Cost Segregation Studies: The Hidden Passive Activity Loss Trap 🏢

[Bruce D. Kowal]

As a CPA focusing on real estate taxation, I frequently encounter property investors excited about cost segregation studies. And why not? The promise of accelerated depreciation and immediate tax savings is attractive. However, there's a critical detail that many tax advisors conveniently overlook when promoting these studies.

Here's the uncomfortable truth: If you're a high-income earner (AGI > $150,000) and not actively managing your properties, those promised tax savings might be locked away for years. 🔒

Let's break this down:

Under IRC §469, rental real estate activities are considered "passive" by default. Unless you qualify as a Real Estate Professional (which has strict requirements), your rental losses can only offset passive income. If you're earning primarily W-2 wages, interest, or dividends, those attractive depreciation deductions from your cost segregation study will be suspended.

Think about it this way: You might spend $10,000-$15,000 on a cost segregation study, expecting immediate tax savings, only to find those deductions suspended indefinitely.

Does this mean cost segregation studies are worthless? Absolutely not. But timing and planning are crucial.

Here's what you need to consider:

1. Future Passive Income: Do you expect to generate passive income from other sources?
2. Exit Strategy: When do you plan to sell the property?
3. Professional Status: Could you qualify as a Real Estate Professional?
4. Income Levels: Will your AGI decrease in future years below the $150,000 threshold?

Mitigation Strategies:

• Consider qualifying as a Real Estate Professional
• Generate passive income through strategic investments
• Plan property dispositions to release suspended losses
• Make appropriate grouping elections
• Structure leases to demonstrate active participation

The Bottom Line:
Cost segregation studies remain a valuable tax planning tool. However, understanding the passive activity loss limitations is crucial before making this investment. The time value of money still favors acceleration, but only if you have a clear path to eventually utilizing these losses.

Don't let your tax savings get trapped in passive activity loss limbo. Consult with a qualified tax advisor who understands these limitations and can help develop a comprehensive strategy aligned with your specific situation.

Remember: The best tax planning looks beyond immediate deductions to your complete financial picture. 📊

Bruce Kowal, CPA, MS Taxation
#RealEstateTax #PassiveActivityLoss #TaxPlanning

[Aaron Zimmerman]

Bruce - thanks for sharing this info. It's absolutely crucial investors know if they can or cannot use losses. In my experience, cost segregation studies are a lot less than $10-15k especially for smaller properties (6 units and below). What I see is typically in the $3k - $6k range for those types of properties.

@Scott Trench - have you considered investing in short term rentals, materially participating, and having the average stay be less than 7 days? This could reduce your help lower your taxable income if the investment aligns with your lifestyle goals.