Several tax incentives exist to help investors free up funds to invest more and stimulate economic activity. Cost segregation in real estate is one such incentive.
Taking advantage of such incentives isn’t just good industry practice; it’s necessary to remain competitive. Savvy investors in your area are already combining real estate cost segregation with bonus depreciation to build a snowball of depreciation deductions that effectively reduce their taxes to as low as zero.
The first step in cost segregation is commissioning an engineering-based study of your property. Talk to our team today to get a free preliminary analysis of your property to estimate potential tax savings.
What Is Cost Segregation in Real Estate?
Cost segregation in real estate can help you significantly reduce taxes, freeing up funds to invest in your next property faster.
In traditional linear depreciation, real estate investors depreciate their properties for residential or commercial use over 27.5 years or 39 years, respectively. In reality, many building components don’t have a useful life that long. Cost segregation helps cure this problem.
A cost segregation study leads to the reclassification of a property’s components into short-life and long-life assets. The long-life building value will typically depreciate over 27.5 years or 39 years. The short-life assets, however, are depreciated over five, seven, or fifteen years, depending on their classification.
The IRS provides detailed guidelines that govern these depreciation schedules.
The shorter depreciation schedules allow you to front-load a significant portion of your property’s depreciation, leading to significant immediate tax relief.
Benefits of Cost Segregation for Real Estate
The following benefits accrue to investors using cost segregation in real estate:
- Front-loaded tax savings: Because of the time value of money, tax savings realized today are worth much more than those in the future. You’ll have better returns in the long term by claiming the deductions early.
- A way to qualify for bonus depreciation: Property components that benefit from accelerated depreciation under cost segregation also qualify for bonus depreciation, as the useful lives are all under 20 years.
- With an extensive portfolio, you can build a snowball of depreciation deductions: When you combine cost segregation with bonus depreciation and invest all your savings in new properties, you can build a snowball of depreciation deductions to a point where you don’t owe any taxes year after year.
- Replace expensive loans with cheap funds: In deferring taxes to later years, you essentially get a loan from the government at 0%. The alternative would be to fund new investments entirely using mortgage loans, which eat into your margins through interest expenses.
- Increased flexibility to snap up good deals: The resulting improved cash flow position makes you nimble enough to snap up good deals as soon as they hit the market.
Types of Properties That Benefit From Cost Segregation
Both residential and nonresidential properties benefit from cost segregation. Since nearly all properties have a good balance of short- and long-life components, most property owners should consider using cost segregation to accelerate depreciation and improve cash flow.
Some properties that can benefit from cost segregation include single-family homes, multi-family homes, retail centers, strip malls, office buildings, hotels, warehouses, healthcare facilities, and industrial buildings.
The IRS has strict guidelines on building components that qualify for accelerated depreciation under cost segregation. For instance, below are some of the building components that would fall under five-, seven-, or fifteen-year schedules:
- Five years: False balcony, fire protection equipment, readily removable floor coverings, and decorative electrical lighting.
- Seven years: Office desks, filing cabinets, workstations, and display cases.
- Fifteen years: Mailboxes, concrete footings, data cables and wiring, decks, gazebos, parking lot canopies, fountains, fencing, and gates.
How to Conduct a Cost Segregation Study for Real Estate
To find and correctly classify the components of your property that qualify for accelerated depreciation, it is best to commission an engineering-based study by a reputable firm like Seneca Cost Segregation.
The cost segregation study will generally unfold as follows:
- A free preliminary analysis: You can request a free initial analysis to determine if your property qualifies for cost segregation and get a rough estimate of your potential tax savings.
- Gathering relevant documentation: Documentation required for cost segregation includes proof of ownership, architectural plans, engineering plans, invoices to support construction/renovation costs, appraisal reports, and other relevant property records.
- Property inspection: An on-site or virtual inspection of the property follows. The inspection helps the firm gather detailed information about the property, including original construction details, improvements made over time, specific uses of components, specialized equipment, and general quality of the components.
