Cost Segregation Pitfalls

By Jason Watson, CPA
Posted Monday, September 29, 2025

There are two big pitfalls and a few gotchas.

Passive Activity Loss (PAL) Limits

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 nonpassive 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 nonpassive 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.

If PAL Limited Must Have Net Rental Income

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.

Depreciation Recapture Can Bite

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.

Cash Flow Juice Worth Cost Seg Squeeze

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 this gotcha- 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?

Cost Segregation Is A One And Done Event

Another 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).

Tangible Personal Property Reporting

This really isn’t a big gotcha or pitfall, but as we discussed in our chapter on short-term rentals, many counties want you to report and pay tax on tangible personal property. While a cost seg study’s only job is to parse property away from typical real property and relabel it as personal property, not all personal property identified in your report is suddenly tangible personal property.

Conversely, many counties are similar to Florida’s 192.001(11)(d) which reads-

“Tangible personal property” means all goods, chattels, and other articles of value (but does not include the vehicular items enumerated in s. 1(b), Art. VII of the State Constitution and elsewhere defined) capable of manual possession and whose chief value is intrinsic to the article itself.

What does this mean? It means that tangible personal property for the sake of county taxes must have value by itself and be capable of manual possession. For example, certain components might be identified as IRC Section 1245 personal property, but their value is tied to the fact they are part of a larger building system. Carpet is a good example since it typically does not have material resale value. Specialized wiring for a restaurant kitchen is likely personal property eligible for Section 179 expensing and bonus depreciation, but is unlikely to be considered capable of manual possession with intrinsic value, and therefore not be tangible personal property by a county assessor.