What If My Property Decreases in Value?

Cost segregation is a tax strategy that reclassifies building components into shorter depreciation lives based on your tax basis. Market value is an economic measure of what the property could sell for. These are separate concepts, and changes in market value do not affect cost segregation.

Your tax basis is typically what you paid for the property plus improvements minus any depreciation taken. This basis is fixed at acquisition and adjusted over time by capital additions and depreciation. Market value fluctuates based on supply, demand, interest rates, and economic conditions.

Because cost segregation is based on tax basis, not market value, a decline in market value does not change the validity or amount of depreciation you can claim. You continue to depreciate the building components as originally classified.

Depreciation and property value are fundamentally different. Depreciation is a tax concept that allows you to recover the cost of an asset over its useful life. Market value is an economic concept that reflects current market conditions.

In many cases, real estate appreciates in market value while being depreciated for tax purposes. This creates a disconnect where you claim depreciation deductions even as the property becomes more valuable. The opposite can also occur: the property may decline in value while you continue to depreciate.

The IRS does not require you to adjust depreciation based on market value changes. Depreciation is calculated based on the original basis, the recovery period, and the depreciation method. Market value is irrelevant to this calculation.

A cost segregation property value drop scenario does not affect the depreciation deductions or the benefit of the study. If your property purchased for two million dollars declines to 1.5 million in market value, you continue to depreciate based on the two million dollar basis (allocated between land and building).

The cost seg declining value situation is common during economic downturns or local market corrections. Property owners may feel concerned that they are claiming depreciation on an asset worth less than the depreciated basis. This is normal and does not invalidate the deductions.

The unrealized loss is not recognized for tax purposes until you sell or dispose of the property. Until then, depreciation continues based on the original basis and recovery period. Cost segregation accelerates the timing of deductions but does not change this principle.

No, declining property value does not stop depreciation. You continue to depreciate the property based on the tax basis until the basis is fully recovered or the property is sold. Market value fluctuations do not trigger adjustments to depreciation schedules.

The only way depreciation stops is if the property is fully depreciated (basis reaches zero), the property is sold or disposed of, or the property is converted to personal use. A decline in market value is not one of these events.

This principle applies to all depreciation, not just cost segregation. Whether you use standard depreciation or cost segregation, market value changes do not affect the annual deduction.

Cost seg during downturn can still make sense if you have taxable income and depreciable basis. Market downturns do not reduce the tax benefit of accelerated depreciation. In fact, during downturns when cash flow may be tighter, the tax savings from cost segregation can be even more valuable.

Some owners delay cost segregation during downturns because they fear the property will not recover in value. This concern is misplaced because cost segregation is a tax strategy, not a real estate investment decision. The tax benefit is independent of market performance.

If the market downturn reduces your rental income or taxable income, the ability to use the deductions may be limited by passive activity rules or lack of income. However, the deductions can be carried forward and used in future years when income recovers.

If you sell a property for less than your adjusted basis, you recognize a loss. This loss may be deductible subject to passive activity rules and other limitations. Cost segregation does not prevent loss recognition, but it does reduce the basis faster, which can reduce the amount of loss on sale.

For example, if you bought a property for two million, took 500 thousand in depreciation through cost segregation, and sold for 1.2 million, your adjusted basis is 1.5 million. The loss is 300 thousand. If you had used standard depreciation and only taken 200 thousand, the loss would be 600 thousand.

This demonstrates that cost segregation can reduce the loss on sale because more depreciation was taken earlier. However, the earlier tax savings may still outweigh the reduced loss, especially when considering the time value of money.

While market value does not affect depreciation calculations, it can affect broader investment decisions. If you believe property values will decline significantly, you may reconsider the investment itself, not just the cost segregation strategy.

Market value considerations in broader planning

• Hold or sell decision: If values are declining, you may decide to sell, which triggers recapture and loss recognition.
• Refinancing: Declining values may reduce loan to value ratios and affect refinancing options, but not depreciation.
• Renovation timing: If values are low, you may delay renovations, which delays new cost segregation opportunities.
• Acquisition strategy: In a downturn, you may acquire properties at lower prices, which affects basis and future depreciation.

These decisions are investment decisions, not tax decisions. Cost segregation remains valid regardless of market value, but market conditions can influence whether you hold the property long enough to realize the full benefit.

When planning cost segregation, consider potential value fluctuations as part of the broader investment analysis. While market value does not affect depreciation, it can affect exit strategy, holding period, and overall return.

Planning tips

• Model multiple scenarios: Include upside, downside, and base case market value assumptions in your ROI analysis.
• Focus on tax benefit: The value of cost segregation comes from tax savings, not market value changes. Evaluate the tax benefit independently.
• Plan for loss scenarios: If values decline and you sell at a loss, the loss may be deductible, which provides some tax benefit.
• Coordinate with CPA: Discuss how market conditions affect your overall tax position and whether cost segregation fits your plan.

Cost segregation is a tax optimization tool. It works in rising markets, declining markets, and stable markets because it is based on tax basis, not market conditions.