Cost Segregation and Passive Activity Losses Under §469

This article is educational only and is not legal or tax advice for any 2025 Form 1040, Form 1065, Form 1120-S, or Form 1120 filing; confirm the treatment of your property, activity status, and depreciation with your tax advisor before you file.

A cost segregation study accelerates depreciation, but the larger deduction lowers this year’s tax only if it clears the loss limits on the return you are about to file, including basis, at-risk (§465), the passive-activity rules (§469) and the excess business loss limit (§461(l)). This article covers the §469 test: a passive loss that passive income does not absorb is disallowed under §469(a) and carried forward under §469(b) instead of reducing tax on wages or business income.

A cost segregation study separates §1245 personal property and 15-year land improvements (generally §1250 property outside the building) from the building shell, which accelerates depreciation that would otherwise be spread over the 27.5-year residential rental or 39-year nonresidential periods under §168(c). Cost segregation does not create a deduction that was not already in the depreciable basis, so the question for a high-income owner is timing: whether the accelerated deduction is usable now or waits.

Will a cost segregation deduction from my rental property be usable this year under §469?

A passive loss is usable this year only against passive income, plus whatever the §469(i) allowance exempts; the rest is disallowed under §469(a) and carried forward under §469(b). Under §469(c)(2) a rental activity is passive unless an exception applies, so a high-income owner of a long-term rental can receive a larger current-year depreciation deduction from cost segregation and still see part or all of it carried forward instead of reducing tax on wages, portfolio income, or business income.

A disallowed loss is carried forward, not forfeited, while the taxpayer keeps the activity: §469(b) treats it as a deduction allocable to the same activity in the next taxable year, where it can offset passive income. Under §469(g), a suspended passive loss is released, meaning it is treated as a loss that is not from a passive activity, when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction (one in which all gain or loss realized is recognized) to an unrelated party. That is why a cost segregation study on a passive rental can be correct and still do nothing for the tax due on the current return.

Will the $25,000 allowance help a high-income owner who actively participates in a rental?

Usually not at high income, because the allowance phases out. Under §469(i), an individual who actively participates in a rental real estate activity (a separate test from material participation, and one that requires an interest of at least 10% by value (a spouse’s interest counts) throughout the year) is exempt from the §469(a) disallowance for up to $25,000 of loss from the rental real estate activities in which the individual actively participates; the $25,000 is reduced by 50% of modified adjusted gross income above $100,000 and is gone at $150,000, and for a married individual filing separately it is $12,500, phasing out between $50,000 and $75,000, only if the spouses lived apart for the entire year, and zero if they lived together at any time during the year.

Because the §469(i) allowance tops out at $25,000 for an owner who actively participates, a large accelerated deduction from cost segregation can exceed it even for an owner inside the income range.

For a W-2 owner of a long-term rental whose modified adjusted gross income is above the phase-out range, §469(i) exempts none of the loss, however much short-life property cost segregation identifies.

Can real estate professional status make cost segregation deductions usable?

It can make the loss nonpassive, which is necessary but not sufficient. §469(c)(7) applies when more than one-half of the personal services the taxpayer performs in trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services in those real property trades or businesses; on a joint return one spouse has to meet both tests alone, and hours worked as an employee count only if the employee is a 5-percent owner of the employer (§469(c)(7)(D)(ii)).

A taxpayer who meets §469(c)(7) has a nonpassive rental loss only for a rental in which the taxpayer also materially participates, and each rental is tested separately unless the taxpayer has elected under Treas. Reg. §1.469-9(g) to treat all interests in rental real estate as one activity. If you meet §469(c)(7) and materially participate in the rental, the accelerated depreciation from cost segregation can offset wages and other nonpassive income on the current return to the extent the basis, at-risk (§465) and excess business loss (§461(l)) limits also allow it.

If you do not meet §469(c)(7), a long-term rental remains passive under §469(c)(2) even when you make management decisions, approve repairs, or communicate with tenants, so the cost segregation deduction is usable only against passive income and any §469(i) allowance.

Does a short-term rental with average stays of 7 days or less avoid the rental passive-loss rule?

Only when a second condition is also met: under Treas. Reg. §1.469-1T(e)(3)(ii)(A) an activity is not a rental activity when the average period of customer use is seven days or less, but its loss is nonpassive only when you also materially participate in it. An average stay of 30 days or less also takes the activity out of the rental definition when significant personal services are provided by or on behalf of the owner (Treas. Reg. §1.469-1T(e)(3)(ii)(B)), as do extraordinary personal services at any length of stay (Treas. Reg. §1.469-1T(e)(3)(ii)(C)), and in each case the loss is nonpassive only when you materially participate.

When one of those exceptions applies and you materially participate, cost segregation depreciation can offset wages and other nonpassive income on the current return to the extent the basis, at-risk (§465) and excess business loss (§461(l)) limits also allow it. When one applies but you do not materially participate, the loss is passive: it is disallowed under §469(a) to the extent passive income does not absorb it, and carried forward under §469(b). When no exception in Treas. Reg. §1.469-1T(e)(3)(ii) applies, the activity is a rental activity and the long-term rental results above apply.

