🇺🇸 Made in America·100% U.S.-Based Team · 24+ Years in Cost Segregation
A building with apartments over retail sits on one depreciation schedule, never two: 27.5 years if 80 percent or more of its gross rental income comes from dwelling units, 39 years if not, with the rental value of any space you occupy yourself counted in the test. Cost segregation works either way, because the 5-, 7- and 15-year components exist in both the apartments and the storefronts, and with 100 percent bonus depreciation for property acquired and placed in service after January 19, 2025, a fully engineered and accounted study deducts those components in year one. The catch is usability: the loss is passive unless you qualify as a real estate professional, have passive income, or fit the $25,000 allowance, and Section 461(l) caps a large nonpassive loss. Run the 80 percent test and the usability question before the first return is filed.
Ruth Whitfield bought a three-story brick building on a corner lot in Providence, Rhode Island, in February 2025 for $2.4 million. The ground floor held three retail suites: a coffee shop, a hair studio, and a small insurance office. The two floors above held eight apartments. Her CPA looked at the closing statement, asked how the building was being used, and said what CPAs often say about a property that does not fit a neat category: "Let's put it on the 39-year schedule and move on."
Ruth pressed. She asked a follow-up question that turned out to be worth tens of thousands of dollars: "Is it really a 39-year building? Eight apartments is the bigger half of the building."
Ruth and her numbers are illustrative, and nothing here replaces advice from your CPA.
Section 168 gives a building one of two straight-line recovery periods: 27.5 years for residential rental property, 39 years for nonresidential real property. The statutory definition of residential rental property is in Section 168(e)(2)(A). A building or structure qualifies if 80 percent or more of the gross rental income for the taxable year comes from dwelling units. A dwelling unit is a house or apartment used to provide living accommodations, but the definition excludes a unit in a hotel, motel, inn, or similar establishment if more than one-half of the units are used on a transient basis.
Section 168(e)(2)(B) adds a detail many owners miss. If any portion of the building is occupied by the taxpayer, the gross rental income for the test includes the rental value of that portion, so an owner who moves their own business into a ground-floor suite cannot ignore that space in the calculation.
Because the statute speaks of a "building or structure," the test is applied to the building as a whole rather than floor by floor. A mixed-use building that clears the 80 percent threshold is a 27.5-year building. One that does not is a 39-year building. There is no blended schedule in between.
On $1,920,000 of depreciable building basis, a 39-year schedule produces about $49,000 of annual depreciation in a full year, while a 27.5-year schedule produces about $70,000. The bigger story is what happens inside the building.
A cost segregation study is a fully engineered and accounted analysis that identifies the parts of a building that qualify as 5-year personal property, 7-year property and 15-year land improvements, so those costs are recovered far faster than the 27.5- or 39-year building. Our guide What Is Cost Segregation? covers the fundamentals.
The legal framework comes from long-standing tax authorities: the distinction between Section 1245 property and Section 1250 property, the Tax Court's decision in Hospital Corporation of America v. Commissioner, and the six-factor test from Whiteco Industries v. Commissioner that courts and the IRS use to decide whether an asset is part of the building or is separate equipment. The IRS describes what a quality study should contain in its Cost Segregation Audit Techniques Guide, Publication 5653.
Mixed-use buildings are unusually rich in reclassifiable components because they combine two property types under one roof, and the study evaluates each part on its own facts. In the apartments: removable carpet and window coverings, kitchen appliances, dedicated electrical and plumbing serving appliances, and decorative lighting where the facts support it. In the storefronts: millwork and counters tied to the tenant's business, specialty electrical and data cabling that serves equipment, specialty plumbing for salon stations or food preparation, signage, display fixtures and non-structural tenant partitions. On the site: parking, striping, curbing, sidewalks, landscaping, irrigation, fencing, site lighting, drainage and dumpster enclosures, typically 15-year land improvements. Our guide to tenant improvements and cost segregation goes deeper on the commercial side.
The study does not assume a percentage. Each property produces its own result based on construction details, finishes, and how the building is actually used, which is why the estimated study, a percentage applied from other buildings, is no substitute.
Return to Ruth and her $2.4 million building. Suppose the land is allocated at 20 percent, or $480,000, leaving $1,920,000 of depreciable basis. (Land is never depreciable, which is why the land value allocation matters so much.) The rental income looks like this:
Apartment income is $168,000 out of $228,000 total, or about 73.7 percent. That is below 80 percent, so the building is nonresidential real property and the building structure is depreciated over 39 years.
