Cost segregation studies can save real estate investors thousands of dollars a year on their tax bill, even for smaller properties. But there are some important things to know to ensure you maximize your deduction and don’t run afoul of the IRS.
We use DIY cost segregation but there are other companies who do cost segs, take a look and feel free to use whatever company you’d like:
Code for residential discount: 1275
Code for Commercial discount: 1275C
Improvement Vs. Land Value For Depreciation
When you buy a rental property, you get to depreciate the acquisition cost, less the land, over 27.5 years. Depreciation is an annual deduction meant to track the deterioration of your property and it helps shelter your ongoing cash flow.
Here’s an example:
- I buy a property for $100k. I allocate $10k to land, so $90k is allocated to Improvements (the building).
- I depreciate the $90k over 27.5 years (39 years for non-residential property).
- This yields $3,273 in annual depreciation.
I get to claim that amount against my rental income every year as an expense. I do not have to spend any additional money in order to claim the $3,273… think of it as a “thank you” from our government for investing in U.S. housing.
But how, exactly, did I determine that I should allocate $10k to land. Why not $5k? Why not $60k?
Many CPAs use a “rule of thumb” method of 20-25%. This means that regardless of where you purchase your property, they will allocate 20-25% of the purchase price to land.
While that may be okay in some cases, you should understand that if you use the rule of thumb method, and you are later challenged under audit, you’re probably going to lose on the allocation because you have no actual support to substantiate your allocation of the value to land.
The BEST way to allocate between land and improvements, and the best way to substantiate the allocation under audit or Tax Court, is to use the property assessor’s allocation.
In my example, the property assessor may have shown a $45k improvement value and a $5k land value.
This means land is 10% of the total value. I apply that 10% to MY purchase price to get MY land value allocation.
So in my example where I purchased a property for $100k, I get a land value allocation of $10k… the remainder of $90k is allocated to improvements.
For our Tax Smart Investors who are in CA, AZ, NYC, NJ, and other high-cost areas, you may find that the property assessor shows a land value allocation of 50-80%!
Think about that.
I buy a property for $1MM and I have to allocate $800k to land, which cannot be depreciated, and only $200k is allocated to improvements.
My annual depreciation, in this case, would be only $7,273.
But if instead I purchased a $1MM property in an area with a 20% land allocation and an 80% improvement allocation, I’d be depreciating $800k of improvements over 27.5 years… or $29,090 per year.
Do you see why allocating more value to improvements is better? It gets you a higher annual derpeciation deduction!
But… BE CAREFUL.
In the Tax Court case Nielsen v. Commissioner, T.C. Summary Opinion 2017-31, the taxpayer lived in Los Angeles and didn’t like the property assessor’s land value allocation so they came up with their own.
The taxpayer contended the county assessor’s data was “extraordinarily inaccurate,” but the Tax Court did not agree and held that the LA assessor valuation was the correct allocation to use.
While the Tax Court acknowledged a taxpayer is qualified to testify as to the value of their entire property, it found no authority suggesting a taxpayer is qualified to allocate the value of property between land and improvements.
So if you work with a CPA, tax preparer, or cost seg firm that tells you to use 20-25%, just know that you may be challenged one day and you may lose.
Especially if you’re in an area where land comes at a premium.
Example: 15400 E 48th St, Kansas City, MO 64136-1181, Jackson County
Land $5,634 + Improvements $62,007 = $67,641
$5,634/$67,641 = 8.33%
Purchase Price $550,000
550,000 x 8.33% = $45,815
$45,815 is the land value on $550,000 purchase price.
FAQ’s
1. How do I determine the land value of a rental property for depreciation?
Pull the latest county assessor record, note the land and improvements values, calculate the land percentage, then apply that % to your closing price—the result is your non-depreciable land basis.
2. What if my assessor data feels off—any estimating land value shortcuts?
Cross-check the assessor ratio against three local sold comps or order a restricted-use appraisal (≈ $600). If the ratio differs by >10 points, keep the appraisal PDF with your tax file.
3. How do I calculate my land value versus improvements, step by step?
1) Land % = land ÷ (land + improvements). 2) Multiply that % by purchase price. 3) Everything else becomes depreciable improvements. Keep the math in your file in case of audit.
4. What does a DIY cost segregation study actually involve?
You answer an online questionnaire, upload photos, and receive a component breakdown that slots assets into 5-, 7-, 15- and 27.5-/39-year buckets—usually within 24 hours for < $500.
5. Is cost segregation DIY safe, or when should I pay for an engineer?
DIY works for sub-$1 M basis rentals where the audit risk is low; once projected extra depreciation tops ≈ $250 K, most CPAs recommend an engineering study for defendability.
6. What goes into a cost segregation calculation?
List every component, assign cost, map each to its MACRS class, run the year-one deduction, and compare to straight-line; quality studies document methodology in a Form 3115 attachment.
7. Does Kansas cost segregation (or cost segregation Kansas) have quirks?
Yes—land is often <15 % of value, so studies there tend to reclassify a larger share to 5- and 15-year property, boosting first-year deductions.
8. How does an Arizona cost segregation study differ?
Desert infill lots push land closer to 25-35 %; the benefit is still solid, but not as dramatic as in the Midwest.
9. Any special considerations for a New Jersey cost segregation?
Because NJ often allocates ≥50 % to land and does not conform to federal bonus depreciation, an engineer-level study is almost mandatory to squeeze value into shorter lives.
10. Is cost segregation worth it in high-land markets like Los Angeles?
If land is 60 %+ of the deal, bonus depreciation savings shrink, but pairing a study with § 179D energy deductions or a partial-disposition election can restore much of the benefit.
11. How to calculate land value for depreciation on a home I’m converting to a rental?
Use the assessor land %, but apply it to your original basis (purchase price + closing costs), not today’s FMV—that’s the method the IRS expects per Publication 527.
12. What does cost segregation mean in plain English?
It’s an IRS-approved way to carve a building into faster-depreciating pieces so you front-load tax write-offs and free up cash today.
