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Can You Take Bonus Depreciation On Rental Property?

Can You Take Bonus Depreciation On Rental Property?

11/4/2023 7:33:47 AM   |   Comments: 0   |   Views: 635

Can You Take Bonus Depreciation On Rental Property?

The Internal Revenue Service (IRS) states that bonus depreciation enables business taxpayers to deduct a large portion of the eligible asset’s cost during the first year of its purchase.

The remaining cost can then be distributed over several years through regular depreciation until it’s completely phased out.

This factor becomes significant when managing rental properties making it important to incorporate depreciation into your financial planning.

One of the most significant advantages of depreciation is that it decreases taxable income without affecting the cash flow. Typically the goal is to attribute as much of the property’s purchase price to the building’s value to maximize the depreciation expense, given that land never depreciates.

As per IRS guidelines, the fraction attributed to the building for residential income property is depreciated over 27.5 years.

Claiming bonus depreciation lets taxpayers write off the total cost of an eligible asset in the first year it’s in service. This deduction doesn’t replace regular depreciation, instead, you get it in addition to it.

This article breaks down everything you need to know about bonus depreciation and how to use it to reduce your tax bill significantly.

Key Takeaways

        
  • Bonus depreciation allows property owners to significantly reduce their tax liabilities.
  •     
  • The Tax Cuts and Jobs Act of 2017 expanded bonus depreciation, increasing the allowable deduction.
  •     
  • Proper record keeping and understanding of rules are crucial for successfully using bonus depreciation on rental properties.
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What Is Bonus Depreciation?

Tax Cuts and Jobs Act

In 2017, the Tax Cuts and Jobs Act (TCJA) introduced major changes to the tax code, including modifications to the bonus depreciation rules. It increased the bonus depreciation percentage from 50% to 100% for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023.

This means that eligible businesses can now deduct the entire cost of certain assets in the first year they are placed in service.

Tcja

Eligibility for Bonus Depreciation

To be eligible for bonus depreciation, the property must meet specific criteria:

        
  • It should have a recovery period of 20 years or less under the Modified Accelerated Cost Recovery System (MACRS).
  •     
  • The property must be new or, if used, it should be the taxpayer’s first use.
  •     
  • The property should be placed in service within the specified timeframe.

Note: The bonus depreciation rules apply to both personal and real property, including rental properties. However, the rental property must meet the above eligibility requirements to qualify for this tax benefit.

Make sure that you consult with a tax professional to determine if your rental property can take advantage of the bonus depreciation rules.

What Is Depreciation In Real Estate?

Let’s discuss depreciation’s role in residential and commercial rental properties.

Residential Rental Property

For residential rental properties, the Internal Revenue Service (IRS) permits owners to claim depreciation on the value of the structure, excluding the land. The depreciation is calculated by spreading the cost of the property over its useful life, which the IRS defines as 27.5 years for residential property.

This depreciation deduction helps offset the income generated by the rental property, which can lead to lower tax bills for the property owner.

Some important points regarding residential rental property depreciation include:

        
  • Depreciation can only be claimed on the structure, not the land
  •     
  • The useful life of a residential rental property is 27.5 years
  •     
  • The Modified Accelerated Cost Recovery System (MACRS) method is used for calculating depreciation

Commercial Rental Property

Commercial rental properties follow a similar depreciation procedure; however, some differences exist.

The useful life is longer for commercial real estate; the IRS defines it as 39 years. Like residential properties, the depreciation is calculated using the MACRS method, but the rate of depreciation is slower due to the longer useful life.

Points to consider for commercial rental property depreciation:

        
  • Depreciation can only be claimed on the structure, not the land
  •     
  • The useful life of a commercial rental property is 39 years
  •     
  • The MACRS method is also applicable for calculating depreciation

Can You Take Bonus Depreciation On Rental Property?

Bonus depreciation is a tax benefit that lets businesses deduct the full cost of certain assets in the first year they’re used. But it doesn’t work for actual rental properties.

Why??

Because to get bonus depreciation, an asset must have a “useful life” (how long it’s expected to be used) of less than 20 years. But rental properties are expected to be useful for at least 27.5 years, remember?

So, even though you can’t use bonus depreciation directly on your rental property, there are other ways to gain extra tax benefits.

As an investor, here’s how you can use bonus depreciation to your advantage:

Land Improvements

Land Improvements

While you can’t take the full tax deduction for the rental property at once, you can use bonus depreciation for your improvements to the land.

These improvements are expected to last 15 years and qualify for bonus depreciation. This includes any permanent structures (except the buildings) or work you do on the land itself.

Here are some examples of land improvements you might make on a rental property that could qualify for bonus depreciation:

        
  • Digging out the land (excavating)
  •     
  • Leveling the land (grading)
  •     
  • Planting trees or flowers (landscaping)
  •     
  • Building fences
  •     
  • Installing swimming pools
  •     
  • Adding or renovating a sprinkler system

Personal Property

Another way to use bonus depreciation with a rental property is to deduct the cost of personal property assets. These are items typically expected to last less than 10 years. This lets you deduct the full cost of these items in a much shorter time than usual.

