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A cost segregation study analyzes the property, so the study itself is the same regardless of how you hold title. What changes dramatically by entity is whether you can actually use the resulting deduction. Losses from a pass-through entity must generally clear three hurdles in order: your basis in the entity, the at-risk rules, and the passive activity rules. A partnership or LLC taxed as a partnership generally gives owners basis for their share of entity-level debt. An S corporation generally does not, which can strand a large cost segregation loss for a shareholder who assumed otherwise. A C corporation does not pass the deduction through at all.
Two brothers in Zanesville, Ohio each bought a small commercial property in the same year, each for roughly $1.4 million, each with 25 percent down and the rest financed. Same size deal, same kind of building, same lender.
One held his property in an LLC taxed as a partnership with his wife. The other, on advice he had received years earlier for his operating business, held his in an S corporation.
Both did cost segregation studies. Both studies produced large first-year losses. In April, one brother used his loss. The other could not use most of his, and the reason had nothing to do with the property, the study, or the quality of the work. It was the entity.
This article explains why that happens, and what the differences actually are.
Start with what is constant. A cost segregation study is an engineering analysis of a building. It identifies components and their proper classification based on the physical property and the applicable law. Whether you hold that building in an LLC, a partnership, an S corporation, or your own name, the components are the same components and the analysis reaches the same conclusions.
So nobody should choose an entity to get a better study. That is not how it works.
What the entity determines is what happens to the deduction after the study produces it. And that is where the outcomes diverge sharply, because a deduction you cannot use this year is worth considerably less than one you can.
For an owner of a pass-through entity, a loss allocated to you must generally clear three separate limitations, applied in sequence. Failing any one of them suspends the loss.
Hurdle one: basis. You generally cannot deduct losses in excess of your basis in the entity interest. Losses beyond basis are generally suspended until basis is restored.
Hurdle two: at-risk. Even if you have basis, the at-risk rules generally limit deductible losses to the amount you have at risk in the activity. Amounts protected against loss, or certain nonrecourse arrangements, may not count.
Hurdle three: passive activity. Even with basis and at-risk amounts, the passive activity loss rules generally limit passive losses to passive income. This is the hurdle most real estate investors know about, and it is the last one, not the first.
The ordering matters because people frequently diagnose the wrong problem. An owner whose loss is stuck at hurdle one is not going to be helped by a grouping election aimed at hurdle three. Figuring out which limitation is actually binding is the first diagnostic question, and it is a question for your CPA.
This is the difference that separated the two brothers, and it is one of the more consequential distinctions in choice of entity for real estate.
In a partnership or an LLC taxed as a partnership, a partner's basis generally includes their share of the entity's liabilities. If the LLC borrows to buy a building, that debt generally increases the partners' outside basis according to the allocation rules. Because real estate is typically leveraged, this frequently gives partners substantial basis well beyond the cash they contributed, which is exactly what is needed to absorb a large first-year depreciation loss.
In an S corporation, the rules are different. A shareholder's basis generally consists of stock basis plus basis in loans the shareholder personally makes to the corporation. Entity-level debt owed to a third-party lender generally does not give the shareholder basis, even though the corporation is obligated on it and the shareholder may have personally guaranteed it. A guarantee alone generally does not create basis.
Follow that through on the Zanesville facts. The brother in the S corporation contributed roughly $350,000 of equity. His corporation borrowed the rest. His stock basis reflected his contribution and his share of income, not the roughly $1.05 million of entity-level debt. When the cost segregation study produced a loss substantially exceeding his basis, the excess was suspended at hurdle one before the passive rules were even reached.
His brother in the LLC, holding the same economics, generally had basis that included his share of the entity's debt. His loss had room to land.
Neither brother did anything wrong. One of them had an entity chosen years earlier for a different business, applied to real estate without anyone revisiting whether it still fit.
The basis issue is not the only reason practitioners generally counsel against holding appreciating real estate in an S corporation. A few others are worth knowing, since they compound.
Distributing appreciated property out of an S corporation is generally a taxable event, which makes it difficult to move a property out later without a tax cost. Partnerships generally offer more flexibility on distributions of property. Special allocations of income and loss among owners are generally available in a partnership and generally not in an S corporation, which has a single class of stock requirement. And contributing appreciated property into an S corporation can trigger gain in circumstances where a partnership contribution would not.
None of this means an S corporation is always wrong. There are situations, often involving operating businesses or self-employment tax planning, where it is clearly right. But real estate held for appreciation, with leverage, and with an eye toward cost segregation is not the fact pattern where its strengths show.
