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Here is the short answer, before the story and the math: for tax year 2026, federal law caps the business losses an individual can use against non-business income at $256,000 for single filers and $512,000 for married couples filing jointly. That cap is called the excess business loss limitation, it lives in Internal Revenue Code Section 461(l), and it sits on top of the passive activity rules most property owners already know about. If you are a real estate professional or a short-term rental owner who materially participates, a well-built cost segregation study can produce a first-year deduction far larger than that cap. Nothing is lost when that happens, but the timing changes, and knowing exactly how it changes before you order a study is the difference between a clean plan and a surprise in March.
This article walks through how the limit works, who it actually affects, what happens to the deduction that gets disallowed, and the specific planning moves that keep a cost segregation study working hard for you. We use two composite examples with real arithmetic so you can see the numbers move.
For years, the excess business loss limitation was a footnote for most real estate investors. It was suspended for a stretch, it was scheduled to expire, and it only applied to large losses. Three things changed that.
First, 100 percent bonus depreciation is back as permanent law for qualified property acquired after January 19, 2025. Qualified property generally means property with a recovery period of 20 years or less, which is exactly the category a cost segregation study creates by reclassifying parts of a building into 5-year, 7-year, and 15-year assets. When bonus depreciation was phasing down, the first-year deduction from a study was smaller. Now it can be very large.
Second, the Section 461(l) limitation was made permanent starting in 2025. It is no longer a rule that might quietly vanish in a few years. Owners and their advisors have to plan around it as a fixed part of the landscape.
Third, the 2026 threshold dropped. The inflation-adjusted amounts under Revenue Procedure 2025-32 are $256,000 for single filers and $512,000 for joint filers, down from $313,000 and $626,000 for 2025. A deduction that squeaked under the line last year can exceed it this year.
Put those together and you get a real planning issue: bigger deductions than ever from a cost segregation study, colliding with a cap that is lower than it used to be. Owners who understand the collision use it to their advantage. Owners who do not often find out on a Form 461 in the spring.
The statute is short, but each phrase matters. Section 461(l) applies to taxpayers other than C corporations, which means individuals, trusts, and the owners of pass-through entities such as partnerships and S corporations. It disallows what the code calls an excess business loss.
An excess business loss for the year is the amount by which your total deductions attributable to your trades or businesses exceed your total income and gain from those trades or businesses, plus the threshold amount. In plain English: take all the deductions from your businesses, subtract all the income and gain from your businesses, and if the result is a loss larger than $256,000 (single) or $512,000 (joint) in 2026, the part above the threshold is an excess business loss and cannot be deducted this year.
A few details in that definition deserve attention.
If you own rental property through a partnership or an S corporation, the limit is applied on your individual return, not at the entity level. Your share of the entity's losses flows to you, and then Section 461(l) is tested against everything on your return that counts as a trade or business. On a joint return, the threshold is a single $512,000 figure for the couple, not $256,000 per spouse.
This is the point that surprises the most people. The statute specifically excludes deductions and income from the trade or business of performing services as an employee. That means your W-2 salary is not counted as business income that can absorb business losses under this calculation. A high-earning physician or executive who buys an apartment building does not get to treat their paycheck as business income when measuring the cap. The wages are still income on the return, and a loss that clears the threshold can offset them, but the loss allowed against them is capped by the threshold plus any genuine business income.
Because the formula compares business deductions to business income plus the threshold, genuine trade or business income raises the amount of loss you can use. If a married couple filing jointly owns an operating business that earns $400,000 of net income and a rental portfolio that generates a $700,000 non-passive loss after depreciation, the net business loss is only $300,000, which is below the $512,000 joint threshold, so no excess business loss arises. This is one of the most useful planning facts in the whole area, and we will return to it below.
Losses face a series of gates, and Section 461(l) is the last one. Your loss first has to be within your basis in the investment, then within your at-risk amount, then it has to survive the passive activity loss rules of Section 469. Only after all of that does Section 461(l) apply. The statute says so directly: the excess business loss limitation applies after the application of Section 469.
The excess business loss rule is not aimed at everyone who owns a rental. Understanding where you sit in the sequence tells you whether it matters to you at all.
If your rental losses are passive, meaning you do not qualify as a real estate professional and you do not materially participate in the activity, Section 469 suspends those losses. They can be used against passive income, and any unused amount carries forward. Because the losses do not make it out of the passive gate, Section 461(l) has nothing to test. For these owners, cost segregation is usually about creating losses that shelter passive income now or that become usable on a future sale, and the excess business loss limit is not the binding constraint.
