Education, Finance, Syndication Structure

A Real Estate Investor’s
Guide to Cost Segregation Studies

smartland-real-estate-investors-guide-to-cost-segregation-studies.mp3 More sophisticated investors know to use a cost segregation study to accelerate depreciation, which effectively front-loads depreciation... Listen to this article

Introduction

Many people invest in multifamily real estate as a way of both diversifying their portfolios and generating stable, passive income.

But what if we were to tell you there’s another benefit to owning multifamily real estate? A benefit that is often overlooked, but potentially worth even more than the cash flow investors can expect to earn?

It may sound too good to be true, but it’s not.

One of the primary benefits of investing in an apartment building is its tax-saving benefits. Specifically, investors can take advantage of what’s known as “depreciation”. Depreciation is a deduction that investors can take each year to account for a property’s physical wear and tear and eventual obsolescence. Typically, apartment buildings are depreciated over a 27.5-year period, which is what the IRS has deemed as the “useful life” of a multifamily property.

An inexperienced investor might simply tax advantage of straight-line deprecation whereby they claim 1/27.5 of the value of that depreciation each year.

Many people invest in multifamily real estate as
a way of both diversifying their portfolios
and generating stable, passive income.

More sophisticated investors know to use a cost segregation study to accelerate depreciation, which effectively front-loads depreciation to offset earnings during the first few years of ownership.

In this article, we offer a complete guide to cost segregation studies for multifamily real estate.

What is a Cost Segregation Study?

A cost segregation study is a necessary precursor for any multifamily investor looking to accelerate their depreciation write-offs.

Most cost segregation studies are conducted by a licensed engineer. That engineer will visit a property, spreadsheet in hand, and will walk through the interior and exterior of a property to identify each of its constituent parts (e.g., roof, electrical wiring, carpet, appliances, driveways and more). Each of these building components will be assigned a useful life, which the IRS then allows the owner to depreciate accordingly.

Therefore, rather than depreciating a property by 1/27.5 each year, it is depreciated based upon the remaining value of those building components. These lifespans may range from 1 to 15 years, depending on the building component. For example, a carpet may depreciate over five years whereas a newer roof might depreciate over 15 years. In any event, most building components will depreciate faster than 27.5 years as they would otherwise if using straight-line depreciation.

What does a Cost Segregation Study Entail?

While there is no prescribed qualifications for who conducts a cost segregation study, the IRS suggests that it be someone who has knowledge of both the construction process and tax laws involving property classifications for depreciation purposes. In practice, this means most cost segregation studies are performed by a licensed engineer.

A quality cost segregation study will include a thorough review of all relevant property information, including but not limited to building cost and market data, building plans, and lease agreements. The preparer will also look at detailed site features, such as its location, topography, and site conditions.

The engineer will also conduct a site visit in which they examine all building components. This portion of the analysis can be extremely detailed. For example, a building door may be assigned one value but the lock used on that door may be assigned its own separate value.

For new construction, the cost of both building and personal property is generally easy to estimate. Estimating the costs for older properties can be more challenging, which is why the surveyor will want to document how they arrived at the pricing for those building components. Detailed notes and photographic evidence are usually included in a final cost segregation study.

Note: land and certain land improvements (e.g., the costs associated with grading a property for future development) are not considered depreciable costs. Only qualifying land improvements, buildings, structural building components or systems, and non-residential real property can be depreciated. In other words, if someone purchases an apartment building for $1 million and the land value for that property is $300,000, then only $700,000 worth of assets are likely to be eligible for depreciation.

In some cases, a cost segregation study will include interviews with various parties. This could include interviews with contractors and subcontractors, building owners, and property managers. These interviews help to add credibility to the depth and accuracy of a cost segregation study.

Taken together, the principal elements of a quality cost segregation report will therefore include:

  • An Executive Summary that identifies who prepared the report, the date of the study, for whom the study was prepared, the subject property, and the property units classified as land, land improvements, building or personal property.
  • A Narrative Report that provides a more detailed description of the apartment building. This will usually also indicate the types and sources of data used in the preparation of the study.
  • A Schedule of Assets that clearly identifies the specific assets that can be depreciated.
  • A Schedule of Direct and Indirect Costs associated with the project.
  • A Schedule of Property Units and Costs that are segregated into land, building property and personal property.
  • The Engineering Methodology was used to determine the costs for each depreciable property unit. This will note whether the costs are actual or estimated.
  • A Statement of Assumptions and Limiting Conditions that can be used to indicate the quality of the study.
  • A Certification by the licensed engineer who completed the study, including their credentials and/or level of experience conducting these types of cost segregation studies.
  • Various Exhibits are usually included at the end of a cost segregation study. These exhibits provide backup and accounting to support the preparer’s analysis.

Learn more about what the IRS classifies as a “quality” cost segregation study.

