Cost Segregation in 2025: Smart Move or Tax Trap?

Understand the Real Rules Before You Claim Big Write-Offs That You Can’t Use

With the finalization of the One Big Beautiful Bill (OBBB) and the return of 100% bonus depreciation, we've been flooded with client questions about cost segregation. It's one of the most powerful and oversold tax tools for real estate owners.

We’ve helped many clients successfully accelerate depreciation and reduce their taxable income by over $100,000, and often into the multiple six figures, using cost segregation. Yes, cost segregation can unlock large amount in deductions —but it’s not a silver bullet for everyone, and even it can be a complete waste of time and money. In this article, I’ll walk you through the basics, bust a few myths, and give you real-life examples of when cost seg is worth it... and when it’s waste.

What Is Cost Segregation?

Cost segregation breaks your rental property into parts that depreciate faster than the standard 27.5-year schedule for residential or 39 years for commercial buildings. With 100% bonus depreciation, shorter life components can be written off in full in the year placed in service. That means more upfront deductions and paper losses, which can translate into real tax savings if you qualify to use them.

A cost segregation study is typically conducted by engineers or specialized firms who reclassify components of your building (like appliances, flooring, landscaping, lighting, etc.) into 5, 7, or 15 year property. The IRS requires that a proper study be done, and they offer six acceptable methodologies, from the detailed engineering approach (best for large properties) to simpler modeling methods (suitable for smaller rentals).

Why Cost Seg Fails for Some Investors

The key question isn’t whether cost segregation generates losses—it’s whether you can actually use those passive losses. By default, rental income and losses are considered passive under the tax code. That means you generally cannot use the losses generated by cost segregation and depreciation to offset active income like W-2 wages or business profits.

The only scenarios where rental losses can provide immediate tax savings are when:

1. You have other passive income (e.g., income from another rental or investment) to offset the loss, or

2. You qualify for one of the loopholes that allow you to reclassify the rental loss as non-passive, making it deductible against other income.

Let’s break this down in practical terms: What “loopholes” might allow you to treat a rental like an active business? There are a few key exceptions that can unlock significant tax savings, such as Real Estate Professional (REP) status, Short-term rentals (STRs), and Self-rentals (e.g. renting your building to your business).

Let’s take Real Estate Professional status fox example. It is one of the most powerful—but also most misunderstood exception. To qualify, you must meet all three of the following IRS requirements:

1. Be a Real Estate Professional

2. Materially Participate in the specific rental activity

3. Have sufficient tax basis in the property

   
   

If you fail any one of these, your cost seg losses will be suspended - they sit unused on your tax return Form 8582 until the year you sell the property. The same logic applies to short-term rentals and self-rentals: while they may allow reclassification of passive losses, each comes with its own unique requirements—often including federal elections, documentation, and careful planning.

Real-Life Examples

Example 1: Tech Couple with a Part-Time Realtor

A high-earning couple both work full-time in tech. The wife also holds a real estate license and has successfully closed a few transactions on the side. They assumed that having a license and some sales activity would qualify her for Real Estate Professional Status (REPS).

Unfortunately, because she still holds a full-time job outside of real estate, she fails the requirement for REPS.

Even though they invested in a cost segregation study for their rental, they can’t use the excess losses to offset their W-2 income—the losses are suspended.

❌ Result: Waste of time and money.

Example 2: Doctor + Contractor Couple

A married couple purchases a duplex. The wife is a physician earning a high W-2 salary. The husband is a general contractor who qualifies as a real estate professional and also materially participates in managing the property.

Because they meet all the requirements—including REPS, material participation, and basis—the cost segregation generated losses can be used to directly offset both spouses’ income, including the wife’s W-2.

✅ Result: Big tax win.

Example 3: Business Owner with a Short-Term Rental

A California business owner purchases a condo in Hawaii, using it as a vacation home for a few days each year. For the rest of the year, he lists it on Airbnb and hires a local property manager to handle all bookings—meaning he’s barely involved in day-to-day operations. He heard that short-term rentals might qualify for active loss treatment—even without Real

Estate Professional Status (REPS)—and hoped to use a cost segregation study to offset his W-2 income. However, he fails the material participation test, as he doesn’t spend enough time actively managing the property himself.

As a result, the cost seg losses are considered passive and are suspended—only usable when he either sells the property or generates other passive income in the future. Refer to our previous article “How One Airbnb Host Turned Tax Confusion Into $80,000 in Strategic Savings”

❌ Result: Waste of time and money.

Take Action

Cost segregation is a powerful, IRS-approved strategy—but it’s not a one-size-fits-all solution. When applied incorrectly, it can waste your time and money. But when done right, it can be a game-changer for your tax savings.

Thinking about a cost seg study? 

Let’s evaluate whether it truly benefits your situation—especially while 100% bonus depreciation is now available for 2025. Book a tax strategy session with LightUp Tax today and make sure your investments are working as hard for your taxes as they are for your returns.

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