Can Cost Segregation Offset W-2 Income?

Whether cost segregation can offset W-2 income is fundamentally a question of passive activity classification. Rental income and losses are passive by default under Section 469(c)(2). Passive losses cannot offset non-passive income, which includes wages. The pathway to using cost segregation depreciation against W-2 wages runs through the real estate professional exception, which converts the rental activity from passive to non-passive for qualifying taxpayers.

For investors without REPS status, the $25,000 passive loss allowance under Section 469(i) provides a partial exception for active participants in rental real estate, but this allowance phases out completely at $150,000 of modified AGI. Most investors for whom cost segregation is economically significant have income well above this threshold, making the allowance irrelevant to their situation.

To use cost segregation to offset W-2 income, the taxpayer must satisfy two sets of tests. First, qualify as a real estate professional: perform more than 750 hours in real property trades or businesses and have those hours constitute more than half of all personal services. Second, materially participate in the specific rental activities generating the depreciation losses.

Both sets of tests must be satisfied in the same tax year. REPS status alone, without material participation at the property level, does not convert the rental losses to non-passive. Material participation alone, without REPS status, does not override the automatic passive classification of rental activities.

When a qualifying real estate professional with material participation generates non-passive rental losses, those losses appear on Schedule E (Supplemental Income and Loss) and flow to the front page of Form 1040 as a reduction to adjusted gross income. They are not separately limited; they reduce AGI in the same way as any other business deduction.

The W-2 wages appear as income on Line 1 of Form 1040. The non-passive rental losses appear as negative income on Schedule E. The net effect is that the combined AGI is reduced by the amount of the non-passive loss. If the loss exceeds all income, the result may be a net operating loss.

Form 8582 is not required for activities that are non-passive. The passive loss calculation on Form 8582 only applies to activities that remain passive. A REPS investor's qualifying rental activities are reported directly on Schedule E without the Form 8582 limitation.

The magnitude of the W-2 income offset depends on how large the non-passive rental loss is, which in turn depends on the depreciable basis of the property, the percentage reclassified through cost segregation, and whether bonus depreciation is available.

The actual W-2 income offset may be limited to the taxpayer's total W-2 wages if the loss exceeds wages. Any remaining non-passive loss reduces other income sources or creates a net operating loss.

Section 461(l) created the excess business loss limitation for tax years 2021 through 2028 under current law. This provision limits the amount of net business losses (including non-passive rental losses for real estate professionals) that a non-corporate taxpayer can deduct against non-business income to $305,000 (single) or $610,000 (married filing jointly) for 2024, indexed for inflation.

Losses exceeding these thresholds are converted to net operating loss carryforwards under Section 172. This means a REPS investor who generates $900,000 of non-passive rental losses in 2024 while filing jointly can use $610,000 to offset wages and other income immediately, with the remaining $290,000 carried forward as an NOL.

The excess business loss limitation is a relatively new and complex provision that interacts with other rules. Tax advisors should be consulted before relying on projections of the full offset available in high-loss years.

Non-passive rental losses for real estate professionals can offset not only W-2 wages but also self-employment income, partnership income, S corporation income, and other non-passive business income. The classification as non-passive allows the losses to net against any income that is similarly non-passive, provided the same taxpayer generates both the loss and the income.

Self-employed investors have a structural advantage in pursuing REPS because they have no W-2 employment hours counting against the more-than-half test. This makes it significantly easier to satisfy the more-than-half threshold, and the resulting non-passive losses are available to offset self-employment income from other businesses.

W-2 employees face a structural challenge in achieving the non-passive treatment needed to use cost segregation against salary. The more-than-half test requires that real estate hours exceed all personal service hours, including employment hours. A full-time employee working 2,000 hours per year must also perform more than 2,000 documented real estate service hours to pass the more-than-half test.

For many high-income professionals, this standard is not achievable without significantly reducing employment hours or transitioning to part-time work. The more practical path for many W-2 employees is to structure their household so that a non-employed spouse qualifies as the real estate professional, allowing the combined family unit to benefit from cost segregation losses on a joint return.

For investors who cannot achieve REPS qualification, cost segregation still has value when they have passive income to absorb the losses or plan to sell properties in taxable transactions. The strategic use of cost segregation alongside passive income planning is the primary alternative for non-qualifying investors.

Passive investors can also evaluate whether pursuing REPS qualification in a future year is realistic, given their employment and real estate activity profile. If REPS qualification is achievable within one to three years, deferring a cost segregation study until a qualifying year may be worth considering, though the decision involves property-specific and market-specific variables that must be weighed carefully.

When non-passive rental losses from cost segregation exceed total income in a given year, the result may be a net operating loss (NOL) under Section 172. NOLs generated after 2017 can be carried forward indefinitely but are limited to offsetting 80 percent of taxable income in the carryforward year.

A REPS investor who takes a large first-year cost segregation loss in a year with modest W-2 income may generate an NOL that shelters income in subsequent years. This creates a multi-year tax benefit from a single cost segregation engagement, extending the value of the depreciation deduction into future high-income years.

Strategic planning for using cost segregation studies to offset wage income requires coordinating the REPS qualification, the material participation analysis, the timing of the cost segregation engagement, and the availability of bonus depreciation in the applicable year. Each of these variables affects how much of the study's depreciation is usable in the current year versus deferred.

For the comparison of passive versus non-passive treatment that underlies this entire analysis, see the detailed breakdown of passive versus non-passive income and cost segregation. And for the qualification steps that make the offset available, the overview of the 750-hour rule in depth explains the threshold that most high-income employees struggle to satisfy.