As a real estate investor, bonus depreciation is an effective tax-saving strategy that you can take advantage of and considerably reduce your taxable net income. Bonus depreciation in real estate gives real estate investors a leeway to fully deduct the 100% cost of capital improvement in the same tax year when the expenditure was incurred. The current 100% bonus depreciation will remain in force until the end of the 2022 tax year. Starting January 2023, bonus depreciation rates will be reviewed downwards up to the end of the 2026 tax year.
How does real estate depreciation work?
According to IRS Publication 946, real estate depreciation refers to an allowance that real estate investors receive due to property wear and tear, deterioration, or becoming obsolete. An investor uses an annual depreciation deduction to recoup the initial cost of the asset over its useful life.
A real estate property must meet the following criteria for it to be depreciable;
- The property must be owned by the taxpayer and not rented
- It must have a factual useful life that exceeds one year
- The real estate property must be used for either investment or business purposes
In real estate, depreciation can be categorized into three types. We have straight-line depreciation, declining balance depreciation, and bonus depreciation which is our main focus for this article.
What is bonus depreciation method?
Bonus depreciation in real estate allows a real estate investor to deduct 100% of property improvement cost during the first tax year. Initially, the bonus depreciation for property improvement capital was 50%. It was later reviewed and increased to 100% by the Tax Cuts and Jobs Act of 2017 (TCJA).
Bonus depreciation schedule
The 100% bonus depreciation deduction will be in operation until the end of the 2022 tax year. From there, the percentage of depreciation deduction will be reduced gradually until it’s faced out by the end of the 2026 tax year.
Bonus depreciation in real estate is only applicable to improvements and items placed in service but not a rental property. The reason behind this principle is that real estate assets have a useful life of more than 20 years. For instance, residential properties are depreciated over a period of 27.5 years while commercial properties are depreciated for 39 years.
Here is a breakdown of the 100% depreciation schedule and the other applicable depreciation percentage for the coming years until the end of the year 2026.
- 2021-2022 tax year- bonus depreciation rate of 100%
- 2023 tax year- bonus depreciation rate of 80%
- 2024 tax year- bonus depreciation rate of 60%
- 2025 tax year- bonus depreciation rate of 40%
- 2026 tax year-bonus depreciation rate of 20%
- 2027 tax year-bonus depreciation of 0%
Since the 100% bonus depreciation is not compulsory, if a real estate investor takes longer to make home improvements, they will enjoy a lower bonus depreciation rate compared to the ones who take advantage of the early 100% bonus depreciation rate.
Is bonus depreciation similar to Section 179 deductions?
These are two often confused deductions but the truth of the matter is that bonus depreciation deductions are different from Section 179. Bonus depreciation is used to recoup expenses on improvements done on a rental property while on the other hand, Section 179 allows a real estate investor to deduct the purchase price of important equipment such as computers and office equipment but with certain limitations. In addition, bonus depreciation is not limited to any annual dollar amount or an annual profit of a real estate investment venture.