Bonus Depreciation in Real Estate Investment is being Phased Out

Dear valued investors and future investors,

It’s time yet again for CPI Capital’s weekly news briefing. This contains a mixture of updates, commentary and informative articles about the lucrative world of passive real estate investment.

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One of the key advantages of investing in syndicated multi-family or BTR-SFR real estate is the various tax breaks which are provided for. Yet one of the most significant provisions of the Tax Cuts and Jobs Act’s (“TCJA”), namely the ability to claim so-called “bonus depreciation” will start to be phased out at the end of this year.

Bonus depreciation is a very useful tool for an investor to significantly reduce taxable net income.

But what does this change mean for real estate investors?

Well, before we talk about the changes in bonus depreciation, let’s quickly look at depreciation in real estate in general.

What is depreciation in real estate investing?

Depreciation is an allowance real estate investors can claim for the wear and tear, deterioration or obsolescence of a property they own and which is used for investment purposes. Such allowance can be deducted from pre-tax income to recover the cost basis of a property over the time an investor owns the property.

Most types of tangible property such as real estate, furniture, appliances and landscaping improvements can be depreciated, although land value cannot.

Types of depreciation in real estate

Straight-line depreciation: is when the value of the real estate used for investment purposes is depreciated by the same amount over a period of years; for residential real estate the period is 27.5 years although some items such as appliances and carpeting can be depreciated over a shorter period of 5 years.

Declining balance depreciation: allows an investor to depreciate assets based on their remaining useful life, with larger depreciation deductions used initially; as the balance declines, the depreciation expense also reduces.

Bonus depreciation: allows a taxpayer to deduct 100% of an item’s cost in the first year and can also be claimed against both new and used items purchased in 2018 or thereafter.

More on bonus depreciation in real estate

Partly to help encourage improvements to real estate, changes were made by the TCJA in 2017 to allow 100% bonus depreciation (up from 50%) on a wide variety of assets that are considered “qualified property”. It’s important to note that bonus depreciation applies only to improvements and not to the rental property itself.

Such bonus depreciation rules were initially set to expire at the end of 2019 for assets in operation after September 27th, 2017 and before January 1st, 2023. However, the availability of the full allowance was extended up to the end of the 2022 tax year, and will then gradually decrease until expiration at the end of the 2026 tax year.

The allowable depreciation amounts on an annual basis are:

Tax Year

2022 100%
2023 80%
2024 60%
2025 40%
2026 20%
2027 0%

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“Qualified improvement property” is also included as “qualified property” for purposes of bonus depreciation, meaning that many interior upgrades to buildings are eligible for accelerated cost recovery.

One of the keys to eligibility for bonus depreciation is that the assets are “placed in service” or operational prior to the deadline. Simply purchasing a qualified property prior to December 31st, 2022 is not enough. The same principle applies for each of the phase-out percentages in the years ahead; in other words, if the asset isn’t in service before the end of the relevant year, it will only qualify for the following year’s bonus percentage amount.

Increasing the value of bonus depreciation

Cost segregation studies are used to accurately categorise components of buildings into different depreciation components of 5, 7, 15, and 27.5 years. This makes them eligible for whatever bonus depreciation percentage is available in the year the property becomes operational. Such studies are undertaken by accountants, engineers and building construction professionals who identify and assign costs to building elements that are “dedicated, decorative, or removable”. The result being that cost recovery may be possible over shorter asset lives than that of real property.

Another allowance, but not as attractive alternative to bonus depreciation

Bonus depreciation and the so-called “Section 179” deduction are different types of deductions but, as bonus depreciation phases out over the next few years, some small businesses may be able to obtain some initial-year expensing using Internal Revenue Code Section 179 rules. Under this section, businesses are subject to total purchase and total deduction rules every year. These place limitations on the amount of first-year depreciation unlike bonus depreciation rules.

Whilst bonus depreciation is used to expense improvements to a rental property, Section 179 allows an investor to deduct the purchase price of equipment such as office equipment, or computers, subject to certain limitations.

CPI Capital always endeavours to capture the benefits of any legal tax deductions so as to enhance the investment returns for our passive investors. Tax benefits are an inherent part of real estate investment as the policies of successive US governments have been to both encourage home ownership, but also try to ensure that the available rental stock is of adequate quality and owners are prepared to undertake improvements.

As mentioned, bonus depreciation in real estate allows an investor to deduct the full cost of capital improvements in the same tax year the expense is incurred and, in fact, can be claimed even if the cashflow from a property in the early years of operation has not yet become positive.

In some cases, a rental property depreciation expense can even eliminate taxable net income which means that CPI Capital has more dividend income for distribution to its passive investors!

Yours sincerely,
August Biniaz
COO, Co-Founder CPI Capital