This article will explore the concept of bonus depreciation, a powerful tool that can significantly reduce taxable income. Before getting to this topic, let’s zoom out to discuss the basics of depreciation.
Depreciation, in simple terms, is the reduced value of an asset over time due to wear and tear. A relatable example: You purchase a car. The value of that car decreases as soon as it's driven off the lot. You will drive the car for two years or five years or fifteen years. The longer you drive the car--the less it will be worth. You’ll rack up miles, get a dent (totally not your fault), the dog will leave some interior scratches, and every part of your car from the grille to the back bumper will undergo wear, tear, and more wear. Your once brand new car is now worth a fraction of what it once was. Your car has depreciated in value.
Rental properties depreciate similarly. Unlike your car’s life of two or five or fifteen years, we expect apartments to last longer. The IRS has set the lifespan of buildings to be 27.5 years. Applied, here’s what that looks like: Let’s take a $1,000,000 apartment building. [Land cannot be factored into depreciation. Let’s estimate that the land’s value is worth 10% of our example property’s value, leaving $900,000 of the property that is depreciation-eligible.] $900,000 depreciated over 27.5 years comes to $32,727 in annual depreciation. This type of depreciation is known as STRAIGHT LINE DEPRECIATION. A “straight line” is drawn from the point of acquisition to a spot 27.5 years down on the timeline (the IRS-determined life span); that value can be claimed annually to deduct from pre-tax income. Other items with shorter life spans can be depreciated on a straight-life basis. Appliances and carpeting can be depreciated over a five-year span. Let’s say new kitchen appliances and carpeting total $10,000. A straight line depreciation of these improvements could be taken at $2,000 per year for five years.
DECLINING BALANCE DEPRECIATION allows an investor to take depreciation over the course of an asset’s useful life. Larger deductions can be taken initially; lesser deductions can be taken as the balance owed on the asset declines.
The $32,727 [in the scenario above] is reported through a K-1 as a passive activity deduction to Members of the LLC. (Each member would receive a pro-rata share. If there were two equal Members, each could claim a $16,363 deduction for tax purposes based on the scenario above.) Because of the significance of depreciation of real estate investments, a net loss can be generated for tax purposes in the same year that the investor benefits from actual cash distributions. Clients who are business owners and have passive activity gains each year are thrilled to learn that these paper losses can offset their gains, thus reducing their overall tax obligation.
BONUS DEPRECIATION is a tax incentive that allows taxpayers to deduct the cost of an asset SOONER rather than later, NOW rather than eventually, thus reducing their tax obligation for the claimed year. In other words, bonus depreciation allows for the tax advantage NOW.
The building may very well last for 27.5 years and beyond; however, renovations, upgrades, and enhancements made to the property may have a shorter lifespan. The new light fixtures, the air conditioning system, the furniture upgrade--those enhancements do not depreciate on the same schedule as the building itself. Those expenditures, through bonus depreciation, can be deducted now.
Let’s apply this and then break down some of the nuances.
Let’s suppose that $200,000 of enhancements are made to a $1,000,000 multifamily property: fencing, landscaping, security system, and other improvements. Rather than claiming depreciation over those items' lifespans or claiming depreciation over 27.5 years of the life of the property, the $200,000 can be deducted from the pre-tax income of the investor in the year they are put into service. Once deducted, however, that deduction cannot be taken again.
Legislation and phase out: The Tax Cuts and Jobs Act of 2017 (TCJA) built upon earlier pieces of legislation, making two significant changes that directly affected commercial real estate:
Barring any new legislation, the opportunity for 100% bonus depreciation has passed. We are now in the phase out period from now until 2027; the schedule follows:
2023: 80%
2024: 60%
2025: 40%
2026: 20%
2027: 0%
Applied to our earlier example, this means $20,000 could no longer be deducted from pre-tax income; however, 80% of it could if those enhancements were put into use in 2023 ($16,000). While not as much as it would have been last year, it is more than it will be next year ($12,000). If investors want to capture some benefit of bonus depreciation, time is of the essence.
Cost segregation study: To maximize advantages of depreciation, cost segregation studies can be performed by CPAs, appraisers, or contractors. The study sees the property not as one collective collective entity to be depreciated over 27.5 but, instead, analyzes the property by its component parts--parts which could have 5, 7, or 15 year life spans. Consolidating the depreciation period of those items will allow the investor to claim its depreciation value sooner rather than later, an aspect that is critical for properties with shorter hold periods. Those enhancements put into place in the current year would be eligible for bonus depreciation.
Several circumstances would encourage property owners and investors to claim bonus depreciation.
If you are interested in the tax advantages of bonus depreciation and the many other benefits of real estate investing, we would love to talk. Please contact our office at (724) 900-0009 or e-mail Mark Brooks at mark@evergreen-pgh.com.
