Cost Segregation for Mixed Use Buildings (2026 Guide)

A building with apartments above and retail below raises a question that changes the entire depreciation schedule. Is it residential rental property on 27.5 years, or nonresidential real property on 39 years?

The answer is not a square footage allocation, and it is not split between the two uses. The whole building goes one way or the other, based on a gross rental income test that owners can partially influence.

The 80 Percent Gross Rental Income Test

Under IRC Sec. 168(e)(2)(A), residential rental property means a building from which 80% or more of gross rental income for the taxable year is rental income from dwelling units.

The test is applied annually, on gross rental income, not on square footage, not on unit count, and not on value.

A building where apartments generate $920,000 and ground floor retail generates $210,000 has residential income of 81.4% and qualifies as residential rental property. The entire building, including the retail portion, depreciates over 27.5 years.

Shift the numbers slightly, to $880,000 residential and $240,000 retail, and residential income is 78.6%. The entire building, including the apartments, depreciates over 39 years.

This is a genuine cliff, and it can move year to year as leases roll. A building can qualify in one year and not the next, which creates real complexity in maintaining the schedule.

What Counts Toward the Test

The test looks at rental income from dwelling units. A dwelling unit is a house or apartment used to provide living accommodations, excluding units in a hotel, motel, or other establishment where more than half the units are used on a transient basis.

Short-term rental units within the building may therefore fail to count as dwelling units, which can push a building that looks residential over the line into nonresidential treatment.

Common area charges, parking income, laundry income, and other non-rental revenue are generally excluded from the computation on both sides, though the treatment of parking rented to residential tenants versus to the public warrants attention.

Where the building has vacant space, income from that space is zero, which can distort the ratio in either direction during lease-up or a re-tenanting period.

Planning Around the Test

Because the test turns on gross rental income, it responds to leasing decisions. An owner near the line who values 27.5-year treatment should be aware that adding retail rent or losing a residential tenant can flip it.

Where a building sits close to 80%, structuring the retail lease so that a larger share of the tenant's payment is a recovery of operating expenses rather than base rent may affect the computation, though the substance has to support the characterization.

Where a building is decisively nonresidential, the analysis shifts to maximizing QIP on the interior improvements rather than fighting for 27.5-year treatment.

This is worth modeling before signing a ground floor lease. The difference between a 27.5-year and 39-year schedule on a $9,000,000 building is roughly $97,000 of annual depreciation.

The Cost Segregation Result Is Strong Either Way

The classification affects only the structural component. The reclassified five-year and 15-year property is unaffected and is bonus eligible regardless.

Mixed use buildings reclassify well, typically 22% to 30%. Residential units contribute appliances, cabinetry, flooring, and window treatments. Retail space contributes tenant finish, decorative lighting, and dedicated power and data. Site work contributes parking, lighting, hardscape, and signage.

Qualified improvement property under IRC Sec. 168(e)(6) applies only to nonresidential real property. In a building classified as residential rental, the retail build-out does not qualify as QIP, which is a meaningful and frequently missed consequence of the 27.5-year classification.

That creates a genuine tradeoff. Residential classification gives a faster structural schedule but forfeits QIP treatment on the commercial build-out. Which is better depends on how much interior improvement work the owner funds.

Worked Example: Urban Mixed Use

An investor acquires a five-story building with 28 apartments and 6,800 square feet of ground floor retail for $11,400,000. Land is allocated at $1,900,000, leaving $9,500,000 depreciable.

Residential rents are $1,046,000 and retail rents are $238,000, so residential income is 81.5% of gross rental income. The building qualifies as residential rental property on a 27.5-year schedule.

A study identifies five-year property of $1,710,000 (18%) and 15-year land improvements of $855,000 (9%). Structure is $6,935,000 (73%).

Reclassified basis of $2,565,000 is deductible in year one under IRC Sec. 168(k), plus $252,182 of structural depreciation, for approximately $2,817,182.

Under 39-year treatment, structural depreciation would have been $177,821, roughly $74,000 less annually. Over a ten-year hold, the residential classification is worth approximately $740,000 of additional depreciation.

The offsetting cost is that the landlord's future retail build-out allowances will not qualify as QIP and will sit on the 27.5-year schedule instead of being fully deductible.

Annual Testing and Documentation

Because the test is applied annually, the classification should be recomputed each year and documented. A building that qualifies in year one and fails in year four presents a genuine question about the appropriate schedule going forward.

The conservative practice is to compute the ratio annually, retain the supporting rent roll, and address any change with a clear position rather than continuing on the original schedule by default.

Where the change is durable rather than temporary, a change in method of accounting on Form 3115 may be the appropriate mechanism to move to the correct recovery period.

Frequently Asked Questions

Is a mixed use building 27.5-year or 39-year property?

The entire building goes one way based on a single test. Under IRC Sec. 168(e)(2)(A), if 80% or more of gross rental income comes from dwelling units, the whole building is residential rental at 27.5 years. Below 80%, the whole building is nonresidential at 39 years.

Is the test based on square footage?

No. It is based on gross rental income for the taxable year. A building where apartments occupy 85% of the square footage but produce only 76% of gross rental income fails the test and is nonresidential property.

Can the classification change from year to year?

Yes, because the test is applied annually. Lease rollover, vacancy, or a rent increase on the commercial space can flip a building across the line. The ratio should be recomputed and documented each year rather than assumed.

Does QIP apply to the retail space in a residential building?

No. Qualified improvement property under IRC Sec. 168(e)(6) applies only to nonresidential real property. In a building classified as residential rental, commercial tenant improvements do not qualify as QIP, which is a real and frequently missed cost of that classification.

Do short-term rental units count as dwelling units?

Often not. A dwelling unit excludes units in an establishment where more than half the units are used on a transient basis. Short-term rental units within a mixed use building can push the residential income ratio below 80% and change the whole building's schedule.

Cost Segregation for Mixed Use Buildings: The 80 Percent Test and Split Schedules