Limited-Service Motel Owner Deducts $2.7M in Year One via Cost Segregation
How the owner of a limited-service motel purchased for $9,250,000 reclassified 36% of depreciable basis and deducted $2,737,900 in the first year, reducing tax by approximately $1,148,500.
Client Profile
| Asset | A limited-service motel |
|---|---|
| Purchase price | $9,250,000 |
| Depreciable basis | $7,458,000 |
| Owner's taxable income | $2,795,000 |
| State | Illinois |
| Reclassified | $2,661,000 (36%) |
| First-year tax reduction | $1,148,500 |
The Situation
The client acquired a limited-service motel for $9,250,000 and placed it in service during the year. The operating business generated $2,795,000 of taxable income, taxed at a 37% federal marginal rate before planning.
The Challenge
The closing statement allocated the purchase price between land and building and nothing further. The entire $7,458,000 building allocation was headed for a 39-year straight-line schedule producing roughly $191,200 per year. For an asset class where a large share of the investment sits in equipment, specialty systems, and site improvements rather than structure, that treatment understated the available deduction substantially.
What We Did
1. Engineering-based component analysis
We engaged an engineering firm to perform a detailed study using construction documents, a site visit, and cost estimating. The study reclassified $2,661,000, or 36% of the $7,458,000 depreciable basis, into 5-year, 7-year, and 15-year MACRS classes.
2. Separated specialty systems from base building
The largest single source of value was the mechanical, electrical, and plumbing installed to serve specific equipment rather than the building generally. Dedicated circuits, specialty piping, and exhaust and make-up air serving equipment were allocated to the equipment they serve rather than to 39-year building systems. This is the allocation a desktop study cannot support and an engineering study can.
3. Captured site improvements
Paving, curbing, sidewalks, site lighting, drainage, landscaping and irrigation, fencing, and exterior signage were identified as 15-year land improvements, all eligible for bonus depreciation.
4. Applied 100% bonus depreciation
Because every reclassified category carries a recovery period of 20 years or less, the full $2,661,000 was deductible in year one under Section 168(k) as restored by the OBBBA. Adding $76,900 of straight-line on the remaining structure brought first-year depreciation to $2,737,900.
The Result
First-year depreciation of $2,737,900 against $191,200 under the original treatment reduced tax by approximately $1,148,500 at a 41.9% combined marginal rate. We also identified Section 179 as the correct vehicle for future roof and HVAC replacements, which are 39-year property that bonus depreciation cannot reach.
Key Takeaways
- Reclassifying 36% of basis moved $2,661,000 from a 39-year schedule into year one.
- Specialty MEP serving equipment, not the building, was the largest single value driver.
- Site improvements are 15-year property and fully bonus-eligible.
- Section 179, not bonus depreciation, is the tool for future roof and HVAC work.
Frequently Asked Questions
How much does a limited-service motel typically reclassify?
In this study, 36% of depreciable basis. That is within the normal range for this asset class, where equipment, specialty systems, and site work make up a substantial share of the total investment relative to the building shell.
Is the deduction limited by passive activity rules?
Not here. The owner materially participates in the operating business, so the deduction is non-passive. Where real estate is held in a separate entity leasing to an operating company, the self-rental rules apply and a grouping election under Reg. 1.469-4 is often needed.
What happens on sale?
5- and 7-year property is recaptured as ordinary income under Section 1245, while land improvements and the building produce unrecaptured Section 1250 gain at up to 25%. A 1031 exchange defers the entire amount.
Why not use a lower-cost desktop study?
The allocations that drive most of the value here, specialty MEP and site improvements, require engineering support. The IRS Cost Segregation Audit Techniques Guide identifies the detailed engineering approach as the most reliable method, and a study without it is the first thing challenged.
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