Cost Segregation · Brief · Pro level
Cost segregation for mixed-use buildings and condos: the 80 percent test
A building is residential rental property (27.5-year) only if 80 percent or more of its gross rental income comes from dwelling units — otherwise the whole building is 39-year nonresidential. How the Section 168(e)(2) test works for mixed-use projects, what it means for QIP, and how condo owners and associations allocate common elements.
Mixed-use real estate — retail under apartments, medical offices beside condos — forces a binary the Code does not soften: under Section 168(e)(2)(A), a building is residential rental property (27.5-year recovery) only if 80 percent or more of its gross rental income for the taxable year is rental income from dwelling units. Fall to 79 percent and the entire building, apartments included, is 39-year nonresidential real property. There is no pro-rata blend for a single building. Cost segregation planning for mixed-use projects therefore starts not with component engineering but with the income fraction — and with how the project is legally divided, because the test runs building by building, and a condominium regime can turn one structure into many separately owned properties.
How the 80 percent test operates
The numerator is gross rental income from dwelling units — houses or apartments used to provide living accommodations, expressly excluding hotel/motel-type units where more than half the units are used on a transient basis. The denominator is all gross rental income from the building. Section 168(e)(2)(A)(ii)(II) adds the wrinkle for owner-occupants: the fair rental value of a unit the taxpayer lives in counts on both sides, which often rescues the classic live-above-the-shop building. The test is annual; a building can change character when a large commercial tenant arrives or leaves, triggering a change-in-use recomputation under Treas. Reg. §1.168(i)-4 rather than an amended return. Pub 946 sets out the mechanics.
Illustration — 60,000 sq ft building, apartments over retail (illustrative rents).
| Income source | Annual gross rent | Dwelling-unit income? |
|---|---|---|
| 48 apartments | $1,150,000 | Yes |
| Ground-floor retail (3 tenants) | $310,000 | No |
| Rooftop antenna license | $40,000 | No |
| Residential share | $1,150,000 / $1,500,000 | 76.7% — fails; whole building 39-year |
Here $40,000 of antenna income and one well-rented storefront cost the owner the 27.5-year life on $1.15 million of apartment income's worth of building. The stakes cut both ways, though: a failed test opens qualified improvement property — 15-year, bonus-eligible interior improvements — that a residential building never gets. For an owner planning a heavy interior renovation cycle, 39-year-plus-QIP can genuinely beat 27.5-year-without-it. Model it; do not assume residential is the prize.
Condominiums: dividing the building divides the test
A condominium declaration converts one structure into separately owned real property interests. Each unit owner classifies their unit on its own facts: an investor's residential condo is 27.5-year property; the commercial condo on the ground floor is 39-year in its owner's hands. This is the standard structural answer for developers who would otherwise fail the 80 percent test — condominiumize the commercial floors away from the residential tower, and each regime gets its correct life.
Common elements — lobby, roof, elevators, structure, shared mechanicals — belong pro rata to the unit owners under the declaration's allocated interests. Each owner's basis includes their share, depreciated at their unit's classification, and a cost segregation study for a unit owner should pick up the owner's share of common-element components (site improvements, common-area finishes and equipment) using the same engineering discipline as any study under the Cost Segregation Audit Techniques Guide. Assessments paid to the association for capital work add to basis; the association itself typically owns nothing to depreciate.
Allocating between uses in a single-owner building
Where one taxpayer keeps the whole mixed-use building, the study does double duty: it pulls Section 1245 personal property and 15-year land improvements out of the building basis regardless of the 27.5/39 outcome (the study mechanics are indifferent to the building's residual life), and it documents the residual building's classification against the 80 percent computation. Costs serving only one use — restaurant kitchen plumbing, apartment corridor finishes — trace directly; genuinely shared systems allocate on a reasonable basis such as square footage or actual load. Keep the income test workpapers with the study: on exam, the building's life is checked before any component is, and a classification that flips mid-hold drags the improvement schedule — and any QIP claimed — along with it. Recapture on the accelerated components at sale follows the usual rules covered in depreciation recapture explained.
Frequently asked questions
- Is a mixed-use building depreciated over 27.5 or 39 years?
- It depends on the 80 percent test in Section 168(e)(2)(A): a building is residential rental property, depreciated over 27.5 years, only if 80 percent or more of its gross rental income for the year is rental income from dwelling units. Ground-floor retail under apartments counts against the test. If the building fails, the entire building — including the apartments — is 39-year nonresidential real property. The test is applied building by building, year by year.
- How does the 80 percent test treat an owner-occupied unit?
- If the taxpayer occupies a dwelling unit in the building, Section 168(e)(2)(A)(ii) includes the fair rental value of that unit in both the total gross rental income and the dwelling-unit income for the 80 percent computation. This helps small owner-occupied mixed-use buildings — a live-above-the-shop owner counts imputed rent on the residence toward the residential side.
- Can qualified improvement property exist in a mixed-use building?
- Only if the building is nonresidential. QIP is defined in Section 168(e)(6) as an improvement to the interior of nonresidential real property. In a building that satisfies the 80 percent residential test, interior improvements are 27.5-year property, not QIP — no 15-year life, no bonus. In a building that fails the test, interior improvements to any unit can qualify. Classification of the building therefore controls the improvement's treatment too.