By Terri S. Johnson, CRE

In J.P. Morgan’s 2023 Commercial Real Estate Outlook, multifamily property was designated as the highest performing of all asset classes. A study commissioned by the National Multifamily Housing Council and National Apartment Association revealed that the United States needs to build 4.3 million new apartments by 2035. The demand for multifamily properties remains strong, reinforcing its reputation as a “safe” investment.

Investors may initially be drawn to this vertical for safety, scalability, and predictable income, but they often stay for the significant tax benefits. Tax strategies include accelerated depreciation, which can be used to offset a portion of predictable rental income. Cost segregation is the vehicle for these tax savings.

So, why doesn’t every multifamily property owner consider cost segregation? Some simply aren’t aware of it, but others have been misinformed. This blog debunks some of the common myths that may be holding back investors in multifamily properties from potential opportunity.

You can only do cost segregation studies on commercial property, not residential rental real estate.

False. Cost segregation can be performed on residential real estate, from multifamily to single family rental properties. In fact, multifamily properties are considered great candidates for cost segregation.

There aren’t a lot of assets to reclassify in a multifamily property.

False. While the exact yield will vary based on project details, layout, and location, between 20% and 35% of assets in multifamily properties may be accelerated.

Without cost segregation, residential real estate capital assets are assigned a 27.5-year class life. With cost segregation, several asset categories can be moved into much shorter class lives. Here are a few:

• 5-Year Personal Property: appliances, carpet, wallpaper, crown molding, window treatments, counters, cabinets, dedicated outlets, decorative lighting, specialty plumbing, security camera systems and keypads, fire extinguishers, and paddle fans.
• 15-Year Land Improvements: Sidewalks, parking lots, landscaping, pools, storm water drainage, sanitary lines, storm water retention systems.

Cost segregation is just a matter of timing. The depreciation will happen eventually.

False. It’s true that cost segregation is a matter of timing, and it’s true that the depreciation will happen eventually. However, waiting around is not to your advantage. With higher inflation, the time value of money is more important than ever. Deductions taken today are much more valuable than deductions taken in the future. Plus, accelerating depreciation gives you additional cash now that can be reinvested for further gains.

Cost segregation is only worthwhile for very high-value properties. It’s not worth doing a study on a small multifamily property.

False. Once upon a time, only projects with a basis of $1 million or more were considered good cost segregation candidates. That changed with the Tax Cuts and Jobs Act (TCJA) of 2018. The one-two punch of reliable bonus depreciation and bonus-eligibility for acquired assets makes small-basis properties viable candidates.

For properties placed in service between Sept. 27,2017, and Dec.31, 2022, 100% bonus depreciation was in effect. If your multifamily property was placed in service during that time, you can still access 100% bonus rates using a look-back cost segregation study, which permits “catch-up” depreciation. If you placed a multifamily property in service during 2023, you are eligible for 80% bonus depreciation. The rate continues to decline 20% each year, dropping to 60% in 2024 and so on. However, cost segregation will still bring benefit at any bonus rate.

When I sell, recapture will just negate all the benefits.

False. While recapture can be an issue, cost segregation still has significant strategic value. As always, the unique facts and circumstances of each taxpayer and the property in question determine the best course of action. There are multiple ways to mitigate the impact of recapture, and we encourage you to discuss your particular circumstances with your tax adviser.

• Situations will vary, but if you plan to hold a multifamily family property for at least three to five years, the increased cash flow from the accelerated depreciation generally more than outweighs the increased tax from recapture.
• Asset dispositions are shielded from related recapture. Look to partial asset disposition elections to reduce a property’s basis.
• Improvements that are expensed immediately under the Tangible Property Regulations will decrease the recapture burden later at the time of sale.

I acquired my multifamily property in a 1031 exchange, so I can’t do a cost segregation study.

False. Cost segregation studies are often used in conjunction with a 1031 exchange, particularly given the aforementioned bonus depreciation rule changes under the TCJA. The step-up in basis on the replacement property can be a great cost segregation opportunity. Plus, if the replacement property has the same amount of Section 1245 assets as the relinquished property, you may be able to defer or avoid Section 1245 recapture tax.

Terri S. Johnson, CRE, is co-founder and managing partner at Capstan Tax Strategies. She works closely with taxpayers and accounting firms to provide practical and customized engineering-based tax solutions. She can be reached at tjohnson@capstantax.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}