Bonus depreciation in real estate can be an effective tool for investors to significantly reduce their taxable net income. Between now and the end of the 2022 tax year, investors can probably reduce the whole cost of some capital improvements in the same tax year the expense is spent. In this article, we will discuss everything you need to know about bonus depreciation on rental property and real estate, including how to use it to reduce pre-tax income.
About Bonus Depreciation
What is bonus depreciation? Knowing the depreciation of a property that an investor owns, means calculating the wealth that the investor owns as well. The more depreciation that a fixed property has, the less the value it has. This will reduce the selling price of the property. If an investor no longer needs the property and decides to sell it, they will know how much profit they will get from the depreciation.
Properties that have depreciated in value will affect the investor’s net income. It is because the depreciation of a property will be calculated as an expense in a financial report. Note that depreciation is only applicable to tangible fixed assets, such as real estate, landscape improvements, flooring, furniture, and appliances. It is not applicable to intangible assets, such as licenses, copyrights, trademarks, franchises, security systems, and so on.
According to IRS Publication 946, depreciation is an allowance that the real estate investors receive for property obsolescence, deterioration, as well as wear and tear. Real estate investors can use an annual depreciation deduction from pre-tax income to recover the basic cost of a property over the time an investor owns a property.
Factors Affecting Bonus Depreciation
There are some factors affecting the depreciation of a property that an investor must know before determining the depreciation itself. Here they are.
1. Acquisition Cost
Acquisition cost is the main factor that an investor has to know before determining how much cost is allocated to the depreciation of their property. In order to figure out this factor, an investor just needs to know the original price or how much money they have spent to purchase the property. There are also some additional costs that must be included in the acquisition cost. For example, transportation costs and installation costs.
2. Economical Lifetime Estimate
Once an investor has figured out how much money they have spent to buy the property, they also need to know its economical lifetime estimate. This is calculated from the estimate, how long the property can generate an income for the investor. The economical lifetime estimate of a property is one of the determining factors of bonus depreciation. It is because smaller depreciation will be given to assets with longer lifetime.
And vice versa, greater depreciation will be given to assets with shorter economical lifetime. Generally, the economical lifetime of an asset is divided into 2, which are physical lifetime and functional lifetime. The physical lifetime is related to the physical condition of the asset. While the functional lifetime is related to the asset’s contribution to an individual or company’s profit.
3. Salvage Value
As the name tells, this is the salvage value of a property or asset that has been in use for a long time. This is obtained when the owner finally decides to sell the asset. Especially, if the asset no longer provides profits as before. This salvage value will not be found if one continues to maintain the asset, especially until it gets obsolete and can no longer be used.
How Real Estate Depreciation Works
What qualifies for bonus depreciation? There are some requirements for a property to meet to be depreciable. Here are the bonus depreciation rules.
- Properties must be owned by a taxpayer rather than rented.
- Properties must be used for investment purposes or business.
- Properties must have a determinable useful life.
- Properties must have an expected useful life of more than a year.
There are 3 major types of depreciation in real estate. Here they are.
Declining Balance Depreciation
The declining balance system for depreciation makes it possible for a real estate investor to depreciate their asset based on their remaining useful life. As the name tells, greater depreciation deductions can be initially taken, and when the balance declines, the depreciation expense goes lower as well. You can find a deep explanation about the declining balance depreciation system for rental estate on IRS Publication 527, Residential Rental Property.
Straight-Line Depreciation
Residential real estate used for investment purposes is depreciable over a period of 27.5 years. If a single-family rental house owns a $110,000 value, excluding the land, the annual depreciation expense of the home would be $4,000. Several goods in a house are also depreciable over a shorter period of time. As an instance, the IRS allows carpeting and appliances to be depreciated over a period of 5 years.
If a real estate investor purchases new carpeting and kitchen appliances worth $10,000 for their property, the depreciation expense would be $2,000 for the upcoming 5 years.
Bonus Depreciation
Another kind of depreciation in real estate is bonus depreciation. This type of real estate depreciation allows a taxpayer to immediately decrease a hundred percent of an item’s cost in the first year. Many investors in real estate are probably unaware of this depreciation tax deduction that expires in a few years. In this article, we will focus more on this type of depreciation in real estate and how it works.
Bonus Depreciation Deduction in Real Estate
The Tax Cuts and Jobs Acts of 2017 or TCJA has increased bonus depreciation deduction for property improvements from 50 percent to 100 percent. And this will be applicable through the 2022 tax year and gradually reduce until it expires at the end of the 2026 tax year. As an example, if you spend $10,000 for your property improvement, the whole cost of the improvement now can be reduced as a bonus depreciation expense in the tax year you spent the cost.
It is better for you to know and understand what differentiates a repair and an improvement before claiming any kind of depreciation expense in real estate.
