Cost Segregation · Brief · Pro level
Cost segregation for office-to-residential conversions
Converting an office to apartments moves the building from 39-year to 27.5-year property — and off the QIP map entirely. How the recovery period changes, what §280B does to demolition costs, and why the study should be staged before the wreckers arrive.
An office-to-residential conversion crosses three depreciation regimes at once. The building's recovery period changes from 39 to 27.5 years when residential use takes over. The improvements lose access to qualified improvement property — QIP exists only inside nonresidential buildings. And the gut demolition sits between Section 280B's capitalization rule and the partial disposition election, where timing and documentation decide whether the ripped-out office interior is a deduction or a permanent loss. The study has to be staged around all three.
The recovery-period flip
Residential rental property is defined by Section 168(e)(2)(A): 80% or more of gross rental income from dwelling units. In the conversion year that test flips, and Treas. Reg. §1.168(i)-4 governs the change in use — the remaining basis of the former office building is depreciated over the residential recovery period beginning with the year of change (using the shorter period prospectively; no catch-up, no recomputation of prior years). New conversion spend is simply 27.5-year property as placed in service. Mixed-use results — ground-floor retail under apartments — keep the whole building nonresidential if dwelling income stays under 80%, which some developers manage deliberately. Mechanics are in Pub 946.
What the conversion loses and keeps
Depreciation treatment of conversion-project dollars (illustrative allocation of a $40M conversion budget on an existing shell):
| Component | Treatment | Share of budget |
|---|---|---|
| Unit appliances, carpet, cabinetry, amenity FF&E | 5-year §1245 | 12% |
| Site work: courtyards, parking, landscaping | 15-year land improvement | 4% |
| Improvements placed in service while still nonresidential | 15-year QIP (if qualifying) | 6% |
| Residential build-out: units, corridors, systems | 27.5-year residential | 70% |
| Structural/facade work, enlargements | 27.5-year residential | 8% |
Illustrative only. The QIP row is the one that evaporates with bad sequencing: interior improvements to a building that is already residential when placed in service are 27.5-year property, full stop — Section 168(e)(6) restricts QIP to nonresidential interiors. Improvements genuinely completed and placed in service during a nonresidential phase (a retained commercial floor, or early-phase work in a still-office building) can hold 15-year, bonus-eligible status. The 5- and 15-year rows take 100% bonus for property acquired after January 19, 2025.
Demolition: §280B versus partial disposition
Section 280B disallows any deduction for demolition of a structure, capitalizing the loss and demolition costs into the land. Full teardowns are caught; interior gutting of a building that remains standing generally is not. That routes conversion demolition into friendlier territory: a partial disposition election under Treas. Reg. §1.168(i)-8 deducts the remaining basis of the office components actually retired — ceilings, partitions, HVAC distribution, electrical — and Treas. Reg. §1.263(a)-3(g)(2) lets related removal costs deduct alongside a claimed disposition loss. The catch is evidentiary: the election requires knowing the retired components' basis, which means a cost segregation analysis of the office building performed before the wreckers arrive. Watch the edge case — demolition so extensive that only the frame remains can be argued to approach a structure demolition, and conservative practice documents what was retained.
Staging the study
The working sequence for a conversion: (1) at acquisition, study the existing office building — this sets up partial dispositions and captures any short-life basis in the interim operating period; (2) at demolition, elect partial dispositions for retired components on that year's return; (3) during construction, classify spend in real time, ring-fencing any QIP-eligible nonresidential work and the 5/15-year property; (4) at the use change, apply §1.168(i)-4 to the carried-over basis. Skipping step one is the expensive mistake — the retired office interior's basis simply continues depreciating inside the 27.5-year account for decades. Broader context by asset class is in cost seg by property type.
Frequently asked questions
- What recovery period applies after an office-to-residential conversion?
- Once 80% or more of the building's gross rental income comes from dwelling units, it is residential rental property under Section 168(e)(2)(A) and depreciates over 27.5 years. The change applies prospectively from the year the use changes: remaining basis in the former office building is depreciated under the change-in-use rules of Treas. Reg. §1.168(i)-4, and new conversion costs are 27.5-year property as placed in service.
- Can conversion build-out costs be qualified improvement property?
- No — not once the building is residential. QIP under Section 168(e)(6) is limited to improvements to the interior of nonresidential real property. Interior improvements made while the building remains nonresidential can qualify, but the residential conversion itself produces 27.5-year property, not 15-year QIP. Personal property within the conversion — appliances, carpet, unit finishes — still segregates to 5-year.
- Are demolition costs in a conversion deductible?
- Interior demolition is generally not lost to Section 280B, which disallows losses only on demolition of an entire structure, capitalizing them to land. Gutting floors for conversion is a partial disposition question instead: the owner may elect under Treas. Reg. §1.168(i)-8 to deduct the remaining basis of components actually retired, if a study documented that basis before demolition.