Cost Segregation & Accelerated Depreciation: How Multifamily Investing Can Erase your Tax Bill

Cost Segregation & Accelerated Depreciation: How Multifamily Investing Can Erase your Tax Bill

Cost Segregation and Accelerated Depreciation can be a real estate investors best friend and can help you save money when it comes to paying taxes!

“Real estate investing comes with excellent tax advantages!” You hear that sound bite parroted to the point of cliché. By now, it probably sounds to you like the parents in the old Peanuts cartoons — “Whomp-whomp-whomp-whomp-whomp…”

Multifamily Real Estate Investing

How many of you really understand all the tax advantages of real estate investing?

Unless you’re a CPA, I’m guessing the answer is “no.” Even if you’re a CPA, the answer might be “no.” My answer would be “no.” The US tax code is over 2,600 freaking pages long. I don’t think anyone really understands them … least of all the Congresspeople who vote on them or the Presidents who sign them.

That being said, I want to take this opportunity to unpack a tax advantage of real estate investing that is more or less exclusive to commercial and multifamily property.

If I do my job well, you will not only learn something new about real estate taxation. You will gain a new enthusiasm to add commercial and multifamily real estate investments to your portfolio.

NOTE:  The tax code is subject to change every year by acts of Congress. Changes in the law could render the specifics of this article obsolete, but the gist will probably still apply. 

For example, suppose Congress changes the real estate depreciation schedule from 27.5 years to 28 years. Who cares? Accelerated depreciation will still be awesome, and you’re about to find out why.

What Is Depreciation?

Depreciation is a beautiful thing. Depreciation is a real estate investor’s best friend.

Basically, depreciation is a quirk of the tax code that allows you to treat “wear and tear” of your assets as a kind of “expense,” and then to write that expense off on your tax return, lowering your tax liability.

Note that this doesn’t just apply to real property, like a rental house or an apartment building. You can also depreciate personal property, like an automobile or an air conditioner. But personal property uses different depreciation schedules as opposed to real property. Don’t worry if you don’t understand what that means yet. Just put a pin in it — it will become important later.

Let’s say you own a rental house, and your CPA tells you that you are entitled to “depreciate” that rental house by $10,000 this year. Basically, in the eyes of the IRS, that house is worth $10,000 less due to wear and tear over the course of the past year … and so you are allowed to write off that loss of value. You can add a $10,000 deduction to your taxes.

See what just happened there? Two magical things:

  1. You didn’t actually have to spend $10,000 to qualify for that deduction. It’s a kind of “phantom expense” that you can use to lower your tax burden, but with no money out-of-pocket.
  1. Now the real golden salami … we all know that one of the beautiful things about real estate investing is that property often becomes more valuable over time, not less! So the IRS allows you to treat your property as being less valuable over time … but if you buy right, its value is likely to increase over time!

Pretty cool, right? By lowering your tax burden without paying money out of pocket, you are effectively increasing your cash flow. 

You can’t really build this cash flow into your underwriting because it’s hard to predict the future with taxes. Suffice it to say, it usually makes tax time a lot more pleasant, leaving you with significantly more money in your pocket in April.

Note that homeowners are not eligible to depreciate their personal residence. This is a perk available only to investment property owners. 

Fun fact — for this reason, many real estate investors actually rent the homes they live in. Even the wealthy ones. Immune to the American dream of “homeownership” and focused on the bottom line, they tie up their equity in rental property rather than personal residences — in part because of this amazing tax advantage.

Real Estate Depreciation Schedule

Multifamily Real Estate Investing

Property can be depreciated according to a depreciation schedule. The tax code stipulates the depreciation schedule, and there’s no mystery to it — the depreciation schedule for real estate is 27.5 years. You can depreciate 3.636% of the depreciable “cost basis” every year during that time period. 

Jargon Alert: Think of the “cost basis” of your property as its “book value” — what you paid for it, but with some adjustments.

Each year, you must subtract the depreciation expense you take from the cost basis. This becomes your adjusted cost basis. Put a pin in that — it will be important later too.

In other words, you can take the value of your depreciable property, multiply it by 0.03636, and you are legally allowed to take that much depreciation every year for the next 27.5 years. After that, the improvements are considered to have an adjusted cost basis of zero, and you can’t take any more depreciation. 

Of course, many investors flip, trade, or otherwise sell their property long before 27 years elapse, so most investors get to write off depreciation every year of their investment cycle.