- Identification and categorization of parts: An analysis is carried out to identify and categorize the assets into various classes of long- and short-life assets.
- Allocating costs to the identified parts: Based on the provided documentation and subsequent analysis, the engineers can accurately allocate costs to the categorized short-life assets qualifying for accelerated depreciation.
- Generating a detailed report: The cost segregation firm then generates a report backing the asset reclassifications and detailing the cost allocations.
It’s essential to take the time to generate a detailed cost segregation report that can stand IRS scrutiny. The report can include photos, diagrams, and other supporting documentation.
Our engineering-based cost segregation studies typically take two to four weeks to complete.
Further, every study comes with an audit defense guarantee. In the unlikely event of an IRS audit, you can rely on Seneca Cost Segregation to help defend the report.
Example of Cost Segregation in Real Estate
While you can do your own cost segregation study, we advise against it as it significantly increases audit risk. It is best to use a qualified firm with engineering expertise to conduct an IRS-compliant cost segregation study.
As indicated earlier, such a study would result in the classification of assets into the following depreciation schedules:
- 27.5 or 39 years for the long-life building value
- 15-year property
- 7-year property
- 5-year property
Let’s walk through what the strategy would likely look like in practice with a cost segregation example.
Assume you have a two-tenant retail center in Minneapolis, Minnesota. It is fully leased to Starbucks and a dental office, resulting in a net operating income of $180,000. The property is valued at $3,200,000 with a land value of $1,100,000, giving you a depreciable building value of $2,100,000.
Seneca Cost Segregation does a study and finds the following:
- $1,365,000 of the depreciable building value is a 39-year property
- $420,000 of the depreciable building value is a 5-year property
- $105,000 of the depreciable building value is a 7-year property
- $210,000 of the depreciable building value is a 15-year property
If you were to depreciate the entire $2,100,000 over 39 years, you’d claim $53,846.15 in deductions annually. Considering an NOI of $180,000, your income before interest and tax (EBIT) would be $126,153.15 ($180,000 less $53,846.15).
If Bonus Depreciation is 100% for this property, the deduction in the first year would be as follows:
With cost segregation, your total deduction is $420,000 + $105,000 + $210,000 = $735,000. The EBIT by doing a cost segregation would be maximized and the taxable income would be $0. This would significantly reduce your tax bill and put more money in your pocket to help grow your portfolio.
As mentioned earlier, one of the benefits of cost segregation in real estate is the ability to take advantage of bonus depreciation.
Bonus depreciation allows investors to claim a significant portion of a qualifying asset’s value in their first year. In 2025, you can claim 40% depreciation (accurate as of May 27, 2025).
In the Minneapolis property above, the $420,000 five-year, $105,000 seven-year, and $210,000 fifteen-year properties totaling $735,000 qualify for bonus depreciation.
At 100% bonus depreciation, you can claim $735,000 depreciation in the first year (100% of $735,000 = $735,000). If bonus depreciation were 40%, the First Year tax deduction would be 40% x $735,000 = $294,000
With such high deductions, you’ll create a paper loss, effectively wiping out your tax obligations in the current year. What’s more, you can carry forward the loss to offset future years’ passive rental income.
How to Find a Qualified Cost Segregation Provider
The effectiveness and defensibility of a real estate cost segregation study hinges on the provider you commission for the project. Below are the filters you need to consider to maximize potential tax savings and minimize the risk of an IRS audit.
- In-house professional expertise: You want the provider to have in-house expertise (engineers). Providers outsourcing work usually mark up prices significantly to ensure comfortable margins for themselves and the vendor. At Seneca Cost Segregation, we have all the required professional expertise in-house.
- Engineering-based methodology: You can generate either accounting- or engineering-based cost segregation reports. The latter is superior as it involves a more comprehensive analysis of building components, including electrical and mechanical components. Seneca Cost Segregation uses an engineering-based methodology.
