Multifamily Investors: Here’s Why Cost Segregation is Your Friend

by | BiggerPockets.com

Investing in multifamily is often considered the fast track to financial freedom and security. Mai Tais on the beach, anyone?

We all know that multifamily investing isn’t all rainbows and butterflies though. Sure, the extra cash is great. But let’s not forget, when renting out multiple units, the passive income tends to be higher than, say, renting out a single family home.

And with more profit comes… more taxes! So, how do you alleviate the tax burden?

The Benefits of Cost Segregation

Cost segregation is a tax planning strategy that accelerates the depreciation of certain components of properties. For real estate investors, benefits include reducing their current tax liability, which results in upfront cash flow.

Without cost segregation, multifamily rentals are depreciated straight-line over 27.5 years. In contrast, with cost segregation, certain components can be depreciated on a faster track (such as five, seven, or 15 years).

Below are a few examples of components typically found in a multifamily that are eligible for cost segregation depreciation:

Item Asset Class New Life
Parking lot Land improvements 15 years
Lawn sprinklers Land improvements 15 years
Carpeting Distributive trades & services 5 years
Kitchen stove Distributive trades & services 5 years

And to give you the bigger picture, here’s a before and after example of a multifamily unit that utilized cost segregation:

spreadsheet depicting property class, depreciation, reclassification for real estate investor tax purposes

For this $800,000 apartment complex, accumulated depreciation without cost segregation was $3,636. Accumulated depreciation with cost segregation, however, amounted to $315,622.

What a difference, right?

It is important to note, though, that just because you have these additional deductions doesn’t mean you can use them right away.

Related: The Ultimate Guide to Real Estate Taxes & Deductions

A Practical Example of Cost Segregation

Let’s say you purchased the above multifamily in November 2018 for $900,000. If you carve out $100,000 for land, the remaining $800,000 will be depreciated straight-line over 27.5 years.

If it has eight units renting at $1,000/month each, here’s what your numbers might look like:

    • $96,000 per year in gross rent
    • $32,000 per year in operating expenses (maintenance, advertising, taxes, vacancy, landscaping, etc.)
    • $38,000 per year in interest on the loan
    • Net operating income is $26,000

When calculating your taxes, you would also get a depreciation deduction of $3,636 (only a month and a half of depreciation your first year). This leaves you with $22,364 in passive income for this property.

Assuming you’re in the 22 percent tax bracket, that means you would pay $4,920 in taxes on this passive income. On the flip side, if you do take advantage of cost segregation, you can pick up an extra $311,986 in deductions.

These additional deductions can wipe out your passive income of $22,364 and save you the $4,920 in taxes. The remaining $289,622 carries forward and will offset passive income in future years until it’s used up.

This is what we call utilization!

Related: Cost Segregation Study: Could This Strategy Dramatically Reduce Your Tax Bill?

closeup of hand using scissors to cut paper that reads taxes

Final Notes

This passive income and passive loss analysis can be done across your entire rental portfolio. In other words, the $311,986 that you can capture for this property can also offset the passive income from your other properties.  

Plus, if your tax preparer agrees that you can be designated as a “real estate professional,” then the $311,986 could offset your active income (ie., your W2 wage), as well. In this case, if you did cost segregation and are permitted to use the $311,986, you would save a whopping $68,637!

At the end of the day, I strongly recommend you enlist your tax professional to ensure that you can make use of cost segregation. They know your financial situation and will walk you through the process, which can definitely be somewhat complicated.

Bottom line: cost segregation is valuable! In the above example, using the full $311,986 is like borrowing $68,637 from the federal government—interest-free!

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Want to learn how you could be saving more on your real estate taxes using loopholes, deductions, and more? Get the inside scoop from Amanda Han and Matthew MacFarland, real estate investors and CPAs, in Tax Strategies for the Savvy Real Estate Investor. Pick up your copy from the BiggerPockets bookstore today!

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What would you do with all that extra cash? Do you plan to take advantage of this tax benefit? Or have you already? 

