Cost Segregation for Trusts and Estates

Trusts and estates are separate taxable entities that file their own tax returns. Trusts file Form 1041, and estates also file Form 1041. These entities are taxed on income they retain, and they can distribute income to beneficiaries, who then report it on their own returns.

The key concept is distributable net income (DNI), which determines how much income can be passed through to beneficiaries. Depreciation deductions reduce DNI, which can reduce the amount of taxable income distributed to beneficiaries or retained by the trust.

For cost segregation purposes, trusts and estates calculate depreciation at the entity level using the same methods as other taxpayers. The accelerated depreciation from cost segregation reduces taxable income and can provide significant tax benefits.

Trust cost segregation works by having the trust calculate depreciation on real estate it owns. The trust performs a cost segregation study to reclassify building components into shorter depreciation lives, which increases depreciation deductions in earlier years.

The depreciation deductions reduce the trust's taxable income. If the trust distributes income to beneficiaries, the depreciation deductions may flow through to the beneficiaries on Schedule K-1. If the trust retains income, the trust claims the depreciation deductions on its own return.

Understanding how entity structure affects tax planning is critical when evaluating whether a trust structure is appropriate for your real estate portfolio and whether cost segregation delivers meaningful tax benefits.

Inherited property cost segregation is particularly valuable because property inherited at death receives a stepped-up basis to fair market value as of the date of death. This creates a new basis for depreciation purposes and a fresh opportunity to perform cost segregation.

The estate or trust can perform a cost segregation study on the stepped-up basis to accelerate depreciation on the reclassified components. This provides significant tax benefits to the estate or beneficiaries by reducing taxable income during the holding period.

For example, if a property was acquired decades ago with significant accumulated depreciation, the step-up at death resets the basis and allows a new cost segregation study to be performed on the fair market value, which may be substantially higher than the original basis.

Distributable net income (DNI) determines how much income can be passed through to beneficiaries and how deductions are allocated between the trust and the beneficiaries. Depreciation deductions reduce DNI, which can reduce the amount of taxable income distributed to beneficiaries.

If the trust distributes all of its income, the depreciation deductions generally flow through to the beneficiaries. If the trust retains income, the trust claims the depreciation deductions on its own return and pays tax on the retained income.

Trust real estate depreciation planning requires coordination between the trustee, the beneficiaries, and the tax advisor to determine the optimal distribution strategy and allocation of deductions.

A revocable trust is a grantor trust for tax purposes, meaning it is disregarded and the grantor reports all income and deductions on their personal return. Cost segregation depreciation from a revocable trust is reported on the grantor's Schedule E or business schedule.

An irrevocable trust is a separate taxable entity. It files Form 1041 and either retains the depreciation deductions or passes them through to beneficiaries based on the distribution policy and the trust document.

The choice between revocable and irrevocable trust affects the tax treatment of cost segregation deductions and should be made in consultation with an estate planning attorney and tax advisor.

An estate is a temporary entity created at death to settle the decedent's affairs. The estate may hold real estate during the administration period, which can last from months to several years.

During this period, the estate can claim depreciation deductions on the property. If the property has a stepped-up basis, the estate can perform a cost segregation study to accelerate depreciation on the new basis.

The depreciation deductions reduce the estate's taxable income during the administration period. If the estate distributes income to beneficiaries, the deductions may flow through to the beneficiaries. If the estate retains income, it pays tax on the retained income after depreciation.

Trusts and estates reach the highest federal tax bracket at very low income levels. For 2025, the top rate of 37% applies to taxable income above approximately $15,000 for trusts and estates, compared to over $600,000 for married couples filing jointly.

This compressed tax bracket structure makes depreciation deductions particularly valuable for trusts. Cost segregation can reduce taxable income and keep the trust in lower brackets, or it can allow the trust to distribute income to beneficiaries who may be in lower brackets.

Trustees should coordinate with tax advisors to determine whether retaining income and claiming depreciation at the trust level or distributing income and passing deductions through to beneficiaries results in the lowest overall tax liability.

Cost segregation affects distribution planning because it reduces distributable net income. By increasing depreciation deductions, the trust may have less income available for distribution, or it may choose to distribute less income to beneficiaries to retain the tax benefit at the trust level.

Trustees should consider the tax brackets of the beneficiaries when making distribution decisions. If beneficiaries are in lower brackets than the trust, distributing income and passing through depreciation deductions may result in lower overall tax. If beneficiaries are in high brackets, retaining income and claiming depreciation at the trust level may be more efficient.

For more on how foreign investors handle cost segregation, review the dedicated page, which discusses similar entity-level tax considerations.

Trusts offer estate planning benefits but are subject to compressed tax brackets and complex distribution rules. Partnerships and LLCs offer more allocation flexibility and are subject to individual tax brackets rather than trust brackets.

For real estate held for income production, a partnership or LLC may be more tax efficient than a trust. For real estate held for estate planning or asset protection, a trust may be the better choice despite the tax disadvantages.

The entity choice should balance tax, estate planning, and asset protection objectives. Work with your CPA, estate planning attorney, and financial advisor to determine the best structure for your real estate portfolio.