Cost Segregation for S-Corps

An S-corporation is a pass-through entity for federal income tax purposes. The entity itself does not pay tax. Instead, income, deductions, gains, and losses pass through to the shareholders, who report their share on their individual tax returns.

This pass-through structure means that cost segregation depreciation calculated at the S-corp level flows directly to the shareholders. Each shareholder reports their proportionate share of the depreciation deduction based on their stock ownership percentage.

Unlike partnerships, S-corporations cannot make special allocations. All items must be allocated pro rata based on stock ownership, which limits flexibility in allocating cost segregation deductions among shareholders.

When an S-corp implements cost segregation, the entity calculates the reclassified depreciation on its tax return. The depreciation is then allocated to shareholders and reported on Schedule K-1.

Shareholders receive their Schedule K-1 and report the depreciation deduction on their individual return. The character of the deduction at the shareholder level depends on whether the activity is passive or non-passive for that shareholder.

For rental real estate owned by an S-corp, the activity is generally passive at the shareholder level unless the shareholder meets the real estate professional tests and materially participates in the rental activity. Understanding how ownership structure affects tax planning is critical when evaluating cost segregation for an S-corp.

S-corp depreciation from rental real estate is subject to passive activity rules at the shareholder level. For most investors, this means the depreciation can only offset passive income unless the shareholder qualifies for an exception.

If the shareholder qualifies as a real estate professional and materially participates in the rental activity, the depreciation can offset ordinary income such as wages or business income. This dramatically increases the value of s corp depreciation deductions.

Shareholders who do not meet the real estate professional tests will have their cost segregation deductions treated as passive. If they have no other passive income, the deductions are suspended and carried forward until they have passive income or dispose of their interest in the S-corp.

S-corp shareholders must track their stock basis, which is adjusted annually for the shareholder's share of income, deductions, gains, and losses. Cost segregation depreciation reduces the shareholder's stock basis.

If your stock basis is reduced to zero, you cannot claim additional losses until you restore basis through capital contributions, loans, or income allocation. This is why basis tracking is critical when implementing s corp real estate depreciation strategies.

Additionally, if you take distributions from the S-corp, those distributions are tax free to the extent of your stock basis. If distributions exceed basis, the excess is taxed as capital gain. Cost segregation increases depreciation deductions, which reduces basis and may limit the amount you can distribute tax free.

Unlike partnerships, S-corporations must allocate all items pro rata based on stock ownership. If you own 40% of the S-corp stock, you receive 40% of the cost segregation depreciation deductions.

This pro rata allocation rule limits planning flexibility. You cannot make special allocations to direct more depreciation to one shareholder and less to another, which is possible in a partnership structure.

If you need allocation flexibility, a partnership or multi-member LLC taxed as a partnership may be more appropriate. For more on how different entity structures compare, see the cost segregation for LLCs page.

S-corp distributions are not taxable to the extent of the shareholder's stock basis. Because cost segregation increases depreciation deductions, which reduce basis, planning distributions becomes more important.

If cost segregation reduces your basis to a low level and the S-corp makes significant distributions, you may have taxable gain on the distributions. Coordinate with your CPA to ensure distributions do not create unexpected tax liability.

Some S-corp owners choose to leave cash in the entity rather than distribute it if basis is low. This preserves basis for future loss deductions and avoids triggering gain on distributions.

If you sell your S-corp stock, your gain or loss is based on your stock basis. Suspended passive losses may be released to offset the gain on the stock sale. However, depreciation recapture remains at the entity level when the S-corp sells the property.

If the S-corp sells the property, the entity recognizes gain and recapture, which flows through to the shareholders on Schedule K-1. Shareholders then report their share of the gain and recapture on their individual returns.

The choice between an S-corp, partnership, or LLC taxed as a partnership affects how cost segregation deductions are allocated and used. S-corps require pro rata allocation, while partnerships allow special allocations.

For investors who need flexibility in allocating depreciation deductions or who plan to bring in new investors with different economic arrangements, a partnership structure may be more appropriate. For more on how partnerships handle pass through cost segregation, see the dedicated partnership page.

S-corps may still be preferred for non-tax reasons, such as self-employment tax planning for active businesses or state law considerations. The entity choice should balance tax, legal, and operational factors.