Improvement Vs Repair
An improvement is something that restores, adapts, or betters a property. The cost of an improvement must be expensed and depreciated in accordance with the depreciation schedule that the IRS provides. On the other hand, a repair is something that maintains a rental property in its original condition, such as cleaning home details or fixing a broken roof to make it ready for the next tenant.
Unlike an improvement, a repair is deducted from gross rental income the same tax year when the repair is performed. Using the acronym BAR is a nice way to differentiate between an improvement and a repair.
- Betterment is a material change or addition to a property. For example, adding another bathroom to increase the amount of rentable square footage.
- Adaptation turns a property into a different or new use. As an example, renovating a basement into another bedroom to rent.
- Restoration replaces a major component or structure of the property, such as replacing the air conditioning and heating system.
In order to be eligible for bonus depreciation, an improvement must have a useful life of 20 years as well as must be bought from an entity or individual that does not have any relation with the taxpayer. You can also claim bonus depreciation on both new and secondhand items bought in 2018 or after. Before Tax Cuts and Jobs Acts, bonus depreciation was limited to new items only.
Examples of Rental Property Bonus Depreciation
Now, here is a bonus depreciation example. Let’s say that you own a single-family rental house worth $110,000, excluding the value of the lot. The single-family rental house produces an annual rental income of $14,000 with operating expenses of $5,600 without any mortgage payment, leaving $8,400 in pre-tax income. The property is depreciated over a period of 27.5 years. Therefore, it has an annual depreciation expense of $4,000.
Now, let’s assume that you spend $10,000 on new carpeting and kitchen appliances. By claiming 100 percent bonus depreciation, you are able to deduct the whole improvement cost of $10,000 to decrease the taxable net income. In this instance, by using bonus depreciation, you would not have a taxable net income:
- Rental income: $14,000
- Operating expenses: <$5,600>
- Pre-tax income: $8,400
- Property depreciation: <4,000>
- Bonus depreciation: <$10,000>
- Taxable income: $0
Can Bonus Depreciation be Claimed with a New Investment?
Real estate investors may also claim bonus depreciation from a new property purchase by conducting a cost segregation study. Though the phrase may sound confusing, a real estate cost segregation study breaks down a property into different depreciation components of 5 years, 7 years, 15 years, and 27.5 years. As an illustration, let’s say that you have bought the single-family home mentioned above for $120,000, excluding the land value.
One of the options for depreciation would be to depreciate the whole basic cost of $120,000 using a straight-line depreciation schedule of 27.5 years. With this choice, the annual depreciation expense would be $4,364, which is from a $120,000 cost basis divided by 27.5 years. However, you are probably able to claim more depreciation by conducting a cost segregation study. For instance, assume you determine the cost of your property:
- Single-family home: $110,000
- New carpeting and kitchen appliances: $10,000
Carpeting and appliances are normally depreciated over 5 years. However, you could claim 100 percent bonus depreciation of $10,000 for the first tax year. The rental single-family home worth $110,000 would be depreciated over 27.5 years, for a $4,000 annual depreciation expense. So, the total depreciation for the first tax year would be:
- Single-family house: $4,000 each year for 27.5 years.
- Carpeting and appliances: $10,000 with 100 percent bonus depreciation.
- Total depreciation expense: $14,000 compared to $4,364 without a cost segregation study.
If the extra depreciation expense causes a loss for the current tax year, you are able to continue the loss to future tax years to balance future income.
Does Bonus Depreciation Have to be Recaptured?
Just like any other types of real estate depreciation expenses, bonus depreciation is taxed and recaptured when a real estate investor sells their rental property. By using the previous example mentioned above, if you put your rental single-family home on the market 2 years from now, the $10,000 bonus depreciation is taxed and recaptured as a regular income.
But depreciation recapture is only taxed up to a maximum rate of 25 percent. In other words, even if a real estate investor is included in an upper income tax class, the tax on depreciation recapture is limited to 25 percent.
Is Bonus Depreciation the Same as Section 179?
The section 179 deduction and bonus depreciation are 2 different kinds of deductions. Section 179 of the IRS tax code makes it possible for a real estate investor to reduce the purchase price of equipment, such as computers, office equipment, vehicles, and so on, subject to particular limitations. On the other hand, bonus depreciation is in use to expense improvements to a rental property. Different from a Section 179 deduction, bonus depreciation is:
- Not limited to an annual profit of a business.
- Not limited to an annual dollar amount.
- Items do not have to be used more than 50 percent of the time for business.
In other words, an investor can claim bonus depreciation even if their business does not generate them a profit. This can be an essential difference for real estate investors since sometimes a rental property depreciation expense can greatly decrease or even remove taxable net income.
FAQs About Bonus Depreciation
- What are the benefits of bonus depreciation?
The 100 percent bonus depreciation in real estate can help to generate a higher rental income for the future years, while significantly reducing the amount of today’s income adhere to tax.
- Can I claim bonus depreciation with a new investment?
Real estate investors may also claim bonus depreciation from a new property purchase by conducting a cost segregation study.
That is all you need to know about bonus depreciation
