A Cost Segregation Example With Real Numbers

The property and study

Property: a $600,000 residential rental purchased in 2025. Assume $50,000 is land, so the depreciable building basis is $550,000. Under standard straight-line 27.5-year depreciation, annual deduction = $550,000 ÷ 27.5 = $20,000/year.

A cost segregation study identifies $110,000 of components qualifying as 5-year property (specialty flooring, appliances, cabinets) and $55,000 as 15-year land improvements (landscaping, parking lot, fencing). The remaining $385,000 stays as 27.5-year building.

First-year deduction

With a 40% bonus depreciation rate (2025 example), the 5-year and 15-year components each receive a 40% bonus in year one, with the remaining 60% continuing on their MACRS schedules. Year-one calculation:
• 5-year components: $110,000 × 40% bonus = $44,000 bonus + regular MACRS on remaining $66,000 (year 1 ≈ $13,200) = $57,200
• 15-year land improvements: $55,000 × 40% bonus = $22,000 + regular MACRS on remaining $33,000 (year 1 ≈ $3,300) = $25,300
• 27.5-year building: $385,000 ÷ 27.5 = $14,000 (pro-rated for mid-month)
Total year-one deduction: ≈ $96,500 vs. $20,000 under straight-line. At a 32% tax rate, the extra $76,500 deduction saves roughly $24,500 in year-one taxes.

Recapture at sale (10 years later)

Assume the property sells for $750,000 after 10 years of ownership. By then, total depreciation claimed is roughly $300,000 (the cost-segregated schedule front-loaded the deductions, so the bulk was claimed early). Adjusted basis ≈ $600,000 − $300,000 = $300,000. Total gain = $750,000 − $300,000 = $450,000.

Of the $300,000 of depreciation, some was on Section 1245 property (5-year components, taxed at ordinary rates) and the rest on Section 1250 (capped at 25%). Modeling this precisely requires breaking out each category — use the depreciation recapture calculator to estimate your specific split.

The same example at 100% bonus depreciation

The 40% bonus rate above reflected 2025 phase-down law. The One Big Beautiful Bill Act (July 2025) restored 100% bonus depreciation permanently for qualified property placed in service after January 19, 2025, which changes the year-one math considerably. Rerun the example at 100% bonus: the $110,000 of 5-year components and $55,000 of 15-year land improvements — $165,000 combined — are now deductible in full in year one, instead of only 40%. Add the pro-rated first-year building depreciation of about $14,000 and the year-one deduction jumps to roughly $179,000, versus $96,500 at the old 40% rate and $20,000 under straight-line. At a 32% marginal rate, that is about $57,000 of first-year tax savings from a single study — provided you can actually use the loss (see below). Match the bonus rate to your property's real placed-in-service date; a property placed in service before the January 19, 2025 cutoff uses that year's lower rate.

Breaking out the recapture split with numbers

Return to the sale. Of the $300,000 depreciated, say the study assigned $165,000 to reclassified 5- and 15-year components and $135,000 to the 27.5-year building over the holding period. The 5-year components are Section 1245 property: all depreciation taken on them is recaptured as ordinary income to the extent of gain — potentially at rates up to 37%. The building portion is unrecaptured Section 1250 gain, taxed at a maximum 25% rate. The remaining appreciation above original cost is long-term capital gain at 0/15/20%. A rough split at sale: ~$165,000 taxed up to ordinary rates as 1245 recapture, ~$135,000 at up to 25% as 1250 gain, and $150,000 ($750,000 − $600,000) at long-term capital-gain rates. Layer the 3.8% net investment income tax on top for higher earners. This is why the true benefit is deferral and rate arbitrage, not tax elimination.

Can you use the year-one deduction?

A $179,000 first-year deduction only helps in year one if you can deduct it against income. Rental losses are generally passive and deductible only against passive income, unless you qualify under the $25,000 active-participation allowance (phasing out between $100,000 and $150,000 of modified AGI), hold real estate professional status with material participation, or run a short-term rental (average stays of seven days or less) in which you materially participate. If none applies, the loss is suspended and carries forward until you have passive income or sell the property. In our example, a high-income investor who is not a real estate professional and rents on annual leases would likely see most of the $179,000 loss suspended — turning the study's headline savings into a slower, deferred benefit.

You do not have to do the study in year one

If you bought this $600,000 rental a few years ago and never ran a study, a look-back study can still capture the missed acceleration. You file Form 3115 to change your accounting method and claim the cumulative catch-up as a single Section 481(a) adjustment in the current year — no amended returns required. For an owner several years in, this can drop a large one-time deduction onto the current return, often with a better ROI than waiting for a future purchase.