Changing entities after the fact is not free either. Moving property between entities can trigger tax, transfer taxes, lender consent issues, and title work. This is a decision that is far cheaper to get right at acquisition than to fix in year four.
A single-member LLC is generally disregarded for federal income tax purposes, meaning the activity is generally reported on the owner's return as though the LLC did not exist. The LLC provides liability protection without adding a separate tax layer.
For cost segregation purposes, a disregarded entity generally behaves like direct ownership. The basis question is straightforward because there is no separate entity basis to track, and debt on the property generally factors into the owner's amount at risk under the applicable rules. The passive activity analysis still applies in full.
For many single-owner real estate holdings, this is the simplest structure that does not create the problems described above.
A C corporation does not pass deductions through to shareholders. The depreciation deduction stays at the corporate level and reduces corporate taxable income. Shareholders see nothing on their personal returns.
For a real estate owner whose goal is offsetting personal income, that generally defeats the purpose. There are also long-standing concerns about holding appreciating real estate in a C corporation related to the tax cost of getting the property or its proceeds back out. Where a C corporation owns its own operating facility, the analysis differs and cost segregation can still reduce corporate tax meaningfully. But it is a different objective than the one most real estate investors have.
One more interaction worth flagging because it catches business owners constantly.
The common and generally sensible structure of holding your operating business in one entity and the building it occupies in a separate entity, with rent paid between them, runs into the self-rental rules. Under those rules, net rental income from a self-rental to a business you materially participate in is generally recharacterized as non-passive, while net rental losses generally remain passive. A cost segregation study produces a loss, and that loss can stay stuck in the passive bucket where it cannot offset your active business income.
That is its own topic with its own planning responses, including grouping elections. The point here is that the entity structure question and the self-rental question are connected, and a business owner separating real estate from operations should have both conversations at the same time.
Assuming the entity does not matter because the study is the same. The study is the same. The usability of the deduction is not.
Holding leveraged appreciating real estate in an S corporation. Entity-level debt generally does not give shareholders basis, which can strand a large cost segregation loss before the passive rules are even reached.
Believing a personal guarantee creates S corporation basis. A guarantee alone generally does not.
Diagnosing a passive activity problem when the real constraint is basis. The three hurdles apply in order. Fix the binding one.
Choosing the entity for the operating business and applying it to real estate by default. They are different problems with different right answers.
Waiting until after acquisition to think about it. Moving property between entities later can trigger tax, transfer taxes, and lender issues.
If you are about to acquire a property, have the entity conversation before closing, and have it in the context of the cost segregation deduction you intend to claim. The question to put to your CPA and attorney is specific: given how this will be financed and what I intend to do with the depreciation, which structure lets the deduction actually land?
If you already hold property in a structure that is limiting you, do not assume it is unfixable, but do not assume it is free to fix either. Get the analysis before you move anything.
And in either case, the deduction the structure is meant to deliver still has to be created. The Cost Seg America team performs engineered studies using IRS Approaches 1 and 2, and raises the usability questions before the study rather than after. More than 16,000 studies completed. More than 125 IRS audits defended with zero losses and zero dollars ever returned to the IRS. Engineered, not estimated.
Request a free proposal, or reach out to the Cost Seg America team directly:
1-888-365-5023
info@costsegamerica.com
Does the entity affect the cost segregation study itself?
No. The study analyzes the physical property and reaches the same conclusions regardless of how title is held. The entity affects whether you can use the resulting deduction.
Why can't I use my loss from an S corporation?
Most likely a basis limitation. An S corporation shareholder's basis generally consists of stock basis plus basis in loans the shareholder personally makes to the corporation. Third-party entity-level debt generally does not create shareholder basis, even with a personal guarantee.
How is a partnership different?
A partner's basis generally includes their share of entity liabilities. On leveraged real estate, that frequently gives partners substantial basis beyond their cash contribution, which is what allows a large first-year depreciation loss to be absorbed.
What are the three limitations on using a loss?
Basis, then at-risk, then passive activity. They apply in order, and identifying which one is actually binding determines what the right fix is.
Is a single-member LLC a good structure for this?
For many single-owner holdings, yes. It is generally disregarded for federal income tax purposes, so it behaves much like direct ownership while providing liability protection, without the S corporation basis complications.
Does a C corporation work for cost segregation?
The deduction stays at the corporate level and does not pass through to shareholders, so it generally does not serve an owner trying to offset personal income. Where a C corporation owns its own operating facility, it can still reduce corporate tax.
Can I change entities later?
Sometimes, but moving property between entities can trigger tax, transfer taxes, lender consent requirements, and title work. It is substantially cheaper to structure correctly at acquisition.
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