Depreciation is one of the most effective tax-saving tools for commercial real estate owners. Depreciation enables taxpayers who own commercial or residential rental properties to deduct the cost of their property (excluding land) over time, accounting for wear and tear. The IRS mandates a 39-year straight-line depreciation schedule for commercial properties; however, advanced strategies, such as cost segregation studies and bonus depreciation, can significantly enhance tax savings. This article examines these strategies, offers practical examples, and provides guidance to help you optimize your tax position.
Understanding Depreciation Basics
Depreciation enables property owners to recover the cost of their investment by deducting a portion of it annually from their taxable income. For commercial real estate, the IRS assigns a 39-year useful life, meaning the property’s cost (excluding land, which is not depreciable) is divided equally over 39 years using the straight-line method.
How It Works
The depreciable basis is the property’s cost minus the land’s value. For example, a $1,000,000 office building with $200,000 allocated to land has a depreciable basis of $800,000. Dividing this by 39 years yields an annual deduction of approximately $20,512.82 ($800,000 ÷ 39). At a 37% tax rate, this results in a tax savings of approximately $7,589.74 per year.
Eligibility
To qualify, the property must be used for business or investment purposes, must be in service for its original intended use, have a determinable useful life, and be expected to last more than one year. Land improvements, such as parking lots, may qualify for shorter depreciation periods (15 years), but the land itself is not eligible for depreciation.
Accelerating Depreciation with Cost Segregation
Cost segregation is a powerful strategy to accelerate depreciation deductions by reclassifying interior land improvements into shorter recovery periods of 5, 7, or 15 years rather than the standard 39-year recovery period. These studies involve detailed engineering-based calculations to identify building assets, such as kitchens, various types of flooring, accent lighting, security systems, finishes, or land improvements, that qualify for faster depreciation.
How Cost Segregation Works
A cost segregation study requires a team of tax professionals and engineers to examine the property’s components. They allocate costs to categories based on IRS guidelines, such as personal property (5 or 7 years) or land improvements (15 years). This reclassification allows owners to front-load deductions, improving cash flow in the early years of ownership.
Example: Office Building
Consider a $1,000,000 office building purchased in 2025, with $200,000 allocated to land, resulting in an $800,000 depreciable basis. Without cost segregation, the annual depreciation is $20,512.82. A cost segregation study reclassifies the following:
This first-year deduction of $53,772.89 nearly triples the standard $20,512.82, saving an additional $12,000 in taxes at a 37% tax rate ($53,772.89 - $20,512.82 × 37%).
When to Conduct a Study
The optimal time is when the property owner experiences a significant tax liability. “Look-back” studies can be performed on properties owned for many years, allowing owners to claim missed deductions without amending prior tax returns using IRS Form 3115, which is used to change an accounting method. The costs for a study typically range from $5,000 to $15,000, but the savings far exceed this expense. The fees for the cost study can also be expensed as tax preparation.
Benefits and Risks
- Benefits: Increased cash flow, reduced tax liability, and potential for retroactive savings
- Risks: Depreciation recapture upon sale, where accelerated deductions are taxed at ordinary income rates, up to 37%. Strategies like 1031 exchanges or Delaware Trusts can defer this tax.
Leveraging Bonus Depreciation in 2025
Bonus depreciation, also known as the special depreciation allowance under Section 168(k), allows owners to deduct a significant portion of qualified property costs (those components with a 20-year class life or less) in the year they are placed in service. In 2025, the bonus depreciation rate is 40% for property placed in service after December 31, 2024, and before January 1, 2026, decreasing to 20% in 2026 and phasing out by 2027 (IRS Publication 946).
Qualified Property
Bonus depreciation applies to property with a recovery period of 20 years or less, including:
- Qualified Improvement Property (QIP): Interior improvements to nonresidential real property, such as lighting, drywall, or HVAC upgrades, placed in service after December 31, 2017. QIP has a 15-year recovery period, making it eligible for bonus depreciation
- Tangible personal property, like furniture or equipment, which have a 5-year class life
- Certain land improvements, such as landscaping or parking lots, have a 15-year class life
Exclusions include property used in utilities, acquired from related parties, or previously owned by the taxpayer.
