Cost Segregation and Multifamily Property: Busting the Myths

February 10, 2023

In J.P. Morgan’s 2023 Commercial Real Estate Outlook, multifamily property is designated as the highest performing of all asset classes. A recent study commissioned by the National Multifamily Housing Council and National Apartment Association revealed that the U.S. needs to build 4.3 million new apartments by 2035. The demand for multifamily units clearly remains strong, reinforcing its reputation as a “safe” investment.  

Investors may initially be drawn to this vertical for safety, scalability, and predictable income, but they often stay for the significant tax benefits. Multiple tax strategies are available, including accelerated depreciation, which can be used to offset a portion of that predictable rental income. Cost segregation is the vehicle for these tax savings.  

So why doesn’t every multifamily property owner consider cost segregation? Some simply aren’t aware of it, while others have been misinformed. Let’s debunk some of the common myths holding multifamily investors back from potential opportunity.  

1. You can only do cost segregation studies on commercial property, not residential rental real estate. 

[ False ]

Cost segregation can be performed on residential real estate, from multifamily to single family rental properties, and in fact multifamily properties are considered great candidates for cost segregation.  

2. There aren’t a lot of assets to reclassify in a multifamily property. 

[ False ]

While the exact yield will vary based on projects details, layout, and location, between 20-35% of assets in multifamily properties may be accelerated.  

Without cost segregation, residential real estate capital assets are assigned a 27.5-year Class Life.  

With cost segregation, these are just some of the asset categories that can be moved into much shorter Class Lives:  

  • 5-Year Personal Property: appliances, carpet, wallpaper, crown molding, window treatments, counters, cabinets, dedicated outlets, decorative lighting, specialty plumbing, security camera systems and keypads, fire extinguishers, paddle fans… 
  • 15-Year Land Improvements: Sidewalks, parking lots, landscaping, pools, storm water drainage, sanitary lines, storm water retention systems… 

3.  Cost segregation is just a matter of timing. The depreciation will happen eventually… 

[ False ]

It’s true that cost segregation is a matter of timing, and it’s true that the depreciation will happen eventually.   However, waiting around is not to your advantage. With inflation on the rise, the time value of money is more important than ever. Deductions taken today are much more valuable than deductions taken in the future. Plus, accelerating depreciation gives you additional cash now which can be reinvested for further gains.  

4. Cost seg is only worthwhile for very high-value properties. It’s not worth doing a study on my small multifamily property. 

[ False ]

It’s true that once upon a time, only projects with a basis of $1M or more were considered good cost segregation candidates. That changed with the Tax Cuts and Jobs Act (TCJA) of 2018. The one-two punch of 100% bonus depreciation and bonus-eligibility for acquired assets makes small-basis properties viable candidates.  

(100% bonus depreciation is in effect for properties placed-in-service between 9/27/2017-12/31/2022. If your multifamily property was placed-in-service during that time, you can still access 100% bonus rates using a look-back cost segregation study which permits “catch-up” depreciation. If you’re placing a multifamily property in service during 2023, you’ll be eligible for 80% bonus depreciation, which is still quite high.) 

5. When I sell, recapture will just negate all the benefit

[ False ]

While recapture can be an issue, cost segregation still has significant strategic value. As always, it’s the unique facts and circumstances of each taxpayer and the property/s in question that determine the best course of action. There are multiple ways to mitigate the impact of recapture, and we encourage you to discuss your particular circumstances with your tax advisor.  

  • Situations will vary of course, but if you plan to hold your multifamily family property for at least 3-5 years, the increased cash flow from the accelerated depreciation generally more than outweighs the increased tax from recapture.  
  • Asset dispositions are shielded from related recapture. Look to PAD elections to reduce a property’s basis. 
  • Improvements that are expensed immediately under the Tangible Property Regulations will decrease the recapture burden later at the time of sale.               

6. I acquired my MF property in a 1031 Exchange, so I can’t do a cost seg study. 

[ False ]

Cost segregation studies are often used in conjunction with a 1031 Exchange, particularly given the aforementioned bonus depreciation rule changes under the TCJA. The step-up in basis on the replacement property can be a great cost segregation opportunity. Plus, if the replacement property has the same amount of Section 1245 assets as the relinquished property, you may be able to defer/avoid Section 1245 recapture tax.  

Multifamily properties will most likely continue to be a popular and profitable vertical for development and investment.

If you own a multifamily property or advise someone who does, it is wise to consider cost segregation to maximize real estate tax savings. If you have specific questions about an opportunity, or would like to learn more, we’re here to help. 

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