By the time tax season arrives, many real estate investors are asking:

“Can I still do a cost segregation study?”

Sometimes, yes.

But that is not always the most important question.

The more useful question is:

If the study creates a large depreciation deduction, can you actually use that deduction this year?

That depends on much more than the cost segregation study itself.

What is a cost segregation study?

When you buy a rental property, most of the building is generally depreciated over a long recovery period.

Residential rental buildings are generally depreciated over 27.5 years, while nonresidential real property is generally depreciated over 39 years.

A cost segregation study analyzes the property more closely and identifies certain components that may qualify for shorter recovery periods.

Depending on the facts, those components can include items such as:

1. certain flooring
2. appliances
3. cabinetry
4. certain electrical components
5. landscaping
6. fencing
7. parking improvements
8. other qualifying building components

Instead of depreciating all of those costs over decades, qualifying property may be depreciated over shorter periods such as 5, 7, or 15 years.

That can significantly accelerate deductions.

Why bonus depreciation matters

Current law restored a 100% additional first-year depreciation deduction for certain qualified property acquired and placed in service after January 19, 2025. IRS

Qualified property can include certain depreciable property with a MACRS recovery period of 20 years or less, which is why property reclassified through a cost segregation study can potentially qualify. IRS

That can make cost segregation significantly more powerful.

A simple cost segregation example

Assume an investor purchases a rental property for $800,000.

After allocating value to land, assume $650,000 remains depreciable.

A cost segregation study identifies $150,000 of the building cost as qualifying shorter-lived property.

If that property qualifies for 100% bonus depreciation, a substantial portion of that $150,000 may potentially be deducted in the first year rather than depreciated over decades.

That can create a very large tax deduction.

But that does not automatically mean the taxpayer receives an immediate tax benefit from the entire amount.

Creating a deduction and using a deduction are different things

This is one of the most important points in cost segregation planning.

Suppose the study creates a $150,000 loss.

If the rental activity is passive and the taxpayer does not have enough passive income to absorb the loss, some or all of that loss may be suspended and carried forward.

The IRS generally limits passive activity losses to passive activity income, with unused passive losses carried forward to future years. IRS

So an investor can receive a perfectly valid $150,000 depreciation deduction and still receive little or no immediate benefit from it.

The deduction exists.

Its current usability is a separate question.

Real Estate Professional Status can change the result

Rental activities are generally passive even when the owner materially participates.

However, if the taxpayer qualifies as a real estate professional and materially participates in the relevant rental real estate activity, the activity may be treated as nonpassive. IRS

That can materially change how a cost segregation loss affects the tax return.

For example, depending on the facts and other limitations, a nonpassive rental loss may potentially offset nonpassive income.

That is why determining whether a taxpayer qualifies for REPS should be part of the planning conversation before assuming how valuable a cost segregation study will be.

Short-term rentals may be different

Certain short-term rental activities can fall outside the definition of a rental activity for passive-loss purposes.

When that happens, material participation can become central to whether the activity is passive or nonpassive.

That means two taxpayers with nearly identical properties and the same $150,000 depreciation deduction may receive very different tax results.

One may be able to use much of the loss currently.

The other may have most of it suspended.

Same cost segregation study.

Very different tax outcome.

Questions to answer before doing the study

Before focusing on the size of the depreciation deduction, I would want to know:

1. When was the property placed in service?
2. Is it residential or commercial?
3. Is it being used as a short-term or long-term rental?
4. Does the taxpayer materially participate?
5. Does the taxpayer qualify as a real estate professional?
6. Are there other passive activities generating income?
7. What does taxable income look like this year?
8. Are there other large deductions already expected?
9. How long does the owner expect to hold the property?
10. Is a sale likely in the near future?

Those answers help determine whether accelerating depreciation is actually valuable.

Cost segregation isn't always “too late” after year-end

This is another good point from your newsletter and I’d keep it.

March is not automatically too late to perform a cost segregation study.

There can be situations where a study is completed after the year of acquisition, and there are procedures that may allow depreciation treatment to be corrected on property already owned.

But some of the facts that determine whether the resulting loss is usable cannot be recreated after December 31.

For example, you cannot go back after year-end and create material-participation hours that did not actually occur.

That is why tax planning during the year still matters.

The biggest mistake: focusing only on the size of the deduction

Many investors ask:

“How much depreciation can the cost seg create?”

That is only half the analysis.

The better questions are:

Can I actually use the deduction?

and

Is this the right year to accelerate it?

A large deduction that sits suspended for years may still have value.

But it is not the same as generating a current-year tax benefit.

The bottom line

Cost segregation can be a powerful real estate tax strategy, especially with 100% bonus depreciation available for qualifying property acquired and placed in service after January 19, 2025. IRS

But the study itself is only one piece.

The real planning involves coordinating:

1. depreciation
2. passive activity rules
3. material participation
4. Real Estate Professional Status
5. short-term rental treatment
6. taxable income
7. expected holding period
8. future sale considerations

Creating the deduction and benefiting from the deduction are two different things.

Considering cost segregation?

If you're thinking about a cost segregation study—or already completed one but aren't sure whether the resulting loss will actually help you—Get a Second Opinion from Whitestone CPA.