If you’re a residential rental real estate owner looking for effective methods to lower your tax burden, cost segregation is the ideal strategy. Running a Cost Segregation Study (CSS) on your rental property can defer your tax burden, while boosting cash-flow.
Residential Rental Property
If you own residential real estate that you rent to others, you have to pay taxes on your rental profits (income less expenses). All types of residential rental properties qualify for this tax treatment.
Types of Rental Properties
Here is a list of the most common types of residential real estate that are commonly rented out:
Apartments
Apartment complexes are usually fully owned by a single person/company. Therefore, for tax purposes, an apartment building would be considered one depreciable asset.
Single-Family Homes
Many rental properties are in the form of single family houses. This is an example of a secondary residence that is owned, but rented out to a tenant or tenants. Cabins may be grouped in with these homes as well, though they also can be classified as Vacation Rentals (anchor tag to Chapter 3).
Row/Townhomes
Townhomes are individual units with their own lawns, sidewalks and other amenities that are connected to each other as one major unit. They share walls and can have multiple stories, but each have their own entrance and are individually owned.
Duplex/Fourplex
Plexes, like apartments, are usually owned by one sole entity or person. The absence of an indivisible interest makes performing a CSS on your plex a lot simpler since it is one whole property.
Condos
Conducting a CSS on condominiums can be a little more complex. Although you may have sole ownership in a condo within a complex, you have an indivisible interest in the complex’s different amenities. For example, if your condo complex were to repave the parking lot, the cost of this improvement would be split evenly between all of the condo owners, regardless of how often/if they use the parking lot themselves. The same goes for complex-wide plumbing and landscaping.
Renting Part of Primary Residence
Since your primary residence does not generate revenue, it’s not considered a “business asset,” and therefore is not subject to the tax rules that a typical commercial real estate investment is. However, if you rent out part of your primary residence, there are tax implications that you need to be aware of.
In this situation, you can generally prorate expenses for the property like property taxes, fire insurance, utilities and repairs, based on the percentage of the home’s total square footage that is dedicated to the rented area(s). You can also directly expense any costs dedicated to the rental area itself, like furniture and liability insurance. Lastly, you can depreciate part of the building’s basis as well (more on that later).
Understanding the different types of residential real estate rentals, as well as how these investments are treated for tax purposes, is essential for proper tax and wealth-generating strategies.
Rental Property Depreciation
To better understand the concept of depreciation, check out our blog post, What Is Cost Segregation? However, for residential rental properties, there are a few additional components to consider.
Short Term Rental vs Long Term Rental
Regardless of the type or rental property you own, how you rent it out is a key factor on its tax treatment. If the lease between the owner and the tenant is for thirty days or more, on average, the property is considered a long-term rental, and is generally depreciated straight-line over 27.5 years.
However, short-term rentals, like vacation rentals, are generally rented for less than thirty days per stay. In this case, the residential rental is treated more like a hotel and is considered commercial property, which needs to be depreciated straight-line over 39 years.
Bonus Depreciation Rental Property
Bonus depreciation equates to additional depreciation deductions that are available in the first year of ownership. The amount of bonus depreciation available for a residential rental property is directly related to the date the property was placed in service, as a performing business asset. For more details on this, check out our blog post, The One Big Beautiful Bill Act Reintroduces 100% Bonus Depreciation for Real Estate Cost Segregation.
Rental Property Depreciation Calculator
Here’s a quick example of how depreciation works for residential rental properties. To calculate your depreciation, you need to consider three details:
- Life: As discussed above, the “life” of the property is typically 27.5 years for long-term rentals, and 39 years for short-term rentals.
- Method: Like all assets with a Life greater than 20 years, the Method for residential rentals (regardless of short- versus long-term) is called “straight-line”. This means you capture the same amount of depreciation expense each year during the life of the rental.
- Convention: Convention has to do with how you compute depreciation in the first year. For residential rental properties (as is for commercial properties), the Method is called “mid-month”. This means you get half a month’s depreciation for the month the property was placed in service, plus all the remaining months in that first tax year.
