Cost Segregation Pitfalls

By Jason Watson, CPA
Posted Sunday, May 25, 2025

There are two big pitfalls and a fewof gotchas.

Pitfall #1. If you are considering a cost segregation study on a rental property, and that activity is considered a passive activity, your tax deduction is limited to $25,000 (passive loss limit). If you earn over $150,000 as a household, your tax deduction might be limited to $0. Yes, you are reading that zero correctly. We discuss passive activity loss limitations later on page xx.

There are two ways to get around this. First, if you qualify as a real estate professional, then your passive activity loss limits go away. To be a real estate professional as defined by the IRS and not what you hear at the bar, an individual must spend more than half of the personal services performed in all businesses and activities during the year in real estate activities. As a reminder, this includes the following-

real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Read this again! If you have another full-time job in which you work 40 hours a week, you will need to work more than 40 hours per week in your real estate business and related activities. Having a W-2 is a red flag, as they say, straight out of the Passive Activities Loss Audit Techniques Guide (ATG) from the IRS.

Next, your hours worked in real estate activities must be more than 750 hours. Any work performed as an investor cannot be counted. There are a bunch of other devils in the details. Yes, most real estate agents qualify, not because they are real estate agents but rather time spent on real estate activities.

Finally, you must materially participate as defined by the IRS in each rental activity. We dive deep into real estate professional or REP status or just “REPS” as the cool kids say in a later section.

The other way to get around the passive loss limits is to have the activity not be considered passive. Makes sense right? Let’s just pencil-whip this activity and add the word “non-“ in front of it all. Done!

To be a non-passive activity, the average stay in the rental must be 7 days or less. Your typical VRBO Airbnb situation. However, you must also materially participate (there’s that darn word again) in the activity. Alternatively, for average stays of 30 days or less, you provide hotel-like services like changing linens during the stay or providing tours (think hunting lodge).

These two situations are considered non-passive activities and losses are not limited. As a small sidebar, or perhaps a minibar, the first example is reported on Schedule E, and the second is on Schedule C possibly subject to self-employment taxes.

Pitfall #2. If you can’t escape the passive activity loss limits, then you must have net rental income from the rental property or from other properties or real estate investments to absorb the accelerated depreciation expense and grab that accelerated cash flow. Self-rentals, where you own the building and lease it back to your business, do not usually absorb passive losses from other rentals. We talk about self-rentals later.

Gotcha #1. Recall that depreciation is a tax deferral. When you sell the property, you have depreciation recapture which simply means you must pay back the deferred taxes. There is some tax arbitrage here, however, since recapture is limited to a 25% tax rate on Section 1250 property (remember our mini chat about this) where you might have deducted depreciation at a 37% marginal tax rate. You can also escape this gotcha with a Section 1031 Like-Kind Exchange.

Sidebar: Recall that Section 1245 property, which might be “created” with a cost segregation report, is recaptured at ordinary income tax rates. We stated that earlier. However, the intersection of Section 1031 and Section 1245 can be problematic since you cannot like-kind exchange Section 1245 property. As such, you can perform a pretty Section 1031 Like-Kind Exchange, and still have a tax bill because of the sale of Section 1245 property in connection with the overall rental property sale.

Gotcha #2. The cost of the report or cost segregation study must be significantly lower than the improved time-value of the accelerated cash flow. In other words, the juice must be worth the squeeze, including the audit risk.

Another way to look at Gotcha #2- accelerated depreciation is not extra depreciation. Two rentals, one with a cost segregation study and one without, will be fully depreciated at 27.5 years. As such, it is purely a time-value of money compared to fee consideration. Then again, if you take the tax savings (deferral in reality) and blast off on a fun vacation, that has value too, right?

Gotcha #3. The last gotcha is one that is often overlooked. A cost segregation study and the subsequent big depreciation deduction is a one and done event. The following tax year, your depreciation comes down to earth and is actually less than it would normally be. Keep mind that cost segregation accelerates depreciation; it does not create new or phantom depreciation. Take a $780,000 building that would normally depreciate $20,000 per year. If you accelerate $150,000 in depreciation the first year, years 2 through 39 will be $16,600ish (versus $20,000).