Cost Segregation for Bay Area Real Estate Investors

Tax strategies are often an overlooked aspect of real estate investment, but for savvy investors, one technique can make a significant difference in cash flow and tax liability—cost segregation. In a recent discussion with Geraldine Serrano of Specialty Tax Group, we explored the ins and outs of this powerful tax strategy and how it can benefit property owners.

What is Cost Segregation?

A cost segregation study is a detailed engineering report that breaks down the components of a building, allowing real estate investors to accelerate depreciation on qualifying assets. Typically, buildings are depreciated over 27.5 years for residential properties and 39 years for commercial properties. However, a cost segregation study identifies certain components—such as flooring, cabinetry, or landscaping—that can be depreciated faster (over 5, 7, or 15 years), reducing taxable income and increasing cash flow.

Who Qualifies for Cost Segregation?

Many real estate investors are unaware that they qualify for this tax strategy. Cost segregation is not just for large commercial properties—it can apply to:

Single-family rental homes
Duplexes and triplexes
Apartment buildings
Accessory Dwelling Units (ADUs)
Commercial buildings

Even if you’re renting out just a portion of your home, such as an ADU or a spare room, you may benefit from a cost segregation study.

Real-World Example: House Hacking and Tax Savings

In the video at the top of this article, Geraldine shares a compelling story about a real estate investor who was prepared to send a $100,000 check to the IRS. A friend advised him to look into cost segregation, and after conducting studies on his 12 rental properties, he was able to completely eliminate his tax liability for that year.

This case illustrates how cost segregation allows property owners to maximize depreciation deductions and reduce taxable income substantially.

How is a Cost Segregation Study Conducted?

The process typically involves:

A Physical Inspection – Geraldine’s firm, unlike some competitors, conducts on-site inspections to identify all eligible depreciable assets.
Engineering Analysis – Every component of the building is categorized and assigned an appropriate depreciation schedule.
Audit-Ready Report – The study is compiled into a document that can be used in tax filings and provides audit defense support if needed.

Why Not Just Have a CPA Handle This?

A common question is why CPAs don’t conduct cost segregation studies. The IRS requires these studies to be performed by professionals with an engineering and construction background. While CPAs handle tax preparation, they typically do not have the expertise to conduct detailed engineering analyses.

Timing: When to Conduct a Cost Segregation Study

Newly Purchased Properties – The best time to conduct a study is soon after acquiring a property.
Existing Properties – Even if you’ve owned a property for years, you can still perform a study and catch up on missed depreciation without amending past returns. This is done using IRS Form 3115.
Short-Term vs. Long-Term Holders – Whether you plan to hold a property for 5 years or 30 years, cost segregation can provide immediate tax benefits.

Depreciation Recapture and IRS Concerns

One concern investors may have is depreciation recapture when selling a property. However, this is an issue regardless of whether cost segregation is used. Investors can mitigate recapture taxes by utilizing a 1031 exchange, deferring capital gains tax by reinvesting in another property.

Additionally, while cost segregation does not inherently raise IRS audit risks, aggressive building vs. land allocationcould attract scrutiny. Proper documentation and working with reputable professionals mitigate this risk.

How Much Does a Cost Segregation Study Cost?

The cost varies depending on the size and complexity of the property:

Small residential properties (condos, duplexes, ADUs) – $2,000 – $3,500
Larger properties (apartment complexes, hotels, commercial buildings) – Fees can range from $10,000 – $15,000 but yield significant tax savings

Is Cost Segregation Worth It?

Consider this: If you own a $1 million condominium (where 100% of the value is improvements and $0 is land value), and a study reallocates 40% of the value to shorter depreciation schedules, you could unlock $400,000 in accelerated depreciation, significantly reducing your taxable income. Using standard depreciation, you could write off $36,3763 per year in depreciation.

Breaking Down the Yearly Accelerated Depreciation Benefit

If 50% of the $400,000 ($200,000) is classified as 5-year property, you would get an annual depreciation write-off of $40,000 per year ($200,000 ÷ 5 years). If the other 50% ($200,000) is classified as 10-year property, you would get an annual depreciation write-off of $20,000 per year ($200,000 ÷ 10 years).

This means instead of waiting 27.5 years for residential properties to fully depreciate the entire $400,000, you are front-loading $60,000 per year in depreciation deductions for the first five years, followed by $20,000 per year for the remaining five years of the 10-year schedule.

Comparing to Standard Depreciation

If the $1,000,000 were depreciated using the standard 27.5-year schedule, you would deduct $36,363 per year. But if 40% of that was subject to accelerated depreciation, 60% of that would use the standard depreciation, for a $21,818 yearly deduction ($600,000 / 27.75 years).

But then you would then get $40,000 per year for the 5-year depreciation schedule, ($200,000 / 5 years) and $20,000 per year for the 10-year depreciation schedule ($200,000 / 10 years) for a total yearly depreciation deduction of $81,818 per year. By using accelerated depreciation, you would increase your yearly depreciation by $45,455 per year for the first 5 years, and $20,000 per year for the next 5 years.

