Bonus depreciation is a tax incentive that allows investors and businesses to immediately deduct a large percentage of the purchase price of qualified business property rather than spreading out those deductions over many years. This results in a more significant tax deduction in the year of purchase and initial usage.
Over the last few years, bonus depreciation has become a notable tool for real estate investors, including those who make property improvements or acquire qualified business property assets.
However, the bonus depreciation phase-out began in 2023, and real estate investors must effectively plan for the changes to their depreciation schedules.
Why is Bonus Depreciation Changing For Investors in 2023?
The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017, and represented the most sweeping tax changes over three decades.
One of the monumental tax benefits it brought to real estate investors was its changes to bonus depreciation. As part of the Tax Cuts and Jobs Act (TCJA) of 2017, bonus depreciation was temporarily increased to 100% for assets purchased after September 27, 2017, and before January 1, 2023.
Unfortunately, those changes were not permanent. Starting in 2023, the bonus depreciation phase-out began.
The rate of bonus depreciation phases out every tax year until 2027:
- 80% for qualified property placed in service after December 31, 2022, and before January 1, 2024.
- 60% for qualified property placed in service after December 31, 2023, and before January 1, 2025.
- 40% for qualified property placed in service after December 31, 2024, and before January 1, 2026.
- 20% for qualified property placed in service after December 31, 2025, and before January 1, 2027.
What does all of this mean, and how will the changes to depreciation affect real estate investors? I’ll address all that in this article.
Straight Line Depreciation
The first form of depreciation is called straight-line depreciation. Straight-line depreciation calculates the annual depreciation expense businesses and investors can claim for tax write-offs based on its purchase price, residual value, and useful life. That expense will be applied equally each tax year over the asset’s useful life.
To better understand this, let’s look at an example. In this hypothetical scenario, a piece of equipment has a purchase price of $80,000. It has a useful life of ten years and a residual value (also known as the salvage or scrap value) of $10,000 at the end of its useful life.
To calculate straight-line depreciation, you subtract the residual value from the purchase price and divide that by its useful life.
Straight Line Depreciation = (Purchase Price – Residual Value) / Useful Life
Applying this formula to our hypothetical example yields the following:
Straight Line Depreciation = ($80,000 – $10,000) / 10 years = $7,000
As an expense, the owner can take $7,000 of depreciation each year for the next ten years. This is how straight-line depreciation works.
The IRS assigns useful life values to thousands of items that can be depreciated. The useful life of real estate has historically been 39 years for commercial real estate and 27.5 years for resident-occupied real estate (residential and multifamily).
There is an alternative depreciation system that uses a 30-year useful life that we won’t be discussing in this article.
Accelerated Depreciation
For some people, straight-line depreciation is all that is necessary. However, there are several reasons why someone would want to accelerate a percentage of the depreciation and use it earlier in their property ownership.
Accelerated depreciation is an essential part of real estate investing. By front-loading the depreciation expense, a more significant tax write-off can be taken early on.
To understand accelerated depreciation for real estate investing, you need to understand some real estate tax terms. So, let’s tackle those now.
Land Value & Improvement
When looking at the purchase price or assessed value, there are two components: the land value and the improvement. The land value is the value of the bare land, and the improvement refers to anything that improves that land. Therefore, the improvement is the building, sidewalks, swimming pool, parking lot, etc.
Understanding these two property components is important because land is not depreciable. Therefore, you must subtract the land value from the assessed value before applying the above formula.
Cost Segregation Study
Permanently affixed building components of the property must be depreciated over their standard 27.5 or 39 year useful life. However, land improvements and personal property can be depreciated on an accelerated basis.
A cost segregation study looks at the improvement we discussed in the straight-line depreciation section and divides it into three categories: personal property, land improvements, and building components. Once these three components are defined, they get separate depreciation schedules.
