When Does Cost Segregation NOT Make Sense?

Understanding when not to do cost segregation is as important as recognizing when the strategy creates value. Cost segregation involves upfront costs, ongoing compliance requirements, and implementation complexity that only make sense when tax benefits exceed these burdens by a meaningful margin. Pursuing cost segregation in inappropriate scenarios wastes resources and creates administrative complexity without corresponding financial benefit.

The decision to skip cost segregation should be based on objective cost-benefit analysis rather than general assumptions. Scenarios where cost segregation is not recommended include properties with insufficient depreciable basis, investors subject to loss limitations without offsetting income, very short hold periods where recapture offsets benefits, and situations where total implementation costs exceed realistic tax savings.

For context on cost segregation strategy principles, refer to the cost segregation strategy hub. This article focuses on scenarios where cost segregation is a bad idea and how to recognize when to avoid cost segregation.

Properties with depreciable basis below certain thresholds rarely generate sufficient tax savings to justify full engineering based cost segregation studies. Study costs typically range from $4,000 to $8,000 for smaller properties, and if total tax savings over a reasonable hold period do not exceed study costs by at least 2:1 or 3:1, the investment is questionable.

The minimum threshold for traditional cost segregation studies is generally $500,000 in depreciable basis, though simplified or automated approaches may be viable down to $250,000 if component mix is favorable. Below $250,000, cost segregation not worth it is the likely conclusion for most property types and investor scenarios.

Property Value Thresholds for Cost Segregation

• Under $250,000 depreciable basis: Cost segregation rarely justified; study costs likely exceed incremental tax savings.
• $250,000 to $500,000 basis: Marginal zone; simplified studies may work if reclassification rates exceed 25% to 30%.
• $500,000 to $1,000,000 basis: Cost segregation typically viable if you can use deductions immediately and hold for 5+ years.
• Over $1,000,000 basis: Cost segregation almost always creates positive ROI if basic eligibility criteria are met.

Investors with smaller properties should focus on strategies that do not require significant upfront costs. Building a portfolio of similar properties and pursuing batch cost segregation when total basis reaches viable thresholds may be more effective than studying individual small properties.

Passive activity loss limitations are one of the most common reasons cost segregation not recommended applies. If you are a passive investor without sufficient passive income to offset losses generated by accelerated depreciation, the deductions will be suspended and carried forward until you have passive income or dispose of the property. Suspended losses provide no immediate tax benefit, eliminating the time value advantage that makes cost segregation economically attractive.

For passive investors, cost segregation only creates value if you have other passive income sources that can absorb the increased losses, if you qualify for the $25,000 special allowance for moderate income taxpayers, or if you plan to dispose of the property within a timeframe that will release suspended losses while you can still benefit from them.

Passive Loss Scenarios Where Cost Segregation Should Be Avoided

• Passive investor with no other passive income and income above $150,000 AGI (eliminating special allowance).
• Investor already carrying forward substantial suspended passive losses from prior years.
• Properties generating small positive income that would become losses with accelerated depreciation, creating suspended loss carryforwards.
• Indefinite hold strategy with no planned disposition timeline to release suspended losses.

If passive loss limitations apply, consider delaying cost segregation until you have passive income capacity, qualify as a real estate professional, or are preparing to dispose of properties. Implementing cost segregation when deductions will be suspended is a waste of study costs and CPA fees.

Very short holding periods create a scenario where depreciation recapture at sale offsets or exceeds the time value benefit of accelerated deductions during ownership. Cost segregation shifts depreciation forward, which increases the amount subject to recapture when the property is sold. For hold periods under 3 years, the recapture penalty often makes cost segregation not worth it.

Recapture applies to personal property and land improvements reclassified through cost segregation. These components are recaptured as ordinary income at sale rather than receiving capital gains treatment, increasing the effective tax cost of disposition. For short-term flips or value-add strategies with 1 to 2 year timelines, the recapture impact typically eliminates any net benefit from accelerated deductions.

For investors focused on short-term strategies, avoid cost segregation when planned hold period is under 3 years unless you have very high current tax rates and very low expected exit year rates that create asymmetric value from timing arbitrage.

Investors with limited taxable income face a scenario where accelerated depreciation creates deductions that exceed income, resulting in net operating losses or suspended passive losses that provide no immediate benefit. Cost segregation not worth it when you lack sufficient income to absorb the deductions in years when they are claimed.

