Cost Segregation for a Development Placed in Service in Phases

In a phased development, cost segregation follows the tax rule that each building, or each separately usable phase, is placed in service when it is ready and available for its intended use under Treas. Reg. §1.46-3(d)(1)(ii), not when the entire project is finished. For a calendar-year taxpayer, each building or separately usable phase placed in service by December 31, 2026, meaning ready and available for rent or use, can be depreciated on the 2026 return, while a phase still under construction waits for the tax year in which that phase is placed in service under Treas. Reg. §1.46-3(d)(1)(ii). A building that is only partly complete is generally placed in service when the building as a whole, or the separately usable part of it, is ready and available for its specifically assigned function.

A cost segregation study on a phased apartment, self-storage, or commercial project assigns each building’s costs to that building’s placed-in-service year and allocates shared costs such as site work, utilities, roads, amenities, and indirect costs among the phases. Cost segregation does not make an unfinished phase depreciable; cost segregation changes the recovery periods and bonus depreciation treatment for the costs of the phase that is already placed in service.

When is each phase placed in service for 2026 depreciation?

Each phase is placed in service when it is in a condition or state of readiness and availability for its specifically assigned function under Treas. Reg. §1.46-3(d)(1)(ii) and Treas. Reg. §1.167(a)-11(e)(1)(i). For an apartment building, that generally means the building is ready and available to rent; for a self-storage building, that generally means units are ready and available for customer storage; for a commercial shell or tenant space, that generally means the space is ready and available for its assigned business use.

For a calendar-year taxpayer, a building placed in service by December 31, 2026 can be depreciated on the 2026 return under the placed-in-service rule in Treas. Reg. §1.46-3(d)(1)(ii). For a calendar-year taxpayer, a building not placed in service by December 31, 2026 because it is not ready and available for rent or use is first depreciated in the later tax year when it is placed in service under Treas. Reg. §1.46-3(d)(1)(ii).

The closing date, final project celebration, or master development completion date is not the controlling date when a specific building is already ready and available for its assigned function under Treas. Reg. §1.46-3(d)(1)(ii).

For a phased development, the practical question is not, Is the whole project done?; the practical question is, Which building or usable phase is ready and available for its assigned function?
Built on the methodology in the IRS Cost Segregation Audit Techniques Guide

How does cost segregation allocate costs across buildings and shared improvements?

A cost segregation study allocates direct and indirect costs to the phase that those costs support, when that phase is placed in service and when the records support a reasonable allocation. Direct building costs usually follow the specific building or tenant area, while indirect costs can be allocated by a method that reflects the facts, such as cost, square footage, units, or another supported driver when the records show that method matches the project.

Shared improvements require special attention because a road, utility run, clubhouse, leasing office, detention pond, or amenity may serve more than one building. When a shared improvement is itself ready and available for its specifically assigned function under Treas. Reg. §1.46-3(d)(1)(ii), the tax advisor decides whether that improvement is placed in service with the first served building, with a later served phase, or through another supported allocation based on the facts.

For a cost segregation review, gather the closing or settlement statement, construction costs and invoices or contractor pay applications, the current depreciation schedule, and a land-value source such as an assessor ratio or appraisal. If your project is still being finished building by building, use ClickDrag Finance’s property qualifier to check whether a cost segregation study fits the phases that are already placed in service and the phases expected to be placed in service on the 2026 return.

Developers using a build-to-rent model can also compare the project’s facts with our build-to-rent cost segregation discussion, but this article focuses on placed-in-service timing for phased developments. If you are comparing providers, see how to evaluate cost segregation companies before you decide how the study should handle multiple buildings, shared site work, and changing placed-in-service years.

What bonus depreciation rate applies when the development is self-constructed?

For self-constructed property, including property built for the taxpayer under a written binding contract entered into before construction began, Treas. Reg. §1.168(k)-2(b)(5)(iv) treats the property as acquired when physical work of a significant nature begins for §168(k) purposes. Whether that significant physical work is tested building by building or for the development as a whole is a facts question for the tax advisor to decide using Treas. Reg. §1.168(k)-2(b)(5)(iv) and the construction records.

If qualified property is acquired after January 19, 2025, §168(k) as amended by OBBBA and IRS Notice 2026-11 allow 100% bonus depreciation for qualified property with a recovery period of 20 years or less. If qualified property was acquired on or before January 19, 2025 and is placed in service in 2026, §168(k) keeps that property on the TCJA phase-down rate of 20% for 2026, with each rate one year later for long-production-period property and certain aircraft under §168(k)(6)(B).

If a developer acquired property under a written binding contract, IRS Notice 2026-11 ties the acquired date to the latest of the date the contract was signed, the date it became enforceable under state law, the end of any cancellation period, and the date any contingency was satisfied under Treas. Reg. §1.168(k)-2(b)(5)(ii)(B), not merely the closing date. A written binding contract means a contract enforceable under state law that does not limit damages to a specified amount, such as through a liquidated damages clause, under Treas. Reg. §1.168(k)-2(b)(5)(iii).

