By Steve Forbes, Jr. | Managing Partner of Forbes & Company
Every real estate developer knows that a project’s success depends on more than design, entitlements and construction schedules. Cash is the fuel that keeps a development pipeline moving, and one of the most effective ways to free up more of it is hiding in plain sight inside the cost of the buildings you’re already putting up. That strategy is cost segregation, and when it’s paired with today’s depreciation rules, it can turn a new building into a substantial tax deduction in the very first year it’s placed in service.
At Forbes & Company, real estate is one of our core specialties. From our offices in Alpharetta, Georgia and Charleston, South Carolina, we work with developers, investors and builders across the country, and we’ve seen how much of a difference the right depreciation strategy can make on a project’s returns. Here’s how cost segregation works, why it can be especially valuable for developers and why the decision to sell or hold a property changes the picture completely.
What is cost segregation?
How does cost segregation accelerate depreciation?
When you build or buy commercial or residential rental property, the tax code generally requires you to depreciate the building over a long period, 27.5 years for residential rental property and 39 years for nonresidential property. Without any further analysis, every dollar of construction cost that isn’t land gets lumped into that long schedule, which means your deductions trickle in slowly over decades.
A cost segregation study is an engineering-based analysis that breaks a building’s total cost into its individual components and identifies which of them actually belong in shorter recovery periods. Things like specialty electrical systems, certain plumbing, cabinetry, carpet, decorative lighting, parking lots, sidewalks and landscaping often qualify as 5-, 7- or 15-year property rather than part of the building itself. The IRS describes the process and what it expects to see in a quality study in its Cost Segregation Audit Techniques Guide, which is worth knowing about because it’s the same guide examiners use when they review a study.
Why does 100% bonus depreciation make cost segregation so powerful right now?
Shorter recovery periods alone would speed up your deductions, but bonus depreciation is what makes cost segregation so compelling today. The One Big Beautiful Bill Act (OBBBA) permanently restored 100% bonus depreciation for qualified property acquired and placed in service after January 19, 2025, and the IRS issued interim guidance in Notice 2026-11 confirming how the acquisition date rules work. Property with a recovery period of 20 years or less, which includes most of the components a cost segregation study identifies, can be deducted in full in the year it’s placed in service rather than over its recovery period. You can find the general depreciation rules, including recovery periods and bonus depreciation, in IRS Publication 946, How to Depreciate Property.
The result is that a meaningful share of a new building’s cost, often somewhere in the range of 20% to 40% depending on the property type, can move from a decades-long schedule into a first-year deduction.
Why cost segregation can be especially valuable for developers
Developers are in a uniquely strong position to benefit from cost segregation, and there are a few reasons why.
- You have the best cost data. Investors who buy existing buildings often have to rely on estimates to allocate a lump-sum purchase price. Developers have detailed construction records, including contractor pay applications, schedules of values, change orders and invoices, which makes the study more precise and easier to defend.
- New construction tends to produce larger reclassifications. Modern buildings, especially those with significant site work, amenities, specialty systems or tenant-specific features, often contain more short-life components than older properties.
- Large projects create large deductions. Because the benefit scales with cost, a multi-million-dollar project can generate first-year deductions that meaningfully change your tax picture for the year.
- Timing can be planned in advance. Developers can bring a cost segregation provider in during design and construction, so costs are tracked in a way that supports the study from day one rather than being reconstructed later.
- Cash flow matters most during lease-up. The first years after a building is placed in service are often when cash is tightest, which is exactly when a large depreciation deduction does the most good.
The critical distinction: Developers who sell vs. developers who hold
Before going any further, every developer needs to understand one rule that determines whether cost segregation helps at all: only property you hold for use in a business or for the production of income can be depreciated. Property you hold primarily to sell to customers is treated as inventory, and inventory can’t be depreciated, no matter how carefully its costs are analyzed.
What happens if you build to sell?
If you’re a merchant builder or developer who constructs homes, condos or commercial buildings for sale, those properties are generally treated as inventory, and you’re likely to be considered a dealer for tax purposes. Your construction costs are capitalized into the property and recovered as cost of sales when each unit or building is sold, and the profit is generally taxed as ordinary income rather than capital gain. Cost segregation doesn’t create any additional deductions in that situation because there’s nothing to depreciate.
That doesn’t mean tax planning stops there. Build-to-sell developers can focus on properly capitalizing and allocating costs, timing closings between tax years, choosing the right entity structure to manage self-employment tax and considering installment treatment where it’s available. It does mean, however, that cost segregation is really a strategy for developers who keep what they build.
What happens if you build to hold?
If you develop property to lease out, whether that’s an apartment community, a build-to-rent subdivision, an office building, a retail center or industrial space, the property is depreciable once it’s placed in service, and that’s where cost segregation shines. Developers who hold their projects can capture large first-year deductions, use those deductions to offset income and keep the resulting cash working in their business for years.
