Cost Segregation Ownership Structures & Tax Planning Guide
Cost segregation tax planning requires understanding how depreciation deductions flow through different ownership structures and how tax rules apply at the owner level. Whether you own property through an S-corp, partnership, LLC, REIT, trust, or as an individual, the entity structure affects how you can use cost segregation deductions.
This guide covers how cost segregation ownership structures interact with passive activity rules, net operating losses, and other tax planning strategies. Understanding these interactions is essential for maximizing the value of a cost segregation study and avoiding unexpected tax consequences.
TL;DR – Key Takeaway
How Ownership Structure Affects Cost Segregation
Ownership structure affects cost segregation in three main ways: how depreciation deductions are calculated, how deductions flow to owners, and how tax rules apply at the owner level.
At the entity level, cost segregation studies follow the same engineering and methodology principles regardless of entity type. The reclassification of building components into shorter depreciation lives is performed the same way whether the owner is an individual, S-corp, partnership, or other entity.
The differences emerge at the owner level. How deductions are allocated, whether losses are passive or non-passive, and how basis is tracked all depend on the entity structure and the owner's tax profile. Understanding these differences is critical for evaluating whether cost segregation makes sense for your situation.
Pass-Through Entities Overview
Most real estate investors use pass-through entities such as S-corporations, partnerships, or LLCs taxed as partnerships or disregarded entities. Pass-through entities do not pay federal income tax at the entity level. Instead, income, deductions, gains, and losses flow through to the owners.
For cost segregation, this means the entity calculates the depreciation deduction, but the owner reports the deduction on their individual or entity tax return. The character of the deduction at the owner level depends on the nature of the activity and whether the owner meets tests such as material participation or real estate professional status.
Table 1: Pass-Through Entity Comparison
| Entity Type | Allocation Rules | Basis Tracking | Key Considerations |
|---|---|---|---|
| S-corporation | Pro rata by stock ownership | Stock basis | Cannot make special allocations; distributions limited by basis. |
| Partnership | Special allocations allowed (if substantial economic effect) | Partner capital account and outside basis | Flexible allocation; complex basis and capital account tracking. |
| Single-member LLC (disregarded) | All items flow to single owner | Owner's adjusted basis in LLC interest | Simplest structure; treated as sole proprietorship for tax purposes. |
| Multi-member LLC (partnership taxation) | Special allocations allowed | Member capital account and outside basis | Same rules as partnership; operating agreement governs allocations. |
Passive Activity Rules and Loss Limitations
For most real estate investors, rental real estate is treated as a passive activity under IRC Section 469. Passive losses can generally only offset passive income unless you qualify for an exception such as the active participation exception or real estate professional status.
Cost segregation increases depreciation deductions, which can create or increase passive losses. If you have no other passive income and do not qualify for an exception, those losses are suspended and carried forward until you have passive income or dispose of the property in a taxable transaction.
Understanding passive activity loss limitations is essential before implementing cost segregation. The value of accelerated depreciation depends on whether you can actually use the deductions in the current year or whether they will be suspended.
Tax Loss Harvesting Strategies
Cost segregation can be used strategically to generate tax losses in years when you want to reduce taxable income. These losses are often called paper losses because they are non-cash depreciation deductions that do not require any cash outlay.
Tax loss harvesting with cost segregation works best when you have other passive income to offset or when you qualify as a real estate professional and can use losses against ordinary income. If you cannot use the losses immediately, they are suspended and carried forward.
For a detailed guide on how to create tax losses with cost segregation, including strategic planning considerations and common scenarios, see the dedicated tax loss harvesting page.
Net Operating Loss Planning
If your total deductions from all sources exceed your total income, you have a net operating loss. Cost segregation can create or increase an NOL by accelerating depreciation deductions beyond what is required to offset current income.
Under current law, NOLs can be carried forward indefinitely but are limited to 80% of taxable income in the year they are used. This means you can offset most, but not all, of your future income with NOL carryforwards.
The strategic use of net operating losses for cost segregation depends on your income profile and whether you expect to have taxable income in future years that can absorb the NOL. If you already have substantial NOL carryforwards, generating additional NOLs through cost segregation may not provide immediate benefit.
Entity-Specific Considerations
Each entity type has unique rules that affect how cost segregation deductions are treated. The following entity-specific guides provide detailed analysis of how cost segregation works for each structure.
S-Corporations
S-corps allocate deductions pro rata based on stock ownership. Shareholders cannot make special allocations, and distributions are limited by stock basis. For a complete guide, see Cost Segregation for S-Corps.
LLCs
LLCs can be taxed as disregarded entities, partnerships, or corporations. Single-member LLCs are the simplest structure, while multi-member LLCs allow flexible allocations. See Cost Segregation for LLCs.
Partnerships
Partnerships can make special allocations of depreciation deductions among partners, subject to substantial economic effect rules. Partner basis and capital account tracking is complex. See Cost Segregation for Partnerships.
REITs
REITs must distribute most taxable income to shareholders, so cost segregation benefits are primarily at the shareholder level. REIT distributions are generally taxable as ordinary income. See Cost Segregation for REITs.
Trusts and Estates
Trusts and estates have unique rules for allocating income and deductions between the trust and beneficiaries. The type of trust affects how depreciation is treated. See Cost Segregation for Trusts and Estates.
