What Is the Segregated Cost Method in Accounting?
Explore a tax accounting strategy that reclassifies a building's assets to accelerate depreciation, resulting in deferred tax liability and increased cash flow.
The segregated cost method is a tax planning strategy for real estate owners that reclassifies building components to accelerate depreciation deductions. This allows property owners to increase near-term cash flow by deferring federal and state income taxes. The strategy uses a detailed analysis, known as a cost segregation study, to separate costs that would otherwise be depreciated over a long period into shorter recovery periods. This process identifies assets that can be depreciated more quickly than the building structure, leading to larger tax deductions in the early years of property ownership.
Property Components and Depreciation Schedules
The segregated cost method works by breaking down a property’s components to move beyond standard depreciation schedules. The IRS requires residential rental properties to be depreciated over 27.5 years and commercial properties over 39 years using a straight-line method. A cost segregation study challenges this default by identifying parts of the property that qualify for shorter depreciation timelines.
A study sorts a building’s costs into distinct classifications. The first is Section 1250 real property, which includes structural elements like the foundation, roofing, and framing that remain on the 27.5-year or 39-year depreciation schedule.
A second category is Section 1250 land improvements, which are assets outside the building itself. Examples include paved parking lots, walkways, fencing, and landscaping, which are eligible for a 15-year depreciation period.
The final category is Section 1245 personal property, which includes non-structural assets affixed to the building. This can include carpeting, decorative lighting, and specialized electrical systems, which are typically assigned a 5-year or 7-year depreciation life.
A cost segregation study also unlocks bonus depreciation, which allows for an immediate first-year deduction on a percentage of an eligible property’s cost. Assets with a recovery period of 20 years or less, including personal property and land improvements, qualify for this treatment. For 2025, the bonus depreciation rate is 40%, though this rate is part of a scheduled phase-out and subject to change by future legislation.
For example, consider a $1 million commercial building. Without a study, the entire cost would be depreciated over 39 years, resulting in an annual deduction of approximately $25,641. If a cost segregation study reclassifies 20% of the cost ($200,000) as 5-year property and 10% ($100,000) as 15-year property, the first-year deduction becomes substantially larger. By applying bonus depreciation, the first-year deduction could increase to over $160,000.
Qualifying Properties for a Cost Segregation Study
Many real estate types can benefit from a cost segregation study, including commercial properties like office buildings, retail centers, and warehouses, as well as residential rental properties. The benefit is often greater for buildings with more specialized and complex interior components.
The timing for a study is flexible. It can be performed when a property is first constructed, immediately after an acquisition, or following a significant renovation or expansion project. Property owners can also perform a “look-back” study on a property that has been in service for several years to catch up on missed depreciation.
The Cost Segregation Study Process
The process begins by engaging a qualified firm with expertise in engineering and tax law to conduct a study that can withstand IRS scrutiny. The property owner provides comprehensive documentation, including:
- Architectural blueprints
- Construction cost data
- Contractor payment applications
- Change orders and other records detailing costs
The firm’s engineers then conduct a physical site visit to identify, measure, and photograph the building’s components and land improvements. During this on-site analysis, every element is documented and evaluated, from specific electrical wiring to the type of flooring installed.
After the site visit, the team performs a detailed analysis to allocate total project costs across the different asset classes. This involves using construction cost-estimating techniques to assign a value to each component, including personal property, land improvements, and the building structure. Indirect construction costs are also allocated among the asset categories.
The final step is the delivery of a report that breaks down all property costs and assigns each to the correct asset category and depreciation schedule. This report serves as the official support for the depreciation deductions claimed on the owner’s tax return and provides a clear audit trail.
Implementing the Study’s Findings
For newly constructed or acquired properties, the depreciation schedules in the report are used to prepare the income tax return for the year the property was placed in service. This ensures accelerated depreciation deductions begin at the earliest date.
For properties that have been owned for several years, implementing a look-back study requires a change in accounting method. This is done by filing IRS Form 3115, Application for Change in Accounting Method, with the tax return for the year the change is made.
Filing Form 3115 allows the taxpayer to claim the “catch-up” depreciation missed in prior years through a Section 481(a) adjustment. This adjustment allows the total amount of understated depreciation to be deducted in a single year without amending past tax returns.