- Extensive analysis and documentation: The study must be according to IRS guidelines. Working with Seneca Cost Segregation, you’ll get a detailed report backing our findings and reclassifications.
- Audit defense and money-back guarantee: The absence of an audit defense guarantee raises questions about the quality and defensibility of the reports. With Seneca Cost Segregation, you get audit defense in the unlikely event of an audit.
- Post-study support: Your CPA might need help implementing the cost segregation study. You can rely on Seneca Cost Segregation to offer the post-study support you need to get the most out of our detailed cost segregation reports.
Seneca Cost Segregation is the way to go, as we have the required engineering expertise in-house and back all our studies with the water-tight Seneca AuditDefense. Find out how much you can save in taxes with a Seneca Cost Segregation study — or get a quick estimate using our free cost segregation calculator.
Key Factors to Consider in Cost Segregation for Real Estate
Several variables affect the viability, effectiveness, and actual execution of cost segregation in real estate. Below are the key factors you must pay attention to.
- Property type and Prioritization: Commercial or industrial properties with elaborate fixtures and appliances benefit a great deal from cost segregation. Cost segregation on such properties should be prioritized.
- Timing is essential: You want to do cost segregation immediately when you put a building into service. The earlier you do cost segregation, the more time you have to cash in on the compounding benefits of the time value of money. And you don’t need to deal with scheduling tours with tenants.
- Property value: With tools such as bonus depreciation, we believe doing cost segregation on properties valued at $500,000+ is viable as the potential tax savings significantly outweigh the cost of the study. However, even Single Family / Condos under $500,000 can see a strong Return on Investment.
- Renovations and improvements: Where significant improvements are made to a property, you should immediately commission a cost segregation study to capture new short-life components for accelerated depreciation.
- Long-term property holdings: You’ll benefit more from accelerated depreciation when you hold properties for long periods.
- Cost segregation methodology: You should use either an accounting- or engineering-based methodology to put together a cost segregation report. The latter provides a more thorough analysis and contains direct references to the IRS guide for reclassification of costs.
- DIY / Rapid Report / KBKG Studies: These types of studies should only be used for really small properties. For any property over $250,000, your CPA should recommend an accounting-based or engineering-based study.
Frequently Asked Questions (FAQs)
Below are answers to some commonly asked questions about cost segregation in real estate.
What Is the Difference Between Cost Segregation and Traditional Depreciation in Real Estate?
Traditional depreciation allocates the entire depreciable cost of a building linearly over 27.5 or 39 years.
With cost segregation, you get to separate the short-life components of the building from the long-life components and subject them to shorter depreciation schedules of five, seven, and fifteen years.
The aggressive depreciation schedules lead to higher deductions upfront, helping you as a real estate investor front-load the tax savings that come with depreciation.
Can Cost Segregation Be Applied to Real Estate Properties Owned for Multiple Years?
Yes, you can do cost segregation on property owned for multiple years and make an Application for Change in Accounting Method (Form 3115) to “catch up” on missed depreciation.
How Often Should a Real Estate Owner Update Their Cost Segregation Study?
You’ll typically only need one cost segregation study per property. Exceptions that would warrant an additional study include where there are significant improvements/renovations and when there is a significant change in property use.
Can Cost Segregation Be Used on Newly Acquired Properties or Just on Older Properties?
Both newly acquired properties and older properties benefit from cost segregation. It is best, however, to do cost segregation in the year you put a property in service to maximize the benefits of front-loading tax savings.
Conclusion
The idea of investing in real estate is to get your assets to work for you. Real estate cost segregation turbocharges this idea by turning components of your property into immediate cash flow.
That said, the strength and defensibility of cost segregation depends mostly on the firm you commission to do the study.
At Seneca Cost Segregation, we have done more than 1,000 studies nationwide with great success. Schedule a consultation with our team to lower your tax bill with an IRS-compliant cost segregation study.