Let’s say that you are in a combined (Federal + State) tax bracket of 30%. An additional $45,455 tax deduction would result in a lower tax payment of $13,636 per year for the first five years, and a $6,000 lower tax payment for the next 5 years after that. That’s a total additional tax savings of $98,182 by using cost segregation and accelerated depreciation for the first 10 years of ownership.

However, after the first ten years, your deduction would actually decrease in this scenario. You’d only be deducting $21,818 per year versus $36,363 per year using the standard 27.75 year depreciation schedule, since you’d only be depreciating $600,000 instead of the full $1,000,000 at that point.

And yes, if you sell the property all the depreciation would be recaptured and become taxable – unless you do another 1031 tax-deferred exchange, in which case it gets rolled into the basis of your new property, which you can then depreciate all over again. And, when you die, your heirs will inherit the property with a stepped-up tax basis and all that depreciation would vanish.

Accelerated Depreciation of Capital Improvements

Accelerated depreciation allows real estate investors to deduct the cost of certain capital improvements made after initial purchase more quickly than the standard depreciation schedule for buildings (27.5 years for residential rental properties, and 39 years for commercial properties). When investors make qualified capital improvements—such as adding energy-efficient systems, upgrading essential infrastructure, or improving tenant amenities—they can often use Bonus Depreciation or Section 179 expensing to front-load deductions and reduce taxable income.

Some of the most expensive and tax-beneficial upgrades for small-scale residential investors in the single-family and multi-family space include solar panel and battery storage systems, HVAC system replacements, roof replacements, elevator installations, new plumbing systems, fire sprinkler systems, and energy-efficient windows and insulation.

Additionally, items like appliance upgrades, flooring replacements, security systems, and smart home technology can also qualify under shorter depreciation schedules, providing significant tax advantages. Investors often leverage cost segregation studies to reclassify these improvements into shorter-lived assets (5, 7, or 15 years), allowing them to maximize their deductions and cash flow.

What is Bonus Depreciation?

Bonus Depreciation is a tax incentive that allows investors to immediately deduct a significant portion (or even 100%) of the cost of qualifying assets in the year they are placed in service, rather than spreading the depreciation over many years. This provision is especially beneficial for real estate investors who make capital improvements, as it accelerates tax deductions and improves cash flow.

How Bonus Depreciation Works

Bonus Depreciation applies to assets with a useful life of 20 years or less, which includes many common real estate improvements such as:

HVAC systems
Roofs (if classified as qualified improvement property)
Solar panels and battery storage systems
Flooring (carpets, vinyl, and some wood floors)
Security systems
Appliances (stoves, refrigerators, dishwashers, etc.)
Landscaping improvements (irrigation, fencing, paving, etc.)
Parking lot resurfacing

Bonus Depreciation Phase-Out

The Tax Cuts and Jobs Act (TCJA) of 2017 temporarily increased Bonus Depreciation to 100% for assets placed in service between 2017 and 2022. However, this is now phasing out according to the following schedule:

2023: 80% Bonus Depreciation
2024: 60%
2025: 40%
2026: 20%
2027 and beyond: 0% (unless Congress extends it)

Who Can Benefit from Bonus Depreciation?

Real estate investors who purchase properties and make significant improvements can use Bonus Depreciation to front-load deductions, reducing taxable income and freeing up capital for further investments. It is especially useful when combined with a cost segregation study, which reclassifies parts of a building into shorter-lived asset categories that qualify for Bonus Depreciation.

How California Treats Cost Segregation Depreciation

1. State Depreciation Rules Differ

While California generally follows federal depreciation methods, it does not conform to bonus depreciation rules.
This means that while you can use cost segregation to accelerate depreciation, California does not allow 100% bonus depreciation, which is available at the federal level under specific tax laws.

2. No Bonus Depreciation in California

Federally, bonus depreciation allows investors to deduct a large portion of their cost segregation savings upfront (e.g., 100% in prior years, phasing down to 80% in 2023).
California does NOT allow bonus depreciation—so accelerated depreciation must be taken over the standard 5-, 7-, or 15-year schedules.

3. California Adjustments May Be Required

If you claim cost segregation at the federal level, you may need to make depreciation adjustments on your California state tax return.
You must track separate depreciation schedules for federal vs. state purposes.

4. Section 179 Deductions Still Available

California allows Section 179 deductions, but with lower limits than federal rules.
This means some asset categories (like equipment or fixtures) may still qualify for immediate expensing, even if bonus depreciation isn’t available.

5. 1031 Exchanges Still Work

If you use a 1031 exchange, cost segregation can still provide benefits for depreciation recapture strategies at both the federal and state levels.

Getting Started

If you’ve purchased an investment property in the last 5–10 years, a cost segregation study could be a game-changer for your tax strategy. Contact a specialty tax firm to receive a free estimate on potential tax savings and determine if this strategy is right for you. I recommend reaching out to Geraldine Serrano of Specialty Tax Group.

Final Thoughts

Real estate investors who understand and implement cost segregation can drastically reduce their tax burdens, allowing them to reinvest savings into new properties and continue growing their portfolios. The key takeaway? Know your options and take advantage of tax strategies that work in your favor.