State tax and the bottom line

Federal recapture on the building portion is capped at 25%, but most states with an income tax add their ordinary rate on top of both the recapture and the gain — as much as another 9–13% in high-tax states like California or New York. Factor that into any sale projection. The takeaway from this worked example: cost segregation on a mid-sized rental can convert a $20,000 straight-line deduction into a six-figure first-year write-off, but the real, after-tax value depends on your bonus rate, your ability to use the loss, the recapture you will face at sale, and your state. Model all four before assuming the headline number is money in the bank.

Step-by-step: how the study actually happens

Turning this example into a real deduction follows a predictable process. First, the engineer establishes the depreciable basis by separating land (never depreciable) from the building — using the purchase price, a tax-assessor ratio, or an appraisal. Second, they inspect the property and review construction records, blueprints, or a purchase-price allocation to identify components that qualify as 5-, 7-, and 15-year property. Third, each component is valued and assigned to its MACRS class with supporting documentation and citations to the IRS Cost Segregation Audit Techniques Guide. Fourth, the study's schedules feed your depreciation on Form 4562, with bonus depreciation applied to the reclassified classes. Fifth, if the property was placed in service in a prior year, the accountant files Form 3115 to claim the catch-up as a Section 481(a) adjustment.

The study report itself becomes part of your permanent tax file. Keep it alongside the closing statement, the purchase-price allocation, and the engineer's asset detail, because these are exactly what an examiner asks for. Timing matters too: the study should be completed before you file the return for the year you want the deduction (or before an amended return or Form 3115 for a look-back), so build in a few weeks of lead time with the provider.

Frequently asked questions

How much can cost segregation save in year one on a $600,000 rental?

On this example, roughly $24,500 in the first year at a 32% marginal rate and 40% bonus rate, compared to $6,400 under straight-line. Actual savings depend on your tax rate, bonus rate, and reclassification results.

What percentage of a residential rental gets reclassified?

In this example, $165,000 of $550,000 (30%) was reclassified. Studies on residential rentals typically reclassify 15–30%.

Does cost segregation change my recapture at sale?

Yes — it increases total depreciation claimed, which increases recapture exposure. But it also lets you defer or invest that tax savings for years before sale.

What would this example look like at today's 100% bonus rate?

The full $165,000 of reclassified components would be deductible in year one, pushing the first-year deduction to roughly $179,000 and the tax savings to about $57,000 at a 32% rate — provided the loss is usable under the passive-activity rules. The 40% figure above reflects the older 2025 phase-down that the OBBBA reversed for property placed in service after January 19, 2025.

How is the reclassified portion taxed when I sell?

The 5- and 7-year components are Section 1245 property recaptured as ordinary income up to the depreciation taken; the building portion is unrecaptured Section 1250 gain taxed at up to 25%; appreciation above original cost is long-term capital gain. Higher earners may also owe the 3.8% net investment income tax, and most states tax all of it as ordinary income.

Do I need an engineer, or can I estimate the reclassification myself?

For a defensible deduction, an engineering-based study performed by a qualified provider is strongly preferred, especially on larger properties. Self-estimates and software-only studies without a site inspection are cheaper but far weaker if the IRS examines the return. The calculator here is useful for screening whether a study is worth commissioning, not as a substitute for one.

Can I run a cost segregation study on a property I bought a few years ago?

Yes. A look-back study lets you claim the cumulative missed depreciation as a single Section 481(a) catch-up adjustment on Form 3115 in the current year, without amending prior returns — often a large one-time deduction for a longer-term owner.

Does the depreciable basis include closing costs and improvements?

Yes. Your depreciable basis starts with the purchase price allocated to the building (not the land) and includes certain capitalized closing costs and any improvements you make. In the example, the $600,000 price less $50,000 land gives a $550,000 building basis; if you later add a $40,000 improvement, that becomes its own depreciable asset. A study allocates all of that across the appropriate recovery periods.

What if my income is too high to use the loss the study creates?

The deduction is not lost — it becomes a suspended passive loss that carries forward to future years with passive income, or is released in full when you sell the property in a fully taxable disposition. But because you cannot use it now, the present value of the study drops. High earners who are not real estate professionals and rent on annual leases should model this carefully before commissioning a study, since much of the headline deduction may sit unused for years.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.