As the markets continue to adjust to a post-pandemic world with high interest rates and inflation, multi-family new construction projects and acquisitions remain an area of growth. As more investors move into this area, maintaining a competitive edge is more important than ever, and taking advantage of cost segregation and its benefits can give investors the boost needed to stay ahead.

Cost Segregation and How It Impacts Multi-Family Housing

When a multi-family rental property is purchased or constructed, the depreciable basis defaults to 27.5 years, so every year for 27.5 years, an investor can write off 1/27.5th of the property’s depreciable basis against their taxable income. This form of depreciation is referred to as “Straight-Line Depreciation.”

With Cost Segregation, certain components of your multi-family rental property considered “tangible personal property” or “land improvements” are reclassified to shorter depreciable lives, 5 and 15 years respectively. This significantly increases depreciation deductions in the early years of ownership and generates substantial tax savings. This form of depreciation is referred to as “Accelerated Depreciation.”

Taking larger depreciation deductions in the early years of ownership generates significant cash flow that can be reinvested in the property, used to purchase additional properties, or simply reinvested in money markets to earn a better ROI over time. The circumstances surrounding multi-family real estate transactions are always different, however the fact that a depreciation expense is worth more now than it will be in the future is a constant, and one of the core principles behind cost segregation.

An example of the power of cost segregation is below. In this example, we’ll compare the depreciation expense for a multi-family investor using straight-line depreciation vs accelerated depreciation.

An investor purchased a 120-unit apartment complex in 2022 and his depreciable basis was $10,000,000. Average monthly rent per unit was $1,850 and his total rental income for 2023 was $2,664,000. Let’s take a look at his 2023 depreciation deduction using each approach.

• Straight-Line Depreciation without Cost Segregation
  • For the 2023 tax year, his depreciation expense using standard straight-line depreciation was $363,636.
  • After deducting his depreciation expense, his 2023 taxable income was $1,856,364.
  • At a 37% federal tax rate, the depreciation saved him from paying $134,545 in taxes for 2023.
• Accelerated Depreciation with Cost Segregation:
  • In 2023, after having a cost segregation study performed, his depreciation expense was $2,546,288.
  • After deducting his depreciation expense, his taxable income was $117,712.
  • At a 37% federal tax rate, the depreciation saved him from paying $942,127 in taxes.
  • Compared with the straight-line depreciation example, this investor had additional depreciation of $2,182,652 in 2023 which amounted to an additional cash flow of $807,581. 

As you can see in this example, the year one tax savings created by a cost segregation study can be immense. In the above example, the effects of bonus depreciation allowed investors to fully depreciate the costs of all 5 and 15-year property components in year 1. It should be noted that every property is different, and the results from any study will be based on physical nature of the property as well as the facts and circumstances surrounding the acquisition or construction.

While cost segregation can be a great tool to help generate significant tax savings up front, it is not without complexities. There are many factors at play such as bonus depreciation, evolving tax law, length of property ownership, and long-term expense expectations. Additionally, there may be other related tax incentives such as the Section 45L credit or Section 179D deduction that can be applied in conjunction with a cost segregation study. This is where working with a full-service property incentives firm like CTI becomes extremely important, as our experts can identify and guide you on significant interplay between these different opportunities.

If you would like to learn more about cost segregation and other property incentives, contact our team of professionals.