What Is Segmented Depreciation and How Does It Work?

Segmented depreciation is a tax strategy that accelerates depreciation deductions by breaking down a building into its various components for tax purposes. This approach separates shorter-lived assets from long-term structural components, permitting a faster write-off for those items. The objective is to reduce taxable income in the early years of property ownership, improving cash flow. Instead of treating a building as a single asset, this method recognizes that different parts wear out at different rates.

Identifying Depreciable Asset Components

A commercial building is normally depreciated over a 39-year period, while residential rental property is depreciated over 27.5 years. This standard approach treats the entire structure as one asset. Segmented depreciation reclassifies specific components into categories with shorter recovery periods under tax law, allowing a portion of the building’s cost to be depreciated more quickly.

Section 1245 Personal Property

A portion of a building’s interior components can be classified as Section 1245 personal property, which has a depreciable life of five or seven years. This category includes items such as carpeting, certain types of wallpaper, decorative lighting fixtures, and custom cabinetry. It also extends to dedicated electrical or plumbing systems installed to support equipment rather than for general building operation. The distinction is whether the component relates to the building’s maintenance or serves a more specialized function.

Land Improvements

Land improvements are another category of assets depreciated over 15 years. These are man-made additions to the land external to the building’s foundation, such as paved parking lots, sidewalks, fencing, and exterior landscaping. These items are distinct from the land itself, which is not depreciable, and from the building structure. Separating their cost from the main building allows for a much shorter depreciation period.

Building Structure

After all Section 1245 personal property and land improvements are segregated, the remaining value is allocated to the building structure. This portion is classified as Section 1250 real property and retains the longer depreciation schedule of 27.5 or 39 years, depending on the property type. The building structure consists of the elements necessary for the building to function, such as the foundation, structural frame, roofing, and exterior walls.

A benefit of reclassifying assets into shorter-lived categories is their potential eligibility for bonus depreciation. This tax incentive allows property owners to immediately deduct a portion of the cost of eligible property. For assets placed in service in 2025, the bonus depreciation rate is 40%. This provision enhances upfront tax savings, though the rate is scheduled to decrease to 20% in 2026 before being eliminated.

The Cost Segregation Study Requirement

To implement segmented depreciation, property owners must substantiate their asset classifications through a formal cost segregation study. The Internal Revenue Service (IRS) requires detailed documentation to support the reclassification of assets and defend the deductions in an audit. Without a credible study, the IRS may disallow the faster depreciation, leading to back taxes and potential penalties. The study justifies moving assets from a long-term recovery period to shorter 5, 7, or 15-year schedules.

Conducting a cost segregation study requires gathering extensive documentation to allocate the total property cost among different asset classes. This documentation can include:

• As-built blueprints and architectural drawings
• Detailed construction cost data
• Contractor payment applications and invoices
• Sworn statements of cost

If the property was purchased rather than constructed, the analysis would rely on appraisal documents and replacement cost estimates.

Cost segregation studies are performed by specialized firms with expertise in engineering, architecture, and tax law. The IRS’s Cost Segregation Audit Techniques Guide outlines the principles for an acceptable study, favoring a detailed engineering approach based on actual cost records. A qualified professional will conduct a site visit to physically inspect the property to ensure classifications are accurate. An analysis based on estimates or non-contemporaneous records is less likely to withstand IRS scrutiny.

Reporting Segmented Depreciation on Tax Returns

Once a cost segregation study is complete, the findings must be reported on the owner’s federal tax return. If the study is for a property already in service, the taxpayer must file IRS Form 3115, Application for Change in Accounting Method. This form notifies the IRS of the change in depreciation method. A change from one depreciation method to another requires IRS consent, which is often automatically granted for this type of change.

Filing Form 3115 often results in a one-time “catch-up” deduction, known as a Section 481(a) adjustment. This deduction represents the difference between the depreciation claimed in prior years and the amount that should have been claimed using segmented depreciation. This adjustment is taken in the year the accounting method is changed. For all subsequent years, depreciation for the different asset classes is calculated and reported on Form 4562, Depreciation and Amortization.

Form 4562 details the depreciation for each asset class, listing personal property, land improvements, and the building structure with their respective costs and recovery periods. A summary of the cost segregation study is attached to the tax return as supporting documentation. This provides the IRS with the methodology behind the asset classifications.