Here’s how it works. Let’s say you bought a property for $500,000 with the intent of renting it out as a vacation rental (i.e. short-term), and placed it in service on July 1. The Life is 39 years, the Method is straight-line, and the convention is mid-month. Next, for depreciation purposes, you have to “carve-out” an amount for the land, that doesn’t depreciate.
Let’s say you determine that 20% of the purchase price is associated with the value of the land. Therefore, the remaining 80%, or $400,000, is the depreciable bases of the improvements (i.e. building and land improvements). Here’s how you calculate your depreciation in Year 1:
Your annual straight-line depreciation is $400,000/39 years = $10,256. However, with mid-month convention, you can only claim 45.83% of this your first year (half of July, plus the remaining five months). Therefore, your Year 1 depreciation deduction is $4,701. Then, for the next 38 years, your deduction is the $10,256, and your 40th year of ownership has the deduction of the remaining $5,555.
Allowed or Allowable Depreciation
Depreciation is considered an “allowed” or “allowable” expense. “Allowed depreciation” is the amount of depreciation you actually deducted as an expense on your tax returns, over the tax years that you’ve owned the property to date. “Allowable depreciation,” on the other hand, is the total amount of depreciation you could have deducted, whether you claimed this amount as an expense against income during the ownership period or not.
Although this distinction is largely irrelevant during the years of ownership, it’s an important concept when it comes time to sell your residential rental property. When you sell the property, you must reduce the basis of the asset by the depreciation that was allowed or allowable, whichever is greater.
This means that even if you didn’t deduct the full amount of depreciation you were entitled to, the IRS will adjust the basis of the property as if you had taken the full allowable expense. You will then be liable for depreciation recapture tax on that amount, regardless of whether you claimed all that deprecation as expenses against income in the years you owned it.
Rarely is claiming less than the allowable depreciation deduction each year beneficial. However, you should verify this with your tax professional (i.e. CPA) for your specific tax situation.
Cost Segregation Study for Rental Property
You can do a cost segregation study (CSS) on any residential rental property to accelerate your depreciation deductions in the earlier years of ownership. For a deeper dive on cost seg, check out our blog post, What Is Cost Segregation? However, you should make sure you can use these addition deductions before you decide to move forward with a CSS.
Because depreciation deductions offset income in determining your tax liability, you need to determine what “bucket” of income can be offset. If you’re generally “hands-off” from the day-to-day management of your residential rental, this would be considered passive income, and your expenses can only offset the passive income from this rental property and any other passive income you may have realized.
However, if you materially participate in the rental activity, the accelerated depreciation from your CSS could offset your active income as well, possibly including your W2 wage income. To learn more on this, check out our blog post, Cost Segregation and the Real Estate Professional Designation.
Cost Segregation Study Residential Rental Property
Completing a CSS on residential rental property is similar to that of commercial property. However, there are nuances in the Legal Analysis (LA) of some of the Items you find in a residential rental.
For example, some underground utilities that may be reclassified as personal property for a commercial building may need to remain as real property in a residential rental CSS. That’s why it’s imperative that whoever is completing the LA component of scope in your CSS be proficiently familiar with the complex cost segregation body of law.
Cost Segregation Study Short Term Rental
Likewise, if your residential rental is deemed a short-term or vacation rental, you may have additional details to consider. As discussed above, a short-term rental has to be treated more like a hotel than a single-family house or an apartment building. Therefore, the tax treatment of the real property components, as well as some of the specific Items you identify in your CSS, may need to be modified compared to a long-term residential rental.
Although it’s best to perform a CSS in the first year of owning your property, this is not required. If you’ve owned the property for more than a year, and you’ve been depreciating it straight-line on at least one filed tax return, a CSS will give you the opportunity to “catch-up” on the accelerated depreciation deductions you originally missed. For more on this, check out our blog post, IRS Form 3115: How to Apply Cost Segregation to Existing Properties.