If the contract is not binding in that sense, the acquired date is generally when the taxpayer has paid or incurred more than 10 percent of the total cost, excluding land and preliminary activities, under Treas. Reg. §1.168(k)-2(b)(5)(iii) and Treas. Reg. §1.168(k)-2(b)(5)(v). For self-constructed property, paying or incurring more than 10 percent of the total cost, excluding land and preliminary activities, is a safe harbor for the beginning of physical work of a significant nature under Treas. Reg. §1.168(k)-2(b)(5)(iv)(B)(2).

Bonus depreciation applies only to qualified property with a recovery period of 20 years or less under §168(k), which is why cost segregation matters for the 5-year, 7-year, and 15-year components identified in the study. Bonus depreciation does not apply to land, and bonus depreciation does not apply to the 27.5-year residential rental building shell or the 39-year nonresidential real property shell under §168(k).

Can a late 2026 phase trigger the mid-quarter convention?

A late 2026 phase can trigger the mid-quarter convention when the aggregate basis of MACRS property placed in service during the last three months of the tax year is more than 40% of the aggregate basis of all MACRS property placed in service during that year under §168(d)(3)(A), with residential rental property and nonresidential real property excluded from the test under §168(d)(3)(B). For a calendar-year taxpayer, property placed in service from October 1 through December 31, 2026 is placed in service in the last three months for the §168(d)(3) mid-quarter test.

Residential rental property with a 27.5-year recovery period and nonresidential real property with a 39-year recovery period use the mid-month convention under §168(d), under which property placed in service in any part of a month is treated as placed in service at the middle of that month, so for a calendar-year taxpayer a building shell placed in service (ready and available for its intended use) in December 2026 receives half a month of first-year regular depreciation on the 2026 return. The 5-year, 7-year, and 15-year property that cost segregation identifies generally uses the half-year convention under §168(d) unless the mid-quarter convention applies under §168(d)(3).

When the mid-quarter convention applies, fourth-quarter property receives one and a half months of first-year regular depreciation under §168(d)(3) and the MACRS convention rules. Bonus depreciation under §168(k) is not reduced by a convention, so the mid-quarter convention matters mainly for property on which bonus depreciation is not claimed or for property that is not eligible for bonus depreciation.

Do not assume the late phase is harmless when a cost segregation study identifies substantial 5-year, 7-year, or 15-year property under §168(d) and §168(k). Basis expensed under §179 is left out of the 40% test (Treas. Reg. §1.168(d)-1(b)(4)); have the tax advisor confirm how bonus-depreciated basis is counted and run the test on the full placed-in-service schedule.

Will the 2026 depreciation be usable if the development creates a loss?

The 2026 depreciation is usable only to the extent the owner’s tax posture allows the loss to be used under §469, §465, and §461(l). A rental activity is passive under §469(c)(2) unless an exception such as §469(c)(7) applies, and a passive loss that passive income does not absorb is disallowed under §469(a) and carried forward under §469(b).

Under §469(i), an individual who actively participates in a rental real estate activity (a separate test from material participation, and one that requires an interest of at least 10% by value (a spouse’s interest counts) throughout the year) is exempt from the §469(a) disallowance for up to $25,000 of loss from the rental real estate activities in which the individual actively participates; the $25,000 is reduced by 50% of modified adjusted gross income above $100,000 and is gone at $150,000, and for a married individual filing separately it is $12,500, phasing out between $50,000 and $75,000, only if the spouses lived apart for the entire year, and zero if they lived together at any time during the year.

Under §469(c)(7), a taxpayer is a real estate professional only if more than one-half of the personal services the taxpayer performs in trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates (on a joint return, one spouse must meet both tests alone); the rental loss is then nonpassive only if the taxpayer also materially participates in that rental activity, with each rental tested separately unless the election under Treas. Reg. §1.469-9(g) to treat all interests in rental real estate as one activity was made.

An activity is not a rental activity when the average period of customer use is seven days or less under Treas. Reg. §1.469-1T(e)(3)(ii)(A), or 30 days or less with significant personal services provided by or on behalf of the owner under Treas. Reg. §1.469-1T(e)(3)(ii)(B). In either case, the loss is nonpassive only if the taxpayer materially participates under Treas. Reg. §1.469-5T(a), and participation must be real, documented, and counted only for the tax year in which the work was performed.

If a loss is nonpassive, it can offset wages or other nonpassive income only when the basis rules, at-risk rules under §465, and excess business loss rules under §461(l) also allow the deduction. Under §469(g), a suspended passive loss is released, meaning it is treated as a loss that is not from a passive activity, when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction (one in which all gain or loss realized is recognized) to an unrelated party.

When is a phased-development cost segregation study worth doing?

