There’s no doubt that investing in multifamily properties is great but with more units obviously comes more taxes. Thankfully, with cost segregation, you can ease your tax burden and make life a little easier for you as a multifamily investor.
If you’re unfamiliar with cost segregation, this article will break down the in’s and out’s of how it works and most importantly, how you can apply it to your business.
What Exactly Is Cost Segregation?
“Cost segregation maximizes income tax savings by correcting the timing of deductions. … Taxpayers can capture immediate retroactive tax savings on the multifamily property (or any for that matter) built or acquired since January 1, 1987. With cost segregation applied, taxpayers are allowed to take 100% of their Sec.” – Source: Welling’s Capital
Cost Segregation is quite literally a multifamily real estate investors “best friend” because it accelerates the depreciation of certain parts of a property faster than others. This enables investors to reduce the tax liability that they are paying right now while also increasing their upfront cash flow.
Thanks to cost segregation, a multifamily investment property can be depreciated over a period of time from 5 to 15 years compared to a period of about 27.5 years to 30 years.
Some of the components of a multifamily property that can be depreciated thanks to cost segregation include the following:
- Parking lot (Land Improvements) – 15 years
- Lawn Sprinklers (Land Improvements) – 15 years
- Carpeting (Distributive Trades and Services) – 5 years
- Kitchen stove (Distributive Trades and Services) – 5 years
Cost Segregation Accelerates Deductions
One common misconception about cost segregation is that it creates “extra deductions” over the life of a property. The reality is that it only accelerates those deductions. This creates a higher net “present value” since the deductions which were going to be claimed over a period of 27.5 years will be able to be claimed a lot sooner than that. This will provide a multifamily real estate investor with better cash flow now, rather than having to wait decades to utilize it.
If you’re thinking about utilizing cost segregation for your multifamily investment property, you’re going to need to have a cost segregation study done. This can cost anywhere from $2,000 to $10,000 but it’s possible that you can conduct a cost segregation study yourself with the help of a CPA.
During the process of conducting a cost segregation study, you must explain your rationale for wanting to reclassify assets and substantiate the costs for each asset.
Cost Segregation is especially beneficial for any building that has been constructed, remodeled, purchased or expanded since the late 1980s.
When is the best time for a cost segregation study? If you currently own a multifamily investment property then the answer to this question is right now because this study will enable you to maximize any deductions that you have from year one while lowering your tax burden.
Got soft costs? If so, you may be able to allocate certain soft costs to shorter-lived assets. Some of the most common soft costs include engineering fees, planning, architectural, legal fees, permits, movable furniture, and building equipment.
Still not sure about the benefits of cost segregation? Another reason you may want to consider it is the retroactive benefits. This means that once you have a cost segregation study completed, you may be able to utilize any depreciation that’s been unrecognized in one year after your cost segregation study has been completed.
Besides that, retroactive benefits of cost segregation, depreciation recapture can also be deferred through the use of a 1031 exchange.
Also known as Starker exchange or like-kind exchange, a 1031 exchange is another commonly used Tax deferment strategy which enables investors to defer paying capital gains taxes on the sale of an investment property when the proceeds from that sale are used to purchase another property that can be classified as “like-kind.”
Thanks to the tax deferment strategies like cost segregation in 1031 exchange, multifamily Real Estate Investors can focus on building their portfolio of investment properties without having to focus on the potential tax liability.
What Is A Pitfall of Cost Segregation?
The Biggest Pitfall of utilizing cost segregation is that the IRS has been known to penalize investors who aggressively utilize this strategy so, it’s best to first consult with your CPA before considering this strategy since you want to make sure that the costs will justify the obvious benefits.
An Example of How Cost Segregation Can Work for You
Now that we’ve provided you with a ton of information about Cost Segregation, let’s give you an example of how you could use this strategy in your real estate investing business.
Let’s say that you purchase a 150-unit multifamily property in Florida for $6,060,000 and the land that this property sits on is currently valued at $1,210,000. This is going to leave you with $4,850,000 as the depreciable basis for the buildings.
Now, without utilizing cost segregation, you would depreciate the multifamily buildings on a “straight line” basis for about 39 years. This means that you could depreciate about $125,000 annually.
When using a 36% tax rate, your straight-line deductions only amount to roughly $45,000 per year. With a cost segregation study in place though, the results are far different.
With cost segregation, we can take that same $4,850,000 building and depreciate roughly 45% of it in shorter periods of time typically within periods of 5, and 15-year “buckets”.
If you were to stay at the same 36% tax rate, you would be able to enjoy a tax savings of more than $600,000 over a period of 5 years compared to the savings that you would enjoy when utilizing straight-line depreciation.
Every year many people hold off on their desire to invest in multifamily properties due to their fear of paying a ton of taxes.
You now know that taxes can be deferred as an investor when you utilize cost segregation and or a 1031 Exchange so there’s no excuse to not move forward as an investor and use these tax deferment strategies to your advantage.
Before implementing cost segregation, it’s best to consult with your CPA and or attorney to verify if this strategy is right for you.