The use of the property can also change the recovery period of the shell: under §168(e)(2)(A) a dwelling unit does not include a unit in a hotel, motel, or other establishment more than one-half of the units in which are used on a transient basis, so a short-term rental that fits that description is generally nonresidential real property with a 39-year shell rather than a 27.5-year one, a determination your tax advisor makes.

The material-participation tests, including the hour counts, are walked through in our guide to short-term rental cost segregation. The records that decide the question are platform reports and booking records that show the average stay, an owner work log kept during the year, and management contracts that show who performed the work.

Can I still add a cost segregation study by October 15, 2026 if I filed an extension and have not yet filed my 2025 return?

If you filed Form 4868 and have not yet filed your 2025 individual Form 1040, October 15, 2026 is the extended due date for that individual return under Form 4868, and a cost segregation study has to be complete before the return that uses it is filed. If a calendar-year C corporation filed Form 7004 and has not yet filed its 2025 Form 1120, October 15, 2026 is the extended due date for that corporate return under Form 7004.

Partnerships filing Form 1065 and S corporations filing Form 1120-S did not have until October 15: their extended 2025 returns were due September 15, 2026 under Form 7004, so an owner who holds the property through one of those entities cannot treat the individual date as the entity’s date.

The return can report the study only if the study is finished first, so a return filed before the study is complete goes in without the study’s allocations. Where the Form 3115 conditions described below are met, filing without the study does not forfeit the depreciation, because Form 3115 with a later return remains available for a property you placed in service in an earlier tax year and still own.

ClickDrag Finance’s cost segregation qualifier asks about your situation, the property type, when you acquired the property and its approximate depreciable basis; it does not ask about your passive-loss position, which is a question for your tax advisor.

How does bonus depreciation change the size of the cost segregation deduction and of the passive loss?

Bonus depreciation makes the first-year deduction larger, which makes the §469 question larger with it: under §168(k), as amended by OBBBA in 2025, bonus depreciation is 100% for qualified property acquired after January 19, 2025. Per IRS Notice 2026-11 the acquired-date test turns on the written binding contract, not the closing date: the acquired date is the latest of the date the contract was signed, the date it became enforceable under state law, the end of any cancellation period, and the date any contingency was satisfied (Treas. Reg. §1.168(k)-2(b)(5)(ii)(B)). This applies to a written binding contract, meaning one enforceable under state law that does not limit damages to a specified amount (for example through a liquidated damages clause); under a contract that is not binding in that sense, the acquired date is generally when the taxpayer has paid or incurred more than 10 percent of the total cost, excluding land and preliminary activities (Treas. Reg. §1.168(k)-2(b)(5)(iii) and (v)).

Self-constructed property, including property built for the taxpayer under a written binding contract entered into before construction began, is acquired when physical work of a significant nature begins; paying or incurring more than 10 percent of the total cost (excluding land and preliminary activities) is a safe harbor. If the property was acquired on or before January 19, 2025 and placed in service in 2025, §168(k) keeps it on the TCJA phase-down, with 40% bonus depreciation for 2025.

Bonus depreciation under §168(k) applies only to qualified property with a recovery period of 20 years or less, so the 5-year, 7-year, and 15-year property a cost segregation study identifies may qualify, while the 27.5-year residential rental shell, the 39-year nonresidential shell, and land do not. For a long-term rental owner with no passive income and no §469(c)(7) status, a larger §168(k) deduction from cost segregation produces a larger loss disallowed under §469(a) and carried forward under §469(b), not a larger current tax reduction.

Can Form 3115 still catch up the depreciation if I already filed without a cost segregation study?

Yes, where the Form 3115 conditions are met: for a property you placed in service in an earlier tax year and still own, the missed depreciation can be claimed on Form 3115, filed with the return for a later year, as a §481(a) adjustment. Form 3115 reports missed depreciation on the current return as a §481(a) adjustment, with no amended returns, when the property has been depreciated under the old method on two or more filed returns and the taxpayer still owned it at the start of the year of change. For property the taxpayer placed in service in the tax year immediately before the year of change, with one filed return, either Form 3115 with the current return or an amended return for that year, filed before the return for the following year (the year of change) is filed, is available. A property placed in service in the current year goes on the original return and needs no Form 3115. (Section 6.01 of Rev. Proc. 2025-23, filed under the procedures of Rev. Proc. 2015-13; eligibility rules apply.)

On a 2025 return that is on extension and not yet filed, a building placed in service in 2025 goes on that return and needs no Form 3115. A building placed in service in 2024 or earlier can use Form 3115 with the 2025 return when it has been depreciated on two or more filed returns, or on one filed return if the taxpayer placed it in service in 2024, and the taxpayer still owned it at the start of 2025 and meets the other eligibility rules (for a 2024 building, an amended 2024 return filed before the 2025 return is the alternative); the mechanics are in Form 3115 Cost Segregation Catch-Up Depreciation for a 2025 Return on Extension.

The §469 rules apply to a catch-up as they do to a current-year deduction: when the activity is passive, the §481(a) adjustment from a cost segregation look-back generally adds to the passive loss, and whatever passive income does not absorb is disallowed under §469(a) and carried forward under §469(b).

