Bonus Depreciation and Cost Segregation: The Ultimate Guide for Residential & Commercial Investors

Bonus depreciation, formally known as additional first year depreciation under Section 168(k) of the Internal Revenue Code, is a tax incentive that allows businesses to immediately deduct a large percentage of the purchase price of eligible business assets in the year the asset is placed in service. Rather than depreciating property gradually over its useful life using regular MACRS depreciation, bonus depreciation accelerates the deduction into the first year.

For real estate investors, bonus depreciation applies to certain building components and improvements that have MACRS recovery periods of 20 years or less. This includes personal property, land improvements, and qualified improvement property identified through cost segregation. The ability to immediately deduct 60%, 80%, or even 100% of these components in year one creates substantial upfront tax benefits and improved cash flow.

The bonus depreciation percentage has changed multiple times through tax legislation. The Tax Cuts and Jobs Act of 2017 increased bonus depreciation to 100% for property placed in service between September 27, 2017 and December 31, 2022, and scheduled a phasedown thereafter. More recent legislation, including the One Big Beautiful Bill Act, has modified these timelines and percentages, making it essential for property owners to understand the current rules.

Bonus depreciation is not technically mandatory, meaning taxpayers can elect out of it on a class by class basis if they prefer to use regular MACRS depreciation instead. This flexibility allows property owners to tailor their depreciation strategy to their specific tax situation, income levels, and long term planning goals. Understanding when to use and when to forgo bonus depreciation is a critical decision point in real estate tax planning. For a more detailed explanation of how bonus depreciation works as it relates to cost segregation, including common misconceptions and practical examples, property owners should consult comprehensive educational resources.

Cost segregation and bonus depreciation work together synergistically to maximize upfront tax deductions on real estate. Cost segregation is the engineering analysis that identifies building components and improvements that can be reclassified from the building's 27.5 or 39 year life into shorter depreciation categories. Bonus depreciation is the tax rule that allows immediate deduction of a percentage of these shorter life components.

Without cost segregation, a building is typically depreciated as a single asset over 27.5 years for residential property or 39 years for commercial property using straight-line depreciation. With cost segregation, the building is broken down into its component parts, and those components with recovery periods of 20 years or less become eligible for bonus depreciation. This can include items like carpeting, lighting fixtures, appliances, cabinetry, parking lots, landscaping, and many other components.

The mechanics work as follows: First, a cost segregation study allocates the building's purchase price or construction cost among the various components. Second, each component is assigned to its appropriate MACRS class based on IRS guidelines. Third, components in the 5, 7, and 15 year classes are eligible for bonus depreciation. Fourth, the applicable bonus depreciation percentage is applied to the basis of each qualifying component, creating an immediate deduction in the year the property is placed in service.

For property owners who complete a cost segregation study after the year of acquisition, Form 3115 and a Section 481(a) adjustment can be used to capture the missed bonus depreciation from prior years. This makes cost segregation valuable even for properties that were purchased or placed in service several years ago, provided bonus depreciation was available in those years and the taxpayer did not previously elect out.

Property must meet several requirements to qualify for bonus depreciation. First, the property must have a MACRS recovery period of 20 years or less. This automatically includes most personal property, land improvements, and certain building components identified through cost segregation. Buildings themselves, which are 27.5 or 39 year property, do not qualify for bonus depreciation, but many of their components do.

Second, the property must be new to the taxpayer. Under the Tax Cuts and Jobs Act, bonus depreciation was expanded to include both new and used property, provided the property was not previously used by the taxpayer or a related party. This means you can purchase a used building and claim bonus depreciation on qualifying components identified through cost segregation, even though the building itself is not new.

Third, the property must be acquired by purchase and cannot be acquired from a related party. Self constructed property also qualifies, and in fact, many construction and development projects benefit significantly from bonus depreciation when combined with cost segregation to identify all qualifying components built into the project.

Fourth, the property must be placed in service during the tax year. Placed in service generally means the property is ready and available for its specific use, whether or not it is actually used. For real estate, this typically coincides with the date the property is purchased, substantial completion of construction, or when the property is ready for rental. Understanding TCJA bonus depreciation rules helps property owners ensure they meet all qualification requirements.

The Modified Accelerated Cost Recovery System, or MACRS, is the depreciation system used for most business assets in the United States. MACRS assigns property to specific depreciation classes based on the property's useful life, with each class having its own recovery period and depreciation method. Understanding MACRS classes is essential for cost segregation because it determines which components qualify for bonus depreciation.

