What is bonus depreciation and how does it work?

Bonus depreciation lets you maximize your return and minimize your tax liabilities. With bonus depreciation, you can deduct a substantial portion of the cost of qualifying assets during the year they are placed in service.

Unfortunately, understanding bonus depreciation, how it works, and whether it’s right for your real estate investment strategy is no small feat – but that’s where we come in.

In this guide, we’ll walk you through everything you need to know about bonus depreciation.

What is Bonus Depreciation?

Your assets naturally depreciate over time due to use and normal wear and tear. If you run a business, depreciation lets you write off a portion of your asset’s cost over its estimated “useful life,” as long as:

• you’re the boss
• You use the property in your business or other income-generating activity
• The useful life of the asset is more than one year

In normal depreciation, the portion you write off is equal to its estimated useful life. For example, let’s say you remodel the kitchen of your new rental property with cabinets that cost $7,000. Cabinets have a seven-year depreciation life cycle, meaning you can claim $1,000 in depreciation for seven years.

Bonus depreciation accelerates this process. Instead of claiming $1,000 per year for seven years, you can get much more when you claim bonus depreciation. In 2022, you can claim 100% of your cabinet depreciation, meaning you must write off all $7,000 immediately. Then, you can use the money saved through the depreciation tax deduction on other things, such as reinvesting in your business.

Unfortunately, bonus depreciation is already ending, so if you want to take advantage of the massive tax write-off, now is the time.

How Bonus Depreciation Works

Let’s say your kitchen cabinets actually cost $10,000. Here is the step-down schedule for depreciation bonus:

Comment: If you have claimed 100% depreciation in 2022, then that asset is no longer eligible for tax deduction. You cannot claim total depreciation in excess of the cost of the asset. Also, bonus depreciation is only good for the first year you use the asset. Taking 80% bonus depreciation for an asset in 2023 does not qualify for the remaining 20% ​​in 2024. You can only claim the standard depreciation percentage of the asset from the second year onwards till you claim the entire 100%.

Also, before reading on, check to see if your state allows accelerated depreciation. Some of them are not including Florida, Hawaii, California and New York.

When did bonus depreciation start and why does it exist?

Bonus depreciation became a tax incentive for the first time when Congress passed the Job Creation and Worker Assistance Act of 2002. Thereafter, you could claim 50% depreciation in the first year of use of the asset. Its initial purpose was to encourage businesses to take the money saved through bonus depreciation and reinvest it in the post-9/11 economy.

In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA). One of the fundamental changes to the TCJA is that property eligible for bonus depreciation can be claimed in full as long as the property was acquired and placed in service between September 27, 2017, and January 1, 2023. In other words, if you bought and held those $10,000. For the kitchen cabinets used in October 2016, you can write off $5,000. In October 2017, you can write off a total of $10,000.

However, the TCJA also implemented the phase-out schedule shown in the table above. Without any further action from Congress, bonus depreciation will expire in 2027.

Assets that are eligible for bonus depreciation

To qualify for bonus depreciation, the asset must generally have a recovery period or useful life of 20 years or less. Here are some of the most common assets eligible for bonus depreciation:

Residential Rental Property with Cost Segregation Study

Cost segregation is another strategy that helps maximize your depreciation deduction and reduce your overall tax burden. Cost segregation measures the depreciation of specific assets in your rental property, including flooring, cabinets, countertops, appliances and lighting, to name a few. Given that this is incredibly relevant in the BiggerPockets community, let’s dive a little deeper:

You can write off a ton of money in bonus depreciation through a cost segregation study. For example, let’s say you buy a vacation property with an estimated building value of $275,000. Since residential properties have a useful life of 27.5 per year (which disqualifies them from bonus depreciation), you write off $10,000 in depreciation: $275,000 / 27.5 = $10,000

You also spend $40,000 on interior upgrades eligible for bonus depreciation, which puts all of that to use in 2023.

Let’s also assume that you earn $40,000 in rental income that year and pay 25% in federal income tax.

• Taxes owed without depreciation = $40,000 * 25% = $10,000
• Taxes owed with depreciation = ($40,000 – $10,000) * 25% = $7,500

Thanks to normal depreciation, you save $2,500 in taxes. When you include a cost-segregation study, you save a lot. Your cost-segregated asset is $40,000 eligible for bonus depreciation, and in 2023, you can claim up to 80%.

