Cost Segregation for LLCs

An LLC can be taxed as a disregarded entity, a partnership, an S-corporation, or a C-corporation. The default classification depends on the number of members. A single-member LLC is disregarded by default, and a multi-member LLC is taxed as a partnership by default.

The tax classification affects how llc depreciation is reported and allocated. A disregarded entity reports depreciation directly on the owner's tax return. A partnership files Form 1065 and allocates depreciation to members on Schedule K-1. An LLC electing S-corp or C-corp taxation follows the rules applicable to those entity types.

For cost segregation purposes, the engineering analysis and asset reclassification are identical regardless of tax classification. What changes is how the resulting deductions are reported and who can use them.

A single-member llc cost segregation study produces depreciation deductions that are reported directly on the owner's tax return. The LLC is disregarded for federal tax purposes, so the property is treated as if owned directly by the individual or entity that owns the LLC.

The owner reports the depreciation on Schedule E if the property is rental real estate, or on the appropriate business schedule if the property is used in a trade or business. Passive activity rules apply at the owner level based on their participation and real estate professional status.

Single-member LLCs offer liability protection without the complexity of partnership tax reporting. For investors with one property or who do not need to allocate income and deductions among multiple owners, the single-member LLC structure is straightforward and effective for cost segregation tax planning.

A multi-member llc cost segregation implementation requires the LLC to calculate depreciation at the entity level and allocate it to members based on the operating agreement. The LLC files Form 1065 and issues Schedule K-1 to each member showing their allocated share of depreciation.

By default, depreciation is allocated based on the members' ownership percentages. However, the operating agreement can provide for special allocations, which allow depreciation to be allocated differently than the ownership percentages, subject to substantial economic effect requirements under IRC Section 704(b).

This flexibility is one reason why multi-member LLCs taxed as partnerships are preferred for real estate syndications and joint ventures. Investors can structure allocations to direct more depreciation to members who can use it, improving the overall tax efficiency of the investment.

Multi-member LLCs taxed as partnerships can make special allocations of depreciation if the allocations have substantial economic effect. This means the allocations must reflect the economic arrangement among the members and be respected by the IRS.

Special allocations allow depreciation to be directed to members who have higher tax rates, more passive income to offset, or who can otherwise use the deductions more effectively. This is a powerful tax planning tool not available to S-corporations, which must allocate all items pro rata.

The operating agreement must clearly document the allocation method and ensure that capital accounts are maintained properly. For guidance on how partnership structures handle cost segregation, review the dedicated partnership page.

Each LLC member has an outside basis in their membership interest. This basis is increased by the member's share of income and contributions, and decreased by the member's share of deductions, losses, and distributions.

Cost segregation increases depreciation deductions, which reduces member basis. Distributions are tax free to the extent of basis, so if basis is reduced significantly by depreciation, future distributions may trigger taxable gain.

Members must track their basis carefully to avoid unexpected tax consequences. If a member's basis is reduced to zero, additional losses cannot be claimed until basis is restored through capital contributions, debt allocation, or income.

For rental real estate owned by an LLC, the activity is generally passive at the member level. Passive losses can only offset passive income unless the member qualifies for an exception, such as the real estate professional safe harbor or the active participation allowance.

Members who do not qualify for an exception will have their cost segregation deductions suspended if they do not have sufficient passive income. Suspended losses are carried forward indefinitely and can be used when the member has passive income or disposes of their LLC interest in a taxable transaction.

Understanding passive activity limitations is critical before implementing cost segregation. The deductions provide a tax benefit only if the member can use them. Work with your CPA to determine whether you can use the losses in the current year or whether they will be suspended.

LLC members who qualify as real estate professionals can treat rental real estate losses as non-passive, allowing the losses to offset ordinary income such as wages or business income. This dramatically increases the value of llc real estate tax deductions from cost segregation.

To qualify, the member must spend more than 750 hours per year in real property trades or businesses and more than 50% of their personal services in such activities. They must also materially participate in the rental activity.

Real estate professional status is a powerful tool for unlocking the full benefit of cost segregation. However, it requires contemporaneous time tracking, proper documentation, and careful planning to ensure the tests are met.

When an LLC member sells their membership interest, their gain or loss is based on their outside basis in the interest. Suspended passive losses may be released to offset the gain on the sale. However, the buyer does not receive a step-up in the inside basis of the LLC's assets unless a Section 754 election is in place.

If the LLC sells the property, the entity recognizes gain and recapture, which flows through to the members on Schedule K-1. Members then report their share of the gain and recapture on their individual returns.

The tax outcome on sale depends on the depreciation taken, the property's basis, and whether the LLC or the members are selling. For more on how depreciation recapture affects real estate sales, review the cost segregation for REITs page, which discusses similar disposition considerations.

LLCs offer more flexibility than S-corporations because they can make special allocations and can choose how they are taxed. For investors who need allocation flexibility or who plan to bring in new members with different economic arrangements, an LLC taxed as a partnership is often the best choice.

S-corporations require pro rata allocation and may be better suited for active businesses where self-employment tax planning is a priority. C-corporations do not offer pass-through taxation and are rarely used for rental real estate unless there is a specific reason such as REIT planning.

The entity choice should balance tax, legal, and operational considerations. Work with your CPA and attorney to determine the best structure for your real estate portfolio and cost segregation strategy.