A cost segregation study splits a building's cost into parts that can be depreciated faster, such as fixtures, flooring and site improvements, instead of depreciating the whole building over 27.5 or 39 years. A 1031 exchange lets you sell investment real estate and defer the tax on the gain by buying like-kind real estate under strict deadlines. Cost segregation increases deductions now. A 1031 exchange postpones the tax when you sell, including some of the depreciation you took. Planned together, they can defer a great deal of tax. Planned separately, the recapture can arrive when you least expect it.
What is a cost segregation study?
When you buy a rental property, the purchase price (minus land, which is never depreciated) is normally depreciated as one asset: over 27.5 years for residential rental property and 39 years for commercial property. In reality, a building contains many components. Carpet, cabinets, some electrical work, appliances and parking lots wear out much faster.
A cost segregation study, usually done by engineers or specialists, identifies those components and assigns them shorter recovery periods, commonly 5, 7 or 15 years. That moves depreciation into the early years of ownership. The IRS publishes an audit techniques guide for cost segregation, and a well-documented study is what holds up.
How did bonus depreciation change?
Bonus depreciation lets you deduct a large share of the cost of qualifying shorter-lived property in the first year. It had been phasing down after 2022. The July 2025 federal tax law (Public Law 119-21) restored 100% bonus depreciation permanently for qualifying property acquired after January 19, 2025. Combined with a cost segregation study, that can produce a very large first-year deduction on a newly bought property. Property bought under a written binding contract signed before January 20, 2025 does not count as acquired after that date. For the first tax year ending after January 19, 2025, an owner can elect 40% instead of 100% (IRS, Notice 2026-11, January 2026).
Depreciation is a loan from your future self. Recapture is when it comes due.
Can you actually use the losses?
Not always. Rental activity is generally passive, and passive losses can only offset passive income, with the rest carried forward. Exceptions include:
- Real estate professional status. If you spend more than 750 hours a year in real property businesses you materially take part in, and that is more than half your working time, rental losses can offset other income. The record-keeping matters.
- Short-term rentals. When the average guest stay is seven days or less and you materially participate, the rental may not be treated as passive. The rules are detailed.
- The $25,000 allowance. Owners who actively participate can deduct up to $25,000 of rental losses against other income, phasing out between $100,000 and $150,000 of modified AGI.
A large deduction that cannot be used this year still has value later, but the plan should know which case applies.
What is recapture?
When you sell, depreciation you took comes back into the tax calculation. Gain from depreciation on the building itself is "unrecaptured section 1250 gain", taxed federally at up to 25%. Gain from depreciation on the shorter-lived components identified in a cost segregation study is generally recaptured as ordinary income, at your regular rate. Faster depreciation means more of the eventual gain is taxed that way.
How does a 1031 exchange work?
Under section 1031, if you sell real property held for investment or business use and buy like-kind real property, you can defer the tax on the gain, including the recapture. Since 2018, only real property qualifies. The rules are strict:
- 45 days from the sale to identify replacement property in writing.
- 180 days from the sale to close on it, or the due date of your return if earlier.
- A qualified intermediary must hold the proceeds. If you touch the cash, the exchange fails.
- Equal or greater value and debt to defer the full gain. Cash or debt relief you receive, called boot, is taxable.
One catch for cost segregation owners: shorter-lived components in the old property are personal property for some purposes. If the replacement property has less of that kind of property, some recapture may be taxable even in a valid exchange (Internal Revenue Code section 1245(b)(4); Treasury Regulation section 1.1031(a)-3, December 2020).
What happens at the end?
Under current law, property held until death generally receives a basis stepped up to market value, which can erase the gain deferred through years of depreciation and exchanges. That makes estate planning part of the real estate strategy. Utah has no state estate tax. Utah taxes the gain on a taxable sale at its flat individual rate, 4.45% for 2026. Utah starts from federal adjusted gross income under the Internal Revenue Code in effect for the year, and its list of additions and subtractions has no adjustment for bonus depreciation or 1031 exchanges, so it follows the federal treatment of both (Utah Code sections 59-10-103, 59-10-104 and 59-10-114, current as of October 2026).
A hypothetical example
Hypothetical. A Utah investor buys a small apartment building and orders a cost segregation study, which identifies a meaningful share of the price as 5-, 7- and 15-year property. With 100% bonus depreciation, much of that is deducted in year one. Because the investor qualifies as a real estate professional, the loss offsets other income. Five years later the investor sells. Without a plan, a large part of the gain is recaptured as ordinary income. With a plan, the investor exchanges into a larger property under section 1031 and orders a new study, deferring the tax again. Whether that chain makes sense depends on how long the investor intends to hold, and what heirs will receive.
Real estate wealth runs on taxes. Our page for real estate professionals describes how a CPA and a fiduciary advisor work deals, depreciation and estate planning as one plan. We take no commission on any property or exchange.
Educational only. Not investment, tax, or legal advice. Every situation is different; the right answer depends on the numbers, and that's what the strategy session is for. Investing involves risk, including possible loss of principal.