Cost Segregation Without Real Estate Professional Status

For investors who do not qualify as real estate professionals, rental activities are passive by statute. This means all income, losses, and deductions from those activities are subject to the passive activity limitations under IRC Section 469. Cost segregation accelerates depreciation within the passive activity, but those accelerated deductions produce passive losses rather than non-passive ones.

Passive losses cannot reduce wages, self-employment income, or other active or portfolio income. They can only offset passive income. If the investor has no passive income in the year the cost segregation losses arise, those losses are suspended and carried forward to future years.

The study itself produces the same engineering output for a passive investor as for a real estate professional. The difference is entirely in how the resulting depreciation deductions are characterized for tax purposes and when they become usable.

When a passive investor completes a cost segregation study, the reclassified components generate accelerated depreciation on the property's tax return. That depreciation reduces the activity's net income or increases its net loss. The resulting passive loss is reported on Schedule E, Part II and then flows to Form 8582, which applies the passive activity loss limitations.

Form 8582 calculates how much of the passive loss is currently deductible based on the investor's passive income from all passive sources. Any amount that exceeds passive income is suspended and added to the passive loss carryforward for that activity.

The mechanics are the same whether the passive loss arises from straight-line depreciation or from an accelerated cost segregation study. The difference is magnitude: cost segregation creates larger losses in the early years of ownership.

IRC Section 469(i) provides an exception to the passive loss rules for active participants in rental real estate. Taxpayers who actively participate (a lower standard than material participation) can deduct up to $25,000 of passive rental losses against non-passive income per year, subject to an income phase-out.

The phase-out begins at $100,000 of modified AGI and is completely eliminated at $150,000. For most investors pursuing cost segregation, AGI well exceeds $150,000, making the $25,000 allowance irrelevant. However, for investors in the phase-out range, partial use of this allowance is possible.

Active participation is not the same as material participation. Active participation simply requires that the taxpayer have at least a 10% ownership interest and make management decisions in a bona fide sense, such as approving new tenants, deciding rental terms, and approving capital improvements. Most direct property owners qualify for active participation even if they are not real estate professionals.

For investors who cannot use their cost segregation losses currently, those losses accumulate as suspended passive losses on Form 8582. The carryforward is indefinite; there is no expiration date. Suspended losses from a property purchased ten years ago remain available when the property is eventually sold.

The accumulation of suspended losses has value, but it is a deferred value. The present value of a deduction available in ten years is substantially less than the present value of the same deduction taken today. This time value discount is a key input in evaluating whether cost segregation makes economic sense for a passive investor.

Passive losses from cost segregation can be offset against any passive income, not just income from the same property. Useful sources of passive income that can absorb suspended cost segregation losses include:

• Net rental income from other rental properties not generating cost segregation losses
• Distributions from real estate limited partnerships or syndications
• Income from other passive activities such as limited partnership interests
• Gain on sale of passive activities (before the suspended loss release)

Investors with a diverse portfolio of passive activities may have passive income from other sources that allows them to absorb cost segregation losses in the current year, making the passive nature of the losses less of a constraint.

When a rental property is sold in a fully taxable transaction, all suspended passive losses from that activity are released and become deductible in the year of sale. This is the most reliable mechanism for a passive investor to eventually use cost segregation losses.

The release on disposition means that cost segregation losses create a kind of "stored deduction" that reduces the taxable gain on sale or creates an additional deduction in the year of sale. This is less valuable than using the deductions in the year of acquisition, but it is not without value.

Investors who use like-kind exchanges (1031 exchanges) to defer gain on sale do not release suspended passive losses at the time of the exchange. The losses continue to carry forward and will only be released upon a taxable disposition. This is an important planning consideration for passive investors who routinely exchange rather than sell properties.

The economics of cost segregation for a passive investor depend on three factors: whether the investor has passive income to absorb the losses, when the investor expects to sell the property, and what the investor's marginal tax rate will be at the time the losses become usable.

Non real estate professional cost segregation investors can still structure their situations to extract more value from passive losses. Several strategies apply:

• Pair cost segregation properties with passive income-generating investments to absorb losses currently
• Time the cost segregation study to coincide with a year of high passive income
• Plan property dispositions to coincide with the release of large accumulated suspended loss balances
• Evaluate whether qualifying for REPS in the near future changes the planning calculus
• Consider the interaction between suspended passive losses and the step-up in basis at death for estate planning

Each of these strategies requires coordination with a tax advisor familiar with both the passive activity rules and how cost segregation studies work.

The gap between passive and non-passive cost segregation outcomes is most visible in high-income years. A REPS-qualifying investor who takes $500,000 of non-passive depreciation deductions at a 37% marginal rate saves $185,000 in federal taxes in the current year. A passive investor with the same $500,000 of passive losses and no passive income saves nothing in the current year.

Over time, if the passive investor eventually uses those losses at a 37% rate, the nominal savings are the same. But the time value of a deferred $185,000 versus an immediate $185,000 is substantial. If the passive investor holds for ten years before realizing the benefit, the present value at a 5% discount rate is approximately $114,000 compared to $185,000 received immediately.

The analysis of cost segregation without REPS naturally raises the question of whether it is worth pursuing real estate professional status. For investors who are close to qualifying - for example, a spouse who could transition to managing the portfolio full-time - the incremental effort may generate enormous additional value from cost segregation studies already in progress.

For a complete analysis of the passive activity framework that governs both REPS and non-REPS situations, the guide to passive activity loss rules explained covers the full structure of Section 469 and how different investor profiles interact with it. And for the offsetting income question, the analysis of whether cost segregation can offset W-2 income directly addresses the question most passive investors are trying to answer.