Changes In the Bonus Depreciation Rules and How It Impacts Real Estate Investments
A big tax benefit from 2017’s Tax Cuts and Jobs Act (TCJA) begins phasing out at the end of 2022. The 100% bonus depreciation will phase out after 2022, with qualifying property getting only an 80% bonus deduction in 2023 and less in later years.
So why is this important in 2022?
As part of the TCJA, a rule was extended and updated to pull forward 100% of the depreciation of a fixed asset including commercial real estate in the year of acquisition.
This can generate significant tax savings (possibly even refunds) so 2022 is the time to take full advantage before time runs out (Or at least the benefit of 100% benefits in year 1).
Benefits likely to be reduced after 2022
Like all good incentives, this will eventually go away and start reducing in at the end of 2022. Starting in 2023, the amount that can be pulled forward into year 1 is 80% and eventually dropping to 0% in 2027
- 2022 = 100%
- 2023 = 80%
- 2024 = 60%
- 2025 = 40%
- 2026 = 20%
- 2027 = 0%
How does this work for a new acquisition?
A real estate investor may also claim bonus depreciation from a new property purchase by conducting a cost segregation study. Although the phrase may sound complicated, a real estate cost segregation study simply breaks down a property into different depreciation components of 5, 7, 15, and 27.5 years.
Assume a new investor purchased the single-family rental home discussed above for $120,000 (excluding the land value).
The traditional approach would be to depreciate the entire cost basis of $120,000 using a straight line depreciation schedule of 27.5 years. With this option, the annual depreciation expense would be $4,364 ($120,000 cost basis / 27.5 years).
However, by conducting a cost segregation study, an investor may be able to claim more depreciation. For example, assume that an investor determines the cost of the property are:
- Building: $110,000
- Appliances and carpeting: $10,000
Normally appliances and carpeting are depreciated over 5 years. But, an investor could claim 100% bonus depreciation of $10,000 for the first tax year. The single-family rental home with a value of $110,000 would be depreciated over 27.5 years, for an annual depreciation expense of $4,000.
The total depreciation the first year would be:
- Single-family: $4,000 per year for 27.5 years
- Appliances and carpeting: $10,000 with 100% bonus depreciation
- Total depreciation expense: $14,000 vs $4,364 without a cost segregation study
If the extra depreciation expense results in a loss for the current tax year, an investor may be able to offset other gains or carry forward the loss to future tax years to offset future gains or income.
Now, scale this up to a commercial multi-family property with 100 units, 100 appliances, and 100 units of flooring. It’s a significant benefit that will pass through to the investor through their K1 at the end of the year.
What happens in 2023?
The benefit is still there, but it will drop by 80%.
Once you find the right deal, 2022 is the time to take advantage of this tax benefit.
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