Although you can catch up on missed depreciation deductions, the longer you wait, the less valuable it may be. That’s why it’s important to run a Matrix Benefit Estimate through Titan Echo before pulling the trigger on a Cost Segregation Study.
Cost Segregation Real Estate Examples
Here are two examples of how cost seg benefits a residential rental owner.
Cost Segregation Study - Residential Rental Property Example
Let’s assume you’ve owned a duplex, where you’ve rented out both units since you bought it on 9/1/23. If you were to conduct a CSS on this property, and capture the catch-up depreciation on your 2025 tax return, here’s what the numbers might look like:
- Purchase Price: $650,000
- Land Value: $140,000
- Accumulated Depreciation as of 12/31/24: $23,955
- Reclassified personal property via cost seg: $130,000.
In this scenario, you could have accumulated as much as $101,593 in depreciation on last year’s tax return. The good news is, you can capture this on your 2025 return by completing the CSS and including the Form 3115 on the return.
Cost seg short term rental example
Let’s say, for example, that you purchased a vacation rental property in Capitola, California for $1,500,000 on 02/01/2025. Although a short-term rental like this will likely generate significant revenue, this comes with a greater tax burden. If you were to conduct a CSS on your rental property in the 2025 tax year, you could severely reduce this tax burden and use that extra cash to reinvest. Here’s what it might look like:
First, you’ll need to carve out the cost of the land, since it doesn’t depreciate (whether you do cost seg or not). For this example, let’s say the land is worth $600,000 of the initial purchase price. This leaves you with a $900,000 depreciable asset. Of this dollar amount, a percentage will be reclassified as tangible personal property with depreciable lives of five or 15-years, instead of the straight-lined 39-year schedule.
Let’s say that 15% ($135,000) of this $900,000 is reclassified as 5-year property, and 10% ($90,000) as 15-year. In this scenario, the tax savings you could capitalize on through cost segregation maths out like this:
As shown above, with cost segregation you would be able to deduct an additional expense of $219,952 on your 2025 taxes. Assuming you have ~220k in taxable income that can be offset, you could use this deduction to offset it completely! Of course, if your 2025 income is less than this amount, the remaining unused deductions will carry over into next tax season.
Assuming a tax rate of 35%, with cost segregation, you would be able to save $76,983 in taxes in 2025. What would you do with this freed-up cash?
Conclusion
For both long-term and short-term (vacation) rental real estate owners, cost segregation is a hugely beneficial tax strategy goldmine that offsets the income you receive from renting (and possibly other income streams), which in turn lowers your tax burden. You can use this newly freed up cash to reinvest in growth, or in any way you deem fit.
FAQs
Here are some frequently asked questions about cost segregation for residential rentals.
Can you do cost segregation on residential rental property?
Absolutely. But before you do, you should verify the additional depreciation deductions will benefit your tax strategy.
Can I use cost segregation on a vacation home?
Yes. Your vacation home is considered business property if you stay there yourself no more than 14 days a year, or 10% of the total days rented. If this is the case, cost segregation is an excellent tax strategy worth considering.
Can You Do Cost Segregation on Primary Residence?
Although the home you occupy does not qualify for cost segregation, if you rent out part of your home, it may be eligible for a cost seg study. See above for more details.
How do you determine depreciation on a rental property?
Depreciation is determined based on the life, method and convention of the asset being depreciated. See above for more details.
Can You Take Bonus Depreciation on Rental Property?
Certainly, once you carve out the personal property from the real property via cost segregation. Bonus depreciation is a statutory calculation, based on the date the personal property assets were placed in service.
Is Depreciation Different for Short Term Rental Property?
Residential rental properties, both short-term and long-term can be depreciated. However, short-term rentals are typically depreciated over 39 years, while long-term rentals are depreciated over 27.5 years.
Can I Rent Out Part of My Primary Residence?
Of course. In addition, you should be able to deduct certain operating expenses that you otherwise wouldn’t if you weren’t generating revenue from the property.
