Cost Segregation, Explained
What a cost segregation study does and the rules it works within. Every legal statement on this page is checked against its primary source, with the citation beside it, and your CPA applies the rules to your facts.
What a Study Does
How the IRS guide describes a study, and how a price is split between land and building.
- The IRS guide describes a cost segregation study, for income tax purposes, as the allocation or reallocation of the total cost of property into the appropriate property classes and recovery periods so that depreciation is computed properly. Source: IRS Publication 5653 (Rev. 2-2025), chapter 3, part A, paragraph (1)
- When a purchase price covers both land and buildings, the cost must be divided between them based on the fair market value of each at the time of purchase. If fair market values are uncertain, the IRS allows the split to follow the assessed values used for real estate tax. Source: Treas. Reg. section 1.167(a)-5; IRS Publication 527 (2025), chapter 2, Separating cost of land and buildings
- Land cannot be depreciated. The costs of clearing, grading, planting and landscaping are usually part of the cost of land. Source: Treas. Reg. section 1.167(a)-2; IRS Publication 527 (2025), chapter 2, What Rental Property Can't Be Depreciated
Recovery Periods and Methods
How long each kind of property is depreciated, and by which method.
- Under the general depreciation system, residential rental property is depreciated over 27.5 years and nonresidential real property over 39 years. The alternative depreciation system, which applies to some property, has longer recovery periods. Source: IRC section 168(c) and (g)(2)(C); IRS Publication 946 (2025), chapter 4
- Under the general rule in section 168(e), property is 5 year property if its class life is more than 4 but less than 10 years, 7 year property if its class life is 10 or more but less than 16 years, and 15 year property if its class life is 20 or more but less than 25 years. The Code puts some property in a class by name, and property with no class life that is not otherwise classified is 7 year property. Source: IRC section 168(e)(1) and (e)(3)(C)(v)
- For residential rentals the IRS says appliances, carpeting and furniture are 5 year property, and roads, fences and shrubbery (if depreciable) are 15 year property. Source: IRS Publication 527 (2025), chapter 2, Property Classes Under GDS
- Land improvements fall in asset class 00.3 of Rev. Proc. 87-56, with a 20 year class life and a 15 year recovery period under the general depreciation system. Examples are sidewalks, roads, drainage facilities, fences and landscaping shrubbery. The class does not include buildings and structural components, or land improvements that another asset class explicitly includes, so a class for the business activity can set a different recovery period. IRS Publication 946, Appendix B lists the class in Table B-1. Source: IRS Publication 946 (2025), Appendix B, Table B-1; Rev. Proc. 87-56, 1987-2 C.B. 674 (as clarified and modified by Rev. Proc. 88-22), asset class 00.3; IRS Publication 5653 (Rev. 2-2025), chapter 2, part L, paragraph (5); Rev. Rul. 2001-60
- Qualified improvement property is 15 year property. Congress added it to the 15 year list in section 2307 of the CARES Act in 2020, effective as if it had been part of the 2017 tax act. Source: IRC section 168(e)(3)(E)(vii); P.L. 116-136 (CARES Act) section 2307(a)(1)(A) and (b)
- Qualified improvement property is an improvement made by the taxpayer to the interior of a nonresidential building, placed in service after the building was first placed in service. It does not include enlarging the building, elevators or escalators, or the internal structural framework. Source: IRC section 168(e)(6)
- Buildings (residential rental property and nonresidential real property) and qualified improvement property use the straight line method. Property in the 3, 5, 7 and 10 year classes generally uses the 200 percent declining balance method, switching to straight line when that gives a larger allowance. Property in the 15 year and 20 year classes, other than qualified improvement property, generally uses the 150 percent declining balance method. Source: IRC section 168(b)(1), (2) and (3)
Which Components Take Bonus Depreciation
Which property can take the allowance. The rates and dates are in our bonus depreciation guide.
- Bonus depreciation can apply to property that has a recovery period of 20 years or less, as long as the property also meets the other tests, such as the original use or used property rule. That covers the 5 year, 7 year and 15 year components a cost segregation study identifies. It does not cover the 27.5 year or 39 year building itself. Source: IRC section 168(k)(2)(A)(i)(I)
What a Quality Study Contains
What the IRS guide says a study should contain, and what the guide is and is not.