What does it mean for property to be “depreciable?” 

Well, first things first — you can’t depreciate land. In IRS-world, land never loses its value. It’s not subject to wear and tear. Only the improvements — structure and fixtures — can be depreciated. 

So to figure out how much of the property is depreciable, you need to figure out how much of its value is attributable to the land and how much is attributable to the improvements. An appraiser will include this estimate in the final appraisal report; you can also find this on the tax assessment.

Basic Real Estate Depreciation Example

Let’s say you buy a rental house for $325,000. The appraiser tells you that the land the house sits on is worth $50,000, which leaves you a depreciable cost basis of $275,000. How much can you depreciate each year? 

$275,000 x 3.636% = $9,999

In other words, without having to shell out an extra dime, you get to write $9,999 off your taxes each year for the next 28 years! Of course, each year you write off that depreciation, you have to subtract that amount from the cost basis, creating a new, lower adjusted cost basis. This will make a difference later. But for the time being, you get to enjoy a much bigger refund in April.

Note that this math doesn’t change even if you bought the property with a loan. Even if you only put 5-20% down, you still get to take $9,999 in depreciation per year on that house. 

Other Depreciation Schedules

Here is where things get interesting, and where we start to brush up against the core topic of this blog — cost segregation and accelerated depreciation. 

The 27.5-year depreciation schedule for rental real estate is not the only depreciation schedule the IRS recognizes.

For example, businesses can depreciate automobiles and computers on a 5-year depreciation schedule. 

Or, they can depreciate office furniture and farm machinery on a 7-year depreciation schedule. 

In other words, you can depreciate a much bigger percentage of that property’s assessed value each year, albeit for a shorter time. For example, a company could depreciate a $50,000 fleet vehicle by $10,000 a year for five years.

Depreciation Recapture

Now a little bit of bad news. The depreciation law assumes that property becomes less valuable over time due to wear and tear. 

If you sell the property for more than you paid for it — as every real estate investor wants to do — you have to account for that disparity with something called “depreciation recapture.”

Remember how every time you write off depreciation, you adjusted the cost basis down? Well, the IRS will look at how much depreciation you wrote off vs. your windfall profit on the sale, and tax those write-offs as income. Worse, whereas most real estate windfall sale profits are taxed as capital gains, depreciation recapture is taxed as ordinary income, which is usually a higher rate.

But this cloud has a silver lining — depreciation recapture is capped at 25% of the capital gain. So even though you’re setting a long-term tax trap in exchange for short-term tax benefits, it’s usually still worth it to take as much depreciation as you can. 

That being said, consult your CPA. You are free to write off less depreciation than the law allows, and that could be a good strategy in the long term.  

What Is Cost Segregation?

Multifamily Real Estate Investing

So now that we understand the basics of depreciation, we get to the fun stuff — cost segregation. If you invest in big commercial property – apartment buildings, retail strip malls, etc. — cost segregation often makes depreciation even more lucrative.

Here’s the gist of cost segregation — large commercial buildings often have assets on the property that can be depreciated on a shorter schedule. Remember, those five- and seven-year schedules?

Cost segregation is the process of appraising those assets separately, so you can depreciate them on the appropriate schedule … usually a shorter schedule. 

What assets within an apartment complex might be eligible for faster depreciation? Examples include:

  • Driveway pavers
  • Fences and gates
  • Landscaping
  • Site walls
  • Site furnishing
  • Flooring
  • Dumpster enclosures
  • Cabinetry and countertops
  • Residential appliances
  • Window treatments
  • Signage
  • Mailboxes
  • Kitchen plumbing
  • Kitchen electrical

We’ll see why this is good news very soon. But first … 

How Do You Perform Cost Segregation?

The short answer is this — hire an expert. A cost-segregation specialist will visit your property, inspect it, and produce a cost-segregation report that you can hand over to your CPA or tax preparation specialist.

What Are The Advantages of Cost Segregation?

Cost Segregation Enables Accelerated Depreciation

Cost segregation is the process. Accelerated depreciation is the benefit.

If a certain portion of your cost basis can be depreciated on a shorter schedule than the real estate schedule — seven years, say, instead of 27.5 — that means you can take more depreciation, sooner. 

Of course, if certain assets on your property can be depreciated on a seven-year schedule, you can only write off that depreciation for the first seven years of the investment cycle. 

