Tax deductions are part and parcel of real estate investing. The most powerful of all is depreciation. Think about it – with every other deduction, e.g., mortgage interest, that’s money you’ve already spent. With depreciation, however, you get it simply because you own the property.
Moreover, you don’t have to linearly spread your entire property’s depreciable value over 27.5 years. The IRS allows front-loading a significant portion, unlocking bigger deductions sooner. You can achieve this by doing a cost segregation study for rental property.
Now’s the time to take full advantage of depreciation to accelerate your tax savings. Talk to our team today to find out how much you can save—get a free savings estimate.
Why Cost Segregation Is a Game-Changer for Rental Property Owners
As a savvy rental property investor, you are here because you understand that deductions aren’t just something to look for during tax-filing time. Any investor looking to minimize their tax liability and maximize their tax savings must proactively do tax planning year-round.
Because depreciation is a non-cash expense, any tax planning strategy that can help you maximize it soon can only improve your cash position. Cost segregation is the go-to tax strategy in this case.
What does cost segregation do to achieve this? It helps you segregate the short-life component parts of your property from the long-life main building structure so you can depreciate them faster.
The accelerated depreciation scenario has many benefits, including:
- Improved cash flow: A lower tax bill means you can keep more of your money. You can use the cash to grow your portfolio faster.
- Better returns over time: A dollar earned, saved, or invested today is worth more than a dollar tomorrow. By front-loading the deductions and re-investing them sooner, you benefit from the compounding benefits of the time value of money.
- Reduces dependence on expensive loans: Front-loading depreciation defers taxes into the future. You’re effectively giving yourself a loan at 0%, which is much better than going to the bank to borrow at ~6.5%-9% depending on the loan type.
- Helps you qualify for bonus depreciation: Bonus depreciation is a tax incentive allowing you to deduct a significant portion of your property’s cost in the first year. You need cost segregation to utilize the incentive.
Given the potential tax savings, cost segregation is an incredibly powerful tool for rental property owners. Relative to the cost of a cost segregation study, the potential return on investment through the additional unlocked deductions is enormous.
Rental Property Types Eligible for a Cost Segregation Study
If you own a rental property and use it to generate income, you’ll benefit from doing a cost segregation study. Notably, this applies to both residential and commercial properties.
The entire landscape of residential rental properties is eligible, especially if the property is valued at $450,000+. You can do cost segregation on single-family homes, multi-family units, mixed-use properties, and short-term rentals.
How Cost Segregation Works for Rental Properties
The IRS allows you to depreciate properties over 27.5 years for residential or 39 years for commercial properties.
For instance, consider a residential property purchased at $1,000,000 with an additional $50,000 in improvements after. The property has a land value of $150,000. That gives you a cost basis of $900,000 (Purchase + Improvements – Land Value)
Traditionally, you spread the entire cost basis over 27.5 years, giving you a $32,727.27 yearly depreciation.
We do know, however, that not all your building components will last 27.5 years. Cost segregation separates the long- and short-life property components so you can subject them to depreciation schedules consistent with their useful lives.
For example, here’s how long the IRS expects some property components in a residential building to last:
- 27.5 years: The main building structure and HVAC systems.
- Fifteen years: Land improvements such as parking lots, driveways, sidewalks, outdoor swimming pools, landscaping, etc.
- Five years: Fire protection equipment, window treatments, carpets, wallpaper, decorative lighting, plumbing fixtures like sinks and toilets, and appliances like fridges, stoves, dishwashers, and washers.
A significant consequence of cost segregation is that you can now take advantage of bonus depreciation. Bonus depreciation is applicable for properties with a recovery period of less than 20 years. Therefore, the five- and fifteen-year assets above qualify.
With bonus depreciation, you can deduct a large percentage of a qualifying property’s cost in the first year. The 2017 Tax Cuts and Jobs Act initially set the percentages as follows:
- Up to 2022: 100%
- 2023: 80%
- 2024 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
However, the One Big Beautiful Bill Act, signed into law on July 4, 2025, reversed this phase-out schedule. Bonus depreciation is now permanently back to 100% for properties put in service after January 19, 2025.
Now, assume you put the property in the example above in service in 2024. What does 60% bonus depreciation mean? Let’s explore what that means with a cost segregation study example with bonus depreciation.
Cost Segregation Study for Residential Rental Property Example
Bonus depreciation = how much of the depreciation of Personal Property and Site improvements can be taken in the first year.
Property details:
- Residential property
- Put in service in 2024 (60% bonus depreciation)
- Purchase: $1000,000
- Improvements: $50,000
- Land value: $150,000
- Cost basis: $900,000
At 60% bonus depreciation for 2024, 60% of the personal property and site improvements will be eligible for a year-one deduction.
Assume a Seneca Cost Segregation study finds that 12% of the cost basis is Personal Property and 16% is Site Improvements. They’ll be subjected to shorter-life depreciation.
Personal Property Depreciation = 12% x cost basis = 12% x $900,000 = $108,000
Site Improvements Depreciation = 16% x cost basis = 16% x $900,000 = $144,000
The remaining 72% stays as Real Property (27.5 years depreciation) = $900,000 x 72% = $648,000.
First Year Deduction
Personal Property x Bonus Depreciation = $108,000 x 60% = $64,800. The remaining 40% comes in over the next 5 years.
