Most real estate investors who commission cost segregation studies expect immediate tax savings. Many won’t get them – not because the study failed, but because IRS passive activity rules determine whether accelerated depreciation can offset their actual income. According to Brian Kiczula, a Real Estate Professional at CostSegRx, this passive activity limitation is one of the most consequential and least-discussed factors in cost segregation planning. Investors who don’t understand it before commissioning a study often find the results disappointing.
The Passive Income Trap
When a cost segregation study generates accelerated depreciation, that depreciation doesn’t automatically reduce an investor’s tax bill. Whether it can offset W-2 wages, business income, or other active earnings depends on the investor’s classification under IRS passive activity rules – and for most residential real estate investors, it can’t.
“If you’re a residential real estate investor and you’re not a real estate professional, you don’t have the real estate professional status, then your residential real estate is going to offset only passive income,” Kiczula says. “The income that the rental property generates, it’s typically not going to flow over and offset, let’s say, your W-2 income.”
An investor with substantial W-2 income and a single rental property may generate significant accelerated depreciation from a cost segregation study and find that none of it reduces their current-year tax liability. The depreciation doesn’t disappear, but it doesn’t help immediately either.
“It’s not a use-it-or-lose-it scenario, so you’d be able to use it up in future years,” Kiczula says, “but you just really want to understand: is it going to offset active or passive income?”
Why This Matters Before Commissioning a Study
Investors who don’t grasp the passive activity distinction before getting a study may proceed based on projected tax savings that don’t materialize in the way they expected. Kiczula says he walks clients through this analysis as part of the upfront benefit estimation process – not because cost segregation is the wrong choice, but because the value of the study depends on how the depreciation will actually be used.
Effective tax rate is the other variable investors frequently overlook. “The client, after they get an estimate of benefit, they need to look at their effective tax rate and multiply our accelerated depreciation by that,” Kiczula says. “Because if you’re in a 15% tax bracket, it’s different than if you’re in a 37% tax bracket as far as what you’re actually going to save dollar for dollar.”
These two factors – income type and tax rate – determine the real-world value of a cost segregation study for a specific investor. Without understanding both, the projected benefit figure tells an investor little about their actual savings.
The Short-Term Rental Exception
There is a path for some investors to offset active income, and it runs through short-term rental properties and real estate professional status.
Investors who actively manage short-term rental properties and meet IRS material participation requirements may be able to treat their rental losses as active rather than passive. When that classification applies, depreciation from a cost segregation study can offset W-2 income directly.
“When you can get it to offset active income, that’s when it really becomes powerful,” Kiczula says. “That’s where we’re seeing a lot of clients take advantage of the quote-unquote short-term rental loophole – because let’s say they’ve got $500,000 in W-2 income, but they’re also actively managing Airbnb properties. They have the real opportunity to offset some of that W-2 income, but that’s not always the case.”
Kiczula notes that this outcome isn’t guaranteed – not every Airbnb investor will meet the threshold. But for investors who do qualify, the combination of cost segregation and active income treatment can produce immediate tax savings against earned income.
CostSegRx and the Upfront Benefit Analysis
CostSegRx addresses the passive activity problem by building the income-type question into the initial client conversation. Rather than presenting a depreciation figure and letting the client assume it translates directly to tax savings, the firm encourages investors to review the estimated benefit with their CPA or tax preparer before committing to a study.
“I don’t know their specific tax scenario and what they’re looking to achieve,” Kiczula says. “So I just tell clients: get an estimated benefit. We’re happy to put it together for you. Review it with your tax preparer or CPA, and if they decide or if they think it’s a good idea to move forward with, we’ll move forward with the study.”
This approach positions the cost segregation study as one component of a broader tax strategy. As more individual investors enter the short-term rental market and seek ways to offset earned income, the intersection of cost segregation and passive activity planning is likely to become a more prominent part of real estate tax conversations.
About the Expert: Brian Kiczula is a Real Estate Professional at CostSegRx, a firm specializing in cost segregation studies for investors with properties up to $15 million.
About CostSegRx:
CostSegRx is an engineering-based cost segregation firm led by Brian Kiczula, a member of the American Society of Cost Segregation Professionals. The firm works with residential and commercial real estate investors nationwide. CostSegRx provides complimentary estimates of benefit and supports investors and their CPAs through the full reporting process. Learn more at costsegrx.com or call (888) 850-4155.
