What is Cost Segregation?
Cost segregation is an IRS-approved tax strategy that accelerates depreciation deductions by reclassifying components of your property into shorter depreciation categories.
Without Cost Segregation
Standard depreciation spreads deductions over 27.5 years for residential or 39 years for commercial property—a painfully slow process.
Example: $1M property = ~$36,400/year deduction (residential)
With Cost Segregation
Reclassify 20-40% of property value into 5, 7, and 15-year categories—or take 100% bonus depreciation in year one.
Example: $1M property = $200K-$400K+ deduction in year one
How It Works
A cost segregation study identifies and reclassifies personal property assets and land improvements that are often incorrectly classified as real property. Items like flooring, cabinetry, electrical systems, parking lots, and landscaping can be depreciated over 5-15 years instead of 27.5-39 years.
Accelerated Depreciation Categories
Cost segregation reclassifies property components into these faster depreciation schedules:
- Carpeting & flooring
- Appliances
- Certain electrical
- Window treatments
- Specialized equipment
- Office furniture
- Cabinetry
- Certain fixtures
- Security systems
- Decorative items
- Parking lots
- Sidewalks & driveways
- Landscaping
- Fencing
- Site improvements
Take 60% bonus depreciation (2024) on all qualifying property in year one. Combined with cost segregation, this creates massive first-year deductions.
The Real Estate Professional Advantage
For those who qualify as Real Estate Professionals under IRS rules, cost segregation becomes even more powerful—allowing you to offset W-2 and other active income.
- More than 750 hours in real property trades or businesses
- More than 50% of personal services in real property activities
- Material participation in each rental activity (or elect to group)
Real Estate Professionals can use rental losses (including depreciation) to offset:
- W-2 wages from employment
- Business income from other sources
- Investment income and capital gains
Real-World Example
Dr. Smith earns $500,000/year as a surgeon. His spouse qualifies as a Real Estate Professional managing their rental portfolio.
They purchase a $2M apartment building and perform a cost segregation study, identifying $600,000 in accelerated depreciation.
Year 1 Tax Impact
How Depreciation Helps High-Income Earners
If you pay a lot in income tax, depreciation is one of the most powerful legal tools to reduce your tax burden while building real wealth.
Paper Losses, Real Savings
Depreciation is a "non-cash" expense—you get the tax deduction without spending any money. Your property may actually be appreciating in value while you claim depreciation losses against your income.
Tax Bracket Arbitrage
Take deductions at your highest marginal rate (37%+ for high earners), then when you eventually sell, pay back depreciation recapture at only 25%. That's a 12%+ spread on every dollar of depreciation—plus you've had use of that money for years.
1031 Exchange: Defer Forever
Use a 1031 exchange to defer all capital gains and depreciation recapture when you sell. Continue exchanging into larger properties, building wealth tax-deferred. At death, your heirs receive a stepped-up basis—potentially eliminating all deferred taxes.
Cash Flow Enhancement
By reducing your tax liability, depreciation increases your after-tax cash flow. This extra cash can be reinvested into more properties, retirement accounts, or paying down debt—accelerating your wealth building.
The Bottom Line
For high-income earners, real estate depreciation—especially when accelerated through cost segregation— is one of the few remaining legal tax shelters. Combined with strategic financing, it allows you to build significant wealth while legally minimizing your tax burden.
Properties That Benefit Most
Cost segregation works for almost any commercial or residential rental property, but some property types yield particularly strong results.
Apartments, duplexes, and rental complexes with significant personal property components
Office buildings, retail centers, and industrial properties with specialized systems
Vacation rentals and Airbnbs with furnished units and frequent improvements
Generally, cost segregation is most beneficial for properties valued at $500,000+, but even smaller properties can see significant tax savings.