Under Section 469(c)(7), a taxpayer who spends more than half of their personal service time in real property trades or businesses in which they materially participate, and who puts in more than 750 hours in those activities, is treated as not being in a passive rental activity for purposes of their rentals, provided they also materially participate in the rentals themselves. Their rental losses are non-passive. That is the entire appeal of the status, and it is also why they walk straight into Section 461(l).
When the average guest stay is seven days or less, the property is not treated as a rental activity under the passive activity regulations, so the loss is not automatically passive. Instead, the owner is tested under the ordinary material participation rules. The most commonly used tests are 500 hours, or more than 100 hours and at least as many hours as any other individual who participates in the activity. An owner who clears one of those tests has a non-passive loss, and that loss, like a real estate professional's, is measured against the Section 461(l) threshold.
Because business income raises the effective cap, owners who also run profitable operating businesses often find the limit does not bind, or binds much less than a headline comparison of the study to the threshold would suggest.
Dana and Priya are not real Cost Seg America clients. They are a composite, built from the kinds of numbers we see across multifamily investors, so we can walk through the math without exposing anyone's return.
Dana qualifies as a real estate professional and materially participates in the couple's rentals. Priya is a physician with W-2 wages of $780,000. They file jointly. In March 2026, Dana closes on a 60-unit apartment building for $8,000,000.
An engineered cost segregation study allocates $1,600,000 (20 percent) to land, which is not depreciable, leaving a depreciable basis of $6,400,000. The study reclassifies 27 percent of that depreciable basis, or $1,728,000, into 5-year, 7-year, and 15-year property. With 100 percent bonus depreciation, the full $1,728,000 is deductible in year one. The remaining $4,672,000 of building basis is depreciated straight-line over 27.5 years; with a March placed-in-service date under the mid-month convention, that produces roughly $134,500 of depreciation in 2026.
The property also generates net rental income of about $190,000 in 2026 before depreciation, after operating expenses and mortgage interest.
Here is the year-one tax result at the property level:
Dana is a real estate professional and materially participates, so the loss is non-passive. It passes the basis, at-risk, and passive gates. Now it meets Section 461(l).
Dana and Priya have no other trade or business income. Priya's wages do not count. The aggregate business deductions exceed business income by about $1,672,500. The joint threshold for 2026 is $512,000.
At an illustrative 35 percent blended federal rate, the $512,000 allowed loss reduces their 2026 federal tax by roughly $179,200. That is real money in year one. And the roughly $1,160,500 that was disallowed is not wasted; it becomes a net operating loss carryforward.
Suppose the following year their taxable income before any NOL deduction is $1,000,000. The NOL deduction is limited to 80 percent of that income, so they can use $800,000 of the carryforward and still owe tax on $200,000. The remaining carryforward stays available. Over a couple of years, the entire deduction the study identified gets used, just on a schedule set by the statute rather than all at once.
What if Dana and Priya had skipped the study? Their year-one loss from the property would have been much smaller, roughly $190,000 of income against about $184,000 of straight-line depreciation on the full $6,400,000 basis, essentially break-even, and the cap would never have come into play. They would also have given up nearly $1.7 million of additional first-year deductions and the cash-flow value that comes with them. The cap changes the pace of the benefit. It does not erase it.
When Section 461(l) disallows a loss, the code treats the excess as a net operating loss carryover to the following year. Three characteristics of that carryover determine how much value it holds.
NOLs arising in tax years beginning after 2017 do not expire and cannot be carried back in most cases. The carryforward waits for you until it is used.
In a carryforward year, the NOL deduction is limited to 80 percent of taxable income, computed without regard to the NOL deduction itself. That means that in a year when you might otherwise use the whole carryforward, you will still owe tax on the remaining 20 percent of income. It also means the NOL is best thought of as a smoothing mechanism across several years, not an instant offset.
The limitation is computed on IRS Form 461, Limitation on Business Losses, which is filed with your Form 1040. Your CPA will use it to show the excess business loss and to track the carryforward. If your cost segregation study is large enough that Form 461 will be part of your return, it is worth telling your preparer before the return season begins, not during it.
Many states do not follow federal bonus depreciation, and some handle NOLs differently. A large first-year federal deduction can leave you with a smaller state deduction, or even state taxable income in a year when federal taxable income is low. This is one more reason the study, the return, and the planning conversation need to happen together.
Tomás is another composite, not a real client. He is single, has W-2 wages of $600,000, and in 2026 buys three short-term rental cabins for a combined $3,000,000. The average guest stay is four nights, and Tomás handles booking, guest communication, and coordination of cleaning and maintenance himself. He keeps a contemporaneous log of his hours and clears the material participation threshold, so his losses are non-passive.