Now suppose the retail suites are smaller or rent for less, producing $36,000 per year. Apartment income is $168,000 out of $204,000, or about 82.4 percent. The building passes the 80 percent test and is residential rental property on a 27.5-year schedule.
A single change in the rent roll moved the same building from one schedule to the other. Know where you stand before the first year of depreciation is claimed, and run the calculation when buying or leasing. Whether a later change in the rent mix affects the classification is a question for your CPA.
Suppose Ruth decides to move her own consulting business into the vacant ground-floor suite. Under Section 168(e)(2)(B), the rental value of that space must be added to gross rental income for the 80 percent test. If the fair rental value is $18,000 per year, the nonresidential share of the denominator grows, and a building that previously passed the test can fall below 80 percent. Owners who plan to occupy part of a mixed-use building should model this before deciding on the layout.
The following is an illustration. It assumes the first scenario above, a 39-year building placed in service in February 2025 with $1,920,000 of depreciable basis, and a study that reclassifies 22 percent of that basis to shorter lives. Actual percentages vary widely by property.
| Item | Without a study | With a study |
|---|---|---|
| Basis reclassified to 5-, 7-, and 15-year property | $0 | $422,400 |
| Year-one deduction on reclassified property (100% bonus) | $0 | $422,400 |
| Year-one depreciation on remaining building (39-year, February placed in service, 2.247% table rate) | $43,142 | $33,651 |
| Total year-one depreciation | $43,142 | $456,051 |
| Illustrative federal tax value at a 37% bracket | $15,963 | $168,739 |
In this example, the study accelerates $412,909 of additional deductions into year one. Total depreciation over the life of the property does not increase, because you cannot depreciate more than your basis. What changes is timing, and timing has value because a dollar of tax saved today can be invested, used to pay down debt, or put toward the next acquisition. Two limits apply to a deduction that size. The loss has to be nonpassive, which is covered below. And Ruth and her husband file jointly, so Section 461(l) caps the business loss they can deduct against other income at $626,000 for 2025 ($313,000 single), adjusted annually; for 2026 the cap is $512,000 joint and $256,000 single. The $412,909 clears the 2025 joint cap, and a single owner would carry about $99,909 forward as a net operating loss. Our article on the 2026 loss cap has the detail.
Had the same building passed the 80 percent test, the remaining building would produce $47,654 of year-one depreciation at the 3.182 percent February table rate for 27.5-year property, and the total would be $470,054. The study works in both scenarios.
Bonus depreciation turns reclassification into a large first-year deduction. Under Section 168(k), property with a recovery period of 20 years or less qualifies, and the One Big Beautiful Bill Act, signed July 4, 2025, restored 100 percent bonus permanently for qualifying property acquired and placed in service after January 19, 2025. Our article on 100 percent bonus depreciation under the OBBBA walks through the details. Only the segregated components with shorter recovery periods qualify; the building structure, whether 27.5 or 39 years, stays on its schedule. That is exactly why a mixed-use building without a study leaves value on the table: the bonus-eligible components are buried inside the long-lived building cost. Used property qualifies when you did not previously use it and bought it from an unrelated party, which most arm's-length purchases of existing mixed-use buildings satisfy.
Owners who renovate a commercial suite sometimes hear that the work qualifies as qualified improvement property, or QIP, a 15-year straight-line category eligible for bonus depreciation. That is often correct for nonresidential buildings, because the statutory definition of QIP is an improvement by the taxpayer to an interior portion of a building that is nonresidential real property, after the building was placed in service, excluding enlargements, elevators and escalators, and the internal structural framework.
If a mixed-use building passes the 80 percent test and is residential rental property, the interior improvements to its retail suites are not QIP simply because they are in the commercial portion. The work can still be accelerated. A cost segregation study can identify tenant-specific components, such as specialty plumbing and electrical, millwork and fixtures, that qualify as 5- or 7-year property under the Whiteco factors. The route is different, and the analysis has to be done carefully.
Short-term rentals are now common in mixed-use buildings. A unit in a hotel, motel, inn or similar establishment does not count as a dwelling unit if more than half of the units are used on a transient basis, so an owner who converts most of a building's units to nightly rentals can push the whole building onto the 39-year schedule. Owners who keep long-term tenants in the majority of units are in a different position. Take the facts to your CPA before the schedule is set.
A large first-year deduction only helps if the loss can be used. Rental real estate is generally a passive activity under Section 469, and passive losses can offset only passive income unless an exception applies. The exceptions matter a great deal to mixed-use owners:
Losses that cannot be used in the current year carry forward as suspended passive losses and are released when substantially all of the activity is sold in a fully taxable transaction. Section 461(l), shown above, sits on top of the passive rules.
