Net Operating Losses (NOLs) for Cost Segregation

Cost segregation creates net operating losses by increasing depreciation deductions in the year the study is applied. When total deductions from all sources exceed total income from all sources, the result is an NOL.

For real estate investors, the additional depreciation from cost segregation can turn a taxable income position into a loss position. This is especially true when bonus depreciation applies, which can produce large first year deductions.

The ability to create an NOL through cost segregation depends on your overall income and deductions. If you have significant income from other sources, cost segregation may reduce taxable income without creating an NOL. If your income is lower or you have other deductions, an NOL is more likely.

Under current law, NOLs can be carried forward indefinitely. However, NOL carryforwards are limited to 80% of taxable income in the year they are used. This means that even if you have a large NOL, you can only offset 80% of your income in any given year, and the remaining 20% will be taxable.

NOL carryback rules have been modified multiple times in recent years. As of the current tax law, most taxpayers cannot carry back NOLs to prior years, though specific provisions may allow carrybacks in certain situations. Confirm the applicable rules with your CPA.

A net operating loss is different from a passive loss. An NOL occurs when total deductions exceed total income. A passive loss is a rental or passive business loss that is subject to passive activity limitations.

You can have suspended passive losses without having an NOL if you have other income sources. For example, if you have $50,000 of rental losses and $100,000 of W-2 income, you do not have an NOL. You have a passive loss that may be suspended under IRC Section 469.

To create an NOL from real estate, the rental losses must exceed all other income, or you must qualify as a real estate professional so that rental losses are treated as non-passive. Understanding the interaction between passive activity loss rules and NOL rules is critical for tax planning.

Creating a net operating loss through cost segregation can be a strategic tax planning tool in specific situations. If you expect higher income in future years, generating an NOL today can offset that future income and reduce your overall tax liability.

Common scenarios where cost segregation NOL strategy makes sense

• You expect significant income from a business sale or other liquidity event in the near future.
• You are a real estate professional and can use NOLs to offset ordinary income in future years.
• You plan to sell rental properties and want to offset gains with NOL carryforwards.
• You have variable income and want to smooth taxable income over multiple years.

If you already have substantial NOL carryforwards, generating additional NOLs through cost segregation may not provide immediate benefit. The value depends on your ability to use the NOL within a reasonable time frame.

NOLs are calculated on your tax return by netting all income and deductions. If the result is negative, you have an NOL. Your CPA should calculate the NOL and determine the amount that can be carried forward to future years.

The NOL is reported on your tax return and tracked on Schedule A of Form 1045 or similar forms depending on your entity type. Proper documentation is essential to ensure the NOL is claimed correctly in future years.

If cost segregation creates or increases an NOL, your CPA should account for the NOL carryforward and ensure it is properly applied in the first year you have sufficient income to absorb it.

The 80% limitation on NOL utilization is the most significant restriction. Even if you have a large NOL carryforward, you can only offset 80% of your taxable income in any given year. This extends the time required to fully utilize the NOL.

Additionally, NOLs cannot be transferred or sold to other taxpayers. They are personal to the taxpayer who generated them. Corporate NOLs may carry over in certain mergers or acquisitions, but individual and pass-through entity NOLs generally do not transfer.

When you sell a property after using cost segregation to create NOLs, depreciation recapture may apply. Personal property components are subject to ordinary income recapture, while real property may be subject to unrecaptured Section 1250 gain at 25%.

The recapture tax partially offsets the benefit of the NOL created in earlier years. The net tax benefit depends on the timing of the deductions, your tax rates in each year, and the structure of the disposition.

If you expect to hold the property long term or plan to use a 1031 exchange to defer gain, the recapture impact may be deferred or eliminated, which can increase the value of the NOL strategy.

Before using cost segregation to create an NOL, evaluate whether you can use the NOL within a reasonable time frame. If you expect low income for many years, the NOL may take a long time to utilize, which reduces its present value.

Consider the following when evaluating a cost segregation NOL strategy:

• Your projected income over the next 5 to 10 years.
• Whether you qualify as a real estate professional, which affects how NOLs can be used.
• The cost of the study relative to the expected tax benefit from the NOL carryforward.
• Disposition plans and whether recapture will offset the NOL benefit on sale.

Work with your CPA to model the expected cash flow impact of creating an NOL through cost segregation. The analysis should account for the 80% limitation, your projected income, and the time value of money.