An engineered study allocates $450,000 (15 percent) to land, leaving depreciable basis of $2,550,000, and reclassifies 32 percent of that, or $816,000, into shorter-lived property eligible for 100 percent bonus depreciation. To keep the illustration simple, assume the cabins' operating income roughly offsets their ordinary building depreciation, so the study's bonus deduction is effectively the whole loss.
At the same illustrative 35 percent rate, the allowed $256,000 lowers Tomás's federal tax by about $89,600 in 2026, and the $560,000 carryforward is available to reduce future taxable income, subject to the 80 percent limit.
This example carries a second lesson. Many short-term rental owners hear that the seven-day rule plus a cost segregation study can erase a large W-2 income. That is an overstatement. The strategy is real, it is grounded in the tax code, and it can produce very large deductions, but for a single filer the current-year benefit against wages is bounded by the threshold, and the balance is a carryforward. A firm that tells you otherwise is not describing the law the way the law is written.
In most cases, yes, and the reasons are worth spelling out because this is the question we hear most often after owners learn about the limit.
The carryforward has value. Dana and Priya used $512,000 of deduction in 2026 and preserved more than $1.1 million for later years. Without the study, they would have had neither.
Without a study, most of a building's cost is written off over 27.5 or 39 years. Skipping the study because a cap exists means choosing the slowest possible path for every dollar, including the dollars that would have been usable in the first year or two. A carryforward is a much better place to hold a deduction than an unclaimed 39-year schedule.
A dollar of deduction in 2026 is worth more than a dollar of the same deduction in 2029. Even when the cap slows the pace, front-loading through a study puts more of the deduction earlier than straight-line depreciation ever would.
Business income can rise. A large gain can arrive from a sale, an equity event, or a partnership distribution. A NOL carryforward built today can be waiting when that income shows up. Owners who did not build the carryforward have nothing to use.
Accelerated depreciation is generally subject to recapture when you sell. Personal property components are typically recaptured as ordinary income up to the depreciation taken, and the building's depreciation is subject to the unrecaptured Section 1250 gain rules, taxed at a maximum 25 percent federal rate. Many owners still come out well ahead by claiming the deductions early, especially when a future sale is structured through a Section 1031 exchange, but the recapture math belongs in the plan from the first conversation.
There are honest cases where a study does not make sense, such as very small properties, properties you plan to sell within a short time in a fully taxable sale, or situations where you cannot use the losses for years and the study's cost outweighs the time value. A good provider will tell you when the math does not work. The excess business loss limit is rarely one of those cases on its own.
Owners who get the most from cost segregation treat the excess business loss limit as a design constraint, not a verdict. These are the levers we see used most often. None of them is right for every taxpayer, and each should be evaluated with a CPA.
Because Section 461(l) compares business deductions to business income plus the threshold, other trade or business income increases capacity. Net income from an operating company, a consulting practice, or a profitable property portfolio that is itself a trade or business raises the amount of loss you can use without triggering an excess business loss. Your CPA can model whether the income you have is the kind that counts.
Section 168(k)(7) allows a taxpayer to elect out of bonus depreciation for any class of property placed in service during the year. The election applies to the entire class, not to individual assets. Electing out means those assets are depreciated under regular MACRS schedules, which spreads deductions across several years. For a taxpayer who knows the cap will disallow most of a first-year deduction and who would otherwise be building a large NOL, spreading deductions across years can smooth the usage. It is a trade-off, since bonus depreciation followed by a carryforward is not always worse than slower depreciation, but it is a real option that belongs in the conversation.
A property placed in service in December rather than in January can pull a large deduction into a tax year with more capacity, or push it into the next. The same is true for improvements. Because the date a property is placed in service controls the year of the deduction, coordinating closings and projects with your income picture is one of the least glamorous and most effective moves available.
If you own several properties, you do not have to study them all in the same year. A study can be commissioned for the property that fits your capacity this year, with the next property's study planned for a year when you expect more capacity. In many cases, the studies can be staged so each year's deduction is close to what you can actually absorb.
For property you already own, a lookback study captures depreciation you did not claim in prior years and takes it in a single catch-up adjustment on the year you file Form 3115. That adjustment is a deduction in the year of change, so it interacts with the same limits. Because the timing of the accounting method change is within your control, you can often choose a year in which the catch-up deduction fits your capacity best.
Some owners find that a portion of their portfolio is better left passive, especially when they have passive income to offset. Grouping elections under Section 469 and your documented participation determine which activities generate non-passive losses, and those questions should be settled before the study rather than after. A cost segregation study creates the deduction; your participation and grouping choices decide which limits the deduction meets first.
The mistakes below account for most of the unwelcome surprises that owners describe when they first learn about Section 461(l).
