Cost segregation and bonus depreciation
Also called Cost seg, Bonus depreciation.
A cost segregation study reclassifies parts of a building into shorter-lived asset categories, typically five, seven and fifteen year property. Bonus depreciation then allows a percentage of that reclassified basis to be deducted immediately rather than over the shorter schedule.
How it works
An engineering-based study separates components that are not structural: carpeting, cabinetry, specialty electrical and plumbing, appliances, site improvements such as paving, landscaping and site lighting. Instead of recovering all of it over 27.5 or 39 years, those components move to five, seven or fifteen year schedules. The typical reclassified share is 20 to 35 percent of depreciable basis, varying widely by property type.
Bonus depreciation applies to the qualifying reclassified property and allows an immediate deduction of a set percentage of it. That percentage is set by statute and has changed several times, so the rate applicable to a given placed-in-service date should be confirmed rather than assumed. The combination of a study plus bonus can produce a very large first-year deduction.
The benefit is timing, and it is partly borrowed from the future. Accelerating a deduction into year one means less deduction in later years, and the reclassified basis recaptures at ordinary income rates rather than under the 25 percent cap that applies to straight-line real property. On a short hold with a high ordinary rate, an aggressive study can accelerate a deduction into year one only to give a chunk of it back at a higher rate in year five. The study itself also costs money and the position has to be supportable.
Worked example
Illustrative, using a 25 percent reclassified share and full expensing on a $44,720,000 depreciable basis. The bonus rate that actually applies depends on the placed-in-service date and should be confirmed, not assumed from this example.
| Depreciable basis | $44,720,000 |
|---|---|
| Reclassified to shorter-lived property at 25% | $11,180,000 |
| Bonus deduction in year one at a 100% rate | $11,180,000 |
| Straight-line year-one deduction with no study | $1,626,182 |
| Straight line on the remaining real property basis$33,540,000 over 27.5 years | $1,219,636 |
| Accelerated basis that recaptures at ordinary rates | $11,180,000 |
| Bonus deduction in year one | $11,180,000 |
The bonus deduction alone is nearly seven times the whole straight-line deduction, and the remaining real property basis keeps depreciating on its own schedule on top of it. The offset is a matching block of basis that will recapture at ordinary rates rather than under the 25 percent cap. Whether that trade is worth taking depends on the holding period and on rates specific to the taxpayer.
The common mistake
Modelling the deduction without the ordinary-rate recapture
Cost segregation is frequently presented as a first-year benefit with no offset, which makes it look strictly better than doing nothing. It is not strictly better. The reclassified basis recaptures at ordinary income rates rather than under the 25 percent cap that applies to straight-line real property, and the later years lose the deduction that was pulled forward. On a three to five year hold the net benefit can be much smaller than the headline, and in some rate situations it is negative. Model the deduction and the exit together, and take advice specific to the taxpayer, because this is a description of mechanics and not tax advice.
Related terms
- DepreciationDepreciation is the annual deduction that lets an owner recover the cost of a building over a fixed period set by statute. It reduces taxable income without reducing cash flow, which is why after-tax returns on real estate exceed pre-tax returns more often than in most asset classes.
- Depreciation recaptureDepreciation recapture is the portion of the gain on sale attributable to depreciation previously deducted, taxed at a rate above the long-term capital gains rate. For real property the recaptured amount is unrecaptured section 1250 gain, subject to a statutory rate cap of 25 percent.
- Section 1031 exchangeA section 1031 exchange lets an owner defer capital gains tax and depreciation recapture on the sale of investment real property by reinvesting the proceeds into like-kind replacement property within statutory deadlines. It is a deferral, not a forgiveness: the deferred gain carries into the basis of the new property.
- Capital expenditure versus operating expenseAn operating expense keeps a property running in its current condition and is deducted above the net operating income line. A capital expenditure replaces or improves a component with a life beyond the current year and is deducted below it. Which side of the line an item lands on changes the property's value.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.