Depreciation is the method by which investments in capital assets are accounted for as business expenses. Bonus depreciation is a tax concept that allows for a larger than normal portion of a business asset during the first year it is placed into service, and it can be a major tax benefit to all types of small businesses, including real estate investors.
Before we get into the specifics, let's briefly discuss what depreciation is and what it means to rental real estate investors.
When you buy supplies or incur general expenses for your business, those costs are typically deductible as business expenses. For example, if you spend $2,000 on airfare to get to business meetings, you can take a $2,000 tax deduction to offset your business income for the year.
However, not all business expenses can be deducted like this. In general, if an expense is for something that is temporarily available or is used up immediately (like our airfare example), it can be deducted all at once. On the other hand, if an asset is expected to last for an extended period, its cost typically must be deducted a little at a time over the course of several years, a process known as depreciation.
For example, if you buy an appliance for a residential rental property, the IRS defines the expected lifespan as five years. Note that this is only for depreciation purposes -- we know some appliances can last for decades. So, depreciation rules state that you'll deduct a portion of the cost each year on your next five years of tax returns.
When it comes to claiming your depreciation deductions, you have a few options:
- Straight-line depreciation: This means spreading your cost basis evenly over the useful life (as defined by the IRS) of the asset. For example, if you depreciate a $1,000 refrigerator using the straight-line method over five years, you would take a $200 deduction each year.
- Declining balance depreciation: Without getting too deep into the calculation methods, this means depreciating assets based on their remaining life span. Larger depreciation deductions are taken at first, and they gradually get smaller until 100% of the asset's cost basis has been depreciated.
- Bonus depreciation: This alternative depreciation system refers to taking a large initial depreciation, followed by smaller deductions in subsequent years. In a nutshell, this gets you the largest immediate tax deduction.
How the Tax Cuts and Jobs Act changed bonus depreciation
Prior to the Tax Cuts and Jobs Act's implementation in 2018, the bonus depreciation rules allowed for 50% first-year bonus depreciation. In other words, if you spent $1,000 on a capital asset, you could use $500 of depreciation in the first year the asset was placed into service.
However, the new rules are far more generous. The IRS now allows for 100% bonus depreciation for capital assets, meaning that you can deduct the entire cost of certain assets right away. The goal is to encourage businesses to invest in new equipment and machinery over the next few years.
The 100% bonus depreciation rule is only in effect through the 2022 tax year. It is scheduled to phase out beyond that, according to this chart:
|Tax Year||Bonus Depreciation Percentage|
|2027 and later||No bonus depreciation allowed|
Bonus depreciation for rental property owners
The first thing that real estate owners need to know about bonus depreciation is that it cannot be used on rental properties themselves. Specifically, the bonus depreciation method isn't allowed on assets with a useful life of 20 years or more. Residential real estate has a depreciation period of 27.5 years, and nonresidential real property is depreciated over a 39-year lifespan. When depreciating real estate, you'll need to use the straight-line method and take equal depreciation each year.
Having said that, the bonus depreciation rules can benefit real estate investors in other ways. While it cannot be used to depreciate real property, it can be used for many types of assets and improvements that are common in real estate investing. For example, real property improvements (like landscaping) have a depreciation period of 15 years and qualify for bonus depreciation.
In other words, if you spend $10,000 on landscaping for a rental property, you can use bonus depreciation to deduct the entire cost in the year you spend the money. Just to name a few other types of property that can qualify for immediate expensing, real estate investors could potentially expense furniture, appliances, and other property improvements.
Another important point is that the property doesn't necessarily need to be new when you acquire it -- used items can be depreciated in this manner as well, which is another favorable change to the law resulting from the Tax Cuts and Jobs Act.
To qualify, the property must have been both acquired and placed in service after September 27, 2017, and there are certain IRS rules that need to be followed, like you can't have used the property before acquiring it and you can't have acquired the property from a related party.
The bottom line
Bonus depreciation can allow rental property owners to deduct the entire cost of certain capital investments all at once, maximizing their federal income tax deductions for the current tax year. However, there's a tradeoff -- namely, that your deductions will be lower in subsequent years -- so be sure to weigh the pros and cons before deciding, and consult with an experienced tax professional to help you make the best choice.
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