Bonus depreciation in real estate can be a powerful tool for an investor to use to significantly reduce taxable net income. Between now and the end of the 2022 tax year, an investor may be able to deduct the entire cost of some capital improvements in the same tax year the expense is incurred.
In this article, we’ll take an in-depth look at real estate bonus depreciation, including an example of how to use bonus depreciation to reduce pre-tax income, and discuss how long the 100% bonus depreciation will last.
- Bonus depreciation in real estate allows an investor to deduct the full cost of capital improvements in the same tax year the expense is incurred.
- Bonus depreciation currently is 100% but is scheduled to be phased out by the end of the 2026 tax year.
- Unlike a Section 179 deduction, bonus depreciation in real estate is not limited to an annual dollar amount.
How real estate depreciation works
Before we talk about bonus depreciation, let’s begin with a quick review of real estate depreciation in general.
As IRS Publication 946 explains, depreciation is an allowance real estate investors receive for property wear and tear, deterioration, or obsolescence. A real estate investor may use an annual depreciation deduction from pre-tax income to recover the cost basis of a property over the time an investor owns a property.
Most types of tangible property such as real estate (excluding the land value), furniture, flooring, appliances, and landscape improvements can be depreciated.
However, a property must meet the following requirements to be depreciable:
- Property must be owned by a taxpayer rather than rented
- Property must be used for business or investment purposes
- Property must have a determinable useful life
- Property must have an expected useful life of more than 1 year
In the real estate, there are three main types of depreciation:
Residential real estate used for investment purposes can be depreciated over a period of 27.5 years. If a single-family rental home has a value of $110,000 (excluding the land), the annual depreciation expense would be $4,000.
Some items within a home can also be depreciated over a shorter period of time. For example, the IRS allows appliances and carpeting to be depreciated over a period of 5 years.
If an investor spends $10,000 to buy new kitchen appliances and carpeting for the bedrooms, the depreciation expense would be $2,000 for the next 5 years.
Declining balance depreciation
The declining balance system for depreciation allows an investor to depreciate assets based on their remaining useful life. As the name suggests, larger depreciation deductions may be taken initially, and as the balance declines the depreciation expense goes down as well.
IRS Publication 527, Residential Rental Property, provides an in-depth explanation of the declining balance depreciation system for rental real estate.
The third type of depreciation in real estate is 100% bonus depreciation that allows a taxpayer to immediately deduct 100% of an item’s cost in the first year.
Many real estate investors may be unaware of this depreciation tax deduction that expires in a few years. So, in the rest of this article, we’ll take a closer look at bonus depreciation in real estate and how it works.
100% bonus depreciation deduction in real estate
Bonus depreciation deduction for property improvements was increased from 50% to 100% by the Tax Cuts and Jobs Act of 2017 (TCJA) and will be available through the 2022 tax year, then gradually decrease until it expires at the end of the 2026 tax year.
For example, if an investor spends $10,000 on an improvement, the entire cost of the improvement can now be deducted as a bonus depreciation expense in the tax year the cost was incurred.
Before claiming any type of depreciation expense in real estate, it’s important to understand the difference between a repair and an improvement.
Repair vs improvement
A repair is something that keeps a rental property in its original condition, such as fixing a leaky sink or detail cleaning a home to make it ready for the next tenant. Repairs are deducted from gross rental income the same tax year that the repair is made.
On the other hand, an improvement is something that betters, adapts, or restores a property. Unlike a repair, the cost of an improvement must be depreciated and expensed according to the depreciation schedule provided by the IRS.
A good way to think about the difference between a repair and improvement is by using the acronym BAR:
- Betterment is a material addition or change to a property, such as increasing the amount of rentable square footage by adding another bedroom.
- Adaptation changes a property to a new or different use, such as renovating a basement into a separate studio apartment to rent.
- Restoration replaces a major structure or component of the property, such as replacing the heating and air conditioning system.
In order to qualify for bonus depreciation, an improvement must have a useful life of 20 years or less, and must be purchased from an individual or entity that a taxpayer is not related to.
Bonus depreciation can also be claimed on both new and used items purchased in 2018 or after. Prior to the TCJA, bonus depreciation was limited to new items only.
Example of rental property bonus depreciation
Assume an investor owns a single-family rental home worth $110,000 (excluding the value of the lot). The property generates an annual rental income of $14,000 and the operating expenses are $5,600 (excluding any mortgage payment), leaving $8,400 in pre-tax income.