Site Improvements x Bonus Depreciation = $144,000 x 60% = $86,400. The remaining 40% comes in over the next 15 years.
Real Property / 27.5 or 39 = $648,000 / 27.5 = $23,563.64 every year until Year 28
TOTAL 1st year deduction = sum of all = $174,763.64
Additional 1st year depreciation = Bonus Depreciation 1st Year – SL depreciation 1st year = $174,763.64 – $32,727.27 = $142,036.37
You then get a tax deduction of $142,036.37 instead of $32,727.27. At a 39% federal tax rate, this nets you a check from the IRS for $55,394.18.
When to Perform a Cost Segregation Study
Ideally, you should do a cost segregation study in the year you put a property in service or undertake significant renovation/improvement.
If the idea is to cash in on the compounding benefits of the time value of money, you should lock in massive tax savings as soon as possible. You can then reinvest the money to grow your portfolio faster.
Nonetheless, if you didn’t do a cost segregation study initially, you haven’t missed out entirely. “Catch-up” depreciation provisions make doing a cost segregation study on properties put in service in prior tax years highly worthwhile.
You’ll file an “Application for Change in Accounting Method” to adjust your depreciation method and catch up on all the depreciation you’ve missed by not segregating your short- and long-life property components earlier.
It’s a reasonably straightforward process; you don’t have to amend prior tax returns.
Potential Pitfalls of Cost Segregation on Rentals
When doing a cost segregation study for rental property, you seek strategic tax savings. Therefore, you must avoid mistakes that can limit your ability to maximize tax savings. Let’s explore these potential pitfalls.
Failing to Engineer an Active Income Scenario
As a rule, you cannot use passive losses to offset active income. Generally, rental income is considered passive income.
There are exceptions, however, where the IRS can consider your rental income as active income. You can then use the paper losses you created by having a huge first-year deduction to offset your active business income and W-2.
These exceptions include when:
- You pass material participation tests
- You run short-term rentals and pass material participation tests
- You achieve Real Estate Professional (REP) status and file as such
Operating with a Short-Term Investment Strategy
The expectation as an investor is that you’ll hold your property for the long term. The IRS requires property owners to “recapture” depreciation they’ve claimed when they sell a property at an amount higher than the book value.
Therefore, when you do cost segregation and accelerate depreciation then sell properties soon after, you’ll end up with a significant tax bill, making your cost segregation tax strategy quite inefficient.
That said, if you do have to sell a property, you can mitigate this problem using a 1031 exchange where you postpone paying the tax by reinvesting the proceeds of the sale in a like-kind property.
Not Working with a Reliable Cost Segregation Firm
The IRS has strict guidelines that every cost segregation study must abide by.
To generate a defensible cost segregation report that can withstand IRS scrutiny, it’s best to work with an experienced cost segregation firm.
Failure to meet IRS guidelines might trigger an audit, costing you time and money.
Steps to Begin a Cost Segregation Study for Your Rental Property
As stated earlier, your cost segregation study is best handled in partnership with an experienced cost segregation firm. It helps to do the following when beginning a cost segregation study:
- Define the scope of work: Which/how many properties do you want to study?
- Gather documentation: You’ll need proof of ownership and documents to help with costing, such as building/architectural plans, appraisal reports, contractor invoices, or other relevant construction records.
You can then reach out to a firm for an initial consultation and feasibility analysis.
At Seneca Cost Segregation, we’ll do a free preliminary analysis to give you a general idea of your potential tax savings. It will help you determine if investing in the study is worthwhile.
Our estimates aren’t just theoretical—they’re grounded on over 10,200 studies our engineering team has done nationwide. The extensive experience allows us to identify common asset classification and depreciation patterns, making the initial assessment a fairly close projection.
See if your property qualifies for cost segregation. Talk to our team today to find out how much you can save.
Frequently Asked Questions (FAQs)
Want to learn more about cost segregation for rental properties? Let’s answer some of the common questions we get about the topic.
Is a Cost Segregation Study Worth It for Small Rental Owners?
A cost segregation study is worth it when the potential tax savings outweigh the cost of the study. That said, we’ve found rental properties valued at $450,000+ to be great candidates.
Can I Apply Cost Segregation Retroactively on My Rental Property?
Yes, you can do cost segregation on a rental property you put in service years ago. The IRS allows you to adjust your depreciation schedule by filing Form 3115. You’ll effectively be “catching up” on missed deductions.
What’s the Minimum Improvement Amount to Justify a Study?
There isn’t an established minimum improvement amount to qualify for cost segregation. It all depends on the ROI you are comfortable with.
As an investor, you should always be running the numbers. For instance, if a study costs a couple of grand and gets you $20,000 in immediate tax savings, is it worth it?
Can I Conduct a Cost Segregation Study Myself?
We advise against doing your own cost segregation study as it significantly increases audit risk.
The IRS provides detailed guidelines that every study must abide by. It’s best to let professionals like Seneca Cost Segregation handle the exercise because there’s a lot that goes into knowing what to look for and how to correctly classify it.
Conclusion
A cost segregation study for rental property can yield significant returns for your real estate business. For a relatively small investment in the study, you can unlock massive upfront deductions to free up cash to grow your portfolio much faster.
Also, you can do cost segregation at any time of the year. You shouldn’t wait until tax time. To plan effectively, you want to know early on how much tax savings you can expect when it’s time to file.
Lock in tax savings now. Contact us for a free preliminary review of your property.
