Cost Segregation, Bonus Depreciation, and the California Gap

If you bought, built or improved real estate this year, or plan to before December 31, the federal rules for 2026 are generous. Bonus depreciation is back at 100 percent for property acquired after January 19, 2025, and it no longer phases down. A building does not qualify, but many of its parts do. A cost segregation study finds them.

California does not follow these rules, so a large federal loss may barely change the California return. Here is what to watch this quarter.

What bonus depreciation reaches

Residential rental buildings are depreciated over 27.5 years and commercial buildings over 39, with no bonus depreciation. Property with a recovery period of 20 years or less qualifies. Appliances, carpets and furniture in a rental are 5-year property. Roads, fences and shrubbery are 15-year property. Used property counts too, unless you used it before or bought it from a related party.

Qualified improvement property, also 15-year, covers interior improvements you make to a nonresidential building after it was first placed in service, except enlargements, elevators, escalators and internal structural framework. It does not apply to apartment buildings or rental homes.

The 100 percent rate turns on when you acquired the property. A binding contract signed before January 20, 2025, or construction started before then, generally means the old phase-down rate: 20 percent for property placed in service in 2026. IRS guidance on these rules is not yet final.

Placed-in-service timing decides the year

The deduction belongs to the year the property is placed in service. For a rental, that means ready and available for rent, even before a tenant moves in. A December closing on a property that needs work first may not produce a 2026 deduction. Keep proof of the date, such as the listing, photos and the first lease.

If the property is ready in December, the building gets half a month of 2026 depreciation, but bonus-eligible components are written off in full.

How a cost segregation study works

A study allocates your purchase price or construction cost among land, the building and shorter-lived components. The IRS's cost segregation audit guide calls detailed engineering studies built from actual cost records the most accurate approach.

A study tends to pay off when the property has substantial site work, specialized systems or finishes, and the owner can use the deduction now and plans to hold for years. It makes less sense when the loss will sit unused or a sale is near. We weigh the study fee against the tax saved.

For property bought in earlier years, a look-back study claims missed depreciation this year through an accounting method change on Form 3115, usually without amending old returns. Older property generally gets the bonus rate of the year it went into service, which was 100 percent for most property placed in service from late 2017 through 2022.

Section 179 and factory buildings

Federally, Section 179 lets you expense improvements to nonresidential buildings that often miss bonus depreciation: roofs, HVAC, fire protection and alarm systems, and security systems added after the building was first placed in service. The 2026 limit is $2,560,000, reduced once qualifying purchases pass $4,090,000. It requires a business you actively conduct and enough active business income to absorb it, and landlords that are not corporations face extra tests. Apartment buildings are not covered.

Manufacturers have a separate new option: an elective full deduction under Section 168(n) for the production part of a factory whose construction begins after January 19, 2025 and before 2029. California does not follow it.

A deduction you can use

Rental losses are generally passive, so they offset only passive income. If you actively manage the rentals, up to $25,000 of losses can offset other income, but that allowance phases out between $100,000 and $150,000 of modified AGI. Losses you cannot use carry forward until you have more passive income or sell your entire interest in a fully taxable sale. A large study on a long-term rental often produces a loss that waits.

Real estate professionals can treat rental losses as nonpassive. That takes more than half your working time, and more than 750 hours a year, in real property businesses in which you materially participate, plus material participation in the rentals. Short-term rentals averaging seven days or less per guest are generally not rental activities at all. If you materially participate, for example more than 100 hours and at least as much as anyone else, including cleaners, their losses can offset other income. Even then, for 2026, net business losses above $256,000, or $512,000 on a joint return, carry forward to later years.

Selling or exchanging later

When you sell, gain up to the depreciation on the building is unrecaptured Section 1250 gain, taxed at up to 25 percent federally. Gain up to the depreciation on 5- and 7-year components is Section 1245 recapture, taxed as ordinary income. Fifteen-year improvements are generally Section 1250 property, but gain up to the bonus depreciation taken on them beyond straight-line is also taxed as ordinary income. Years of deferral often outweigh the rate difference, but a quick sale can erase much of the benefit.

A 1031 exchange can defer the gain. Many components a study treats as personal property still count as real property in an exchange, but recapture can be triggered if the replacement property has a smaller amount of them. An exchange is not a fully taxable sale, so suspended passive losses generally stay suspended.

The California gap

California allows no bonus depreciation. Its Section 179 limit is $25,000, reduced once qualifying purchases pass $200,000, and it does not recognize the 15-year life for qualified improvement property. A study still helps because components keep shorter lives, but the deduction comes over years.

The bigger surprise is passive losses. California does not follow the real estate professional rule, so a loss that is nonpassive federally because of that status is generally passive for California and stays suspended. Each property needs a separate California depreciation schedule, and its California gain on sale will differ.

What to bring

Bring the closing statement and purchase contract with the signing date, the property tax bill showing land and improvement values, and construction cost records if you built or renovated. If you rely on real estate professional or short-term rental treatment, bring your hours log. Tell us your expected holding period and any planned sale or exchange. For more, see our year-end checklist.

Book a planning call

If you are closing on a property before year end or weighing a study, book a time with our team at calendly.com/kirkcole/15-minute-meeting.

This article is general information, not tax advice for your situation. Tax rules change, and the right move depends on your facts.