The home is depreciated over a period of 27.5 years, so the depreciation expense is $4,000 per year. Now assume an investor spends $10,000 to buy new kitchen appliances and carpeting.
By claiming 100% bonus depreciation, an investor could deduct the entire improvement cost of $10,000 to reduce the taxable net income. In this example, by using bonus depreciation, an investor would have no 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?
A real estate investor may also claim bonus depreciation from a new property purchase by conducting a cost segregation study. Although the phrase may sound complicated, a real estate cost segregation study simply breaks down a property into different depreciation components of 5, 7, 15, and 27.5 years.
To illustrate, assume a new investor purchased the single-family rental home discussed above for $120,000 (excluding the land value).
One option for depreciation would be to depreciate the entire cost basis of $120,000 using a straight line depreciation schedule of 27.5 years. With this option, the annual depreciation expense would be $4,364 ($120,000 cost basis / 27.5 years).
However, by conducting a cost segregation study, an investor may be able to claim more depreciation. For example, assume that an investor determines the cost of the property are:
- Single-family home: $110,000
- Appliances and carpeting: $10,000
Normally appliances and carpeting are depreciated over 5 years. But, an investor could claim 100% bonus depreciation of $10,000 for the first tax year. The single-family rental home with a value of $110,000 would be depreciated over 27.5 years, for an annual depreciation expense of $4,000.
The total depreciation the first year would be:
- Single-family: $4,000 per year for 27.5 years
- Appliances and carpeting: $10,000 with 100% bonus depreciation
- Total depreciation expense: $14,000 vs $4,364 without a cost segregation study
If the extra depreciation expense results in a loss for the current tax year, an investor may be able to carry forward the loss to future tax years to offset future income.
Bonus depreciation schedule and phase out
It’s important to note that bonus depreciation in real estate applies only to improvements and not to a rental property itself.
That’s because real estate has a useful life of more than 20 years. Residential rental property is depreciated over 27.5 years, while commercial real estate is depreciated over a period of 39 years.
The 100% bonus depreciation in real estate lasts until the end of the 2022 tax year.
Improvements and items placed in service between now and the end of 2022 may be depreciated 100%, after which the bonus depreciation phases out through 2026:
|Tax year||Bonus depreciation|
|2027 and beyond||0%|
To illustrate, assume an investor spends $10,000 before the end of the 2022 tax year to buy new kitchen appliances and carpeting for the bedrooms.
Normally, these improvements would need to be depreciated over a period of 5 years, creating a depreciation expense of $2,000 per year. By using the 100% bonus depreciation, an investor could claim the entire $10,000 expense the year the money was spent.
However, as the chart above illustrates, the longer an investor waits to make improvements, the lower the bonus depreciation is.
Is bonus depreciation the same as Section 179?
Bonus depreciation and the Section 179 deduction are two different types of deductions.
While bonus depreciation is used to expense improvements to a rental property, Section 179 of the IRS tax code allows an investor to deduct the purchase price of equipment such as autos, office equipment, or computers, subject to certain limitations.
Unlike a Section 179 deduction, bonus depreciation is:
- Not limited to an annual dollar amount.
- Not limited to the annual profit of a business.
- Item does not need to be used more than 50% of the time for business.
In other words, bonus depreciation can be claimed even if a business is not turning a profit. For real estate investors, that can be an important distinction, because sometimes a rental property depreciation expense can significantly reduce or even eliminate taxable net income.
Does bonus depreciation have to be recaptured?
As with any other type of real estate depreciation expense, bonus depreciation is recaptured and taxed when a rental property is sold.
Using the example above, if an investor sells the rental property 2 years from now, the $10,000 bonus depreciation is recaptured and taxed as regular income to an investor.
However, depreciation recapture is only taxed up to a maximum rate of 25%. In other words, even if an investor is in an upper income tax bracket, the tax on depreciation recapture is capped at 25%.
By making strategic improvements and updates, an investor may be able to raise the monthly rent price, attract more qualified tenants, and keep tenant turnover low. The 100% bonus depreciation in real estate may help generate a higher rental income for years to come, while significantly reducing the amount of income subject to tax today. As with any tax strategy, investors may wish to consult with a licensed tax professional for advice.