As the size of a first-year deduction grows, so does the scrutiny that can follow it, and so does the value of documentation. A rule-of-thumb study that applies a percentage to the purchase price is not the same product as an engineered study that identifies, measures, and prices individual building components from plans, invoices, and a site inspection where appropriate.
The IRS's own Cost Segregation Audit Techniques Guide describes the qualities of a reliable study: a detailed engineering approach, quantity takeoffs, a clear methodology, and documentation that links each classification to a legal basis such as the Whiteco factors for distinguishing personal property from structural components. An examiner reading a study built that way has answers on the page.
Cost Seg America's record reflects that approach. Our team has completed more than 16,000 studies and defended more than 125 IRS audits without a single loss, with 24 or more years of combined cost segregation experience behind the work. Every study is engineered, not estimated, and every study comes with lifetime audit support at no additional cost. When your first-year deduction runs into six or seven figures, that kind of documentation is the difference between a deduction you can keep and a deduction you have to argue about.
If you think Section 461(l) may affect you, bring these questions to your CPA and to your cost segregation provider before the study begins:
For tax year 2026, the Section 461(l) threshold is $256,000 for single filers and $512,000 for married couples filing jointly, according to IRS Revenue Procedure 2025-32. Business losses above that amount, after taking into account business income and gain, are treated as an excess business loss and are not deductible in the current year.
Yes. The One Big Beautiful Bill Act made the limitation permanent beginning in 2025. It was previously scheduled to expire after 2028.
It can. A real estate professional who materially participates in rental activities has non-passive rental losses, and those losses are tested against the Section 461(l) threshold after the passive activity rules have been applied.
It can apply to short-term rental owners whose average guest stay is seven days or less and who materially participate in the activity. Their losses are non-passive, and any non-passive business loss above the threshold, net of business income, is limited.
No. The trade or business of performing services as an employee is excluded from the calculation, so wages do not increase how much business loss you can deduct under the limit.
The disallowed excess business loss is treated as a net operating loss carryover to the following year. NOLs from these years carry forward indefinitely, and the deduction in any single year is limited to 80 percent of taxable income.
It is computed on IRS Form 461, Limitation on Business Losses, filed with your Form 1040. Your tax preparer will complete the form if your business losses exceed the threshold.
Often yes, because the deductions the study identifies are not lost; they carry forward and the earlier deduction has time value. Whether it makes sense for you depends on your income, your expected holding period, your state, and your planning options, which is exactly what your CPA and your cost segregation provider should model together.
Electing out under Section 168(k)(7) spreads depreciation over a longer period for a class of property, which can reduce the size of the first-year loss. It is an option, not a cure, and it is not always the right choice. It should be evaluated with a CPA before the return is filed.
An engineered study built on IRS-recognized methodology, with full supporting documentation, does not create audit exposure on its own; it creates the paper trail that makes an examination easy to defend. Cost Seg America has defended more than 125 IRS audits without a loss.
The excess business loss limitation does not close the door on cost segregation. It changes the way you plan around it. For 2026, if you are a real estate professional or a materially participating short-term rental owner, the first thing to understand is that there is a cap on how much non-passive business loss you can use in a single year: $256,000 if you file single, $512,000 if you file jointly, adjusted upward by any genuine trade or business income you have. The second is that losses above the cap are not forfeited, they convert to a carryforward that can be used over time. The third is that the tools for managing the timing, from choosing the placed-in-service date to sequencing studies across properties to electing out of bonus for a class of assets, are already in the tax code and are available to you.
What you cannot do is pretend the limit is not there. The owners who benefit most from cost segregation are the ones who know their numbers before the study, tell their CPA early, and order an engineered study that will stand up to scrutiny. The owners who are surprised are usually the ones who heard about the deduction and did not hear about the cap.
If you own commercial property, multifamily, or short-term rentals and you want to understand what an engineered cost segregation study could mean for your 2026 return, including how the excess business loss limit fits into the picture, the first step is a conversation, not a commitment. Cost Seg America has worked with commercial property owners, residential rental investors, and short-term rental investors across the country, in every city, for more than two decades, helping owners reduce their federal tax burden with engineered, defensible studies backed by lifetime audit support at no additional cost.
Talk to Jim Dougherty and his team at 1-888-365-5023 or info@costsegamerica.com, and bring your CPA into the conversation early so the study, the return, and the plan all point in the same direction.
This article is for general educational purposes and is not tax, legal, or accounting advice. Tax outcomes depend on individual facts and circumstances, and the examples above are illustrative composites, not actual client results. The figures reflect federal law as of the date of publication, including IRS Revenue Procedure 2025-32 and the One Big Beautiful Bill Act. Consult a qualified tax professional before making decisions based on this information.
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