Here are some examples of personal property items you might have in a rental property that could qualify for bonus depreciation:

        
  • Appliances like stoves or fridges
  •     
  • Tools you use for repairs or maintenance
  •     
  • Tech devices like computers or security systems
  •     
  • Furniture for furnished rentals
  •     
  • Cars or vans used for business purposes related to the rental

These items can be fully deducted using bonus depreciation, but there are some restrictions to remember.

Property Improvements

You can use bonus depreciation for rental property improvements but not repairs. It’s really important to understand the difference between repairs and improvements when it comes to bonus depreciation.

Repairs are things you do to keep the property livable. They maintain or bring the property back to its original state. For example, fixing a broken heater or replacing a damaged floorboard are repairs. You can’t depreciate repairs but can deduct them as a normal business expense in the year you do them.

On the other hand, improvements are changes that upgrade or enhance your rental property. They make the property better over the long term.

For example, converting an attic into an extra bedroom is an improvement. These changes need to be depreciated over time when you calculate expenses. You can use bonus depreciation if the improvement is expected to last 20 years or less.

So, you can use bonus depreciation on rental property improvements expected to last 20 years or less.


 
 

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Types of Depreciation on Rental Property

#1. Straight-Line Depreciation

Straight-line depreciation is the most straightforward of the depreciation methods. With this approach, the cost of rental property is divided equally over its useful life, typically set at 27.5 years for residential real estate.

Each year, the property owner can take a depreciation deduction that reflects a consistent amount, typically calculated by dividing the rental property’s cost basis by the property’s useful life.

Residential Real Estate

Example: 

Let’s say you buy a single-family home for $275,000. The land the home is built on is worth $25,000, so the cost of the actual house (also known as the “cost basis”) is $250,000 ($275,000 total cost – $25,000 land value).

The IRS lets you spread out (or “depreciate”) the cost of a residential rental property over 27.5 years. So, every year, you can take a depreciation deduction of $9,091 ($250,000 cost basis ÷ 27.5 years).

This is the straight-line depreciation method. You deduct the same amount each year for 27.5 years, which is the estimated “useful life” of the property according to tax rules.

                                                                                                                                                                                                                                     
DescriptionAmount ($)
Home Purchase Price275,000
Land Value25,000
Cost Basis (Home Value)250,000
Depreciable Amount (Annual)9,091

#2. Modified Accelerated Cost Recovery System (MACRS)

The Modified Accelerated Cost Recovery System (MACRS) is an accelerated depreciation method that allows property owners to deduct more depreciation in the earlier years of owning the rental property. Under the MACRS, real estate is classified under one of two property classes:

        
  • Residential rental property, which has a 27.5-year recovery period
  •     
  • Nonresidential real property, which has a 39-year recovery period

Rental property owners are required to use the General Depreciation System (GDS) by default and can only switch with the IRS’s permission.

#3. Alternative Depreciation System (ADS)

The Alternative Depreciation System (ADS) is a less aggressive depreciation method that spreads deductions across a more extended period, resulting in smaller deductions each year. Rental property owners may elect to use the ADS under special situations.

For example, they might choose to use ADS if they claim the property as a qualified business asset with international tax implications or if the property is subject to leasehold improvements.

#4. Section 179 Deduction

Section 179 of the Internal Revenue Code allows business owners to deduct the cost of qualified property, such as tangible property and software, in the year it’s placed in service, up to a specified limit.

However, Section 179 deductions typically do not apply to rental property. The IRS treats residential rental property as non-qualifying property for Section 179 deduction purposes, as it’s considered a passive activity rather than an active business.

While Section 179 cannot be used to deduct expenses related to the rental property itself, it may be applicable for personal property utilized for rental activities, such as appliances and furniture. 

Tax Benefits of Bonus Depreciation for Rental Property

Here are the two main bonus depreciation tax advantages:

#1. Lower Taxable Income

Bonus depreciation allows property owners to deduct a larger portion of their rental property’s cost in the initial years of ownership. This upfront deduction helps to reduce their taxable income, allowing them to pay less in taxes on their rental income.

Owners can minimize their tax liability by taking advantage of bonus depreciation, especially in the early years of ownership when costs are often higher.

#2. Enhanced Cash Flow

Another major benefit of bonus depreciation on rental property is the improvement in cash flow. As the property owner reduces their taxable income, they also decrease their tax liability. This can result in more available cash for other investments or expenses.

Better cash flow can also provide a buffer for any unexpected costs or vacancies in the rental property, ensuring the owner has greater financial stability.

If you want to learn more about bonus depreciation, check out this video:

Rules and Restrictions for Bonus Depreciation

Used Property

Under the Tax Cuts and Jobs Act (TCJA), bonus depreciation can be claimed on used property, provided it meets specific criteria. The property must be new to the taxpayer and can’t be acquired from a related party or through a lease or contract.

Additionally, the taxpayer must not have used the property previously during their business.

