Bonus depreciation in real estate allows you to deduct the full amount of a normally depreciable asset in a single year.
There are few things as satisfying as knowing that your tax bill has been reduced, whether it’s because you have claimed mileage deductions or advertising and marketing costs.
Depreciation is one such reduction that can significantly lower the amount of tax you owe. Standard depreciation is the process of deducting the value of the asset and any improvements against your taxes. For residential rental properties, this depreciation is spread out over 27.5 years, and for commercial property over 39 years which is its deemed useful life by the IRS.
What if we told you that there was a way to immediately deduct 100% of an item’s cost in the first year?
Bonus depreciation is an optional depreciation acceleration method. It was originally introduced in 2002 through the Job Creation and Worker Assistance Act. It allowed taxpayers to deduct 30% of the cost of qualifying property with a recovery period of 20 years. It has been through a few iterations since then with the most recent expansion being through the 2017 Tax Cuts and Jobs Act which increased depreciation to 100%. This means that certain expenses can be deducted in full during the first year.
While this is a huge advantage to landlords, 100% bonus depreciation will phase out at the end of 2022 and will decrease incrementally by 20% a year until 2027 and beyond when it will be 0%. This means that if you buy something in 2024, you will only be able to claim 60% in bonus depreciation.
There are currently no plans to reintroduce 100% bonus depreciation in real estate after 2027.
Once you have established how much bonus depreciation you can claim, you will need to determine which assets are eligible for deduction. In order for a property to be depreciable, it must meet certain requirements:
However, bonus depreciation can only be used on assets that have a useful life of 20 years or under, meaning that residential properties (with a useful life of 27.5 years) are not eligible for full bonus depreciation.
The IRS outlines further bonus depreciation guidelines including that the asset must not have been used before the taxpayer acquired it and that the taxpayer did not acquire it from a relative.
Although rental properties cannot be depreciated by 100%, new or used equipment for your business can be deducted as long as the items are at least new to you. This means that they cannot have been handed down to you by a family member or friend, for example.
Improvements, but not repairs, are also eligible for bonus depreciation in real estate. An improvement is considered to be something that upgrades, adapts, or enhances a property. For example, converting a loft into another bedroom could be considered an improvement. If the improvement has a useful life of 20 years or less, it can be depreciated.
On the other hand, a repair is something that maintains the property or restores it to its original condition. For example, replacing a damaged floorboard or fixing a broken heater is classified as a repair and is therefore not depreciable but is deductible.
Taking advantage of bonus depreciation allows you to minimize your set-up costs as you can take greater tax deductions during the first years of property ownership. This means that you can start making profits sooner rather than having to wait a few years to break even.
Another benefit of bonus depreciation in real estate is that it enables you to take higher deductions upfront instead of having to spread deductions over a number of years. This will reduce your end-of-year tax bill which will allow you to put more resources into expanding your portfolio.
While bonus depreciation does come with its benefits, there are reasons why you may choose to opt out. If you claim bonus depreciation, you may be subject to depreciation recapture when you sell the asset. This means you may have to pay back a percentage of the value that was deducted in the first place. Depending on your growth strategy, it may not make sense to use bonus depreciation.
Like bonus depreciation, Section 179 of the U.S. internal revenue code also allows you to accelerate depreciation. However, it differs from bonus depreciation in that it is limited to an annual dollar amount ($1,050,000 for 2021) and the taxpayer must opt-in. Bonus depreciation, on the other hand, applies automatically unless you opt-out of it when you are filing your taxes. Up until recent years, Section 179 was the only way to depreciate used equipment so was previously the best option for this.
In order to accurately calculate your depreciation and avoid unwanted attention from the IRS, it is essential that you track expenses properly throughout the year. Keeping your records organized and easily accessible will provide valuable insights into the financial health of your portfolio and save you time and money. Purpose-built software like Landlord Studio will allow you to track depreciation throughout the year and then instantly generate reports for your CPA.
When utilized by landlords, bonus depreciation in real estate can be a huge benefit resulting in higher returns and a lower tax bill. Given that it is on a limited timeline though, you may want to frontload some of your capital expenditure now to take advantage of high depreciation rates.
“We hope you found this blog interesting! However, do note that the information in this article does not constitute advice. This blog is for general informational and educational purposes only and should not be used as a substitute for competent legal and/or other advice from a licensed professional.”