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Building Components
Buildings and structures cannot be depreciated or accelerated. Instead, they are depreciated over their useful life (39 years for commercial real estate and 27.5 years for resident-occupied buildings).
Land Improvements
When you hear the term “land improvements,” don’t confuse it with the word “improvement.” Remember that a cost segregation study divides the “improvement” into three categories: land improvements, personal property, and building components.
Land improvements are typically improvements outside of the buildings/structures. These include parking lots, sidewalks, irrigation, landscaping, fencing, etc. With accelerated depreciation, these land improvements are assigned a 15-year useful life.
Personal Property
Personal property is considered the non-structural component of a building. These typically include the flooring, fixtures, and finishes. If the property has furnishings, those are also included in personal property.
Personal property has the shortest useful life. Depending on the property, it can be assigned a five—or seven-year recovery period.
An Accelerated Depreciation: Property Investment Example
Now that you understand the terms you’ll encounter with accelerated depreciation, let’s look at a hypothetical example. As a fractional investor, let’s say you invest in a multifamily property purchased for 25 million dollars with an assessed value of 80% improvement/ 20% land.
That means that the depreciable improvement equals 20 million dollars. Five million in value is assigned to the land and is non-depreciable. A cost segregation study further defines the improvement and allocates 50% of its value as building components, 20% as land improvements, and 30% as personal property.
So, the depreciation expense shakes out as follows:
Land – Assessed at $5 million, but $0 of depreciation expense
Improvement – Assessed at $20 million and can be depreciated as outlined below:
Building Components – Assessed at $10 million and depreciated over 27.5 years
Land Improvements – Assessed at $4 million and depreciated over 15 years
Personal Property – Assessed at $6 million & depreciated over 5 or 7 years
Bonus Depreciation
Bonus depreciation was first introduced in 2002 through the Job Creation and Worker Assistance Act.
Through the years, bonus depreciation has had different rules, but the one constant was that it only applied to new construction projects. So bonus depreciation likely escaped your radar unless you were building or investing in new construction.
With bonus depreciation, a cost segregation study is still essential. However, it eliminates the complex five, seven, or fifteen-year depreciation schedules. Instead, it takes a percentage of the allowable accelerated depreciation in year one.
Initially, that percentage was 30%, but over time, it had grown to as much as 50%. So, by 2016, 50% of accelerated depreciation could be taken as year one bonus depreciation. The other 50% was depreciated over the standard five-, seven-, and fifteen-year schedules.
There are clear benefits to this, but new development is highly risky, so for most investors, it was irrelevant. It’s also important to note that depreciation allowances, regardless of form, are subject to recapture.
Tax Cuts and Jobs Act of 2017
2017 was a game changer for real estate investors. The Tax Cuts and Jobs Act (TCJA) of 2017 was enacted and represented the most significant tax overhaul in three decades. Two of the most prominent changes from this law are those related to 1031 Exchanges and Bonus Depreciation.
The TCJA repealed 1031 exchanges for personal property and limited them only to real estate. Before 2017, aircraft, boats, collectibles, machinery, artwork, and other personal property could be sold and exchanged for like-kind replacements while deferring taxation.
That is no longer allowed. Only real estate retains the right to utilize a 1031 exchange to defer taxation.
The TCJA also made significant changes to bonus depreciation. Before 2017, bonus depreciation was only for new construction and was limited to 50% of the accelerated depreciation. Only half of the accelerated depreciation could be used in year one.
The TCJA changed those rules to allow 100% of the accelerated depreciation to be used in year one. It also opened this benefit up to properties that were already in service. These properties no longer had to be new; they just had to be new to you.
So, if you purchased an investment property after September 27, 2017, and before January 1, 2023, you are eligible for 100% bonus depreciation in year one. The dates matter because bonus depreciation is only temporary.