Qualified Property

To qualify for bonus depreciation, the property must meet specific requirements. The property should have a useful life of 20 years or less, be subject to depreciation under the Modified Accelerated Cost Recovery System (MACRS), and be either:

        
  • Tangible personal property
  •     
  • Computer software
  •     
  • Qualified film, television, or theatrical production
  •     
  • Qualified improvement property

Also note that certain properties, such as those used for lodging or deriving income from the use of real property, are excluded from claiming bonus depreciation.

Placed in Service

The timing of when a property is acquired and placed in service plays a crucial role in claiming bonus depreciation. The property must have been acquired after September 27, 2017, and placed in service before January 1, 2023, to claim a 100% bonus depreciation.

For the property to be considered “placed in service,” it must be in a condition or state of readiness for its intended, specific use in the business. This includes operational readiness and availability for use without significant delays or interruption.

Keep in mind that different deadlines apply to specific property types, and the bonus depreciation percentage may decrease in the subsequent years before being phased out entirely.

What Are The Potential Drawbacks of Bonus Depreciation?

#1. Recapture Risk

While bonus depreciation can provide significant tax savings for rental property owners, there is the risk of recapture. Recapture occurs when a property is sold, and the IRS requires the property owner to pay back the tax benefits they received from bonus depreciation.

This can surprise some property owners, who may find themselves owing a large tax bill upon selling their rental property.

The recapture amount is based on the difference between the property’s sale price and its adjusted basis, which includes the total depreciation claimed.

Thus, the more bonus depreciation claimed, the higher the recapture amount. Property owners should be aware of this risk and factor it into their decision-making process when considering using bonus depreciation.

Rv Park

Here’s an example:

Suppose you purchased an RV park for $1,000,000, with $200,000 of this price allocated to the land, and $800,000 to the improvements and personal property (the RV stalls, swimming pool, recreation room, etc.).

Now imagine you’ve been using bonus depreciation, and after five years, you’ve depreciated $400,000. This would mean your RV park’s adjusted basis is now $600,000 ($1,000,000 original price – $400,000 depreciation).

Let’s say you decide to sell the RV park after these five years and manage to sell it for $1,200,000. The difference between your sale price and the adjusted basis is $600,000 ($1,200,000 sale price – $600,000 adjusted basis). This is your gain from the sale.

The recapture comes into play because the IRS will treat part of your gain as ordinary income up to the amount of your total depreciation ($400,000), which is taxed at your ordinary income tax rate. This is the depreciation recapture, and it can significantly impact your tax bill.

Any remaining gain above the total depreciation is treated as a capital gain, which is usually taxed at a lower rate than ordinary income. In this case, that would be $200,000 ($600,000 total gain – $400,000 depreciation recapture), which is treated as a long-term capital gain.

It’s important to be aware of this possibility and to factor it into your decision-making process when considering whether to take advantage of bonus depreciation.

                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
DescriptionAmount ($)
RV Park Purchase Price1,000,000
Land Value200,000
Improvements/Personal Property Value800,000
Total Depreciation400,000
Adjusted Basis (Purchase Price – Depreciation)600,000
Sale Price1,200,000
Gain on Sale (Sale Price – Adjusted Basis)600,000
Depreciation Recapture (part of gain treated as ordinary income)400,000
Capital Gain (remaining gain treated as long-term capital gain)200,000

#2. Reduced Deprecation in Future Years

Another potential drawback of bonus depreciation is that it can reduce the amount of depreciation that can be claimed in future years. Since the bonus depreciation is taken upfront, it accelerates the depreciation timeline, which can result in lower depreciation deductions in subsequent years.

For example, if a rental property owner claims 100% bonus depreciation on a $10,000 improvement in the first year, they can’t claim any additional depreciation for that improvement in future years. This can reduce the overall tax benefits of owning rental property and may affect the property’s cash flow.

Frequently Asked Questions

Are land improvements eligible for bonus depreciation?

Yes, land improvements are eligible for bonus depreciation. These improvements can include landscaping, parking lots, and fencing. However, the land itself is not eligible for bonus depreciation.

What property is not eligible for bonus depreciation?

Property that is not eligible for bonus depreciation includes any property used in a residential rental activity for more than 80% of its use during a taxable year, as well as property with a useful life of less than 20 years. Additionally, buildings and their structural components are not eligible for bonus depreciation.

Can you take 179 depreciation on rental property?

Section 179 depreciation can be taken on rental property, but only on specific types of property. Qualified real property, which includes improvements to nonresidential real property such as roofs, HVAC systems, and fire protection systems, can be eligible for Section 179 depreciation. However, the residential portion of rental property, such as the building itself, is not eligible for Section 179 depreciation.

Which depreciation method is best for rental property?

The Modified Accelerated Cost Recovery System (MACRS) is the most common depreciation method used for rental property. It allows property owners to recover the cost of their rental property over a set period through yearly deductions. The recovery period for residential rental property is typically 27.5 years, and nonresidential real property is typically 39 years.

Do improvements to a rental property qualify for bonus depreciation?

Improvements to a rental property may qualify for bonus depreciation if they meet specific criteria. Generally, improvements must have a recovery period of 20 years or less, be new property, and be placed in service during the tax year the taxpayer claims the deduction. However, property improvements that are related to residential rental activities may not be eligible for bonus depreciation.

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