Bonus depreciation in real estate can be a powerful tool for an investor to use to significantly reduce taxable net income.
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.
- 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 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 3 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 bonus depreciation that allows a taxpayer to deduct some 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.
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 only lasted until the end of the 2022 tax year.
The bonus depreciation phases out through 2026:
|2027 and beyond
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 2 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.
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. Bonus depreciation in real estate may help generate a higher rental income for years to come, while 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.