Bonus Depreciation

Understanding Depreciation

Depreciation is a real estate tax strategy that allows property owners to reduce their taxable income by accounting for the wear and tear on their assets. For residential rental properties, the IRS requires that depreciation be spread over 27.5 years, reflecting the property’s deemed useful life. Similarly, commercial properties are depreciated over 39 years. This process helps property owners recover some of the costs associated with their investments over time.

Related: Read What Is Depreciation In Real Estate?

What is Bonus Depreciation?

Bonus depreciation is an accelerated depreciation method that allows taxpayers to immediately deduct a substantial portion of the cost of qualifying assets in the first year of ownership. Introduced in 2002 through the Job Creation and Worker Assistance Act, bonus depreciation has undergone several changes, with the most recent and significant update being the 2017 Tax Cuts and Jobs Act. This legislation temporarily increased bonus depreciation to 100%, enabling taxpayers to deduct the full cost of eligible assets in the year they are placed in service.

However, this favorable treatment has begun to be phased out. From 2023, the percentage of bonus depreciation allowed will decrease by 20% each year until it is completely phased out by 2027. For instance, assets placed in service in 2024 will only qualify for 60% bonus depreciation. Property owners should plan their purchases accordingly.

Bonus Depreciation Phase-Out Schedule

While the 100% bonus depreciation rate was available for assets placed in service between 2017 and 2022, it is set to phase out gradually. Here is the phase-out schedule for bonus depreciation:

• 2022: 100% bonus depreciation
• 2023: 80% bonus depreciation
• 2024: 60% bonus depreciation
• 2025: 40% bonus depreciation
• 2026: 20% bonus depreciation
• 2027 and beyond: 0% bonus depreciation

Unless new legislation is introduced to extend the provision, bonus depreciation will phase out completely after 2026.

Qualifying Assets for Bonus Depreciation

Not all assets are eligible for bonus depreciation. The asset must meet several requirements, including:

• Ownership: The asset must be owned by the taxpayer and used for business or investment purposes.
• Useful Life: The asset must have a useful life of 20 years or less. This means that residential rental properties, which have a useful life of 27.5 years, and commercial properties with a 39-year lifespan, do not qualify for full bonus depreciation.
• New or Used: The asset can be new or used, but it must be new to the taxpayer. This means that the taxpayer cannot have previously used the asset, and it cannot have been acquired from a relative.

Eligible assets might include furniture, appliances, or certain land improvements (such as fences or parking lots) used in the management or operation of rental properties. Importantly, improvements made to a property—such as adding a new roof or upgrading a kitchen—may also qualify for bonus depreciation if their useful life is 20 years or less.

Improvements vs. Repairs: Why It Matters

Investors need to be able to distinguish between improvements and repairs when considering bonus depreciation. Improvements, which are enhancements or adaptations that upgrade the property, may qualify for bonus depreciation if they have a useful life of 20 years or less. For example, converting an attic into a bedroom would be considered an improvement and could be eligible for bonus depreciation.

Repairs, on the other hand, are expenses incurred to maintain the property or restore it to its original condition. These do not qualify for bonus depreciation but can be deducted as ordinary expenses. Examples include fixing a broken furnace or replacing damaged flooring.

Benefits of Bonus Depreciation in Real Estate

The primary benefit of bonus depreciation is that it allows property owners to accelerate their tax deductions, leading to immediate tax savings. This can be particularly advantageous during the early years of property ownership when cash flow may be tight. By taking a larger deduction upfront, landlords can reduce their tax liability, freeing up more capital for reinvestment or other financial needs.

Another benefit is the potential for increased rental portfolio profitability. By lowering the tax burden in the early years, property owners can potentially start realizing profits sooner, making it easier to expand their real estate portfolio.

Drawbacks of Bonus Depreciation

Despite its advantages, there are some drawbacks to consider. One significant downside is the potential for depreciation recapture upon the sale of the property. If you claim bonus depreciation, you may have to pay back a portion of the deductions when you sell the asset, depending on the sale price and the amount of depreciation claimed. This can result in a larger tax bill at the time of sale, which could negate some of the earlier tax benefits.

Additionally, bonus depreciation may not align with all investment strategies. For instance, if you plan to hold onto the property for a long time, the benefits of accelerating depreciation may be outweighed by the future tax liability.

Bonus Depreciation vs. Section 179

Bonus depreciation is often compared to Section 179 of the U.S. Internal Revenue Code, which also allows for accelerated depreciation. However, Section 179 has limitations, including an annual dollar cap ($1,050,000 for 2021) and the requirement that taxpayers opt-in. Bonus depreciation, on the other hand, is automatic unless you choose to opt-out, and it does not have an annual limit.

Bonus Depreciation: Conclusion

Bonus depreciation offers significant tax benefits for landlords, but it requires careful consideration and planning. With the phase-out of 100% bonus depreciation on the horizon, it may be wise to frontload capital expenditures to maximize tax savings. However, investors should also weigh the potential drawbacks, such as depreciation recapture, against the immediate benefits.