What about developers who build, lease up and then sell?
Many developers fall somewhere in between, building a project, stabilizing it with tenants and then selling within a few years. Those properties are often depreciable while they’re held, but the plan to sell changes the math. When a property is sold, depreciation you claimed is generally recaptured. Depreciation on personal property components is typically taxed as ordinary income, accelerated depreciation on land improvements can be partly recaptured at ordinary rates too, and straight-line depreciation on the building itself is generally taxed at a maximum federal rate of 25% for individual owners. IRS Publication 544 explains how depreciation recapture works on the sale of business property.
Recapture doesn’t erase the benefit, because you’ve had the use of the tax savings in the meantime and the deduction may have offset income taxed at a higher rate. Even so, a short hold period shrinks the advantage, so it’s important to model the expected sale date before ordering a study. A like-kind exchange under Section 1031 can defer gain on a sale, although recapture on personal property components can still be triggered unless the replacement property includes enough similar property, which is one more reason to plan these transactions together. It’s also worth documenting your intent on each project at the start, since the IRS looks at factors like how long you hold properties, how often you sell and how you market them when deciding whether you’re a dealer or an investor.
Step 1: Identify assets that qualify for faster depreciation
Which building components qualify for shorter recovery periods?
The first step is identifying which parts of your project aren’t really part of the building’s structure. A qualified cost segregation professional, usually an engineer working alongside your CPA, reviews plans, specifications, cost records and the property itself to find components such as:
- 5-year and 7-year personal property, including carpet and certain flooring, cabinetry and millwork, decorative lighting, appliances, window treatments, dedicated electrical and plumbing for equipment, and security, data and telecommunications systems
- 15-year land improvements, including parking lots, sidewalks, curbs, site lighting, landscaping, fencing, signage, outdoor amenities, stormwater systems and site utilities
- 15-year qualified improvement property, which covers certain interior improvements to nonresidential buildings made after the building is first placed in service, a category that’s especially relevant for tenant build-outs and renovations
When should a developer start the cost segregation process?
The best time is early. Bringing a cost segregation provider in during design or construction lets your team organize contractor billing and cost tracking in a way that maps cleanly to asset categories. That makes the study more accurate, reduces fees and gives you a stronger file if the study is ever examined.
Does the construction start date matter?
It does, and it matters more each year. For self-constructed property, the acquisition date for bonus depreciation purposes is generally when physical work of a significant nature begins, which can be different from the day a project officially breaks ground. Projects where that work began on or before January 19, 2025 stay under the older phase-down schedule, which generally allows only 20% bonus depreciation for property placed in service in 2026 and none for property placed in service in 2027 or later, with a one-year delay for certain longer production period property. That means a project started in 2024 and finished in 2027 may get no bonus depreciation at all on its components. Under existing regulations, developers can sometimes elect to treat individual components that weren’t substantially underway by that date separately, which can preserve 100% bonus depreciation on part of the project. Keeping clear records of when construction started and when each major component began is well worth the effort.
Step 2: Reclassify eligible costs into shorter recovery periods
What makes a cost segregation study defensible?
Once components are identified, their costs have to be reclassified out of the 27.5- or 39-year building category and into the appropriate shorter recovery periods. This is where the quality of the study matters. The IRS Audit Techniques Guide outlines the elements it considers part of a quality study, including preparation by someone with the right expertise, a clear explanation of the methodology, use of actual cost records where available, engineering take-offs, and a reconciliation of allocated costs to the project’s total actual cost.
For developers, the strongest studies tie each reclassified component back to your actual construction documentation, such as the general contractor’s schedule of values, subcontractor invoices and change orders. Indirect costs like architectural fees, permits, construction interest and developer fees also need to be allocated properly across asset categories, and a good study explains how that was done.
How are land and building costs separated?
Land isn’t depreciable at all, so the study also needs to separate land from improvements. Land improvements such as paving and site utilities are depreciable over 15 years, which is a big reason developers with significant site work often see larger reclassifications.
What if a building was placed in service in a prior year?
You haven’t necessarily missed your chance. If you own a building that was placed in service in an earlier year without a cost segregation study, you can usually commission a “look-back” study and claim the depreciation you missed in the current year by filing Form 3115, Application for Change in Accounting Method, rather than amending prior returns. The catch-up deduction, called a Section 481(a) adjustment, can be substantial, although the bonus depreciation rate available depends on when the property was acquired and placed in service.
Step 3: Claim larger deductions earlier
How much can cost segregation lower taxable income?
Here’s a simplified example. Suppose a developer completes a $12 million nonresidential project, with $2 million allocated to land and $10 million to the building and site improvements, and places it in service this year. Without cost segregation, that $10 million would be depreciated over 39 years, producing a first-year deduction of roughly $250,000 at most, and often less depending on the month it’s placed in service.
