Should You Consider a Cost Segregation Study for Your Rental Property?

Cost segregation for rental and short-term rental properties: what it is, how it works, tax benefits, bonus depreciation, Section 481(a), and real-estate professional rules.

Tram Le, CPA

11/1/20254 min read

If you own rental real estate — especially a short-term rental (STR) — you may have heard of “cost segregation.” It sounds technical, but at its core, cost segregation is simply a tax timing strategy: it helps you deduct more of your investment sooner.

With proper planning, it can be one of the most impactful tax tools available to real estate investors. But like any strategy, it must fit your situation.

Let’s break it down.

What Is Cost Segregation?

When you buy property, the IRS requires you to depreciate the structure slowly — over 27.5 years for residential rentals or 39 years for commercial buildings.

Cost segregation analyzes the building and identifies items that can be depreciated much faster — over five, seven, or fifteen years — rather than decades.
Examples include:

  • Cabinets and built-ins

  • Flooring

  • Decorative lighting

  • Appliances

  • Window treatments

  • Sidewalks, landscaping, parking pads

Reclassifying these components allows you to deduct a larger portion of the property’s cost earlier in its life.

Why this matters:
A deduction today is worth more than the same deduction spread over 27+ years. Earlier deductions mean:

  • Lower current-year tax burden

  • More cash flow to reinvest

  • Faster payback on your investment

The total depreciation doesn’t change — only the timing does — but timing can make a big difference.

Why Short-Term Rentals Benefit Most

Most long-term rentals are “passive activities,” meaning depreciation losses can typically only offset passive rental income.

Short-term rentals can qualify as non-passive if:

  • The average stay is seven days or less, OR

  • The average stay is 30 days or less AND you provide substantial services,
    AND

  • You materially participate

When a property is treated as non-passive, depreciation — including from cost segregation — can offset:

  • W-2 income

  • Business income

  • Portfolio income

This opens the door to significant tax savings in the year the study is done.

This is why cost segregation has become especially relevant for STR owners.

Bonus Depreciation Magnifies the Benefit

Many of the components identified in a cost segregation study qualify for bonus depreciation, which allows you to deduct a large portion of the cost in year one.

Even though bonus depreciation is phasing down, it still provides meaningful acceleration. And if your property was placed in service in a year with a higher bonus rate, you may still be able to use that rate when a study is done later.

For example:
A property placed in service in 2022 can still potentially capture 100% bonus depreciation after a study is performed.

This timing detail is one of the most overlooked opportunities.

You Can Apply Cost Segregation Retroactively

Many investors believe that if they didn’t perform cost segregation the year the property was placed in service, they missed their chance. Not true.

If cost segregation wasn’t done in prior years, you can “catch up” depreciation through a Section 481(a) adjustment, which is reported on Form 3115. This adjustment allows you to deduct all the extra depreciation you would have taken in past years — in one current-year deduction, without amending prior returns.

For clients with a high-income year, this can be extremely valuable.

When Cost Segregation Makes Sense

Cost segregation is worth considering when:

  • Your property has a meaningful value (often $500K+)

  • You operate a short-term rental and materially participate

  • You qualify as a Real Estate Professional

  • You have high taxable income

  • You plan to hold the property at least 3–5 years

  • You’ve made significant improvements

  • You purchased or renovated in the last 10 years (or want to use §481(a))

In these cases, the tax benefits often outweigh the study cost by a wide margin.

It can also make sense when:

  • You have passive income from other rentals

  • You plan to 1031-exchange or hold long-term

  • You’re doing estate planning, where step-up in basis resets depreciation

When Cost Segregation Is NOT Worth It

Cost segregation is not always the right move.
It may not be worthwhile if:

  • Property value is relatively low

  • You cannot use the losses (e.g., long-term rental + no passive income)

  • You plan to sell soon (recapture too soon)

  • You elected out of interest limitation rules under §163(j) (ADS → no bonus)

  • The building is very old with little remaining basis

  • Personal-property components are minimal

Suspended passive losses are not wasted — they carry forward — but immediate tax benefit may be limited.

This is why planning and modeling matter.

Frequently Asked Question:

“Does tax savings today just mean I’ll pay more later?”

Not exactly.

When you sell, some of the accelerated depreciation may be subject to depreciation recapture. But:

  1. Recapture may be taxed at lower rates than your ordinary income tax rate today

  2. You receive the time value of money benefit

  3. You may avoid or defer recapture entirely via:

    • A 1031 exchange

    • Estate step-up in basis

In estate planning, step-up often eliminates recapture entirely — making accelerated depreciation effectively permanent tax savings.

How Much Can You Save?

It depends on:

  • Purchase price (and land allocation)

  • Property type

  • Amount of reclassifiable components

  • Bonus depreciation available

  • Your tax bracket

  • Whether you can use the losses

Residential properties often reclassify 15–25% into shorter lives; commercial buildings can be higher.

In practice, a cost segregation study often produces tax savings of 3–10 times the study cost in year one, especially for STRs and high-income taxpayers.

That’s why many investors explore it early in ownership.

What a Study Involves

A professional cost segregation provider typically:

  • Reviews building plans & records

  • Evaluates each component

  • Identifies short-life assets

  • Performs an engineering-based analysis

  • Prepares a written report

  • Provides depreciation schedules

  • Assists your tax professional with Form 3115, if relevant

A quality study offers detailed support that stands up to IRS scrutiny and provides the documentation your CPA needs to apply the deductions correctly.

How to Decide

If you own a rental or STR, the next best step is a feasibility review.
This is simply a high-level estimate based on:

  • Acquisition cost

  • Land allocation

  • Property type

  • Bonus eligibility

  • Your tax profile

From there, you can decide whether it’s worth engaging a study provider.

Final Thoughts

Cost segregation is a powerful, IRS-approved strategy that can significantly reduce taxes and enhance real-estate cash flow — particularly for short-term rental hosts and active real-estate investors.

It isn’t appropriate for everyone, but when applied thoughtfully, it accelerates deductions into the years when tax benefits matter most.