Mixed-use properties (think retail space on the ground floor with residential apartments above, or a multi-unit building where some units are long-term rentals and others operate as short-term stays) are among the most tax-complex real estate assets an investor can own. Yet they’re also among the most rewarding when handled correctly.
This guide breaks down exactly how depreciation works for mixed-use properties, what the IRS requires, and how a properly executed cost segregation study can help you maximize your tax position while maintaining full defensibility.
What Makes a Mixed-Use Property Different?
Under standard depreciation rules, the IRS assigns recovery periods based on how a property is used:
- Residential rental property depreciates over 27.5 years (IRC §168(e)(2)(A))
- Nonresidential (commercial) real property depreciates over 39 years (IRC §168(e)(2)(B))
The problem with mixed-use properties is that a single building can qualify for both (or neither) depending on how income is generated and how each portion of the property is used. Getting the classification wrong means you’re either leaving money on the table or creating an audit exposure you could have avoided.
The 80% Rule: Residential vs. Commercial Classification
The IRS uses a straightforward income-based test to determine whether a building qualifies as residential rental property. Under Treasury Regulation §1.168(e)-1, a building is classified as residential only if 80% or more of its gross rental income comes from dwelling units.
This test is based on income, not square footage, not unit count.
Example: A mixed-use building generates $900,000 in annual rental income, $600,000 from apartments and $300,000 from ground-floor retail. Residential income represents only 67% of total income. The building fails the 80% test and must be depreciated over 39 years as commercial property, even though the majority of its space is residential in nature.
This is a result many property owners don’t anticipate, and it illustrates why classification analysis needs to happen before you file, not after.
When You Can Split the Depreciation
If the residential and commercial portions of a property are functionally distinct and generate separate income streams, the IRS permits an allocation of depreciable basis between the two uses. This gives you the opportunity to apply the more favorable 27.5-year life to the qualifying residential portion while separately depreciating the commercial space over 39 years.
The IRS allows “any reasonable method” of allocation under Treas. Reg. §1.168(e)-1 and the IRS Cost Segregation Audit Technique Guide. The most widely accepted approaches are:
Square footage allocation is appropriate when the value of each portion of the building roughly aligns with its physical size.
Income ratio allocation is preferred when the revenue generated from different portions of the building varies significantly.
Whichever method you choose, consistency and documentation are essential. The IRS expects you to apply your allocation method in a principled, documented, and repeatable way.
Short-Term Rentals Add Another Layer of Complexity
One of the most frequently misunderstood elements of mixed-use depreciation involves short-term rentals (STRs). Many investors assume that all residential-looking units depreciate the same way. They don’t.
The IRS draws a hard line based on average length of stay:
- Average stay greater than 7 days → the unit is treated as a dwelling unit → 27.5-year depreciation
- Average stay of 7 days or fewer → the unit is treated as transient lodging (similar to a hotel) → 39-year commercial depreciation
This matters enormously for mixed-use properties that combine long-term leases with short-term rental units. Even if two units are identical in size and layout, their depreciation lives may be entirely different based on how they are operated.
Basis must be allocated between 27.5-year and 39-year assets using a documented, reasonable method; income ratio, square footage, or unit count; applied consistently and supported by your records.
What About Activity Grouping?
Some property owners wonder whether grouping elections under Treas. Reg. §1.469-4 can simplify their depreciation situation. The short answer: no.
Grouping elections exist solely for passive activity testing, determining whether losses from one activity can offset income from another. They have no effect on depreciation lives, which are governed exclusively by IRC §168. You cannot group STR units with long-term units to change their depreciation classification, and you cannot combine residential and commercial portions to apply a single recovery period.
The Role of Cost Segregation in Mixed-Use Properties
Here’s where the real opportunity lies.
Once you’ve correctly classified and allocated your mixed-use building, a cost segregation study can significantly accelerate the depreciation on both the residential and commercial portions. Rather than depreciating every component of a building over 27.5 or 39 years, cost segregation identifies personal property and land improvements that qualify for much shorter recovery periods; 5, 7, or 15 years; allowing you to front-load deductions and improve cash flow in the near term.
For mixed-use properties specifically, this analysis requires careful coordination:
- Identifying which components belong to the residential portion vs. the commercial portion vs. shared common areas
- Applying the correct depreciation life to each component
- Documenting the allocation methodology in a way that stands up to IRS review
- Ensuring that bonus depreciation treatment is applied correctly for qualifying assets
Done properly, a cost segregation study on a mixed-use property can unlock substantial accelerated deductions that would otherwise be spread over decades.
Why Engineering-Based Analysis Matters
Mixed-use properties don’t fit neatly into a single tax category, and that complexity demands more than a spreadsheet estimate. CSSI’s cost segregation studies are grounded in detailed, site-level engineering analysis; the same methodology the IRS expects and that its own Audit Technique Guide describes as the standard for defensible studies.
With more than 23 years of experience and over 60,000 completed studies, CSSI has worked across every property type, including some of the most complex mixed-use assets in the country. Our team understands how to structure the analysis, document the allocation, and deliver results that hold up; whether you’re filing a return, responding to an inquiry, or planning a future disposition.
Key Takeaways for Mixed-Use Property Owners
Mixed-use properties can involve multiple depreciation lives, multiple asset classifications, and separate basis allocations — all within the same building. The right approach depends on:
- How income is generated from each use
- Whether the average rental period qualifies units as residential or transient
- Which allocation method is most appropriate and defensible for your specific property
- How cost segregation can accelerate deductions across both portions
Getting this right requires careful analysis and proper documentation, and the potential upside makes it well worth doing.
Curious what your mixed-use property may qualify for? CSSI offers a no-cost analysis to help you understand your potential tax savings before committing to a study. There’s no obligation, just a clear picture of what may be available to you.
