24-Unit Apartment Complex: $980K Year 1 Deduction via Cost Segregation

The Problem

This client acquired a 24-unit apartment complex in Grand Rapids, Michigan for $2.8M. The property generated $432,000 in annual gross rental income ($1,500/unit average) with $198,000 in operating expenses. The client's prior accounting firm was depreciating the property on a 27.5-year straight-line schedule, producing $89,500 per year in depreciation on the $2.46M depreciable basis (after $340,000 land allocation). At this rate, the property would produce modest tax losses in the early years but would shift to taxable income within 5-7 years as depreciation decreased relative to rising rents.

The client was a full-time real estate investor with five other properties managed through an S-Corporation property management company. Despite qualifying for Real Estate Professional Status, the client had never performed a cost segregation study on any property. The prior accountant had dismissed cost segregation as "only for commercial properties" — a common misconception. The client was paying approximately $42,000 per year in federal income tax on combined rental income and management company profits that could have been significantly reduced or eliminated through accelerated depreciation.

AE Tax Strategy

1. Engineering-Based Cost Segregation Study Under IRC §168

We commissioned a full engineering-based cost segregation study compliant with the IRS Cost Segregation Audit Techniques Guide. The study identified $980,000 (39.8% of the $2.46M depreciable basis) in components eligible for reclassification: $420,000 in 5-year property (appliances across 24 units, carpeting, vinyl flooring, window treatments, light fixtures, cabinetry hardware, individual HVAC units), $245,000 in 7-year property (laundry room equipment, maintenance equipment, specialty lighting, built-in shelving), and $315,000 in 15-year property (parking lot with striping, sidewalks, landscaping, site drainage, fencing, exterior lighting, signage, playground equipment). Under 100% bonus depreciation, the entire $980,000 was deductible in Year 1.

2. REPS Qualification and Grouping Election

The client, as a full-time real estate investor and property management company owner, logged 2,340 hours annually in real property trades or businesses and zero hours in non-real-estate activities. REPS was clearly established. We filed a grouping election under Treas. Reg. §1.469-9(g) to treat all rental properties as a single activity, and the client's 2,340 hours of aggregate involvement satisfied the 500-hour material participation test for the grouped activity. This converted all rental losses from passive to non-passive.

3. Year 1 Deduction and Multi-Year Depreciation Planning

The $980,000 in bonus depreciation combined with $53,800 in straight-line depreciation on the remaining 27.5-year components produced total Year 1 depreciation of $1,033,800. Against net operating income of $234,000, the property generated a net loss of $799,800. Combined with losses from other properties in the grouped activity, the client's total Year 1 deduction eliminated all federal income tax liability. We also prepared a five-year depreciation projection showing the impact of cost segregation on future years' depreciation, ensuring the client understood the trade-off between accelerated deductions now and reduced depreciation in later years.

Before & After Comparison

Tax Category	Before	After	Savings
Standard Depreciation (27.5-Year)	$89,500	$0	$89,500
Cost Seg Bonus Depreciation	$0	$980,000	$980,000
Remaining Straight-Line	$0	$53,800	$53,800
Total Year 1 Depreciation	$89,500	$1,033,800	$944,300
Total	$89,500	$1,033,800	$980,000 (Year 1 deduction)

Key Takeaways

• Multifamily residential properties frequently yield 35-40% reclassification rates in cost segregation studies because of the high density of personal property and land improvements per building.
• Common 5-year property in apartments includes individual unit appliances, window treatments, flooring, and cabinetry hardware — items present in every unit that add up quickly across 24 units.
• The 15-year property category (land improvements) is often the largest single component in multifamily cost segregation, including parking, sidewalks, and site improvements.
• Five-year depreciation projections are essential for understanding the post-cost-seg depreciation profile and planning for depreciation recapture upon eventual sale.