How Cost Segregation Generates Tax Savings for Multifamily Investors

Savvy investors know that multifamily real estate is a great way to generate passive income and build your wealth. 

But there’s one tax-saving secret that experienced firms will exploit. That secret is cost segregation. Cost segregation, when properly implemented, can substantially accelerate depreciation deductions, potentially resulting in millions of dollars in tax savings over the life of an investment. 

This article will walk you through the mechanics of cost segregation, its application in multifamily properties, and the tangible financial benefits it offers to astute investors.

What is Cost Segregation?

Cost segregation is a tax strategy that allows multifamily real estate owners to accelerate depreciation deductions by reclassifying certain property components as shorter-lived assets. 

This is just one example of the numerous tax benefits that come with investing in multifamily real estate.

Typically, residential rental properties are depreciated over 27.5 years, while commercial properties are depreciated over 39 years. With cost segregation, investors can identify and separate assets that depreciate faster, such as land improvements, personal property, and certain building components. 

By allocating more costs to these shorter-lived assets, investors can front-load depreciation deductions, reducing taxable income in the early years of ownership. Investment firms will do this for their clients, providing immense tax benefits to their investors. 

Cost Segregation Categories

When performing a cost segregation study, assets are typically classified into four main categories:

1. Personal Property: This includes assets that are not structurally part of the building, such as appliances, furniture, and carpeting. 
2. Land Improvements: This includes assets that are outside the building, such as sidewalks, landscaping, and parking lots. 
3. Building Components: This includes structural components of the building that have a shorter useful life than the overall structure, such as electrical systems, plumbing, and HVAC.
4. Building Structure: This includes the core structural components of the building, such as the foundation, walls, and roof. These assets are typically depreciated over 27.5 years for residential properties and 39 years for commercial properties.

You won’t need to know these particulars if you invest with an experienced firm. This is just an example of how firms leverage cost segregation when handling a property. 

How Cost Segregation Studies Work

A cost segregation study is a detailed engineering analysis of a multifamily property that identifies and reclassifies assets into the appropriate depreciation categories. 

The study is typically performed by a team of experts who thoroughly examine the property’s blueprints, construction documents, and physical condition. The study process usually involves the following steps:

1. Property Inspection: The team visits the property to identify and measure all building components and site improvements.
2. Document Review: The team analyzes construction documents, blueprints, and invoices to determine the cost basis of each asset.
3. Asset Classification: The team classifies each asset into the appropriate depreciation category based on IRS guidelines and industry standards.
4. Cost Allocation: The team allocates the total property cost among the identified assets based on their relative value.
5. Report Preparation: The team prepares a detailed report summarizing the study findings, including the reclassified assets, their cost basis, and the accelerated depreciation schedule.

As you can see this is a rigorous process, which makes it all the more important to select the right firm to invest with.

IRS Standards for Cost Segregation

To ensure the validity of cost segregation studies, the IRS has established guidelines and standards that must be followed. These standards are outlined in the IRS Cost Segregation Audit Techniques Guide, which provides a framework for evaluating the accuracy and completeness of cost segregation studies.

Some key IRS requirements for cost segregation studies include:

• The study must be performed by qualified professionals with expertise in engineering, construction, and tax law.
• The study must be based on a detailed analysis of the property’s construction documents, blueprints, and physical condition.
• The asset classifications and cost allocations must be supported by objective evidence and industry standards.
• The study report must include a summary of the methodology, findings, and conclusions, as well as a detailed asset listing and depreciation schedule.

This is an intense process, but the effort is well worth the payoff for the firm and its investors.

An Example of Cost Segregation for a Multifamily Property

To illustrate the power of cost segregation, let’s consider a hypothetical example of a 100-unit multifamily property purchased for $10 million. 

Without cost segregation, the entire $10 million would be depreciated over 27.5 years, resulting in an annual depreciation deduction of $363,636.

However, with a cost segregation study, the property’s cost basis might be allocated as follows:

• Building Structure (27.5-year life): $7,000,000
• Land Improvements (15-year life): $1,000,000
• Personal Property (5-year life): $1,500,000
• Building Components (7-year life): $500,000

Under this scenario, the annual depreciation deduction in the first year would be:

• Building Structure: $254,545
• Land Improvements: $66,667
• Personal Property: $300,000
• Building Components: $71,429

The total first-year depreciation deduction with cost segregation would be $692,641, nearly double the deduction without cost segregation. Over the first five years of ownership, the accelerated depreciation from cost segregation could result in over $1 million in additional tax deductions.

This leads to substantial tax savings for the investors in the property, so you can see the benefits cost segregation can bring come tax season.

How Cost Segregation Benefits Investors

Cost segregation offers several compelling benefits for multifamily real estate investors:

1. Increased Cash Flow: By reducing taxable income, cost segregation frees up cash that can be reinvested into property or used for other opportunities.
2. Deferred Taxes: While cost segregation doesn’t eliminate taxes, it allows you to defer them to later years when your income may be lower or you may have more deductions.
3. Improved ROI: By boosting cash flow and deferring taxes, cost segregation can significantly improve your overall return on investment.
4. Retroactive Application: Even if a firm has owned a property for several years, it can still conduct a cost segregation study and catch up on the accelerated depreciation you’ve missed out on.

These are just a handful of the benefits that multifamily investing can bring. This makes multifamily real estate an excellent addition to a savvy investor’s portfolio.

Master Multifamily Investing With Our Free Investor Guide

Cost segregation is a powerful tax strategy that can significantly enhance the returns of your multifamily real estate investments. By accelerating depreciation deductions, cost segregation allows you to reduce your taxable income, increase your cash flow, and ultimately maximize your wealth. 

If you are interested in investing in multifamily real estate and want to reap the numerous tax benefits that come with it, it’s time to start looking for a qualified investment firm with experience and a strong track record to help you. 

To help you select the right firm, we prepared a free guide to investing in multifamily real estate to distill our decades of experience. Fill out the form below to download it.