This scenario is common for retirees with limited income, early-career investors building portfolios before they have substantial active income, or investors in low tax brackets where the value of deductions is minimal. If marginal tax rates are below 22% to 24%, the present value of tax savings may not justify study and implementation costs even if deductions are fully usable.

Income Scenarios Where Cost Segregation Should Be Delayed

• Current year income is insufficient to absorb accelerated depreciation without creating NOLs or suspended losses.
• Marginal tax rate is below 22% to 24%, reducing the value of incremental deductions to levels that may not justify costs.
• Already carrying forward substantial NOLs that will take multiple years to absorb before current deductions create value.
• Expecting significant income increases in future years, making delayed cost segregation potentially more valuable.

In these scenarios, consider delaying cost segregation until income increases, tax rates rise, or you have sufficient passive income capacity to absorb accelerated losses. A lookback study in a high-income year can recover missed depreciation when it creates maximum value.

Certain property types have component mixes that make cost segregation economically unviable. Properties with minimal personal property, simple construction, limited site improvements, or already substantial depreciation taken typically achieve reclassification rates too low to justify study costs.

Examples include raw land (no depreciable basis), basic warehouse buildings with minimal HVAC and simple finishes, very old properties where most components are fully depreciated, and properties on land leases where you own only the building improvements. These property types should skip cost segregation unless unusual circumstances create significant reclassifiable components.

Property Types Generally Not Suitable for Cost Segregation

• Raw land: No depreciable improvements; cost segregation not applicable.
• Land lease properties: Limited depreciable basis if you own only tenant improvements.
• Simple warehouse buildings: Minimal MEP systems and basic finishes typically achieve under 15% reclassification.
• Fully depreciated older properties: Limited remaining basis makes study costs exceed incremental savings.
• Properties held in inventory: Dealers cannot use depreciation; cost segregation not applicable to inventory.

For specialized property types, consult with a cost segregation provider to evaluate component mix before assuming cost segregation is viable. Some property types that appear unsuitable may have hidden opportunities, while others that seem promising may achieve disappointing results.

The fundamental question when evaluating when not to do cost segregation is whether present value of tax savings exceeds total implementation costs by a sufficient margin to justify the investment. A common threshold is 3:1 benefit to cost ratio, meaning $3 of present value tax savings for every $1 of study and implementation costs.

Total implementation costs include cost segregation study fees ($5,000 to $15,000 for most properties), incremental CPA fees for implementation and compliance ($1,500 to $5,000), and ongoing administrative burden for tracking depreciation schedules. If projected tax savings do not clear a 3:1 ratio, the investment is marginal and other priorities may deliver better returns.

Run this cost-benefit analysis with your CPA before commissioning a study. Use realistic assumptions about reclassification rates, deduction usability, hold period, and discount rates to ensure the model reflects probable outcomes rather than optimistic projections.

When cost segregation is not viable, focus on alternative tax strategies that deliver better returns for your specific situation. Options include maximizing retirement contributions, optimizing entity structure, pursuing opportunity zone investments if eligible, or timing property dispositions to harvest losses or defer gains through 1031 exchanges.

For investors with smaller properties, consider building a portfolio to reach cost segregation viability thresholds in future years. Batch cost segregation on 5 to 10 similar properties can achieve economies of scale that make the strategy viable even when individual properties are below standalone thresholds.

Alternative Tax Strategies When Skipping Cost Segregation

• Maximize standard depreciation deductions without cost segregation; ensure property is depreciated correctly under normal schedules.
• Optimize entity structure to maximize qualified business income deduction or other entity level benefits.
• Focus on portfolio growth to reach batch cost segregation thresholds in future years.
• Implement tax loss harvesting strategies on securities or other investments to offset real estate gains.

Understanding when not to do cost segregation allows you to allocate resources to strategies with better returns. Cost segregation is a powerful tool when conditions align, but forcing it into inappropriate scenarios creates costs without corresponding value. For guidance on when cost segregation does make sense, review Is Cost Segregation Worth It Under $500K?, which addresses value thresholds for smaller properties. If you are evaluating specific property type considerations, see Is Cost Segregation Worth It for Small Properties?.