The passive loss problem
Rental activities are generally classified as passive under the Internal Revenue Code regardless of how much time you spend on them (with narrow exceptions). Passive losses can only offset passive income — not wages, self-employment income, or portfolio income such as dividends and interest. If a cost segregation study creates a $200,000 paper loss and you have no other passive income, that loss is suspended and carried forward until you generate passive income or sell the property.
Three ways to use the losses currently
(1) Real Estate Professional Status (REPS): spend more than 750 hours per year in real property trades and more than half your total working hours in real estate, and materially participate in each property. Losses then offset any income, including wages. (2) Short-term rental exception: if the property has an average rental period of 7 days or fewer and you materially participate, it is not a rental activity for PAL purposes, and losses may offset ordinary income without REPS. (3) Other passive income: cost seg losses offset income from passive investments such as limited partnerships.
The suspended loss silver lining
Suspended passive losses are not gone — they accumulate tax-free and release entirely in the year you sell the property. In that year, they offset all income including the gain from the sale. This makes cost segregation worth considering even if you cannot use the current losses: you are building a tax shield for your exit. The trade-off is timing — you may wait years before accessing the benefit.
Frequently asked questions
Can cost segregation losses offset my W-2 income?
Only if you qualify as a real estate professional or the property is a short-term rental with material participation. Otherwise losses are passive and suspend until you have passive income or sell the property.
What happens to suspended passive losses when I sell?
They fully release in the year of sale and can offset all income in that year — including the recapture and capital gain from the sale itself.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.