Cost Segregation Mechanics

By Jason Watson, CPA
Posted Sunday, May 25, 2025

How does all this black magic work? With a cost segregation report, or some say a cost segregation study, all the sticks, bricks and stuff inside are figuratively torn down and put into different piles. Some piles are eligible for instant depreciation (unlike the hominy grits in My Cousin Vinny), one pile might be a 5-year pile, another be a 15-year pile, and the remaining pile might revert to the 27.5- or 39.0-year typical residential or non-residential commercial use depreciation.

Sidebar: A short-term rental property that has an average guest stay of 7 days or fewer where you materially participate in the activity is considered a commercial activity, and as such will be 39.0 years. We discuss the short-term rental (STR) loophole in great detail.

Technically, and with full-on geek-speak, cost segregation separates property elements that are “dedicated, decorative or removable” from those that are “necessary and ordinary for operation and maintenance of the building.” These piles are called asset classes, and they are maintained separately within your property’s depreciation schedule.

From there, and with the help of bonus depreciation and in some cases Section 179 expensing, you compress the multiple years into one. Yay! Whether this accelerated rental property depreciation or expensing yields a tax deduction / tax benefit and therefore increased cash flow (an improved IRR) is contingent on three general things-

• Short-term rental (7 days average guest stay + material participation), or

• Real Estate Professional designation, or

• Net rental income (profit) from the rental property, other rental properties, or other real estate investments that can be reduced by the loss.

Or some combination of the above. We’ll dig in deep on these goodies.

Please don’t groan as we go into the weeds with more nerdy accounting terms like Section 1245 and Section 1250 Property. This one is important, and we’ll try to keep it relevant. A building that is or has been depreciable is considered Section 1250 property. When a cost segregation study is performed, certain asset classes are deemed personal property and when depreciable, they become Section 1245 property.

Why do you care? Not to get too far of track, but one of the big benefits of identifying property as Section 1245 property is that it becomes eligible for Section 179 expensing (there are additional exceptions as Qualified Improvement Property or QIP for short). There is a downside too- depreciation recapture, which we have not discussed yet, is limited to 25% on Section 1250 property, but Section 1245 property is recaptured at your ordinary income tax rate. As such, this becomes a big tax planning consideration. Also, Section 1245 property does not always escape depreciation recapture in a Section 1031 Like-Kind Exchange either. We expand on this and the wonderful 15% exception.

Quick recap-

• 5- or 7-year property is Section 1245 property.

• 15-year property can be either Section 1245 or Section 1250 property. However, it is usually Section 1250 if attached to the land. Can you dig up a shrub and relocate it? Maybe. However, if you accelerate depreciation on 15-year property, such as land improvements, then it becomes Section 1245 property (which alters depreciation recapture slightly).

• 27.5- or 39.0-year property, such as the building and its structural components, is Section 1250 property.

Sidebar: Asset Class 00.3, as defined by the IRS, refers to Land Improvements and mentions that they can be either Section 1245 or Section 1250 property. This is because assets that are integral to the manufacturing / production process are defined as Section 1245 property in IRC Section 1245(a)(3)(B). Therefore, a plant could have inherently permanent improvements to the land that would be considered Section 1245 property because they support the manufacturing / production process. A massive diversion in a book about rental properties, but you’re better for it.

How does the IRS distinguish between Section 1245 and Section 1250 property? According to IRS Publication 5653 Cost Segregation Audit Technique Guide (ATG)–

From a regulatory standpoint, the primary test for determining whether an asset is § 1245 property eligible for ITC [investment tax credit] is to ascertain that it is not a building or other inherently permanent structure, including items which are structural components of such buildings or structures. In other words, if an asset is not a building or a structural component of a building, then it can be deemed to be § 1245 property. The determination of structural component hinges on what constitutes an inherently permanent structure, how permanently the asset is attached to such a structure and whether it relates to the operation or maintenance of the structure. See Treas. Reg. §§ 1.48-1(c)-(e).

ITC references investment tax credit. How does that matter? IRC Section 1245(a)(3) and Treasury Regulations Section 1.1245-3(b)(1) read that the distinction between tangible personal property (Section 1245) and structural components (Section 1250) should be based on the criteria once used to determine whether property qualified for the now repealed investment tax credit (ITC) under IRC Section 38.

Huh? The IRS is using old tax code to define current tax code. You still awake? In 1975, the IRS refined its definition and stated in Revenue Ruling 75-178,

Rather, the problem of classification of property as ‘personal’ or ‘inherently permanent’ should be made on the basis of the manner of attachment to the land or the structure and how permanently the property is designed to remain in place.

As such, the inherently permanent test, is illustrated in the landmark Whiteco Industries, Inc. v. Commissioner, 65 Tax Court 664 (1975) court case. No, we don’t bore you with all the factors, but it is an interesting read if you cannot get enough.

You see the IRS Publication 5653 Cost Segregation Audit Technique Guide (ATG) here-

https://wcginc.com/wp-content/documents/tax/IRS_Cost_Segregation_Audit_Technique_Guide_Publication_5653.pdf