Bonus Depreciation
Bonus depreciation is a tax incentive allowing businesses and real estate investors to immediately deduct a large percentage of the cost of eligible property in the year it's placed in service, accelerating tax savings and boosting cash flow.
Key Takeaways
- Bonus depreciation allows for an immediate deduction of a significant percentage of eligible property costs, accelerating tax savings and improving cash flow.
- It applies to tangible personal property with a recovery period of 20 years or less, including new and used assets, and Qualified Improvement Property (QIP).
- The bonus depreciation rate is phasing out, from 80% in 2023 to 60% in 2024, 40% in 2025, 20% in 2026, and 0% in 2027.
- Unlike Section 179, bonus depreciation has no income limitation and can create or increase a net operating loss (NOL).
- Cost segregation studies are crucial for real estate investors to identify and reclassify property components, maximizing eligible bonus depreciation.
- Investors must consider depreciation recapture upon sale, as prior deductions may be taxed at ordinary income rates.
What is Bonus Depreciation?
Bonus depreciation is a tax incentive that allows businesses, including real estate investors, to immediately deduct a significant percentage of the cost of eligible property in the year it is placed in service, rather than depreciating it over its useful life. This accelerated deduction reduces taxable income, leading to substantial tax savings and improved cash flow in the early years of an investment. It is a powerful tool for real estate investors looking to minimize their tax liability and enhance investment returns.
How Bonus Depreciation Works
Traditionally, the cost of most business property is recovered over several years through regular depreciation methods, such as the Modified Accelerated Cost Recovery System (MACRS). Bonus depreciation allows taxpayers to bypass this multi-year process for a portion of the asset's cost, effectively accelerating the tax benefits. Instead of spreading the deduction over 5, 7, 15, or 39 years, a large percentage of the asset's cost can be deducted upfront. This immediate write-off reduces the investor's taxable income, which can offset other income sources and potentially create a net operating loss (NOL) that can be carried forward or back.
Key Characteristics
- Accelerated Deduction: Allows for a large portion of an asset's cost to be deducted in the first year it's placed in service.
- Tax Savings: Directly reduces taxable income, leading to lower tax bills.
- Cash Flow Improvement: By reducing taxes, investors retain more capital, improving their cash flow.
- Applicable to New and Used Property: Unlike some other accelerated depreciation methods, bonus depreciation applies to both new and used qualifying property.
- No Income Limitation: There are generally no income limitations for claiming bonus depreciation, making it accessible to a wide range of investors.
Eligible Property Types
Bonus depreciation primarily applies to tangible personal property with a useful life of 20 years or less. For real estate investors, this often includes:
- Appliances: Refrigerators, stoves, dishwashers, washing machines, dryers.
- Fixtures: Lighting fixtures, ceiling fans, window treatments.
- Carpeting and Flooring: Non-structural floor coverings.
- Landscaping: Certain improvements like fences, driveways, and non-permanent landscaping elements.
- Qualified Improvement Property (QIP): Interior non-structural improvements to non-residential real property placed in service after the building was first placed in service. This category was clarified by the CARES Act to have a 15-year MACRS recovery period, making it eligible for bonus depreciation.
- Other Equipment: Office furniture, computers, security systems, and other equipment used in the business of real estate.
Eligibility Requirements and Limitations
To qualify for bonus depreciation, property must meet specific criteria set by the IRS. Understanding these requirements is crucial for investors planning to utilize this tax strategy.
Property Requirements
- Depreciable Property: The property must be eligible for depreciation under MACRS.
- Short Recovery Period: It must have a recovery period of 20 years or less. This includes 3, 5, 7, 10, 15, and 20-year property.
- Acquisition Date: The property must be acquired and placed in service after September 27, 2017. For property acquired before this date, different rules apply.
- New or Used Property: The Tax Cuts and Jobs Act (TCJA) of 2017 expanded bonus depreciation to include certain used property, provided it was not previously used by the taxpayer or a related party.
Business Use Requirement
The property must be used in a trade or business or for the production of income. This means personal use property does not qualify. For real estate investors, this typically refers to rental properties, commercial buildings, or equipment used in property management.
Phase-Out Schedule
Bonus depreciation was initially set at 100% for property placed in service after September 27, 2017, and before January 1, 2023. However, it is currently phasing out. The rates are as follows:
- 80% for property placed in service in 2023
- 60% for property placed in service in 2024
- 40% for property placed in service in 2025
- 20% for property placed in service in 2026
- 0% for property placed in service in 2027 and later years
Section 179 vs. Bonus Depreciation
Both Section 179 expensing and bonus depreciation allow for accelerated deductions, but they have key differences. Section 179 has annual dollar limits and taxable income limitations, meaning the deduction cannot exceed the taxpayer's business income. Bonus depreciation, however, has no such income limit and can create or increase a net operating loss. While Section 179 can only be applied to the amount of income, bonus depreciation can be applied even if it results in a loss. Often, investors will use both, applying Section 179 first up to its limit, and then using bonus depreciation for any remaining eligible costs.