Leave a comment below.

About Author

Mary Hitchcock

Mary is a Marketing Manager for a cost segregation software solution, Titan Echo (www.titanecho.com), located in BiggerPockets' hometown - Denver, Colorado! Mary was first introduced to the world of real estate investing when starting at Titan Echo. In her spare time, Mary enjoys exploring the Denver food scene or cooking in the comfort of her kitchen.

16 Comments

  1. Chester Lee

    Hi Mary,

    Clear example. Good illustration At sales, the depreciation is recaptured and taxed as a capital gains. Is this correct? Is the cost segregation software solution, Titan Echo available or individuals to use? or does cost segregation require a 3rd party professional? I’ hearing they cost $10,000 or more. Can you speak on these areas? Thanks.

  2. Charles Bellanfante

    Hello. I like the post but it’s not accurate about depreciation. That’s just not how depreciation work. In your example of a home purchased for 900k, minus 100k for land, there is no way possible the depreciation could be $3,636. Even if you used the federal straight line rate of 27.5 for residential, the lowest depreciation you can get is 29K (800k ÷ 27.5 = 29,090). And that’s the lowest you can get unless you owned the property for 27.5 years and no longer eligible for depreciation. That’s 29k before we get to the extra depreciation your allowed for other improvements. And cost segregation is a normal advantage that anyone will get If they use reputable accountant, preferably a CPA. I am a CPA, so I find it a little misleading when people enter a realm (depreciation & MACRS) that is more complicated than you may really understand.

    • Mary Hitchcock

      Hello Charles,

      Great catch on my initial depreciation number. However, I think Ben Davies’ response does a great job of explaining. Let me try to say it in a different way:

      As I stated in the post, the client bought the building in November, with a 12/31 tax year end. The depreciation method (how to handle depreciation in the first year of ownership) is “mid-month.” This means during the owner’s first year of ownership, their depreciation deduction is only for half of November and all of December, or 1.5 months.

      You are correct that straight-line depreciation yields $29,091 a year, but since we only get 1.5 months of depreciation the first year, that equals the $3.636 stated.

      Hope that helps!

  3. ben davies

    This depreciation rule makes me crazy until I figured this out.

    I am not an accountant so use this at your peril.

    Depreciation is allowed for 27.5 years which is 27*12+6=330 months. But there is an awkward half month rule that is in play for the first tax year and the last tax year. To account for this we double the months to make half month units, or 660 half month depreciation units.

    Now take your basis of $800,000 and divide by the number of half month depreciation units there are, 800,000 / 660 = $1,212.1212 per half month depreciation unit. While it seems odd to go to four decimal places this can add up.

    What day was the asset put in service? If not at the very end or very beginning of the month you only get half a month credit. So November 15 is half a credit for November and two half credits for December (the end of the tax year) giving 3*1212.1212= $3,636.3636 which you will gladly record as $3,636.36 or three depreciation units.

    Every year but the last year you take 24 half month depreciation credits or (24*1212.1212=$29,090.9088) Dutifully recorded as $29,091. (rounding is your friend, well not so much in this example but still.)

    The year you liquidate the asset OR take the last half month depreciation unit, you can only count that half months that you owned it, or ran out of credits.

    The real world is more complicated that this, which is why CPA’s drive nice cars, so leave it to the professionals. Help your CPA help you buy the CPA a nice car.

  4. Mary Hitchcock

    Hello Charles,

    Great catch on my initial depreciation number. However, I think Ben Davies’ response does a great job of explaining. Let me try to say it in a different way:

    As I stated in the post, the client bought the building in November, with a 12/31 tax year end. The depreciation method (how to handle depreciation in the first year of ownership) is “mid-month.” This means during the owner’s first year of ownership, their depreciation deduction is only for half of November and all of December, or 1.5 months.

    You are correct that straight-line depreciation yields $29,091 a year, but since we only get 1.5 months of depreciation the first year, that equals the $3.636 stated.

    Hope that helps!

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