the potential tax savings. That report goes to your CPA, who applies the new depreciation schedule—helping you lower your tax bill and keep more cash in your pocket, especially in the early years of ownership.
PS: Performing a cost segregation study on your own isn’t practical because it requires specialized knowledge in tax law, construction, and engineering to identify and value building components correctly. A level of detail that goes beyond what most property owners or accountants can do alone. It typically takes a team of professionals, including tax advisors and engineers, to ensure the study is accurate, IRS-compliant, and actually maximizes your tax savings without risking penalties.
Pros and Cons of Cost Segregation
Benefits of Cost Segregation
1. Bigger Tax Deductions Now
Instead of spreading depreciation over 27.5 or 39 years, you get larger write-offs in the first 5, 7, or 15 years—freeing up cash sooner.
2. Boosts Cash Flow
Accelerated depreciation means lower taxable income, which improves cash flow that can be reinvested or used to grow your portfolio.
3. Wealth-Building Strategy
This isn’t about avoiding taxes—it’s about using tax rules to your advantage. The upfront savings can help you acquire more property or improve existing ones.
4. Real Estate Professionals Benefit More
If you qualify as a real estate professional, there are no limits to how much of these deductions you can apply—even against W-2 income.
5. May Lower Insurance Premiums
In some cases, a cost segregation study can help reassess your building’s insured value, potentially reducing high commercial insurance premiums.
Cons of Cost Segregation
1. It Costs Money
Studies typically range from $4,000 to $20,000 depending on property size—but the tax savings often far outweigh the cost.
2. Depreciation Recapture
You’ll pay back some of the accelerated deductions when you sell the property (typically at a 25% tax rate), though the upfront benefits can still outweigh this.
3. Risk of IRS Scrutiny
Being too aggressive with write-offs can trigger penalties. Always work with specialists—not just your regular accountant.
4. Deduction Limits for Some
If you’re not a real estate professional or if your income exceeds certain limits, you may not be able to use all the deductions right away.
5. Bonus Depreciation is Phasing Out
100% bonus depreciation began phasing out after 2022 and will reduce yearly until it disappears, so there’s urgency in acting sooner.
Final Thoughts: Is It Right for You?
If you own—or are planning to buy—a high-value property and you want to free up cash, cost segregation is worth a serious look. Don’t wait 30 years to claim your tax savings. Explore cost segregation now and start putting your building to work for you—faster.