Calculating Bonus Depreciation: Step-by-Step
Calculating bonus depreciation involves a few straightforward steps. It's often used in conjunction with a cost segregation study for real estate, which identifies and reclassifies components of a building into shorter depreciable lives, making them eligible for accelerated depreciation.
- Determine Eligible Property Cost: Identify all assets within your real estate investment that qualify for bonus depreciation. This often requires a cost segregation study to break down a property's purchase price into its various components (e.g., land, building, land improvements, personal property).
- Identify Applicable Bonus Depreciation Percentage: Based on the year the property is placed in service, determine the current bonus depreciation rate (e.g., 60% for 2024, 40% for 2025).
- Calculate Bonus Depreciation Amount: Multiply the eligible property cost by the applicable bonus depreciation percentage.
- Calculate Remaining Depreciable Basis: Subtract the bonus depreciation amount from the total eligible property cost. This remaining amount will be depreciated using standard MACRS schedules.
- Apply MACRS for Remaining Basis: Depreciate the remaining basis over its respective MACRS recovery period (e.g., 5, 7, 15 years) using the appropriate depreciation method.
Real-World Examples and Scenarios
Let's illustrate how bonus depreciation can significantly impact a real estate investor's tax situation with practical examples.
Example 1: New HVAC System for a Rental Property (2024)
An investor purchases a new HVAC system for their residential rental property in March 2024, costing $15,000. An HVAC system is typically classified as 5-year property for depreciation purposes.
- Cost of HVAC system: $15,000
- Bonus depreciation rate for 2024: 60%
- Bonus depreciation amount: $15,000 * 60% = $9,000
- Remaining depreciable basis: $15,000 - $9,000 = $6,000
- Tax Savings (assuming 30% marginal tax rate): $9,000 * 30% = $2,700 in the first year.
The investor can deduct $9,000 immediately, and the remaining $6,000 will be depreciated over the remaining 5-year MACRS schedule.
Example 2: Office Furniture for a Commercial Investment (2023)
A commercial real estate investor purchases $20,000 worth of office furniture for a newly acquired office building in October 2023. Office furniture is typically 7-year property.
- Cost of office furniture: $20,000
- Bonus depreciation rate for 2023: 80%
- Bonus depreciation amount: $20,000 * 80% = $16,000
- Remaining depreciable basis: $20,000 - $16,000 = $4,000
- Tax Savings (assuming 30% marginal tax rate): $16,000 * 30% = $4,800 in the first year.
Example 3: Qualified Improvement Property (QIP) Renovation (2025)
An investor completes a $50,000 interior renovation (non-structural) on a retail space in April 2025. This qualifies as Qualified Improvement Property (QIP), which has a 15-year recovery period.
- Cost of QIP renovation: $50,000
- Bonus depreciation rate for 2025: 40%
- Bonus depreciation amount: $50,000 * 40% = $20,000
- Remaining depreciable basis: $50,000 - $20,000 = $30,000
- Tax Savings (assuming 30% marginal tax rate): $20,000 * 30% = $6,000 in the first year.
Example 4: Used Appliances in a Multi-Family Property (2024)
A real estate investor purchases a multi-family property in January 2024. As part of the acquisition, they acquire used appliances (refrigerators, stoves) valued at $12,000. These appliances were not previously used by the investor.
- Cost of used appliances: $12,000
- Bonus depreciation rate for 2024: 60%
- Bonus depreciation amount: $12,000 * 60% = $7,200
- Remaining depreciable basis: $12,000 - $7,200 = $4,800
- Tax Savings (assuming 30% marginal tax rate): $7,200 * 30% = $2,160 in the first year.
Strategic Considerations for Real Estate Investors
Bonus depreciation is a powerful tool, but its effective use requires strategic planning and an understanding of its implications.
Maximizing Tax Savings
- Cost Segregation Studies: Essential for identifying and reclassifying components of a building (e.g., electrical, plumbing, finishes) into shorter depreciable lives (5, 7, 15 years), making them eligible for bonus depreciation. This can unlock significant deductions from a property's purchase price.
- Timing of Purchases: Consider the phase-out schedule. Purchasing and placing eligible property in service in earlier years (e.g., 2024 vs. 2026) will yield higher bonus depreciation percentages.