The most relevant MACRS classes for real estate cost segregation are 5 year property, 7 year property, 15 year property, 27.5 year property, and 39 year property. Five year property includes carpeting, decorative fixtures, and certain equipment. Seven year property includes office furniture, appliances, and most other personal property not in other classes. Fifteen year property includes land improvements such as parking lots, sidewalks, fencing, and landscaping.

Residential rental buildings are classified as 27.5 year property, while commercial buildings are 39 year property. These building structures do not qualify for bonus depreciation. However, qualified improvement property, which includes interior improvements made to nonresidential buildings after the building is placed in service, has a 15 year recovery period and does qualify for bonus depreciation, making it a valuable planning opportunity.

Each MACRS class also has a designated depreciation method, either 200% declining balance, 150% declining balance, or straight-line. The depreciation method determines how deductions are spread over the recovery period for the portion of basis not subject to bonus depreciation. For a detailed breakdown of the MACRS depreciation system, including depreciation rates and schedules, property owners should consult comprehensive depreciation resources or their tax advisors.

The bonus depreciation percentage depends on when the property was placed in service and the applicable tax law at that time. The Tax Cuts and Jobs Act set bonus depreciation at 100% for property placed in service after September 27, 2017 and before January 1, 2023. Starting in 2023, the law provided for a scheduled phasedown: 80% for 2023, 60% for 2024, 40% for 2025, 20% for 2026, and 0% for 2027 and beyond.

However, subsequent legislation, including the One Big Beautiful Bill Act of 2025, has modified these phaseout schedules. Property owners should consult current tax law and their advisors to determine the exact bonus depreciation percentage applicable to their specific placed in service date. Even at reduced percentages like 60% or 80%, bonus depreciation combined with cost segregation provides substantial tax benefits compared to straight-line depreciation over 27.5 or 39 years.

The phaseout applies based on the placed in service date of the property, not when the cost segregation study is completed. This means a property placed in service in 2022 can qualify for 100% bonus depreciation even if the cost segregation study is completed in 2024 or later, provided Form 3115 is filed properly. This creates opportunities for retroactive cost segregation on properties acquired during high bonus depreciation years.

Long production period property and certain aircraft have special rules that can extend the 100% bonus depreciation period or modify the phaseout schedule. For most real estate, the general phaseout schedule applies, but property owners with unique situations should verify the specific rules applicable to their property type and acquisition date. For detailed strategies on navigating the bonus depreciation phase-out, including timing considerations and ROI modeling, property owners should review comprehensive planning resources.

The Tax Cuts and Jobs Act of 2017 made dramatic changes to bonus depreciation that significantly enhanced the value of cost segregation for real estate investors. Prior to TCJA, bonus depreciation was limited to 50% and applied only to new property. TCJA increased the percentage to 100% and expanded eligibility to include used property, fundamentally changing the cost segregation landscape.

The expansion to used property was particularly significant for real estate investors because most real estate transactions involve existing buildings rather than new construction. Under pre-TCJA rules, purchasing an existing building meant the buyer could not claim bonus depreciation on any components, even those identified through cost segregation. TCJA eliminated this limitation, allowing purchasers of used buildings to claim bonus depreciation on all qualifying components.

TCJA also made changes to qualified improvement property, initially providing it with a 15 year life and eligibility for bonus depreciation. However, a drafting error in the original legislation temporarily created confusion about QIP eligibility. The CARES Act of 2020 corrected this error retroactively, confirming that QIP has a 15 year life and qualifies for bonus depreciation, creating significant planning opportunities for interior improvements to commercial buildings.

The scheduled phaseout of bonus depreciation starting in 2023 was also established by TCJA, though subsequent legislation has modified the specific percentages and timelines. The combination of 100% bonus depreciation, used property eligibility, and QIP treatment made TCJA arguably the most impactful tax legislation for cost segregation in decades, driving substantial interest in the strategy during the years immediately following enactment.

Bonus depreciation and cost segregation apply to both residential and commercial real estate, but there are important differences in how they work for each property type. Residential rental property, defined as property where 80% or more of the gross rental income is from dwelling units, is depreciated over 27.5 years. Commercial property is depreciated over 39 years. These base building depreciation periods are the same regardless of bonus depreciation.

For residential property, cost segregation typically identifies components such as appliances, carpeting, vinyl flooring, window treatments, garage door openers, and site improvements like parking areas and landscaping. These components are reclassified from the 27.5 year building life into 5, 7, or 15 year lives and become eligible for bonus depreciation. The percentage of the total building that can be reclassified varies but often ranges from 15% to 30% depending on property type and construction.

