How Bonus Depreciation and Cost Segregation Interact

Cost segregation and bonus depreciation are separate rules that work together. A study identifies which components have short recovery periods. Bonus depreciation, where available, decides how quickly the cost of those components can be deducted. Understanding the division of labor prevents a common confusion.

A simple division

• The study decides the classification: which parts of the cost are 5, 7, 15, 27.5, or 39 year property.
• Bonus depreciation decides the pace of deduction for qualifying property: how much is deductible in the first year.

A study without bonus still accelerates depreciation, because 5, 7, and 15 year property depreciates faster than 27.5 or 39 year property. Bonus accelerates it further.

Without bonus

Suppose a component is classified as 5 year property. Without bonus, it is generally depreciated using an accelerated method over about six tax years, because of the convention. The deduction is spread, though front-loaded. Similarly, 15 year property is depreciated using a declining balance method over 15 years. Even so, the pace is faster than 27.5 or 39 years straight line.

With bonus

If bonus applies at 100 percent, the whole cost of qualifying property may be deducted in the first year, subject to any election out and other limits. At a lower percentage, that percentage is deducted at once and the remainder is depreciated under regular rules. See Bonus Depreciation: Rules as Currently Understood (Verify).

What does not qualify

The building itself, at 27.5 or 39 years, generally does not qualify for bonus, so a large part of the cost of a typical building stays on the long schedule. Land is not depreciable. That is why the size of the shift matters. A building with a small portion in short-lived categories will not produce a large bonus deduction.

Qualified improvement property

Certain interior improvements to nonresidential buildings, known as qualified improvement property, have a 15 year recovery period and are generally eligible for bonus depreciation, subject to conditions. This is separate from a study's classification but can interact. Discuss with your preparer.

Interaction with the usable-loss question

A large first-year deduction increases the importance of whether you can use it. If the deduction is limited, the bonus may create a suspended loss. See The Passive Activity Loss Rules and Cost Segregation and Suspended Losses and Carryforwards.

Interaction with elections

You can generally elect out of bonus for a class of property. If you do, the regular accelerated schedule applies. Some owners elect out to avoid creating a loss that they cannot use, or to spread deductions. Ask whether that fits your case.

Interaction with recapture

Accelerated deductions can be recaptured on sale, and the character of the gain depends on the property class. Personal property classified through a study is where ordinary-income recapture can arise. See Depreciation Recapture on Sale: What Comes Back.

An illustration with placeholders

Hypothetical: a building with a $500,000 depreciable basis where a study shifts $100,000 into 5, 7, and 15 year categories. With 100 percent bonus as assumed for illustration, $100,000 might be deducted in year one. Without bonus, only a fraction might be deducted that year, with the rest spread over subsequent years. The remaining $400,000 stays on the long schedule either way. See Hypothetical: A Single Rental With Usable Deductions for a fuller labeled hypothetical.

Why calculators can mislead

A calculator that assumes a fixed percentage and full bonus may overstate or understate what applies to your situation. Use calculators only for screening.

Questions to keep in mind

Does bonus apply to the assets the study identified? At what percentage? Do I want to use it? What will it do to my loss limits and my state return? What will it do to the gain at sale? Working through these turns the combined effect of the two rules into a series of answerable questions.

A comparison in words

Consider two owners with identical buildings and identical studies. Owner one is in a year where bonus applies at a high percentage. Owner two is in a situation where bonus does not apply, for example because of an election out. Both benefit from the study's reclassification, but owner one deducts much more in year one, and owner two deducts on the regular accelerated schedule over several years. The study is the same. The bonus rule changes the pace.

Choosing to elect out

Some owners elect out of bonus to avoid creating a large loss that they cannot use, or to spread deductions across years when their income is higher. Electing out applies by class of property for the year and generally cannot be undone casually. Discuss the trade-offs with your preparer, including the effect on state returns and on future recapture.

Why the first-year figure is not the whole picture

The first-year figure is impressive when bonus applies, but it is a timing figure. What matters to the decision is the difference between the study and the no-study path over time and after the exit. Keep that comparison in front of you when a proposal highlights only the first-year deduction.

Next steps

Read Section 179 Versus Bonus Depreciation for the Study Decision for the alternative deduction and Depreciation Classes: 5, 7, 15, 27.5, and 39 Years for the classes involved.