• Cost-segregated asset: $40,000 * 80% = $32,000
• Taxes payable with depreciation and cost-split = ($40,000 – $10,000 – $32,000) * 25% = -$500

In this scenario, your cost-segregated asset lets you claim a $500 net operating loss, which you carry forward and offset against future income.

eligible improvement property

Qualified Improvement Property (QIP) includes improvements made to the interior of non-residential buildings after you put them into service.

QIP also applies to interior improvements made to short-term rental properties thanks to the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).

Additional Bonus Depreciation Eligibility

Additional eligible properties include:

• Vehicles with a useful life of 20 years or less
• Office Equipment and Furniture
• depreciate computer software
• Used equipment that you have not used before receiving
• water utility properties
• land improvements such as fencing and parking lots

Assets that are not eligible for bonus depreciation

Here are some of the main assets that do not qualify:

• primary residence: Your primary residence does not generate income. Therefore, it does not qualify for normal depreciation, much less bonus depreciation.
• rental and commercial property buildings: Residential properties have a useful life of 27.5 years, while commercial properties have a useful life of 39 years. Both asset types exceed the standard 20-year or less bonus depreciation rule.
• specific vehicle: If the useful life of a vehicle is more than 20 years, it is ineligible for bonus depreciation.

How to report bonus depreciation on your taxes

You can report bonus depreciation by filing IRS Form 4562, “Depreciation and Amortization.” Like other tax forms, you must file by the due date (including extensions) for the taxable year you are claiming the bonus depreciation.

What is the difference between Bonus Depreciation and Section 179 Expense?

Bonus depreciation and Section 179 have a lot in common but there are some key differences.

First, bonus depreciation allows you to carry the loss against your income, like in the cost-aggravation example above. If you use Section 179 and take a loss, you must carry it forward until you have income to absorb it. Otherwise, you can take the standard depreciation deduction.

Another important difference is that many states do not allow bonus depreciation. For example, if you’re a California resident, you can’t claim bonus depreciation, so you might consider using Section 179 instead. Different states have different rules for both the tax deduction options.

Also, you have to write off the total amount available to write off the bonus depreciation. If you want to claim only 50% of your bonus depreciation for your 2022 tax year, you can’t. You have to claim full 100%. With Section 179, you can deduct any amount you choose as long as it is within the limits for that taxable year.

What are the Pros and Cons of Bonus Depreciation?

At this point, you’re probably aware of some of the main pros and cons of bonus depreciation.

pros

• Substantial Tax Deductions: In 2022, you can fully deduct a fixed asset in one year regardless of its use (as long as you haven’t used it). Even in 2023, you can still deduct 80%, which is much more than the standard depreciation allowed.
• Reinvestment Opportunities: If you spend $10,000 on a cabinet and recoup that investment in the same year, you can reinvest this money in other things. You can buy more equipment, remodel a second home, or even make a down payment for another property. With instant cash withdrawal in your hand, the possibilities are endless.
• Depreciation can be less confusing: If you can claim 100% depreciation on an asset, you won’t need to worry about including it on future tax returns. Since you can’t claim the full 80% for any property you buy and use in 2023, you’ll still have to account for it, but it will be much less.
• You can claim damages: If claiming bonus depreciation results in a net operating loss, you can carry it forward to offset future taxable income — as long as it stays within the limits of the TCJA.

Shortcoming

• Lack of future deduction: If you fully depreciate an asset, you cannot write it off in future returns. In other words, if you fully depreciate your $10,000 cabinets instead of spreading them out over their 7-year life cycles, you will not accrue depreciation on them in years 2-7.
• Can Disrupt the Expected Tax Return: Claiming bonus depreciation relieves you of your tax burden for the year you claim it. However, keep in mind that this is only for that year. If you account for this, you could be in for a rude awakening when it’s time to pay taxes next year.
• The limits for the damages claimed are: While you can claim a net operating loss, the number of years you can do so is often limited. If you intend to take a loss, make sure you plan ahead.

Should You Take Advantage of Bonus Depreciation?

Bonus depreciation can be a tremendous asset, depending on your long-term plans. This may give you more cash to reinvest in your business or additional assets, but keep in mind that this is not “extra” money by any means. You’re maximizing your tax write-off now in exchange for little-to-no depreciation in future years.

Generally speaking, having extra cash on hand is a good thing as long as you have a plan for it.

If you’re wondering how you can best use the extra money you get through bonus depreciation, check out the BigPockets forum. Our community of real estate investors, agents and other professionals can provide you with some insight.

Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.