Own a San Diego rental and wondering if cost segregation could boost your cash flow this year? With local prices and renovation costs where they are, even small shifts in depreciation can make a real difference. In this guide you’ll learn what cost segregation is, how it accelerates depreciation, what to watch for in California, when a study is worth it, and how it fits with a 1031 exchange plan. Let’s dive in.
What cost segregation does
Cost segregation reclassifies parts of your property into shorter depreciation lives so you can deduct more, sooner. Instead of depreciating almost everything over 27.5 years for residential rentals, a study identifies items that qualify as 5-, 7-, or 15-year property. The result is larger deductions in the early years and improved after-tax cash flow. Total depreciation over time does not change. You are pulling forward deductions, not creating more than your total basis.
How a study works
A typical study is engineering-based. An analyst conducts a site visit, reviews plans and invoices, and prepares a report that allocates your basis into land, building, personal property, and land improvements. This process follows IRS guidance and methods outlined in the IRS Cost Segregation Audit Techniques Guide. A well-documented, engineering-backed report helps reduce audit risk and gives your CPA what they need for your return.
What gets reclassified
- Personal property: items like certain appliances, carpeting, non-structural millwork, and some dedicated electrical or plumbing components. Often 5- or 7-year recovery.
- Land improvements: site fencing, sidewalks, curbs, and similar items. Often 15-year recovery.
- Structural components: walls, roofs, and major systems usually remain on the 27.5-year schedule for residential rental property.
- Land: not depreciable.
Why San Diego investors consider it
San Diego County is a high-cost market. Higher purchase and improvement costs typically mean a larger depreciable basis after you allocate land. That magnifies the dollar value of accelerated depreciation in early years. Many local owners are also in higher marginal tax brackets, which increases the present value of deductions. Property tax under Proposition 13 is not affected by depreciation. Depreciation impacts income taxes, not your assessed value, unless a reassessment event occurs.
California rules to model
California does not fully conform to federal bonus depreciation in many years. If you take federal bonus depreciation, you often add it back for California and then use a different state schedule. The practical outcome is common: federal cash flow improves, while California income may be higher in that year. You want to model combined federal and California results before deciding, especially if you expect large bonus-eligible amounts. California also taxes recapture consistent with its conformity rules when you sell.
Bonus depreciation timing
Bonus depreciation allows immediate expensing of qualifying 5-, 7-, and 15-year property placed in service. Under current phase-down rules, the federal bonus percentage is scheduled to step down over time: 80% for 2023, 60% in 2024, 40% in 2025, and 20% in 2026. The schedule and rules can change, so make timing part of your planning. If bonus depreciation applies to your reclassified items, it can shorten the payback period of a study.
When it is worth it
There is no single cutoff, but common practice uses these screens:
- Below about $200,000 of building basis: unlikely to justify a full engineering study.
- $200,000 to $500,000 of basis: borderline, but often worth a screening or streamlined study.
- Above $500,000 to $1 million and up: frequently supports a full engineering study.
Because many San Diego SFRs and 2–4 unit properties fall above these ranges, a screening is often worth your time.
Costs and payback
Typical fees vary by size and complexity:
- Small SFR or simple 2–4 units: about $2,000-$7,000.
- Larger or more complex assets: $10,000-$30,000 or more.
Payback is usually 1-5 years where a study makes sense, and it can be shorter if bonus depreciation applies and you are in a higher tax bracket. A simple ROI test helps: first-year tax savings divided by study cost. Coordinate with your CPA for an estimate.
Catch-up on older properties
If you did not do cost segregation in prior years, a retrospective study may allow a catch-up adjustment. This is typically filed as a change in accounting method using Form 3115. You do not usually need to amend past returns. The adjustment increases current-year deductions to reflect what you could have taken.
1031 exchanges and cost seg
Accelerating depreciation reduces your tax basis faster. That can increase potential depreciation recapture on sale. For federal tax, unrecaptured Section 1250 gain can be taxed up to 25% for certain amounts. A properly executed 1031 exchange defers both gain and depreciation recapture by rolling into a like-kind replacement property. In practice, many investors combine cost segregation with a future 1031. You get near-term cash flow from faster deductions and can defer taxes at exit if you complete a qualifying exchange.
