Can Cost Segregation Offset W2 Income?

A cost segregation study is a tax planning strategy that allows real estate owners to accelerate depreciation deductions on their investment properties. This involves reclassifying certain building components into shorter depreciation classes. Owners can reduce their taxable income and improve cash flow in the initial years of property ownership.

Understanding Cost Segregation Studies

A cost segregation study is a detailed engineering and tax analysis of a building’s components. Real property, such as a building structure, is depreciated over 27.5 years for residential rental properties and 39 years for non-residential properties using the Modified Accelerated Cost Recovery System (MACRS) straight-line method. A cost segregation study identifies and reclassifies assets within the building that have shorter depreciable lives.

These reclassified assets fall into depreciation periods of 5, 7, or 15 years. Examples include personal property like decorative lighting, carpeting, and specialized plumbing or electrical systems, as well as land improvements such as sidewalks, fencing, and landscaping. Qualified Improvement Property (QIP), which refers to non-structural improvements to the interior of a non-residential building, is also depreciated over 15 years and may be eligible for bonus depreciation.

Accelerating depreciation deductions is the main benefit of a cost segregation study. This allows property owners to deduct a larger portion of their investment sooner, which reduces current taxable income. This increased upfront deduction can boost cash flow in the early years of property ownership. While there is an upfront cost for the study, potential tax savings often outweigh this expense.

How Deductions Interact with Different Income Types

The ability of cost segregation deductions to offset various income types depends on their classification as “active” or “passive” under Internal Revenue Service (IRS) rules. Active income includes wages, salaries, and income from businesses in which the taxpayer materially participates. Passive income is derived from activities in which the taxpayer does not materially participate, such as rental real estate activities and limited partnership interests.

The IRS’s Passive Activity Loss (PAL) rules, outlined in Internal Revenue Code Section 469, place limitations on how passive losses can be utilized. Under these rules, losses generated from passive activities, including accelerated depreciation deductions from cost segregation studies on rental properties, can only be used to offset income from other passive activities. If a taxpayer has no passive income, or insufficient passive income, these losses cannot be used in the current year.

Passive losses cannot offset active income. Therefore, deductions generated by a cost segregation study on a rental property would not directly reduce a taxpayer’s W2 wages or other active business income. Any unused passive losses are suspended and carried forward indefinitely, becoming deductible in future years when passive income is generated or when the entire interest in the passive activity is disposed of in a taxable transaction.

Qualifying as a Real Estate Professional

An exception to the Passive Activity Loss rules allows certain real estate losses, including those from cost segregation, to offset active income like W2 wages. This exception applies to individuals who qualify as a “Real Estate Professional” (REP) under Internal Revenue Code Section 469. For a qualified individual, rental real estate activities may be treated as non-passive, allowing losses to offset other income.

To qualify as a Real Estate Professional, a taxpayer must meet two tests during the taxable year. First, more than half of the personal services performed in all trades or businesses by the taxpayer must be in real property trades or businesses in which they materially participate. Second, the taxpayer must perform more than 750 hours of service during the year in real property trades or businesses in which they materially participate. Real property trades or businesses include development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

The taxpayer must also “materially participate” in their real estate activities. Material participation means involvement in the operations of an activity on a regular, continuous, and substantial basis.

The IRS provides seven tests to determine material participation, with the most common being the 500-hour test, where the individual participates in the activity for more than 500 hours during the tax year. Other tests include performing substantially all the participation in the activity, or participating for more than 100 hours and no one else participates more.

If both Real Estate Professional tests and a material participation test are met, rental real estate losses, including those generated from a cost segregation study, are reclassified as non-passive and can then be used to offset any type of income, including W2 wages. This status requires record-keeping to substantiate the hours and nature of participation to the IRS.