Bonus depreciation is not something you hear about often, and for someone interested in real estate investments, you might miss out if you don’t know what it is.
In this article, you will learn about bonus depreciation. We will cover the basics of bonus depreciation while helping you avoid common mistakes many new investors make. Together, let’s find answers to the following questions:
- What is bonus depreciation?
- Who can use it?
- How can you make it work for you?
Depreciation is a tax deduction that allows you to deduct a portion of the cost of your property over its useful life. It can help lower your taxable income, saving you money at tax time.
The IRS allows you to claim depreciation on items like real estate, cars, and equipment used in your business.
They allow taxpayers to take bonus depreciation on certain assets. One instance is with those placed in service after September 27, 2017, and before January 1, 2023. These would also reflect on January 1, 2024, for certain assets with more extended production periods.
Depreciation methods are complicated and vary by industry. However, the IRS website has tables showing how much depreciation you can take based on your business and asset types.
In addition, there are two types of depreciation: straight-line and accelerated.
Straight-line depreciation is the most common method used for residential property.
It treats all of your property as a single asset. Then divide its cost over the number of years in its expected useful life.
For example, if you spend $100,000 on a piece of machinery expecting it to last ten years, you would divide the $100,000 cost by ten years to get a total annual depreciation expense of $10,000.
While straight-line depreciation is the most common way to depreciate property in real estate, you can use other methods. Straight-line depreciation is more accurate than accelerated methods because it treats all assets equally over their expected useful life.
However, accelerated methods allow businesses to expense more of their investments in the early years when they may have more cash flow restrictions. Then, compared to later years, they may have more cash flow available for investing in new assets or growth opportunities.
Accelerated methods are for commercial properties or assets with short lifespans.
It is a method of writing off a portion of the cost of property in the first few years of ownership. It’s the opposite of straight-line depreciation, which allows for equal deductions over the life of an asset.
The federal government offers accelerated depreciation for rental properties, but it’s unavailable to most homeowners. However, some states offer additional tax benefits that may help offset accelerated depreciation’s limitations.
The idea behind accelerated depreciation is that you can deduct more from your taxes by claiming deductions early on in a property’s life instead of waiting until the end.
Real estate owners have two main types of accelerated depreciation: residential rental and nonresidential property (such as strip malls).
In addition, other types offer special rules for certain types of assets, such as cars and trucks or farm equipment.
For example, if you bought a rental property for $200k, used $10k of your own money, and borrowed $190k from the bank, your tax deduction for the first year would be $20k plus interest (assuming a 30% tax bracket).
So, even though you spent $200k on the property, only $20k is deducted from your taxable income in the first year.
If you had waited until five years to claim all those deductions, they would have been worth only about $33 per month in reduced taxes (assuming a 20% tax bracket).
It is also most commonly used by businesses when buying equipment and parts.
For example, if you buy a new computer system for $6,000 and depreciate it over five years at 30%, your total cost per year is $600 ($6,000 divided by five years).
However, if you use accelerated depreciation, your cost per year drops by $400 because the IRS allows you to take a larger deduction initially: ($6,000 divided by four years).
The Tax Cuts and Jobs Act of 2017 created a new provision called bonus depreciation that allows businesses to write off the cost of certain assets more quickly than in the past.
Bonus depreciation is available for most tangible personal property, including real estate. But there are some limitations and conditions on how you can use it.
Congress introduced it in 2002 and it has been extended multiple times since then. The latest extension expires at the end of 2021, but Congress will likely renew it.
It’s also possible that Congress could change the current program or create new programs altogether during any extensions.
Bonus depreciation allows businesses to deduct 100 per cent of the cost of qualifying assets instead of depreciating them over time under standard depreciation rules.
However, you can only claim it once an asset comes into service; you cannot claim it before it is purchased or during any period when the manufacturer is still producing an investment.
The Internal Revenue Code Section 168(k) allows taxpayers to claim bonus depreciation on qualified investment property placed in service after September 27 2017, and before January 1, 2023.
The 50% bonus depreciation amount is limited to the excess of the cost of the property. In addition, it is over any amount taken into account under section 167 for depreciation or amortization.
You can claim the bonus depreciation on a new or used asset (not including buildings) that meets all of the following requirements:
- It must be tangible personal property, and you must use it for business or investment purposes. Also, it should be new or used (not previously owned) and must be depreciable. Therefore, it cannot be a “listed property” such as a car, boat, or aeroplane.
You must own the property for at least one year before claiming any bonus depreciation. The same goes for your business partner if you claim it as a pass-through deduction on Schedule E or F.
- It must be acquired after September 27, 2017; and
If you’re using Section 179 expensing (also subject to the one-year ownership rule), you can’t claim both Section 179 and bonus depreciation on the same property. However, if you don’t use all of your Section 179 expensing, you can carry over any remaining amount into the next year and treat it as first-year bonus depreciation.
- You must place it in service before January 1, 2023.
Any property that qualifies as “new” under Section 168(k)(2)(A) must be placed in service before January 1, 2023, to allow for bonus depreciation treatment.
If you are considering investing or refinancing one or more properties, this may be the time to act. Of course, you will have to budget for these tax deductions, but the tax savings are not insignificant and could help with your overall cash flow.
The usual advice applies: try purchasing properties that fit your financial plan. Then after you buy these properties, consider the wise use of bonus depreciation and other tax-saving tools available to you.