🇺🇸 Made in America·100% U.S.-Based Team · 24+ Years in Cost Segregation
Yes, a childcare center is one of the better buildings for cost segregation, but only if the loss it creates can reach your return. Most center owners hold the real estate in one LLC and lease it to their own operating company, and that setup can leave a depreciation loss stuck as passive while the operating profit is taxed in full. Settle the structure with your CPA first. Once it is settled, a fully engineered and accounted cost segregation study will usually move 20 percent to 35 percent of the depreciable basis of a licensed center out of 39-year depreciation and into 5-, 7- and 15-year classes, and property bought and placed in service after January 19, 2025 takes 100 percent bonus depreciation on those classes in year one.
What follows applies whether you run the center yourself or lease the building to an operator.
Linda ran a 96-child center in Hilo, Hawaii for eleven years as a tenant. In March 2025 her landlord retired and she bought the building for $2,000,000. The appraisal put the land at $300,000. She put the real estate in Lehua Properties LLC and kept the center itself in her S corporation, because her attorney wanted a wall between the playground and any lawsuit. Her CPA set up a 39-year schedule on $1,700,000 and moved on.
Her first-year depreciation on that schedule was $34,561. The center cleared $410,000 of profit that year and Linda paid tax on all of it. She had just spent $2,000,000 on a building full of kitchen equipment, keypad doors, cameras, fenced play yards, poured rubber surfacing and a drop-off loop paved for 200 car trips a day, and the schedule treated every bit of it as drywall.
When you buy or build a nonresidential building, the default is to depreciate everything but land over 39 years, straight-line. Land is never depreciable. A $1,700,000 depreciable basis produces about $43,600 a year once the mid-month convention settles out, no matter what is inside the walls.
The code does not treat every component that way. Under MACRS, tangible personal property that serves a business function rather than the building is recovered over 5 or 7 years. Land improvements such as paving, fencing, playground surfacing and drainage are recovered over 15 years. Only the structure and the general building systems belong at 39 years. A cost segregation study is the engineering work that sorts a purchase price into those classes with documentation an examiner can follow.
Section 168(k) lets you deduct a percentage of qualifying property, generally property with a recovery period of 20 years or less, in the year it is placed in service. That percentage had been phasing down: 80 percent in 2023, 60 percent in 2024, and 40 percent for property acquired on or before January 19, 2025, since the acquisition date, meaning the binding contract date, controls the rate. The One Big Beautiful Bill Act, signed July 4, 2025, restored 100 percent bonus for property acquired and placed in service after January 19, 2025. Bonus is automatic; the election is to opt out. Under Notice 2026-11 the contract date can matter more than the closing date.
Used buildings qualify. Linda bought from an unrelated seller and had never owned the property, so every dollar her study moves into the short classes takes bonus in year one. Owners who bought in 2023 or 2024 get the rate that applied when the building was placed in service, through the lookback below.
Every building is different and the study decides each item on the facts. These are the categories that come up in nearly every childcare center.
Playground equipment gets its own look. Depending on how it is anchored and whether it is built to be relocated, the study examines it as personal property or as a land improvement, and writes down why.
The shell, roof, foundation, load-bearing walls, windows, general HVAC, sprinklers, restroom plumbing, main electrical service and fire alarm. A credible study leaves these alone. The owner who pushes a toilet partition into a 5-year class to pad the number is the owner who invites a challenge.
Many centers began life as an office, a retail bay or a church. Interior improvements you make to a nonresidential building after it was first placed in service can be qualified improvement property, a 15-year straight-line class of its own that is eligible for bonus. Enlargements, elevators and escalators, and the internal structural framework are excluded, and the improvement must be one you made as the taxpayer. Whether a component is Section 1245 or Section 1250 property decides both its recovery period and the tax on sale.
This example is illustrative. The percentages are hypothetical and are not a typical result for any building. Purchase price $2,000,000, land $300,000, depreciable basis $1,700,000, placed in service in March, federal marginal rate 37 percent.
The full $1,700,000 sits in the 39-year class. The mid-month convention for March gives a first-year rate of 2.033 percent, which is $34,561 of depreciation.
