Starting in 2024, the powerful tax benefits of bonus depreciation provided by the Tax Cuts and Jobs Act of 2017 are continuing to phase out by 20% each year until they reach 0% in 2027. As this benefit phases out, individuals from all backgrounds should understand what this means for their current investments, future investments, and personal financial plans.
This article will discuss what depreciation is, how it’s used in real estate to create tax efficiencies, and how the bonus depreciation phase-out will potentially impact the real estate investing landscape in the coming years.
The IRS allows owners of real estate to deduct specific costs associated with buying and improving an asset from their income taxes. This practice, commonly referred to as depreciation, creates tax efficiency for the owners. Depreciation is based on the concept that a real asset, such as a real estate property and its many components, will decrease in value over time.
The period over which an asset can be depreciated varies depending on how the asset is classified. Many residential properties and their various components have 5/15/20/27.5-year lives, while commercial assets typically have 5/15/20/39-year lives.
Net rental losses, a benefit of depreciation, are typically passed through to owners of real estate partnerships and are usually treated as passive losses on an owner’s tax return.
It is important to note that not all investment opportunities can pass depreciation benefits down to investors, and not all investment opportunities produce the same amount of depreciation benefits.
Before diving into the different types of depreciation, it’s crucial to understand what a cost segregation study is and its role in real estate depreciation practices.
Cost Segregation studies are performed to categorize components of a real estate asset into different buckets based on their estimated useful lives or the time over which an asset can be depreciated. The categories for cost segregation studies are as follows:
Ultimately, by using a cost segregation study and separating the costs of the asset into these categories with different useful lives, an owner may produce more passive loss benefits than could be accomplished through straight-line depreciation.
As an example, the Modified Accelerated Cost Recovery System (MACRS ADS) is one of two MACRS depreciation methods that real estate owners utilize, which allows owners to depreciate assets over a straight-line life based on the various depreciation tables. After a cost segregation study is completed, an owner can categorize certain components of their asset into their appropriate depreciable lives.
Depending on the type of fixed asset of the investment, it may have a 5, 7, 15, or a 27.5-year life. For instance, if the investment has $1,000,000 of appliances, which are depreciated over 5 years instead of 27.5, the annual depreciation benefit is now $200,000 per year for 5 years, assuming no bonus depreciation.
Bonus depreciation allows owners to write off the allowable percentage of the cost basis in the first year for assets with less than a 20-year life in the year of purchase.
After a cost segregation study is completed and the components of an asset are categorized appropriately, an owner may use bonus depreciation to recognize the depreciation benefit quicker than they would through straight-line MACRS ADS depreciation.
Using the same example as above (an investment that has $1,000,000 of appliances, typically depreciated equally over 5 years), bonus depreciation would allow an owner to recognize all $1,000,000 of depreciation in year 1.
This year, 2024, is the second year of the bonus depreciation phase-out, reducing the impact of bonus depreciation by 20% each year for the next 4 years.
As bonus depreciation phases out over the next 4 years, the bonus depreciation schedules will more closely resemble what can be accomplished through MACRS ADS depreciation.
See chart below for a comparison.
As bonus depreciation is phased out, the rate at which the depreciation benefits can be used will shift. Instead of most of the depreciation benefit occurring in the first year of an investment, it will now be spread out over the course of the investment.
While the amount of passive loss an owner receives in Year 1 may decrease as bonus depreciation phases out, the total amount of depreciation received over the asset's useful life will likely remain the same, depending on the hold time of the asset.
Given these changes, it’s important for investors to consider how this shift might impact their tax planning and broader financial picture. We recommend discussing these items with your CPA or financial advisor to create a plan that optimizes tax efficiency within your personal portfolio.
At Wealthstone Group, we're here to help you make informed decisions that align with your financial goals. We can guide you through the implications of the bonus depreciation phase-out by leveraging our network and help you optimize your investment strategy for long-term success. Contact us today to learn how we can support your journey in real estate investing.
General Disclosure
This material is provided for informational and educational purposes only and is based on information from sources we believe to be reliable. However, its accuracy is not guaranteed, and it is not intended to be the sole basis for investment decisions or to meet specific investment needs.
Wealthstone Group does not offer tax or legal advice. This content should not replace professional advice tailored to your individual situation.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only. Securities offered through Arkadios Capital, member FINRA/SIPC. Advisory Services offered through Arkadios Wealth. Wealthstone Group and Arkadios are not affiliated through any ownership.