100% Bonus Depreciation Phase Out
So what happens after January 1, 2023? The bonus depreciation phase-out takes effect. Every year, bonus depreciation decreases by 20% starting in 2023 until it’s gone in 2027. Here’s what that schedule looks like:
- 2023 – 80% Bonus Depreciation / 20% Accelerated Depreciation
- 2024 – 60% Bonus Depreciation / 40% Accelerated Depreciation
- 2025 – 40% Bonus Depreciation / 60% Accelerated Depreciation
- 2026 – 20% Bonus Depreciation / 80% Accelerated Depreciation
By 2027, bonus depreciation will phase out, and we will be back to the old rules, where 100% of the accelerated depreciation takes place over five, seven, or fifteen years.
Why The Phase Out Matters For Investors
The bonus depreciation phase-out is a vital aspect of tax planning for real estate investors. Understanding the rules and timelines becomes crucial as the available tax benefits decrease over the next four years.
- Cash Flow Boost: Businesses rely on predictable cash flows to operate smoothly, and tax deductions like bonus depreciation can directly impact a company’s bottom line. The immediate deductions can allow businesses to quickly recoup a significant portion of their investments.
- Strategic Planning: Real estate investment often involves long-term planning. The phase-out introduces another variable, potentially influencing business decisions about holding versus selling, refinancing, or making capital improvements. Knowing the phase-out schedule allows businesses to plan for future capital investments. For instance, if a business will need new equipment in the next few years, it may invest earlier to take advantage of front-loaded depreciation allowances.
- Tax Compliance: Keeping up with the phase-out rules ensures that businesses claim the correct deduction amount, helping to avoid potential conflicts with tax authorities.
Note: Don’t confuse bonus depreciation with the Section 179 deduction. These are different types of tax deductions that can be utilized in year one.
Section 179 of the IRS tax code permits businesses to deduct the cost of qualifying equipment within specific limits, including vehicles, office machinery, and computers.
According to IRS publication 946, Section 179 deduction dollar limits: For tax years beginning in 2023, the maximum section 179 expense deduction is $1,160,000.
How to Maximize Your Bonus Depreciation Benefit
Accelerating large sums of depreciation to the first year of ownership can be beneficial in certain circumstances. However, it’s not a fit for everyone, and there can be reasons to opt out of bonus depreciation.
Investors who can benefit from bonus depreciation qualify as real estate professionals. Most accredited investors do not have the time, experience, or expertise to acquire, operate, and sell real property. These individuals are better suited to passive investing.
A small subset of active investors may qualify as real estate professionals. For those people, having a large depreciation bank in year one to offset other sources of income can be substantially beneficial.
Passive investors with passive activity gains can also use year one bonus depreciation to offset those gains if they occur in the same year. This is advanced tax planning; we at 37th Parallel Properties are not tax professionals. We don’t give tax advice, but we’ve seen multiple passive investors use bonus depreciation to their advantage. If you have passive activity gains from other sources, talk to your trusted tax advisor and see if investing with 37th Parallel Properties this year could offset those gains with bonus depreciation.
How do you know if you have passive activity gains in the current calendar year that bonus depreciation can offset?
It comes down to this – Did you sell substantial business or investment interests this year? It could be a group practice, equipment, an office building, farmland someone else farmed, investment properties or businesses, etc.
If so, don’t wait until next year to be surprised to learn that you have gained passive activity. By that point, it’s too late. Instead, ask your accounting firm, CPA, or tax attorney how that gain will be treated. If they say it will be classified as a passive activity gain, bonus depreciation can help you materially.
Why Work with 37th Parallel Properties?
37th Parallel Properties is a private real estate acquisition and asset management firm based in Richmond, Virginia. Since 2008, we have provided high-quality multifamily investments for accredited investors, family offices, and institutional investors.
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Disclaimer: 37th Parallel Properties is a real estate acquisitions and asset management firm. We are not tax professionals and do not offer tax advice. This article is for informational purposes only. Your trusted tax professional should run all tax strategies to determine if they suit you and your financial situation.