Assume the engineering supports this split, which is 30 percent of basis, near the middle of the range for a licensed center.
| Class | Share of basis | Amount | First-year depreciation |
|---|---|---|---|
| 5- and 7-year personal property | 17 percent | $289,000 | $289,000 (100 percent bonus) |
| 15-year land improvements | 13 percent | $221,000 | $221,000 (100 percent bonus) |
| 39-year building | 70 percent | $1,190,000 | $24,193 (2.033 percent) |
| Total | 100 percent | $1,700,000 | $534,193 |
First-year depreciation with the study is $534,193. Without it, $34,561. The additional first-year deduction is $499,632. At a 37 percent federal rate that is $184,864 of federal tax Linda does not send in April, if the loss reaches her return. The study fee is a small fraction of that.
Two things are true at the same time. This is a timing benefit; total depreciation over the life of the building is the same and recapture applies when you sell. And the deduction is only worth something if you can use it. That depends on how Linda holds the building, which is the next section and the one most center owners skip.
If the building and the center sit in the same entity and you materially participate in running it, the depreciation is a deduction against a non-passive business. The loss reaches your return and offsets the center's profit, subject to the excess business loss limit below. This is the cleanest case. The material participation tests decide it.
This is Linda, and it is most owners. Under Reg. 1.469-2(f)(6), rent you receive from a business in which you materially participate is recharacterized as non-passive. The rule runs one way: net income is pulled out of the passive basket while a net loss stays in it. So the $499,632 loss in Lehua Properties LLC is passive, and Linda's S corporation profit is non-passive, and the two do not meet. She pays tax on $410,000 while a $499,632 deduction sits in a carryforward. That is the self-rental trap.
There is a fix, and it has to be made before the return is filed. A grouping election under Reg. 1.469-4(d)(1)(ii) can treat the rental and the operating business as one activity when they form an appropriate economic unit and each owner holds the same proportionate interest in both, which is the case when the same person owns both. Grouped, the loss offsets the center's profit. Have that conversation with your CPA before you order the study, while the election can still go on a timely filed return.
If you lease to an unrelated operator and you are not a real estate professional, the loss is passive. It offsets passive income from other rentals and the rest carries forward. Suspended losses wait; a fully taxable sale of your entire interest to an unrelated party releases them. Real estate professionals who clear 750 hours and more than half their working time in real property trades, and who materially participate in the rental, treat the loss as non-passive; spouses cannot combine hours.
Even a non-passive loss runs into Section 461(l). An individual can use a net business loss against wages and investment income only up to $313,000 single or $626,000 on a joint return for 2025, adjusted annually; the excess becomes a net operating loss carryforward. Linda and her husband file jointly, and once the activities are grouped, the $499,632 of depreciation against the center's $410,000 profit leaves a net business loss of $89,632, well under the cap. For tax years beginning in 2026 the cap is $256,000 single and $512,000 joint.
The IRS Audit Techniques Guide describes six approaches to cost segregation and prescribes none. Our team works only under the first two, Approaches 1 and 2: detailed engineering from actual cost records where they exist, and engineering with documented estimates reconciled to the actual purchase price where they do not. Under those approaches an engineer takes Linda's building apart on paper, component by component. The kitchen exhaust hood is measured, costed, tied to the invoice or the reconciled estimate, and assigned a class with a written reason. The drop-off loop is quantified in square yards of asphalt and linear feet of curb. The result is a component schedule the CPA imports straight into the fixed asset system and an examiner can trace line by line back to the purchase price. The report is signed by credentialed professionals, engineered in the United States, and defended for as long as you own the building, with no time limit, hour cap or added fee: written responses and participation in examiner calls alongside your CPA. An estimate from a calculator gives you a percentage and nothing to hand the examiner. That is the whole difference, and it shows up in the one year it matters.
Most center owners bought before anyone mentioned cost segregation. You do not lose the deduction. A study on a building you have owned for years supports a change in accounting method on Form 3115, and the missed depreciation lands on the current return as a Section 481(a) adjustment. No amended returns. The catch-up is computed at the bonus rate of the year the building was placed in service, so a 2022 purchase catches up at 100 percent, a 2023 purchase at 80 percent, a 2024 purchase at 60 percent. Cost Seg America prepares the 481(a) computation and, for a separate fee, the Form 3115; your CPA files it. The lookback study has its own post, and the deadline is the filing date of the return, extensions included.