- Active vs. Passive Income: For individual investors, bonus depreciation deductions from rental real estate are generally considered passive losses. These losses can typically only offset passive income. However, if an investor qualifies as a Real Estate Professional (REP) or materially participates in the activity, these losses may be able to offset active income.
Cash Flow Impact
The immediate tax savings from bonus depreciation can significantly boost an investor's cash flow in the year of acquisition or improvement. This additional capital can be reinvested into other properties, used for further improvements, or provide a buffer for unexpected expenses, enhancing the overall return on investment.
Depreciation Recapture
While bonus depreciation offers immediate benefits, investors must be aware of depreciation recapture. When a property on which bonus depreciation was claimed is sold, the amount of depreciation taken reduces the property's tax basis. Upon sale, any gain attributable to prior depreciation deductions may be taxed at ordinary income rates (up to 25% for Section 1250 property, or higher for Section 1245 property). This means the tax savings are often deferred rather than eliminated, requiring careful planning for future sales.
Interaction with Other Tax Strategies
Bonus depreciation can be combined with other tax strategies, such as Section 1031 exchanges, to further optimize tax outcomes. In a 1031 exchange, the deferred gain from the sale of one property can be reinvested into a like-kind property, potentially allowing the investor to continue deferring depreciation recapture and apply new bonus depreciation deductions on the replacement property.
The Future of Bonus Depreciation
The current phase-out schedule for bonus depreciation is set to continue until it reaches 0% in 2027. However, tax laws are subject to change. There have been discussions and legislative efforts to extend the 100% bonus depreciation or to slow down its phase-out. Real estate investors should stay informed about potential legislative changes that could impact the availability and rates of bonus depreciation in future years. Consulting with a qualified tax professional is essential to navigate these complexities and ensure compliance with the latest regulations.
Frequently Asked Questions
What is the primary benefit of bonus depreciation for real estate investors?
The primary benefit is the immediate reduction in taxable income, which leads to significant tax savings in the year the eligible property is placed in service. This improves an investor's cash flow, allowing them to retain more capital for reinvestment or other financial goals. It also accelerates the recovery of investment costs.
Can I claim bonus depreciation on residential rental properties?
Yes, you can claim bonus depreciation on tangible personal property within residential rental properties. This includes items like appliances, carpeting, window treatments, and certain land improvements (e.g., fences, driveways). A cost segregation study is often used to identify these components and separate them from the longer-lived building structure, making them eligible for accelerated depreciation.
Is bonus depreciation available for used property?
Yes, the Tax Cuts and Jobs Act (TCJA) of 2017 expanded bonus depreciation to include certain used property. To qualify, the used property must be acquired from an unrelated party, and the taxpayer must not have previously used the property or been a related party to the previous owner. This makes bonus depreciation applicable to a wider range of real estate acquisitions.
How does bonus depreciation differ from Section 179 expensing?
While both allow for accelerated deductions, Section 179 has annual dollar limits and an income limitation (deduction cannot exceed taxable business income). Bonus depreciation has no income limitation and can create or increase a net operating loss (NOL). Bonus depreciation is also mandatory unless you elect out, whereas Section 179 is an election. Often, investors use Section 179 first up to its limit, then apply bonus depreciation.
What happens if I sell a property on which I claimed bonus depreciation?
When you sell a property on which bonus depreciation was claimed, the depreciation taken reduces the property's tax basis. Upon sale, any gain attributable to prior depreciation deductions is subject to depreciation recapture. This gain is typically taxed at ordinary income rates (up to 25% for real property) rather than lower capital gains rates. This means the tax savings are often a deferral, not an elimination, of tax.
What is the current bonus depreciation rate for 2024 and beyond?
Bonus depreciation is currently phasing out. For property placed in service in 2024, the rate is 60%. It will decrease to 40% in 2025, 20% in 2026, and reach 0% in 2027 and subsequent years, unless Congress enacts new legislation to extend or modify it.
Can bonus depreciation create a net operating loss (NOL)?
Yes, bonus depreciation can indeed create or increase a net operating loss (NOL). Unlike Section 179, which is limited by taxable income, bonus depreciation can be taken even if it results in a loss for the business. This NOL can then be carried forward to offset taxable income in future years, providing a significant long-term tax benefit.
Are there any specific types of improvements that qualify as Qualified Improvement Property (QIP)?
Qualified Improvement Property (QIP) refers to any improvement to an interior portion of a non-residential building that is placed in service after the building was first placed in service. It specifically excludes improvements that enlarge the building, elevate it, or modify its internal structural framework. Examples include new drywall, flooring, ceilings, interior doors, and certain electrical or plumbing upgrades within the interior of a commercial or retail space.