How does a Cost Segregation Study Save Investors Money?

Most investors will find that, in the aggregate, most apartment buildings can be depreciated within the first seven years of ownership.

Therefore, rather than depreciating 1/27.5 of a property every year by using straight-line depreciation, investors can front-load depreciation in the first few years of ownership.

One does not need to be the sole owner of an apartment building to enjoy the benefits of cost segregation.

Under changes made to the tax code under the Trump Administration, investors can further take advantage of what’s known as “bonus depreciation”. Under these new regulations, real estate investors can deduct 100% of a building value in the first year of ownership.

It used to be that bonus depreciation only applied to new equipment or new construction, but now, it applies to existing assets as well. This creates a giant “paper loss” for investors that they can use to offset their taxable income.

Note: there is some talk of bonus depreciation being tapered down or even eliminated in the years to come, but for now, it still exists and is a significant benefit to real estate investors.

What this does, in practice, is it effectively puts more money back into investors’ pockets sooner than if they were utilizing straight-line (or traditional accelerated) depreciation alone.

It is not uncommon for a cost segregation study to generate hundreds of thousands, even millions, of dollars in net present value savings for investors.

For example, someone who invested $250,000 into an apartment building might be able to use a cost segregation study to save $100,000 in taxes during the first year of property ownership. This is a staggering return on investment compared to the cash flow generated during that time alone.

increase cash flow outlined

Now, let’s say the property does not generate $100,000 in income that first year. An investor can do one of three things: first, they can use that “passive” loss to offset other passive income earned on their other investments. If they have no other passive income to apply the depreciation to that year, an investor can instead apply the depreciation retroactively to passive income earned in the years prior. A third alternative is to save any remaining depreciation benefits, carrying it forward to apply to passive income earned the following tax year.

One does not need to be the sole owner of an apartment building to enjoy the benefits of cost segregation. Passive investors, including those who invest in a real estate syndicate or fund, will also benefit when a multifamily sponsor does a cost segregation study and passes these cost savings on to their limited partners. Both income earned from the investment and depreciation write-offs will be captured on an investors’ K-1 come tax time.

In other words, it may look like an investor is “losing” money on a real estate investment when in fact, they are just claiming a paper loss that, in turn, boosts their total take-home income.

Many investors will continue buying multifamily real estate just for the depreciation benefits, which allow some investors to pay little to no income taxes on an ongoing basis.

FAQ About Cost Segregation Studies for Multifamily Real Estate

Who should consider doing a cost segregation study?

Any multifamily real estate investor who purchases a newly constructed building, or who purchases a building that they then renovate and subsequently lease, will want to consider doing a cost segregation study.

How much does a cost segregation study cost?

A detailed cost segregation study will cost between $5,000 and $30,000 or more, depending on the size of the apartment building and its complexities. For example, a multi-building apartment complex will usually require a more detailed cost segregation system, especially if each building runs on its own systems. A single-building, garden-style apartment building might be much simpler for an engineer to review.

How long does a cost segregation study take?

Cost segregation will generally take 30-60 days to complete, but again, this depends on the size and scale of the apartment building being evaluated. If an owner can pull together relevant property data, building records, lease records, etc. in advance, this can help streamline the process for the examiner conducting the study.

When is the best time to do a cost segregation study?

Most owners and investors will want to do a cost segregation study shortly after purchasing the property or placing it “in service”. This might be in Year 1 of ownership if acquiring an existing assetQuestion Mark, but might not be until Year 3 if the project required ground-up construction. The sooner someone does a cost segregation study, the more likely they are to maximize the benefits of that depreciation (especially given the risk of bonus depreciation phasing out in the years to come).

Will a cost segregation study increase the likelihood of being audited?

No. If conducted by a licensed professional who specializes in cost segregation (vs. your CPA, for example), there is no enhanced risk of being audited. Experienced cost segregation professionals will provide a detailed report that is defensible, even in the event of an IRS audit.

Conclusion

Real estate investors often talk about the tax benefits associated with the asset class. Those who are less familiar with depreciation and cost segregation have a hard time understanding what these benefits include, and more importantly, how much money this translates into in practice.

A cost segregation study is a highly effective
way for multifamily real estate investors
to maximize the value of their property

As shown in this guide, a cost segregation study is a highly effective way for multifamily real estate investors to maximize the value of their property. Taking these “paper losses” is one of the best ways to enhance the overall return on investment. Those savings can be used to re-invest into subsequent deals, which can then likewise be depreciated – a cycle that investors will often use in perpetuity to continue generating income that far exceeds what they’d otherwise earn from rental cash flow alone.

Are you interested in investing in multifamily real estate? Contact us today to learn more about how Smartland maximizes returns for its investors.


Was this article helpful?
reaction thumbnail No

View More
Resources