Improvements you made since buying get their own analysis. The tangible property regulations decide what is a repair you deduct now and what you capitalize, and when you replace a roof or a playground the partial asset disposition election, made as a rule on that year's timely filed return, lets you write off the old one's remaining basis in the year you tear it out.
If you built your center you hold the best documentation there is: pay applications, subcontractor invoices, change orders. The engineer traces actual cost, which is Approach 1 and the strongest file you can have. Site work on a new center can run a quarter of the project cost, and without a study it is buried in the building at 39 years. Placed in service means the day the building is ready and available for its intended use, which for a licensed center can turn on the state inspection, and that day often differs from the closing. Confirm that day before you assume the year.
Depreciation runs on cost, whatever the equity. Linda put $400,000 down and borrowed the rest, and her deduction runs on the full $1,700,000. Operators with several locations should pace the studies so the excess business loss limit does not swallow part of the deduction. Owners trading up through a like-kind exchange keep the deferral, and a 1031 exchange can defer the Section 1245 recapture, subject to the replacement property carrying enough Section 1245 property to absorb it.
Depreciation on the 5- and 7-year property is recaptured under Section 1245 as ordinary income up to the amount claimed; on the 15-year land improvements, the bonus taken in excess of straight-line is ordinary income under Section 1250 and the rest is unrecaptured Section 1250 gain at a maximum 25 percent. Depreciation on the building is unrecaptured Section 1250 gain, taxed at a maximum of 25 percent. If Linda sells in year three, most of the $499,632 comes back as ordinary income and she has traded a 37 percent deduction for a 37 percent inclusion with only the time value between them. If she holds ten years, reinvests the $184,864 in a second location, or exchanges out, the arithmetic favors the study. The recapture math is worked through in its own post. Passive owners should also ask their CPA about the 3.8 percent net investment income tax and the QBI deduction.
Risk comes from the quality of the work: rule-of-thumb percentages, no documentation, and structural components pushed into short classes. An examiner tests the component schedule, the reconciliation to the purchase price and the reasons written beside each class. Cost Seg America has stood behind its studies in more than 125 IRS examinations with zero losses and $0 returned, and the same questions should be put to anyone you consider, including us.
Below $180,000 of depreciable basis after land, the fee eats the benefit and we will tell you so. If you plan to sell within two or three years, recapture usually outweighs the time value of the deduction. If you are a passive investor with no passive income and no plan to sell, the loss sits in a carryforward and the study has paid for a deduction you cannot spend yet. And if your center and your building are in separate entities and your CPA will not make the grouping election, run the numbers on a suspended loss before you spend a dollar.
Yes. You own the building, so you depreciate it. The question is whether you can use the loss, which depends on your passive income and whether you qualify as a real estate professional.
No. A lookback study supports a Form 3115 that catches up the missed depreciation on your current return at the 100 percent bonus rate that applied in 2021. No amended returns.
Surfacing, grading, edging and fencing are examined as 15-year land improvements. The equipment itself can go either way depending on how it is anchored and whether it is built to be moved. The study writes down the reason.
Yes, as long as you had not used the property before and the seller is not a related party, and it was acquired and placed in service after January 19, 2025.
Without a grouping election, usually yes. The self-rental rule makes the rent non-passive but leaves the loss passive. Grouping the two activities under Reg. 1.469-4 is the fix, and it has to be on the return.
Depreciation on the personal property comes back as ordinary income. Depreciation on the building comes back at up to 25 percent. A 1031 exchange can defer both, subject to the replacement property carrying enough Section 1245 property.
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Send Jim Dougherty and his team the purchase price, the closing date, the land allocation and the entity that holds the building. You will have a free proposal in 24 hours showing what a fully engineered and accounted study would move and what it would cost, and a plain answer if a study is not right for your center. Call 1-888-365-5023 or email info@costsegamerica.com, and bring your CPA.
This article is for educational purposes only and is not tax, legal or accounting advice; the example is hypothetical, so confirm your facts with your CPA before acting.
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