- The IRS guide says a cost segregation study and report should always classify assets into property classes, explain the rationale with legal citations for treating assets as section 1245 or section 1250 property, and substantiate the cost basis of each asset and reconcile total allocated costs to total actual costs. Source: IRS Publication 5653 (Rev. 2-2025), chapter 4, part A, paragraph (1)
- The IRS guide lists 13 principal elements of a quality study: preparation by an individual with expertise and experience; detailed description of the methodology; use of appropriate documentation; interviews with appropriate parties; common nomenclature; a standard numbering system; explanation of the legal analysis; determination of unit costs and engineering take off; organization of assets into lists or groups; reconciliation of total allocated costs to total actual costs; explanation of the treatment of indirect costs; identification and listing of section 1245 property; and consideration of related aspects such as section 263A, change in accounting method and sampling. Source: IRS Publication 5653 (Rev. 2-2025), chapter 4, part C, paragraph (1)
- The IRS publishes its Cost Segregation Audit Techniques Guide as Publication 5653. The current revision is February 2025 (cover date 2-6-2025), and the IRS guide index lists its publication date as 02/2025. It predates the July 2025 law, so it does not describe the restored 100 percent bonus rate. Source: IRS Publication 5653 (Rev. 2-2025), Cost Segregation Audit Technique Guide, Catalog Number 20884M
- The guide states on its cover that it is not an official pronouncement of the law or the position of the IRS and cannot be used, cited or relied upon as such. Source: IRS Publication 5653 (Rev. 2-2025), cover page
- The guide says there are no prescribed qualifications for cost segregation preparers, that there are currently no standards for preparing studies, and that the IRS does not prescribe a specific methodology. The guide does not contain a sentence saying the IRS approves or endorses any study or preparer. Source: IRS Publication 5653 (Rev. 2-2025), chapter 4, part C.1, paragraph (1); chapter 1, part C, paragraph (8); chapter 3, part E, paragraph (1)
When You Sell
What happens to depreciation when the property is sold.
- Section 1245 property is depreciable personal property plus certain other listed property. It generally does not include a building or its structural components. Since the 2025 law (Public Law 119-21), section 1245 property also includes qualified production property under section 168(n), which can be a building, when the taxpayer designates and elects it and places it in service after July 4, 2025. When section 1245 property is sold at a gain, the gain is ordinary income up to the depreciation allowed or allowable. Source: IRC section 1245(a)(1) and (a)(3); IRS Publication 544 (2025), chapter 3 and What's New
- Section 1250 property is depreciable real property that is not section 1245 property. The most common example is a building and its structural components. Land itself is not included because it is not depreciable, but depreciable land improvements that are real property can be section 1250 property. Source: IRC section 1250(c); IRS Publication 544 (2025), chapter 3; IRS Publication 946 (2025), Appendix B, Table B-1
- Under section 1250, gain on section 1250 property is ordinary income only to the extent of additional depreciation. For property held more than one year, additional depreciation is the depreciation allowed or allowable above what the straight line method would have given. For corporations, section 291 treats a further part of the gain as ordinary income. Source: IRC section 1250(a)(1) and (b)(1); IRC section 291(a)(1); IRS Publication 544 (2025), chapter 3
- The part of a long term gain on real property that comes from depreciation and is not recaptured as ordinary income is called unrecaptured section 1250 gain. It is taxed at a maximum rate of 25 percent. Source: IRC section 1(h)(1)(E) and (h)(6); IRS Tax Topic 409
Catching Up on a Building You Own
How a study reaches the return for a building already in service.