When does cost segregation not help this year?

Cost segregation does not lower this year’s tax when all of the following are true: your rental loss is passive under §469, you have no passive income, you do not qualify under §469(c)(7), no exception in Treas. Reg. §1.469-1T(e)(3)(ii) combined with material participation makes the loss nonpassive, and the §469(i) allowance is phased out or unavailable to you. In that case the study still accelerates depreciation, but the result is a carryforward under §469(b) rather than a current tax reduction.

A study is generally worth considering only when three conditions hold together: the owner can use the deduction this year, the hold is long enough that §1245 recapture on sale does not erase the timing benefit, and the depreciable basis excluding land is large enough to clear the study fee. The roughly $500K floor is a screening guideline rather than a tax rule, and it moves down as the study fee does, while the usability and hold-period conditions apply at any fee, as worked through in Is Cost Segregation Worth It for a Small Rental Property Under $2 Million?

When the property is sold at a gain, §1245 treats the depreciation taken on the reclassified personal property as ordinary income up to the gain recognized on that property (the lesser of the depreciation taken or the gain), and §1250 continues to govern the building components, so cost segregation accelerates deductions rather than adding to them.

What records show whether a cost segregation study fits before I file?

Two sets of records answer it: the property documents a study is built from, covered in What Documents Does a Cost Segregation Study Need Before You File a Return on Extension? and the §469 records that show whether the deduction is usable. For a short-term rental, the §469 records are booking records that support the average period of customer use under Treas. Reg. §1.469-1T(e)(3)(ii), participation records kept during the year, and management records that show who performed the work. For a long-term rental, they are passive-income schedules, carryforward schedules of losses disallowed in earlier years (§469(b)), and any support for real estate professional status under §469(c)(7).

If you are comparing providers, our guide to the best cost segregation companies covers what to ask about a study built on the methodology in the IRS Cost Segregation Audit Techniques Guide. If the property is in an Opportunity Zone or held through a Qualified Opportunity Fund, depreciation and basis add another layer, covered in our Opportunity Zone cost segregation guide.

Whether the deduction is usable under §469 is a question for your tax advisor; whether the property is large enough for a study to matter is what the ClickDrag Finance cost segregation qualifier estimates from the property type, the acquisition timing and the approximate depreciable basis.

Frequently Asked Questions

Can cost segregation create a passive activity loss?

Yes, cost segregation can create or increase a passive activity loss when the property is a passive rental under §469. The study accelerates depreciation into §1245 property and shorter recovery periods under §168, and §469 then determines whether the resulting loss is deductible this year or is disallowed under §469(a) and carried forward under §469(b).

Can depreciation from a short-term rental offset W-2 income?

Yes, when the activity is not a rental activity and the owner materially participates, and only to the extent the basis, at-risk (§465) and excess business loss (§461(l)) limits also allow it. Under Treas. Reg. §1.469-1T(e)(3)(ii), an activity is not a rental activity when the average period of customer use is seven days or less, or is 30 days or less with significant personal services provided by or on behalf of the owner; if no exception in that paragraph applies and §469(c)(7) does not apply, or if the owner does not materially participate, the loss is passive, and a passive loss that passive income does not absorb is disallowed under §469(a) and carried forward under §469(b).

Does the $25,000 rental real estate allowance make cost segregation useful for high-income owners who actively participate?

Usually not, because the allowance for an owner who actively participates is $25,000 at most and phases out as income rises. Under §469(i), an individual who actively participates in a rental real estate activity (a separate test from material participation, and one that requires an interest of at least 10% by value (a spouse’s interest counts) throughout the year) is exempt from the §469(a) disallowance for up to $25,000 of loss from the rental real estate activities in which the individual actively participates; the $25,000 is reduced by 50% of modified adjusted gross income above $100,000 and is gone at $150,000, and for a married individual filing separately it is $12,500, phasing out between $50,000 and $75,000, only if the spouses lived apart for the entire year, and zero if they lived together at any time during the year.

What happens to suspended depreciation from cost segregation?

It carries forward: a passive loss disallowed under §469(a) is treated under §469(b) as a deduction allocable to the same activity in the next taxable year, where it can offset passive income. Under §469(g), a suspended passive loss is released, meaning it is treated as a loss that is not from a passive activity, when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction (one in which all gain or loss realized is recognized) to an unrelated party.

Do I need Form 3115 to claim missed cost segregation depreciation?

Not always: a property placed in service in the current year goes on the original return and needs no Form 3115. Under section 6.01 of Rev. Proc. 2025-23, filed under the procedures of Rev. Proc. 2015-13, Form 3115 reports the missed depreciation as a §481(a) adjustment when the property has been depreciated on two or more filed returns, or on one filed return if the taxpayer placed it in service in the tax year immediately before the year of change, and the taxpayer still owned it at the start of the year of change and meets the other eligibility rules; for that one-return property, an amended return for the placed-in-service year, filed before the return for the following year (the year of change) is filed, is the alternative to Form 3115.

Will Cost Segregation Help If My Rental or Short-Term Rental Loss Is Passive?