Special Situations and Advanced Planning
Beyond basic entity structure considerations, several special situations require additional planning when implementing cost segregation.
Foreign Investors and FIRPTA
Foreign investors face FIRPTA withholding on disposition of U.S. real property. Accelerated depreciation from cost segregation reduces basis, which can increase the gain subject to withholding. Coordinate cost segregation with FIRPTA planning. See Cost Segregation for Foreign Investors.
Older Buildings and Late Studies
Cost segregation can be performed on buildings owned for many years using a look-back study. You can catch up on missed depreciation without amending prior returns. See Cost Segregation for Older Buildings.
Estate Planning Considerations
Cost segregation reduces basis through accelerated depreciation. On death, heirs receive a step-up in basis to fair market value. Strategic timing of cost segregation relative to estate transfer can affect tax outcomes. See Cost Segregation and Estate Planning.
Choosing the Right Structure
There is no single best ownership structure for cost segregation. The optimal choice depends on multiple factors including your tax situation, number of owners, need for allocation flexibility, and long-term disposition strategy.
Key factors to consider when choosing an entity structure
- Whether you qualify or can qualify as a real estate professional to unlock non-passive treatment of losses.
- Your current and projected passive income from other sources that could absorb passive losses.
- Whether you need flexibility to allocate depreciation deductions differently among owners.
- State law considerations, liability protection, and administrative complexity.
- Exit strategy and whether you plan to hold long term, sell, or do a 1031 exchange.
The entity choice should balance tax, legal, and operational factors. Consult with your CPA and attorney to evaluate your specific circumstances before implementing cost segregation or restructuring ownership.
Table 2: Entity Selection Decision Framework
| Priority | Recommended Entity | Reason |
|---|---|---|
| Simplicity and low cost | Single-member LLC (disregarded) | Simplest tax reporting; no separate return required. |
| Flexible allocation among owners | Partnership or multi-member LLC | Can make special allocations of depreciation and other items. |
| Self-employment tax planning | S-corporation (if active business) | Can split income between wages and distributions to reduce SE tax. |
| Multiple investors with varying interests | Partnership or multi-member LLC | Allows different economic arrangements and preferred returns. |
| Public or institutional investors | REIT | Allows public ownership and provides liquidity for investors. |
Frequently Asked Questions
How does ownership structure affect cost segregation benefits?
Ownership structure affects how depreciation deductions flow through to owners, whether losses are passive or non-passive, and how basis is tracked. Pass-through entities like S-corps, partnerships, and LLCs each have different rules for allocating deductions and applying passive activity limitations.
What is the best entity structure for cost segregation?
There is no single best entity structure. The optimal choice depends on your tax situation, whether you qualify as a real estate professional, how you want to allocate deductions among owners, and your long-term disposition strategy. Consult your CPA to evaluate your specific circumstances.
Can I use cost segregation to create tax losses?
Yes, cost segregation can create tax losses by accelerating depreciation deductions. Whether you can use those losses depends on passive activity rules, your income profile, and whether you meet exceptions such as real estate professional status.
What are passive activity loss limitations?
Passive activity loss limitations under IRC Section 469 restrict the use of rental real estate losses to offset non-passive income such as wages. Passive losses can generally only offset passive income unless you qualify as a real estate professional or meet other exceptions.
Can cost segregation create a net operating loss?
Yes, if depreciation deductions from cost segregation exceed your total income, you can create a net operating loss. NOLs can be carried forward indefinitely under current law, subject to an 80% limitation on utilization in future years.
How does cost segregation work for S-corporations?
S-corporations calculate depreciation at the entity level and pass deductions through to shareholders on Schedule K-1. Deductions are generally passive at the shareholder level unless the shareholder qualifies as a real estate professional. Shareholders must track stock basis, which is reduced by depreciation.
How does cost segregation work for partnerships?
Partnerships can make special allocations of depreciation deductions among partners, subject to substantial economic effect rules. Depreciation flows through to partners on Schedule K-1 and is subject to passive activity rules at the partner level. Partner basis is adjusted for depreciation deductions.
Can REITs use cost segregation?
Yes, REITs can use cost segregation to accelerate depreciation. However, REITs must distribute most of their taxable income, so the benefit is primarily at the shareholder level rather than the entity level. REIT distributions are generally taxable as ordinary income to shareholders.
How does cost segregation work for trusts and estates?
Trusts and estates can implement cost segregation, but the tax treatment depends on the type of trust and how income and deductions are allocated between the trust and beneficiaries. Depreciation may be allocated to beneficiaries based on income distribution rules.
Can foreign investors use cost segregation?
Yes, foreign investors can use cost segregation, but FIRPTA rules apply when foreign persons dispose of U.S. real property. Accelerated depreciation reduces basis, which can increase the gain subject to FIRPTA withholding on sale. Foreign investors should coordinate cost segregation with FIRPTA planning.
Is it too late to do cost segregation on an older building?
No, cost segregation can be performed on older buildings using a look-back study and Form 3115 to catch up on missed depreciation. You can claim the entire benefit in the current year without amending prior returns. The catch-up deduction can be substantial for buildings owned for many years.
How does cost segregation interact with estate planning?
Cost segregation affects estate planning by reducing the property basis through accelerated depreciation. On death, heirs receive a step-up in basis to fair market value, which resets the depreciation schedule. Strategic timing of cost segregation relative to estate transfer can affect overall tax outcomes.