Example: QIP Renovation
Suppose an owner spends $100,000 on QIP in 2025, such as renovating an office’s interior. They can deduct 40% ($40,000) immediately under bonus depreciation. The remaining $60,000 is depreciated over 15 years, yielding an additional $4,000 annually ($60,000 ÷ 15). The first-year total deduction is $44,000, resulting in a savings of $16,280 at a 37% tax rate.
Combining with Cost Segregation
Cost segregation greatly increases bonus depreciation by identifying more assets eligible for the 40% immediate deduction. In the office building example, the $100,000 of a 5-year property and the $100,000 of a 15-year property could qualify for bonus depreciation, allowing an immediate deduction of $80,000 (40% of $200,000), plus regular depreciation on the remaining amounts.
Timing Considerations
With bonus depreciation phasing out, 2025 is a crucial year to take action. Owners should prioritize qualifying improvements before the rate drops to 20% in 2026 or disappears in 2027 unless Congress extends it, as attempted in 2024 (Nolo).
Practical Tips for Maximizing Deductions
- Engage Professionals: Hire a CPA or tax advisor specializing in real estate to ensure compliance and optimize strategies. Cost segregation studies require specialized engineering expertise, so choose firms with a proven track record of experience.
- Conduct Timely Studies: Perform cost segregation studies soon after acquisition or renovation to maximize early deductions as long as there is a tax liability to offset. Look-back studies can recover missed opportunities.
- Track Improvements: Maintain detailed records of all property purchases and improvements to substantiate bonus depreciation and cost segregation claims during IRS audits.
- Monitor Tax Law Changes: Stay informed about potential extensions of bonus depreciation or changes in capital gains rates, which could affect long-term planning.
- Consider 1031 Exchanges: To mitigate depreciation recapture, explore 1031 exchanges or Delaware Statutory Trusts to defer taxes by reinvesting sale proceeds into like-kind properties.
Key Considerations
- Depreciation Recapture: Accelerated deductions increase the risk of recapture upon sale, taxing prior deductions at ordinary income rates. A 1031 exchange can defer this liability by reinvesting in another property.
- Tax Law Complexity: Rules for QIP, bonus depreciation, and cost segregation are intricate and subject to change. Professional Engineering and Tax guidance is essential to avoid errors.
- State Tax Variations: Some states, such as California, do not conform to federal bonus depreciation rules, which can potentially reduce state-level savings (Wolters Kluwer).
- Audit Risk: Overly aggressive cost segregation or improper Qualified Improvement Property (QIP) classifications may trigger IRS scrutiny. Ensure studies comply with IRS guidelines, such as those in the Cost Segregation Audit Techniques Guide.
Case Study: Retail Center Renovation
A real estate investor purchases a $2,500,000 retail center in 2025, with $500,000 allocated to land. The $2,000,000 depreciable basis yields a standard annual deduction of $51,282.05 ($2,000,000 ÷ 39). A cost segregation study reclassifies $600,000 as follows:
- $200,000 (5-year, fixtures): $40,000/year
- $200,000 (7-year, HVAC): $28,571.43/year
- $200,000 (15-year, parking lot): $13,333.33/year
- $1,400,000 (39-year, structure): $35,897.44/year
First-year depreciation without bonus depreciation is $117,802.20, resulting in a savings of $43,586.81 at a 37% rate. If the $400,000 in 5- and 7-year property qualifies for 40% bonus depreciation, an additional $160,000 is deducted immediately, increasing the first-year total to $237,802.20 and tax savings to $87,986.81.
Conclusion
Maximizing depreciation deductions through cost segregation and bonus depreciation can significantly reduce a commercial real estate owner's tax liability, freeing up capital for reinvestment or debt reduction. By reclassifying assets and leveraging immediate deductions, owners can enhance cash flow, particularly in 2025, when bonus depreciation remains available at 40%. However, these strategies require careful planning and professional expertise to navigate complex tax rules and mitigate risks, such as depreciation recapture. Acting promptly and consulting with tax advisors can help you capitalize on these opportunities before they expire.