Timing with exchanges
- Before an exchange: deductions you claim before the sale increase accumulated depreciation that carries into the exchange basis calculations.
- Replacement property: studies are common and often recommended on the replacement asset. If you acquire first in a reverse exchange, place the property in service and complete the study promptly.
Step-by-step checklist
- Estimate your depreciable basis. Start with purchase price and subtract land using your closing statement or appraisal allocation.
- Request a screening. Ask a reputable provider for a quick estimate of items that could shift to 5-, 7-, or 15-year lives and the projected first-year deductions.
- Model federal plus California. Include any California add-back if bonus depreciation is part of the benefit. Focus on after-tax cash flow.
- Choose study depth. Full engineering for higher bases and audit defensibility. Desk or streamlined studies for smaller assets or initial triage.
- Coordinate with your CPA. If you are catching up, discuss Form 3115. Align filing timelines and documentation.
- Align with your 1031 plan. If an exchange is likely, plan the study timeline for your replacement property and keep exchange rules and deadlines in view.
Documents to gather
- Closing statement showing price and any land allocation.
- Invoices and receipts for improvements and equipment.
- Plans, blueprints, permits, and photos.
- Appraisals, cost estimates, or contractor quotes if invoices are incomplete.
- Prior depreciation schedules if the property was placed in service earlier.
Choosing a provider
- Engineering-based methodology. Site visits and quantity takeoffs drive defensibility.
- Tax expertise. Look for CPA or tax attorney review and alignment with IRS guidance.
- Audit support. You want a firm that stands behind its work.
- Sample reports. Review a redacted sample and the classification approach.
- California experience. State conformity issues matter for modeling and documentation.
- References and track record. Confirm experience with SFR and 2–4 unit properties.
Common pitfalls to avoid
- Skipping California modeling. Federal results alone can be misleading if state add-backs apply.
- Choosing low-documentation studies. Thin support increases audit risk and weakens allocations.
- Forgetting catch-up opportunities. Form 3115 can unlock missed depreciation on long-held assets.
- Overlooking renovations. New components placed in service can qualify for shorter lives.
- Ignoring 1031 sequencing. Coordinate study timing with your exchange strategy and deadlines.
Bottom line
For many San Diego SFR and 2–4 unit owners, cost segregation is a practical way to pull forward deductions and improve near-term cash flow. The key is to screen your property, model both federal and California impacts, and align the plan with your hold period and any future 1031 exchange. If the numbers pencil, an engineering-based study can pay for itself quickly and support you in an audit.
Want a second set of eyes on your plan, plus guidance on 1031 timing, replacement options, and property management? Book a consult with Nick Emerson to walk through your numbers and map the next steps.
FAQs
What is cost segregation for a San Diego rental?
- It is a tax strategy that reclassifies parts of your property into shorter depreciation lives to accelerate deductions and improve near-term cash flow.
How does California affect bonus depreciation benefits?
- California often requires an add-back of federal bonus depreciation and uses different state schedules, so you should model combined federal and state outcomes.
When is a cost segregation study worth it on an SFR?
- If your building basis is several hundred thousand dollars or more, a screening is usually worthwhile and a full study often pencils at higher bases.
What does a typical study cost for a duplex or triplex?
- Simple 2–4 unit properties often fall in the $2,000-$7,000 range, with larger or complex assets costing more.
Will a study increase my IRS audit risk?
- A professional, engineering-based report aligned with IRS guidance is designed to be defensible and reduces risk compared with ad hoc allocations.
Can I catch up missed depreciation from prior years?
- Yes. A retrospective study with a change in accounting method (Form 3115) can create a current-year catch-up without amending past returns.
How does cost segregation interact with a 1031 exchange?
- Accelerated depreciation can increase potential recapture, but a properly executed 1031 defers both gain and recapture when you roll into like-kind property.
