How Can Real Estate Investors Take Advantage of Bonus Depreciation?
Bonus Depreciation and Cost Segregation has become the buzz words in the last few years, especially among real estate investors.
What is Bonus Depreciation?
Here is the IRS official Definition:
The 100% additional first year depreciation deduction was created in 2017 by the Tax Cuts and Jobs Act and generally applies to depreciable business assets with a recovery period of 20 years or less and certain other property. Machinery, equipment, computers, appliances and furniture generally qualify. The deduction applies to qualifying property (including used property) acquired and placed in service after September 27, 2017.
In English, it basically means you can immediately write off portions of certain assets in the first year you place the asset in service instead of depreciating them over many years. It is how the government uses tax codes to incentivize investment.
What does it mean for a Real Estate Investor?
Most real estate investors take regular depreciations to offset their rental income so they can achieve Tax Free Cash Flow from their investment property. That means they basically depreciate their residential Real Properties over 27.5 years and commercial Real Properties over 39 years, according to the IRS code.
Can investors take 100% first year depreciation deduction on the total value of real properties they purchase and put into rental during the qualifying years? Of course not, not for Real Properties.
But you can hire an engineering firm to conduct a Cost Segregation study to take advantage of Bonus Deprecation tax code.
What is Cost Segregation?
A cost segregation study examines each property element and separates building components such as flooring, windows, fencing, and sidewalks, resulting in considerably shorter depreciable years like 5, 7 or 15 years for these components rather than the standard 27.5- or 39-year timeline.
And, guess what, now you can take deduct the total cost of those 5,7- or 15-year properties in the first year. That is called the Accelerated Depreciation
Example:
If you purchase a $1,000,000 multi-family in Chicago, the depreciable Real Property will probably be $800,000 (land $200,000), with 27.5-year deprecation, your annual depreciation expense will be $29,091.
And, if you do a cost seg study, there might be $200,000 of the $800,000 structure less than 20-year depreciable property, now your annual depreciation expense will be ($200,000 + $600,000/27.5) =$221,818.
The difference is huge!
How can accelerated depreciation help you lower your tax burden?
We all agree that accelerated depreciation will generate more expenses to offset your rental income, and in many cases, generate paper losses on your tax return. Can you use that loss to reduce your active W2 income to lower your tax liability?
If your MAGI (modified adjusted gross income) is under $100,000, you can use up to $25,000 of those passive rental losses to offset your active income.
When your MAGI is over $100,000, a 50% phaseout will be calculated, until your MAGI hit $150,000. Then, you can no longer use the rental loss to offset your active income.
How can Bonus Depreciation help people whose MAGI is over $150,000?
The answer is self-managed STR (short term rental). That is why STR is such a buzz word in the real estate investor world too. Many of my physician clients have been doing exactly that for the last 6 years since the 2017 tax reform. Most of them are able to get 5 figure refunds from their high W2 withholdings.
Here is the tax loop hole: if you materially participate in renting your property out on a short-term basis (less than 7 days per stay) like Airbnb, the activity will be considered “Active” instead of “Passive” – which is how long-term rental property activity is defined.
Example
In the previous example, due to the BD strategy, you will be able to accelerate $192,727 ($221,818-$29,091) more in depreciation. And, if your marginal tax rate (federal and state combined) is at 50%, you will save $96,363.5 in taxes.
Another way to get that kind of tax write-off is if you are a Real Estate Professional.
How about if I forgot to take advantage of this tax code?
No worries. We have helped a lot of people claim bonus depreciations that they unfortunately forgo due to lack of knowledge. The catch-up depreciation got them a pretty nice refund check from Uncle Sam!
Not everyone will benefit from Cost Segregation and Bonus Depreciation, please consult your Tax Advisor
Joke aside, I have advised some clients not to get a cost segregation report and not to accelerate the depreciation because they will not benefit from the strategy. I actually tell most clients to wait until tax filing time to decide on whether a cost seg study should be conducted.
Bonus Depreciation will phase out by the end of 2026, Act today!
Consult A Tax Professional
If you own real estate investment and would like to seek assistance in tax deductions for your rental real estate, you could contact us to request a consultation session by clicking the button below. We serve clients across different states of the U.S. and would love to provide you with the help you need!
Justine Zhou
Justine Zhou is the CEO of Zhou Agency. She is also a senior CPA and extremely knowledgeable advisor with well-rounded expertise in tax, real estate investment and insurance services.
Justine believes in understanding clients’ needs first and providing tailored consultation to clients’ unique situation. She uses language that the audience can easily understand and is good at incorporating her expertise in both tax & real estate to help real estate investors achieve maximum tax savings.
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This post is to be used for informational purpose only and does not constitute legal, business, or tax advice. Each person should consult his or her own accountant, attorney, or business advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.
