Cost Segregation
Cost Segregation in Practice
An investor acquires a multifamily property for $10,000,000, of which $1,750,000 is allocated to land, leaving $8,250,000 of depreciable basis. Straight-line depreciation over 27.5 years produces $300,000 of deductions per year. A cost segregation study reclassifies 25% of the basis, or $2,062,500, into 5-year and 15-year property such as appliances, flooring, site paving, and landscaping. Those short-life classes depreciate far faster, and where bonus depreciation applies, a large share of that $2,062,500 can be deducted in the first year rather than over decades.
Cost Segregation: What the Market Actually Requires
A cost segregation study is performed by an engineering firm that inspects the property, itemizes its components, and assigns each to its correct recovery class under IRS rules. Personal property such as appliances, carpeting, cabinetry, and specialty electrical falls into 5-year or 7-year classes, while land improvements like paving, fencing, and landscaping are 15-year property. Typical reclassification runs 15% to 35% of depreciable basis depending on property type, with garden-style multifamily, self-storage, and single-tenant retail with heavy site work toward the high end and simple shell industrial toward the low end.
Lenders do not care about cost segregation directly, and that is precisely the point borrowers miss: depreciation sits below the NOI line, so a study changes nothing about how a bank, agency lender, CMBS shop, or life company sizes the loan. What it changes is the investor's after-tax cash-on-cash return, which can improve dramatically in the early hold years. Sophisticated sponsors run the study alongside their financing so the projected tax shield is reflected in investor distributions and equity raises, and value-add borrowers often order a second look after renovation to capture the new components at their fresh cost basis.
The tradeoffs are recapture and fit. Accelerated deductions on short-life property are recaptured at ordinary income rates on a taxable sale, so cost segregation rewards longer holds, refinance-and-hold strategies, and investors who plan to exit through a 1031 exchange, which defers the recapture along with the gain. Short flips gain little. Look-back studies can recover missed depreciation from prior years through an accounting method change without amending returns, which makes the analysis worth running even years into ownership.
Why It Matters for Your Loan
Cost segregation does not change your loan, but it changes what the loan earns you: the same leveraged property can produce materially higher after-tax cash-on-cash in the early hold years, which is when value-add deals are hungriest for cash. It also shapes exit strategy, since accelerated deductions are recaptured on a taxable sale but deferred through a 1031 exchange. Investors who coordinate the study with their financing and hold plan keep more of every distribution without touching the capital stack.
Cost Segregation: FAQ
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