Passive Activity Losses for Cost Segregation

IRC Section 469 was enacted to prevent taxpayers from using passive losses to shelter unrelated income. Under these rules, income and losses are classified as either passive or non-passive. Passive losses can generally only offset passive income, not wages, business income, or other active sources.

For most investors, rental real estate is automatically treated as a passive activity regardless of how much time you spend managing the property. This classification means that rental losses, including depreciation from cost segregation, are subject to passive activity loss limitations.

The passive activity rules apply at the individual taxpayer level, which means the limitation follows you, not the entity. Whether you own property through an LLC, S-corporation, or partnership, the character of the income and loss at your level is what determines how it can be used.

Cost segregation increases depreciation deductions by reclassifying building components into shorter recovery periods. This accelerated depreciation can turn rental income into a rental loss, or it can increase an existing loss.

Because rental real estate is typically passive, the additional depreciation from cost segregation creates or increases passive losses. If you have no other passive income, those losses are suspended and cannot be used to offset wages, business income, or other non-passive sources unless you meet a specific exception.

This interaction is why entity structure and tax planning matter. The value of cost segregation depends not only on the deductions it generates but also on whether you can actually use them in the current year.

Passive income includes rental income, royalties, and income from businesses in which you do not materially participate. Non-passive income includes wages, self-employment income, and income from businesses where you do materially participate.

Passive gains and losses are netted together. If you have multiple rental properties, losses from one property can offset income from another as long as both are passive. Excess passive losses after netting are suspended and carried forward.

There are two main exceptions that allow passive real estate losses to offset non-passive income: the active participation exception and the real estate professional exception.

Active Participation Exception

Taxpayers who actively participate in rental real estate may deduct up to $25,000 of passive losses against non-passive income. Active participation is easier to meet than material participation and generally requires that you make management decisions such as approving tenants and setting rental terms.

This $25,000 allowance phases out for taxpayers with adjusted gross income between $100,000 and $150,000. Above $150,000, the allowance is fully phased out. This limitation makes the exception unavailable to most high-income investors.

Real Estate Professional Exception

Real estate professionals who meet the statutory tests can treat rental real estate losses as non-passive, allowing those losses to offset wages, business income, and other non-passive sources. This exception requires spending more than 750 hours per year in real property trades or businesses and more than 50% of personal services in such activities.

The real estate professional exception is the most valuable for investors using cost segregation to generate losses. If you qualify, the passive activity loss limitations do not apply, and losses can be used immediately against all income sources.

A passive activity grouping election allows you to treat multiple activities as a single activity for purposes of applying the passive loss rules. This can be useful if you have some rental properties with income and others with losses.

By grouping properties together, you can offset losses from one property against income from another within the same group. The grouping election is made by attaching a statement to your tax return and must be applied consistently in future years unless facts and circumstances change.

Grouping elections should be coordinated with your CPA. Incorrect grouping or failure to properly document the election can result in unfavorable treatment of passive losses.

When passive losses exceed passive income, the excess is suspended and carried forward indefinitely. These suspended passive activity loss carryforwards can be used in future years when you have sufficient passive income or when you dispose of your entire interest in the activity in a fully taxable transaction.

Suspended losses do not expire, but they do not provide current year cash flow benefits. This is why the timing of cost segregation studies should be coordinated with your overall tax profile. If you expect to have passive income in future years, a cost segregation study today can create losses that will be usable later.

If you sell one rental property at a passive gain, that gain can be offset by suspended passive losses from other properties. This is a common planning strategy for investors with multiple rental properties and accumulated suspended losses.

For example, if you have $100,000 of suspended passive losses and sell a property generating $80,000 of passive gain, the suspended losses can offset that gain, which can significantly reduce your tax liability on the sale.

Coordinating the timing of cost segregation studies with planned dispositions can maximize the value of passive losses. If you know you will sell a property in the near future, generating additional passive losses through cost segregation for your ownership structure may provide current year tax benefits.

Before implementing a cost segregation study, evaluate whether you can use the losses in the current year or whether they will be suspended. If you have other passive income, the losses can provide immediate benefit. If not, the benefit is delayed until you have passive income or sell the property.

Consider the following when planning for passive activity loss carryforward utilization:

• Your current and projected passive income from all sources.
• Whether you qualify or can qualify as a real estate professional to unlock non-passive treatment.
• The timing of potential property sales and whether suspended losses can offset gains on those sales.
• Whether grouping elections can help you net income and losses across multiple properties.

This analysis should be performed with your CPA before incurring the cost of a cost segregation study. Understanding your passive activity profile is essential to evaluating the true return on investment.