But even buy-and-hold investment cycles are often shorter than seven years. Investor Boardroom targets an investment cycle of 3 – 7 years. So there’s a good chance you will get to take accelerated depreciation every year of the investment.  

Cost Segregation — A Case Study

Multifamily Real Estate Investing

If your brain hurts, I think a case-study example will make it much more clear.

This example comes from a 42-unit apartment complex purchased for $1,400,000. 

The appraiser determined the land represented $112,191 of the property value, leaving us with a total depreciable cost basis of $1,287,809.

$1,400,000 – $112,191 = $1,287,809

So how much depreciation could we take each year if we didn’t use accelerated depreciation? Let’s consult the 27.5-year depreciation schedule for rental real estate.

$1,287,809 x 3.636% = $46,825 per year

Every year for the next 28 years, the ownership group would be eligible to write off nearly $47,000 in depreciation from their taxes. Not bad. Way better than a kick in the ass.

However, a cost-segregation specialist inspected the property and determined the following:

81% of the property value was attributable to real estate, only eligible for the 27.5-year depreciation schedule.

But … 

8% of the property value was attributable to assets eligible for a 15-year depreciation schedule. 

11% of the property value was attributable to assets eligible for a 5-year depreciation schedule. 

8% … 11% … not much, right? But let’s see what those shorter depreciation schedules do to our maximum depreciation expense … 

81% x $1,287,809 = $1,040,126 27.5-year depreciation = $37,818 per year

8% x $1,287,809 = $105,098 15-year depreciation = $7,008 per year

11% x $1,287,809 =  $142,586 5-year depreciation = $28,518 per year

Total Allowed Depreciation: $73,344 per year

Okay … which tax write-off would you rather have each year? $47,000? Or $73,000? For many investors, a write-off this big is enough to erase their entire tax liability for the year.

In other words, imagine getting every dime withheld from your paycheck refunded to you in April.

Now, the write-off would only be that big for the first five years. After five years, the maximum depreciation would drop to $44,826. In 15 years, the max depreciation would drop to $37,818. After 27.5 years, no more depreciation.

But here’s the twist ending — the investor group only held this property three years before selling it. And they took the full $73k depreciation each year.

What Are the Risks of Cost Segregation and Accelerated Depreciation?

With real estate investing, there’s always risk waiting around the corner. Are there risks involved with cost segregation?

Yes. The risk is that the IRS will call bullshit on your accelerated depreciation write-off and audit your cost-segregation report … or audit your taxes as a whole. Never good news — an IRS audit can be costly, burdensome, and nerve-wracking.

To mitigate this risk, take care with who you hire to perform your cost-segregation analysis. Make sure they are experts, with a track record of the IRS accepting their conclusions. 

Can You Perform Cost Segregation on a Rental House?

Multifamily Real Estate Investing

So why is this technique exclusive to bigger properties, like apartment complexes? Can’t you perform cost segregation and take accelerated depreciation on a smaller property, like a single-family rental home?

Yes and no. The law makes no distinction between rental properties. The same tax code applies to a single-family rental house as a 500-unit apartment complex. So yes, it is perfectly legal to perform cost segregation and take accelerated depreciation on a single-family rental house.

But — and a big but — most investors don’t, because it usually isn’t worth it. Cost-segregation analysts charge four-figure fees, regardless of the size of the property. 

Also, single-family homes usually have fewer assets on the property eligible for accelerated depreciation. 

Nine times out of ten, the tax savings do not justify the expense to commission the cost-segregation report.

Do Passive Investors Get to Take Accelerated Depreciation?

Yes! If you are a partial passive owner of a real estate syndication, you are entitled to depreciation, including accelerated depreciation, proportional to your ownership interest in the property.

I hope this study of cost segregation and accelerated depreciation encourages aspiring buy-and-hold real estate investors to consider passive investment in multifamily syndicates rather than buying rental houses. 

Or that current owners of rental houses will start to transition their rental-home equity into multifamily equity to take advantage of this extraordinary tax advantage.

If you fall into either category, don’t hesitate to reach out to us! Investor Boardroom helps private investors passively build wealth through multifamily real estate — and that includes harnessing the tax-saving power of cost segregation and accelerated depreciation.

Resources available to you:

If you’re interested in learning more about the kinds of private real estate investment opportunities I referenced in this blog, download my free ebook titled “The Rapid Millionaire Blueprint” by clicking the link HERE.

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All the Best,
Adam Balsinger

Multifamily Real Estate Investing


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