When a mixed-use building is sold, gain attributable to the 5- and 7-year personal property components is taxed as ordinary income up to the depreciation previously claimed under Section 1245. Gain attributable to the building's straight-line depreciation is "unrecaptured Section 1250 gain," taxed at a maximum federal rate of 25 percent. Fifteen-year land improvements are Section 1250 property with ordinary recapture on the excess over straight-line.
Many owners manage this by holding long term, exchanging into replacement property under Section 1031, which can defer the gain subject to the replacement property's own mix of components, or planning around the holding period and their other income. For the full picture, read our article on what happens to recapture when you sell. A partial asset disposition election, made on a timely filed return, can also be valuable when components are replaced.
If you bought years ago and have depreciated the whole building on one line, a study still works. The missed depreciation is captured in the current year through an automatic accounting method change on Form 3115, as a Section 481(a) catch-up, without amending prior returns and at the bonus rate of the year the property was placed in service. Our article on look-back studies and Form 3115 explains the mechanics. Renovations are a fresh set of assets to analyze, and studying the work in the year it is completed is cleaner than reconstructing it later.
Mixed-use properties carry two sets of facts to support: the closing statement and land value support, plans where they exist, the rent roll with residential and commercial income separated, commercial leases, renovation invoices, any owner-occupancy details with fair rental value, and booking data if nightly rentals are part of the property. The building review is an in-house analyst's proper inspection on larger properties, or the owner walks the building on a live video call or follows a guided photo and video checklist that the team reviews frame by frame.
The IRS Audit Techniques Guide describes six common approaches to a study and prescribes none. A fully engineered and accounted study works under the first two, Approach 1 from actual cost records and Approach 2 from documented estimates reconciled to the purchase price, and delivers a component schedule your CPA can import and the engineering support behind it, signed by credentialed professionals, which an examiner can trace line by line. The estimated study hands you a percentage with nothing underneath it. Cost Seg America defends every study for as long as you own the building, no time limit, no hour cap, no additional fee, with written responses and participation in examiner calls alongside your CPA. Our summary of what the Audit Techniques Guide says covers the rest.
Skip the study when the depreciable basis after land is under $180,000, when you plan to sell within a couple of years so that ordinary-rate recapture arrives before the time value has done much, or when the loss would be passive with no passive income, no real estate professional in the household and no sale in sight. A suspended loss still has value at the eventual sale, but far less than the proposal number, and you should go in knowing that.
Yes. Mixed-use buildings often contain a wide range of reclassifiable components because they combine apartment finishes, commercial buildout, and site improvements.
It depends on the 80 percent test. If 80 percent or more of the building's gross rental income comes from dwelling units, it is residential rental property and depreciates over 27.5 years. If not, it is nonresidential real property and depreciates over 39 years.
The rental value of the space you occupy is included in gross rental income for the 80 percent test under Section 168(e)(2)(B), which can move the building below the 80 percent threshold.
Only on qualifying components with recovery periods of 20 years or less that a cost segregation study identifies, assuming the property was acquired and placed in service after January 19, 2025 and meets the other requirements. The building structure itself stays on its 27.5- or 39-year schedule.
They can. A dwelling unit does not include a unit in a hotel, motel, inn, or similar establishment if more than half of its units are used on a transient basis. If short-term rentals make up most of the building's use, the building may be classified as nonresidential and depreciated over 39 years. Confirm your facts with your CPA.
QIP applies to improvements to the interior of nonresidential real property. If your mixed-use building is classified as residential rental property, its commercial suites do not automatically qualify as QIP, though other components may still be reclassified through a cost segregation study.
Ruth ran the 80 percent test, landed at 73.7 percent, put the structure on 39 years and commissioned the study. The conversation that started with "Let's put it on the 39-year schedule and move on" ended with a plan.
If you own, are buying, or are renovating a mixed-use building, send Jim Dougherty and his team the address, the purchase price and the rent roll split between apartments and commercial suites. You will have a free proposal in 24 hours showing the schedule the building belongs on, the projected first-year deduction from a fully engineered and accounted study and the fee. Call 1-888-365-5023 or email info@costsegamerica.com.
This article is for general educational purposes and does not constitute tax, legal, or accounting advice. The examples are illustrative, and your results will depend on your property, your facts, and current law. Consult your CPA or tax advisor before making any tax decision.
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