Now suppose a cost segregation study reclassifies 25%, or $2.5 million, into 5-, 7- and 15-year property eligible for 100% bonus depreciation. That $2.5 million can be deducted in the first year, on top of regular depreciation on the remaining $7.5 million. For an owner in the 37% federal bracket, an extra $2.5 million deduction could reduce federal income tax by more than $900,000 in that year, assuming the owner can use the loss.
What limits can affect how much of the deduction you can use?
Large deductions are only valuable if you can actually use them, so a few rules deserve attention before you file:
- Passive activity rules. Rental real estate is generally treated as passive, so losses created by depreciation may only offset passive income unless you qualify as a real estate professional and materially participate. Developers who are active in the industry full time are often well positioned to qualify, but the hour-tracking requirements are strict.
- Excess business loss limitation. Very large business losses for individual owners can be capped in the current year, with the excess carried forward, and OBBBA made this limitation permanent.
- The business interest limitation election. Many leveraged real estate businesses previously elected out of the Section 163(j) interest limitation as an electing real property trade or business. That election requires slower depreciation under the alternative depreciation system and makes qualified improvement property ineligible for bonus depreciation. OBBBA restored a more favorable interest limitation calculation, and the IRS issued Revenue Procedure 2026-17 allowing eligible businesses to withdraw a prior election, so it’s worth revisiting that decision if it applies to you.
- State tax rules. Not every state follows federal bonus depreciation. Georgia and South Carolina both decouple from it, so developers in those states need to compute depreciation separately for state purposes, and the state benefit will come in more gradually than the federal one.
Step 4: Put the tax savings to work
How can developers use the cash flow from cost segregation?
The real value of cost segregation shows up in what you do with the savings. Because accelerated depreciation is largely a timing benefit, the goal is to put today’s tax savings to work earning a return before any recapture comes due. Developers commonly use the cash to:
- Fund equity for the next project, reducing the need for outside capital or expensive mezzanine financing
- Pay down construction or bridge debt, especially higher-rate loans, which lowers interest costs going forward
- Build reserves for lease-up, so concessions, vacancies and early operating shortfalls don’t strain the project
- Reinvest in the property through amenities, tenant improvements or upgrades that support higher rents and stronger occupancy
- Strengthen the balance sheet to improve your position with lenders and partners on future deals
Should developers plan for recapture?
Yes. Since depreciation may be recaptured if you sell, it’s smart to keep your expected hold period and exit strategy in mind and to set aside a portion of the savings if a sale is likely within a few years. For long-term holders, the deferral can last for decades, and depending on your estate plan, the benefit may become permanent if the property is held until death and receives a basis adjustment.
Your developer cost segregation checklist
Before your next project is placed in service, work through the following with your tax advisor:
- Confirm whether each project will be built to sell, built to hold or held for a limited period, and document your intent
- Bring a cost segregation provider in during design or construction
- Organize contractor pay applications, schedules of values, invoices and change orders by component
- Document when construction began and when major components were started
- Track the placed-in-service date for each building or phase
- Model the expected hold period and potential depreciation recapture before ordering a study
- Review passive activity, real estate professional status and excess business loss limits
- Revisit any electing real property trade or business election in light of Revenue Procedure 2026-17
- Consider look-back studies with Form 3115 for buildings placed in service in prior years
- Plan for Georgia, South Carolina or other state depreciation adjustments
- Decide in advance how you’ll put the tax savings to work
Frequently asked questions
Can a real estate developer use cost segregation on property built for sale? Generally no. Property held primarily for sale to customers is inventory and can’t be depreciated, so cost segregation mainly benefits developers who hold property for rental or business use.
How much of a new building can be reclassified through cost segregation? It varies by property type and design, but studies often reclassify somewhere in the range of 20% to 40% of a building’s depreciable cost into 5-, 7- and 15-year property.
Does 100% bonus depreciation apply to new construction? Yes, for qualifying components with recovery periods of 20 years or less, as long as the property was acquired, or for self-constructed property construction began, after January 19, 2025, and it’s placed in service after that date. The building structure itself still depreciates over 27.5 or 39 years.
What happens to cost segregation deductions when I sell the property? Depreciation is generally recaptured on a sale, with personal property components typically taxed as ordinary income, so it’s important to model your expected hold period and consider tools like a 1031 exchange.
Can I do a cost segregation study on a building I already own? Yes. A look-back study combined with Form 3115 can let you claim missed depreciation in the current year without amending prior returns.
Let Forbes & Company help you build a smarter tax strategy
Forbes & Company is a family-owned accounting firm that’s been client-focused since 1997, and real estate is one of the industries we know best. Whether your next development is in the greater Atlanta area, the Charleston area or anywhere across the United States, we’d love to help you decide whether cost segregation fits your plans, coordinate the study with your project team and put the savings to work for your next deal. Contact us to schedule some time to visit.