- Changing the depreciation method, period of recovery or convention of an asset for which a method has been adopted is a change in method of accounting. It therefore generally requires Form 3115 rather than an amended return. Before a method is adopted, an amended return can correct the depreciation. Source: Treas. Reg. section 1.446-1(e)(2)(ii)(d)(2)(i); IRS Publication 946 (2025), chapter 1
- Generally, a taxpayer adopts a depreciation method by using a permissible method on the first return or by using the same impermissible method on two or more consecutively filed returns. Once a method is adopted, the IRS guide says it cannot be changed by amended return unless specific guidance allows an exemption. Source: IRS Publication 946 (2025), chapter 1, Adoption of accounting method defined; IRS Publication 5653 (Rev. 2-2025), chapter 6, part B.6, paragraph (2)
- The automatic change from an impermissible to a permissible method of accounting for depreciation is in section 6.01 of Rev. Proc. 2025-23, and its designated automatic accounting method change number is 7. It applies to property the taxpayer owns at the beginning of the year of change and for which the impermissible method was used in at least two tax years immediately before the year of change, with a special rule for property placed in service in the immediately preceding year. Section 6.01 also lists property it does not cover, and property disposed of before the year of change is handled in section 6.07. Source: Rev. Proc. 2025-23, 2025-24 I.R.B. 1476, sections 6.01(1), 6.01(9) and 6.07
- As of September 2026 the current IRS list of automatic accounting method changes is Rev. Proc. 2025-23. It is effective for a Form 3115 filed on or after June 9, 2025 for a year of change ending on or after October 31, 2024. Later revenue procedures (2025-28 and 2026-32) modified sections 7 and 19 but did not replace it. Source: Rev. Proc. 2026-32, background paragraph on current guidance; Rev. Proc. 2025-23, EFFECTIVE DATE section .01
- A negative section 481(a) adjustment, which lowers taxable income, is taken in full in the year of change. A positive adjustment is generally spread over four tax years. The adjustment for a depreciation change equals the difference between depreciation actually taken and depreciation allowable for all years before the year of change. Source: Rev. Proc. 2015-13, 2015-5 I.R.B. 419, section 7.03(1); Rev. Proc. 2025-23 section 6.01(5); IRS Publication 946 (2025), chapter 1
- For an automatic change the original Form 3115 is attached to the timely filed federal income tax return (including extensions) for the year of change, and a signed copy is filed with the IRS no later than the date the original is filed. The IRS does not send acknowledgements for automatic change requests. The current Form 3115 instructions are the December 2022 revision. Source: Instructions for Form 3115 (Rev. 12/2022), When and Where To File; Rev. Proc. 2015-13 section 6.03(1)
Rentals and the Passive Rules
How a deduction can be used depends on the passive activity rules. It is not a promise that losses will reduce your wages or other income; your CPA decides how the rules apply to you.
- A passive activity is a trade or business in which the taxpayer does not materially participate, and it includes any rental activity except as provided for real estate professionals. An activity that falls outside the rental definition is tested under the material participation rules instead. Source: IRC section 469(c)(1) and (c)(2)
- An activity involving the use of tangible property is not a rental activity for a tax year if the average period of customer use is seven days or less. Source: Temp. Treas. Reg. section 1.469-1T(e)(3)(ii)(A)
- An activity is also not a rental activity if the average period of customer use is 30 days or less and significant personal services are provided by or on behalf of the owner. Services similar to those commonly provided with long term rentals, such as cleaning common areas, routine repairs and trash collection, do not count. Source: Temp. Treas. Reg. section 1.469-1T(e)(3)(ii)(B) and (e)(3)(iv)
- An individual materially participates by meeting any one of seven tests: (1) more than 500 hours; (2) substantially all of the participation in the activity; (3) more than 100 hours and not less than any other individual; (4) significant participation activities totaling more than 500 hours; (5) material participation in any five of the ten preceding tax years; (6) a personal service activity with material participation in any three preceding tax years; (7) regular, continuous and substantial participation on the facts and circumstances. For income and loss from a limited partnership interest, an individual can use only the first, fifth and sixth of these tests. Source: Temp. Treas. Reg. section 1.469-5T(a)(1) through (7) and (e)(1) and (2)
- In deciding whether a taxpayer materially participates, the participation of the taxpayer's spouse is counted. Source: IRC section 469(h)(5)
- A taxpayer meets the real property business tests, often called real estate professional status, for a year if more than one half of the personal services the taxpayer performs in trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the year in those real property trades or businesses. Personal services performed as an employee are not treated as performed in a real property trade or business unless the taxpayer owns more than 5 percent of the employer. On a joint return, one spouse alone must meet both requirements, counting only that spouse's own services, although a spouse's work still counts in deciding whether the taxpayer materially participates in an activity. Meeting the tests only lifts the automatic passive treatment of rental real estate: the taxpayer must still materially participate in each rental real estate activity, or, if the taxpayer elects to treat all interests in rental real estate as one activity, in that single combined activity. Source: IRC section 469(c)(7)(A), (B) and (D)(ii); Treas. Reg. section 1.469-9(c)(4), (c)(5), (e)(1) and (g)
The rules on this page were checked against their sources on October 1, 2026.
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