For commercial property, cost segregation can identify similar personal property and land improvements, plus additional components related to the specific business use of the property. Office buildings might include movable partitions, decorative lighting, and specialized flooring. Retail properties might include storefront glass, security systems, and point of sale infrastructure. Industrial properties might include specialized electrical systems, overhead cranes, and process piping.

Qualified improvement property is particularly valuable for commercial property owners because it allows interior improvements made after a building is placed in service to be depreciated over 15 years with bonus depreciation eligibility. This creates planning opportunities for tenant improvements, remodels, and expansions. Residential property does not benefit from QIP treatment because QIP is defined as improvements to the interior of nonresidential buildings.

While bonus depreciation provides immediate tax benefits, it is not mandatory, and there are situations where electing out may be advantageous. Taxpayers can elect out of bonus depreciation on a class by class basis, choosing to use regular MACRS depreciation instead. This election is made on the original timely filed return, including extensions, and once made, cannot be revoked without IRS consent.

One common reason to elect out is insufficient taxable income to utilize the deduction. If a property owner has little or no taxable income in the year the property is placed in service, taking a large bonus depreciation deduction may create or increase a net operating loss that provides little immediate benefit. In this case, spreading the deduction over time using regular MACRS might provide more value in future years when income is higher.

Another consideration is the passive activity loss rules. Real estate investors who do not qualify as real estate professionals may be subject to limitations on deducting passive losses. Large bonus depreciation deductions that create or increase passive losses may be suspended and carried forward, reducing the immediate cash flow benefit. Electing out of bonus depreciation may help manage passive loss limitations more effectively.

State tax conformity is another factor. Some states do not conform to federal bonus depreciation rules, creating differences between federal and state tax calculations. In some cases, electing out of bonus depreciation for federal purposes can simplify state tax compliance and reduce book-tax differences. Property owners should evaluate both federal and state tax consequences when deciding whether to elect out of bonus depreciation.

To illustrate how bonus depreciation works with cost segregation, consider a commercial property purchased for $2,000,000 with land valued at $400,000 and building at $1,600,000. Without cost segregation, the entire $1,600,000 building would be depreciated over 39 years using straight-line depreciation, resulting in annual deductions of approximately $41,026.

With cost segregation, assume the study identifies $240,000 in 5 year property, $160,000 in 7 year property, and $320,000 in 15 year land improvements, with the remaining $880,000 classified as 39 year building. If the property was placed in service in a year with 100% bonus depreciation, the entire $720,000 of qualifying property ($240,000 + $160,000 + $320,000) would be immediately deductible in year one.

The calculation proceeds as follows: First, apply 100% bonus depreciation to the $720,000 of qualifying property, resulting in a $720,000 deduction in year one. Second, depreciate the remaining $880,000 of 39 year property over 39 years using straight-line, resulting in approximately $22,564 per year. The total first year deduction is $742,564 compared to $41,026 without cost segregation and bonus depreciation.

If bonus depreciation is 60% instead of 100%, the calculation changes: Apply 60% bonus depreciation to the $720,000, resulting in $432,000 immediate deduction. The remaining 40% of qualifying property ($288,000) is depreciated under regular MACRS over the applicable recovery periods. The 39 year building portion continues to depreciate at $22,564 per year. Total first year deduction in this scenario would be approximately $550,000, still substantially more than without cost segregation.

Maximizing bonus depreciation benefits requires strategic planning and timing. One key strategy is completing cost segregation studies on properties placed in service during high bonus depreciation years. Properties acquired in 2017 through 2022, when 100% bonus depreciation was available, can still benefit from retroactive cost segregation if the study is completed and Form 3115 is filed properly, even if the current bonus depreciation percentage has decreased.

Timing property acquisitions and placed in service dates can also be valuable. If bonus depreciation percentages are scheduled to change, accelerating or delaying acquisitions by even a few weeks can affect the applicable percentage. Similarly, substantial completion dates for construction projects can be managed to optimize bonus depreciation benefits, though business and practical considerations should take priority over tax timing.

Qualified improvement property provides unique planning opportunities. Interior improvements to commercial buildings can be structured and documented to ensure they qualify for the 15 year recovery period and bonus depreciation. This is particularly valuable for tenant improvement allowances, where proper planning and allocation can ensure maximum tax benefits for both landlords and tenants.

Finally, coordinating with other tax strategies enhances the value of bonus depreciation. Real estate professional status can help property owners avoid passive loss limitations and fully utilize bonus depreciation deductions. Opportunity zone investments can be combined with cost segregation and bonus depreciation for layered tax benefits. Section 1031 exchanges require careful planning to preserve bonus depreciation opportunities on replacement property. Working with experienced tax and cost segregation professionals ensures all strategies are properly integrated and optimized.