Cost Segregation for Tax Loss Harvesting

Cost segregation tax loss harvesting begins with the reclassification of building components. By identifying personal property and land improvements that qualify for shorter depreciation lives, a cost segregation study increases the amount of depreciation you can claim in earlier years.

When depreciation deductions exceed rental income or other property income, the result is a tax loss. This tax loss can offset other income, subject to passive activity limitations and your overall tax profile.

The magnitude of the loss depends on the depreciable basis, the portion eligible for reclassification, and whether bonus depreciation applies. Larger properties with significant eligible components can generate larger losses, which is why cost segregation studies are often prioritized for commercial properties with substantial basis.

Paper losses cost segregation refers to depreciation deductions that reduce taxable income without requiring a cash outlay in the year they are taken. You do not write a check for depreciation. It is an accounting deduction based on the recovery of capital investment over time.

These paper losses are real for tax purposes. They reduce taxable income, which can lower your tax liability and improve after tax cash flow. The term paper loss simply highlights that the loss is a non-cash expense.

Investors often use paper losses to manage taxable income in years when cash flow is strong but they want to minimize current tax. This is one reason why generating losses through cost segregation is a common tax strategy for real estate owners.

The ability to use cost segregation losses depends on passive activity rules under IRC Section 469. For most rental real estate, income and losses are classified as passive. Passive losses can generally only offset passive income unless you meet specific exceptions.

If you have excess passive losses, they cannot be used to offset ordinary income such as wages or business income unless you qualify as a real estate professional. These unused losses are suspended and carried forward until you have sufficient passive income or dispose of the property in a taxable transaction.

Understanding passive activity loss limitations is critical before implementing a tax loss strategy. Your CPA should evaluate whether you can use the losses in the current year or whether they will be suspended.

Real estate professional status unlocks the ability to use passive real estate losses against ordinary income. To qualify, you must spend more than 750 hours per year in real property trades or businesses and more than 50% of your personal services in such activities.

If you meet these tests, rental real estate losses can be treated as non-passive, allowing them to offset W-2 wages, business income, and other sources. This dramatically increases the value of cost segregation tax losses for qualifying investors.

Real estate professional status is fact intensive and requires contemporaneous time tracking and proper documentation. For more on how this status interacts with ownership structures and tax planning, consult your tax advisor.

Once you generate losses through cost segregation, there are several strategic uses. The most common is offsetting income in the current year to reduce tax liability and improve after tax cash flow.

Common strategies include

• Offsetting other passive income from rental properties or passive business activities.
• Using losses to offset ordinary income if you qualify as a real estate professional.
• Carrying forward suspended losses to use against future passive income or upon disposition of the property.
• Creating net operating losses that can be carried forward under current NOL rules.

Investors with multiple properties often coordinate the timing of cost segregation studies to align with years when they have high passive income or plan to sell other properties. This type of tax planning requires a clear view of your entire portfolio.

If you cannot use your cost segregation tax losses in the current year, passive activity losses are carried forward indefinitely. They remain suspended until you have sufficient passive income or until you dispose of your interest in the property in a fully taxable transaction.

Net operating losses created by cost segregation are subject to different rules. Under current law, NOLs can be carried forward indefinitely but are limited to 80% of taxable income in the carryforward year. NOL carryback rules have changed multiple times, so confirm the current rules with your CPA.

For a deeper dive into how cost segregation can create net operating losses, review the dedicated NOL planning page.

Tax loss harvesting in the investment world typically refers to selling securities at a loss to offset capital gains. Cost segregation tax loss harvesting is different. It uses depreciation to generate losses without selling anything.

Both strategies aim to reduce current year taxable income, but the mechanics and rules differ. Securities tax loss harvesting is subject to wash sale rules and capital loss limitations. Cost segregation losses are subject to passive activity rules and depreciation recapture on disposition.

When you sell a property after using cost segregation, previously suspended passive losses may be released and allowed in full. This can offset gain on the sale or other income in the year of disposition.

However, accelerated depreciation claimed through cost segregation may trigger depreciation recapture. Personal property is typically subject to ordinary income recapture, while real property may be subject to Section 1250 recapture or unrecaptured Section 1250 gain at 25%.

The net tax outcome on sale depends on your basis, the amount of accumulated depreciation, and whether you use a tax deferral strategy such as a 1031 exchange. Coordinate with your CPA to model the disposition impact before implementing a tax loss harvesting strategy.