A phased-development cost segregation study is worth doing when the completed phases have enough depreciable basis, usable deductions, and expected holding period to justify the study. A cost segregation study is worth it when three conditions hold together: the basis is large enough for the accelerated deductions to outweigh the cost of the study, the deduction is usable this year given the owner’s passive-activity position, and the hold is long enough to survive recapture. All three, or the honest answer is no.

On a taxable sale at a gain, recapture applies up to the amount of that gain however long the property was held, outside the Opportunity Zone rule that, for a qualifying investment held at least 10 years with the IRC §1400Z-2(c) election, applies on a sale of the qualified opportunity fund interest. Under §1245, recapture on 5-year and 7-year property is ordinary income, and under §1250, recapture of depreciation taken above straight-line on 15-year land improvements held more than one year, including bonus depreciation, is ordinary income.

The remaining depreciation on 15-year land improvements and on the 27.5-year or 39-year structure is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer under IRC §1(h)(1)(E). Cost segregation accelerates deductions; over the life of the building, the same basis is recovered.

If your phased development is in a qualified Opportunity Zone, the recapture result can be different only when the investment is a qualifying Opportunity Zone investment held at least 10 years, the taxpayer makes the IRC §1400Z-2(c) election, and the taxpayer sells the qualified opportunity fund interest; see Opportunity Zone cost segregation planning for that special case. Outside that specific case, a longer hold changes timing and tax character but does not remove recapture on a taxable sale at a gain.

What if earlier phases were already depreciated without cost segregation?

An earlier phase can often be corrected on the current return when the eligibility rules for an accounting method change are met. A building placed in service in 2026 goes on the original 2026 return and needs no Form 3115 because the cost segregation study is being used for the placed-in-service year.

A building you placed in service in 2024 or earlier and still own can generally use Form 3115 with the 2026 return to report missed depreciation as a §481(a) adjustment under section 6.01 of Rev. Proc. 2025-23, filed under the procedures of Rev. Proc. 2015-13, when the other eligibility rules are met. For a building you placed in service in 2025 with the 2025 return filed and that you still own at the start of the 2026 year of change, section 6.01 of Rev. Proc. 2025-23 allows either Form 3115 with the 2026 return or an amended 2025 return filed before the 2026 return is filed, when the other eligibility rules are met.

Form 3115 filed with the return for the year of change reports missed depreciation as a §481(a) adjustment, with no amended returns, when the property has been depreciated on two or more filed returns, or on one filed return if the taxpayer placed it in service in the tax year immediately before the year of change and still owned the property at the start of the year of change, under section 6.01 of Rev. Proc. 2025-23 and Rev. Proc. 2015-13. A prior election out of bonus depreciation cannot be undone through this automatic change under section 6.01(1)(c)(vi) of Rev. Proc. 2025-23.

The year-of-change route should be confirmed with the tax advisor because phased projects often have multiple placed-in-service years, different bonus depreciation acquired dates, and shared improvements that need consistent treatment. The cleaner the construction ledgers, pay applications, and phase-by-phase cost allocations are, the more useful the cost segregation study will be for the 2026 return and later returns.

Frequently Asked Questions

Can cost segregation start before the whole development is finished?

Yes, cost segregation can be applied to each building or separately usable phase when that building or phase is placed in service under Treas. Reg. §1.46-3(d)(1)(ii). The study should not include unfinished phases as depreciable property until those phases are ready and available for their specifically assigned function.

Does a phase placed in service late in 2026 still get depreciation?

Yes, for a calendar-year taxpayer, a phase placed in service by December 31, 2026 gets depreciation on the 2026 return when it is ready and available for rent or use under Treas. Reg. §1.46-3(d)(1)(ii). The regular first-year amount may be affected by the mid-month convention for the building shell under §168(d) or by the mid-quarter convention for certain shorter-life property under §168(d)(3).

Does cost segregation change the bonus depreciation acquired date?

No, cost segregation does not change the acquired date for §168(k); it identifies which costs are qualified property once the acquired-date and placed-in-service rules are applied. For self-constructed property, Treas. Reg. §1.168(k)-2(b)(5)(iv) generally treats the acquired date as the start of physical work of a significant nature, with paying or incurring more than 10 percent of the total cost (excluding land and preliminary activities) as a safe harbor under Treas. Reg. §1.168(k)-2(b)(5)(iv)(B)(2), and whether the facts are tested by building, by phase, or by project is a question for the tax advisor.

Can depreciation from cost segregation offset the developer’s other income?

Sometimes, depreciation from cost segregation can offset other income only when the loss is nonpassive or otherwise allowed under §469 and also allowed under the basis rules, at-risk rules under §465, and excess business loss rules under §461(l). If the activity is passive under §469(c)(2) and passive income does not absorb the loss, §469(a) disallows the current loss and §469(b) carries it forward.

What records are most important for phased-development cost segregation?

The most important records are the settlement statement, contractor pay applications or invoices, construction cost detail by building or phase, the current depreciation schedule, and a land-value source such as an assessor ratio or appraisal. Those records help the study assign building costs to the correct placed-in-service year and allocate shared improvements in a way the tax return can support.