When you buy, build, or improve a building, federal tax law generally recovers its cost slowly: over 27.5 years for residential rental property and 39 years for nonresidential real property (IRC §168(c)). But not every dollar of a building’s cost is really “building.” A cost segregation study identifies the parts that may be recovered much faster.
With 100 percent bonus depreciation back in federal law, the question of whether a study makes sense comes up more often. Here is how it works, where California differs, and what to weigh before you order one.
What a cost segregation study does
A study breaks a property’s cost into components and assigns each one its proper recovery period. The IRS Cost Segregation Audit Techniques Guide (Publication 5653) notes that tangible personal property has a shorter recovery period, such as 5 or 7 years, while the building itself is §1250 property recovered over the longer real property periods.
Depending on the property, items that may qualify for shorter lives can include certain finishes and fixtures, electrical and plumbing that serve specific equipment, and site work. Whether a given item qualifies depends on the facts and on how the rules and case law treat it.
A study does not create new depreciation. Total depreciation over the life of the property stays the same. What changes is timing: more of the deduction moves into the early years.
Why the 2025 federal law raised the stakes
The 2025 federal tax law (Public Law 119-21, §70301) restored a permanent 100 percent bonus depreciation deduction for qualified property acquired after January 19, 2025 (IRC §168(k)). The IRS issued interim guidance in Notice 2026-11.
Bonus depreciation generally applies to property with a recovery period of 20 years or less. That is why cost segregation and bonus depreciation work together: components a study moves into shorter classes may qualify for the immediate deduction, while the building itself does not. Qualified improvement property, generally interior improvements to a nonresidential building made after it was first placed in service, is 15-year property and may qualify as well (IRC §168(e)(6)).
A few details carry real weight:
- Acquisition date. The date you acquired the property, including the date of any written binding contract, determines whether the 100 percent rate applies (Notice 2026-11).
- Elections. You may elect out of bonus depreciation for any class of property (IRC §168(k)(7)). A transition election allows 40 percent instead of 100 percent for property placed in service in the tax year that includes January 20, 2025 (IRC §168(k)(10)).
California keeps its own depreciation
California does not follow federal bonus depreciation. The Franchise Tax Board lists additional depreciation under IRC §168(k) as a difference between federal and California law, and California depreciation adjustments are figured separately on Form FTB 3885A.
In practice, the same building may carry two depreciation schedules: a federal one that may include a large first-year deduction, and a California one without it. A study may still change the timing of your California depreciation, but the state result will generally look different from the federal one. Plan for both returns, not just the federal.
Depreciation recapture: the other side of the deal
Faster deductions today can mean more tax when you sell.
- Reclassified components. Gain on §1245 property is generally recaptured as ordinary income to the extent of depreciation taken (IRC §1245). The IRS guide notes that cost segregation can convert capital gain to ordinary income on disposition.
- The building. Depreciation on the building portion can produce unrecaptured §1250 gain, which the IRS says is taxed at a maximum 25 percent rate (IRC §1(h)).
A study is usually a timing benefit, not a permanent one. Your expected holding period and exit plan belong in the analysis.
Passive activity limits may hold the deduction back
A large depreciation deduction helps only if you can use it.
- Rental activities are generally passive (IRC §469(c)(2)). Passive losses can generally offset only passive income, and disallowed losses carry forward to later years (IRC §469(b)).
- If you actively participate in rental real estate, up to $25,000 of losses may be allowed against other income. That allowance shrinks by 50 percent of adjusted gross income (figured with certain modifications) above $100,000, so it is gone at $150,000 (IRC §469(i)).
- If you qualify as a real estate professional, which requires more than 750 hours and more than half of your personal services in real property businesses in which you materially participate, your rentals are not automatically passive (IRC §469(c)(7)). Losses are nonpassive only if you also materially participate in the rental.
- Suspended losses are generally released when you dispose of your entire interest in a fully taxable transaction (IRC §469(g)).
When a study may make sense
- A recently purchased, built, or substantially renovated property
- A cost basis large enough that the shift in timing outweighs the cost of the study
- A plan to hold the property long enough for the timing benefit to matter
- Income the extra deductions can actually offset, given the passive activity rules
- A property placed in service in an earlier year, where a “look-back” study may allow missed depreciation to be claimed through an accounting method change on Form 3115 instead of amended returns, where the rules allow
A study may make less sense when the basis is small, a sale is near, or the deductions would simply be suspended.
Why the study comes from a specialist
Cost segregation is an engineering exercise as much as a tax one. The IRS guide lists the principal elements of a quality study, including preparation by someone with expertise and experience, a site visit, unit costs and engineering “take-offs,” and a reconciliation of allocated costs to actual costs. It describes the detailed engineering approach from actual cost records as the most methodical and accurate approach. Because examiners use that guide, a study built to its standard is better positioned if it is ever reviewed.
How TreeStar can help
We model how a study may affect your federal and California returns, including recapture and the passive activity rules, and coordinate with the cost segregation specialist you choose. Our tax planning work helps you decide whether a study fits before you commit to one.
This article is general information, not advice for your situation. Rules change; confirm current law before acting.
