So, you’re a real estate investor accustomed to tax mitigation strategies and you are starting to think about your next big project. With that comes so many streams of thought — location, timing, interest rates, partnerships, and, possibly, the most crucial thing, tax incentives. In recent years, bonus depreciation in connection with real estate transactions has been a hot-button topic. Fortunately, it is not scheduled to phase out entirely until 2027. When thinking about your next real estate investment, optimizing your tax strategy and accessing the benefits of bonus depreciation could be vital to desired tax savings and, ultimately, to your bottom line.
Background on Bonus Depreciation
What is bonus depreciation, anyway? It sounds counterintuitive, yet the concept is far from that. Bonus depreciation is an accelerated tax deduction method that allows businesses to immediately deduct a larger percentage of the purchase price of “qualified property” rather than stretching out the deductions over the useful life of the asset. This reduces a business’s net earnings, resulting in a smaller tax liability. The Tax Cuts and Jobs Act of 2017 (“TCJA”) increased bonus depreciation to 100% to promote business investment and stimulate the economy. When first introduced, the TCJA provided for immediate depreciation of 100% of the cost of qualified property placed in service after September 27, 2017, and before January 1, 2023. For example, if a business deducts $20,000 each year over the course of 10 years, this isn’t likely to materially impact each year’s taxable income; however, if we apply bonus depreciation under the TCJA, deducting $200,000 in a single tax year is much more likely to positively impact the business’s tax liability. Bonus depreciation was created as a way for business owners to free up money in the short term, which incentivizes them to further invest in the economy. By accelerating the tax benefit of eligible assets, a penny saved truly becomes a penny earned, allowing business owners to invest their savings into other business ventures.
Bonus Depreciation in Connection With Real Estate Transactions
Not all investable real estate qualifies for bonus depreciation. Because bonus depreciation can only be applied to a business’s assets that: (a) are eligible for depreciation under the modified accelerated cost recovery system (“MACRS”); and (b) have a MACRS recovery period of 20 years or less — only certain types of real estate qualify. A great example of qualifying properties are gas stations and car washes. The underlying land is not depreciable, under MACRS or otherwise, but other business assets such as machinery, equipment and the like, are.
Typically, real estate investors looking to defer income taxes have relied on Section 1031 exchanges to exchange one real estate investment for a different real estate investment in a tax-deferred manner. Another common tax deferral strategy has been reinvesting capital gains into qualified opportunity funds that invest in projects located within an eligible opportunity zone to defer recognizing those gains. A third option — bonus depreciation — has become a contender that more real estate investors are opting into before it phases out entirely. By purchasing a qualified real estate asset, the investor is generally eligible for significant bonus depreciation on the entire purchase price of the asset, as well as MACRS depreciation on the remaining asset basis. When the investor has held the asset long enough, the sale proceeds may even be used to purchase other real property in a Section 1031 exchange, thus further deferring the recognition of gain.
Time Is of the Essence
Like all good things, bonus depreciation will eventually come to an end. The TCJA includes a phase-out schedule for bonus depreciation of 20% annually until it is completely phased out by 2027, absent Congress agreeing on a legislative extension of the tax benefit.
On January 31, 2024, the bipartisan bill deemed H.R. 7024, Tax Relief for American Families and Workers Act of 2024 (“The Act”) was successfully voted to pass by the House and now heads to the Senate. The Act proposes 100% bonus depreciation for qualified property placed in service between January 1, 2023 and December 31, 2025, with a phase-out schedule after that. While there is a chance bonus depreciation rules will be modified and extended, consider taking advantage of the benefit as it currently exists.
Additional Considerations
The primary focus of bonus depreciation is to offset tax liability derived from income, so when evaluating the potential advantages of this tax strategy, there are several components to consider. First, consider how much revenue is being generated from the property. If the property has already incurred a loss or other expenses for the tax year to offset income, the additional depreciation may be less critical to lower tax liability. Second, if the property is sold at a gain in the future, the accelerated depreciation deductions may trigger recapture of some or all of the gain as ordinary income. Third, not all states conform to the TCJA. States have different levels of conformity to bonus depreciation under the TCJA, resulting in inconsistent state tax treatment of federal deductions and bonus depreciation rules. As such, it is advisable for real estate investors to consult an experienced tax advisor to discuss whether bonus depreciation is the right fit for their circumstances.
Conclusion
Bonus depreciation can be an essential tax-saving tool when tackling your 2023 tax filing. Bonus depreciation provides immediate tax deductions for qualified property, resulting in increased cash flow and return on investment from the outset. More cash flow for business owners means the ability to reinvest more in their businesses, other investment vehicles, and ultimately, the economy.
1P.L. 115-97.
2Julia Kagan, What Is Bonus Depreciation? Definition and How It Works (Aug. 29, 2023), https://www.investopedia.com/terms/b/bonusdepreciation.asp.
3I.R.C. §168(k)(2)(A)(i)(I).
4See Julia Kagan, What Is Bonus Depreciation? Definition and How It Works (Aug. 29, 2023), https://www.investopedia.com/terms/b/bonusdepreciation.asp.
5Tax Relief for American Families and Workers Act of 2024, H.R. 7024, 118th Cong. (2024).
6Lynn Mucenski Keck, House Passes Tax Relief Act With A Decisive Bi-Partisan Vote, Forbes (Feb. 1, 2024), https://www.forbes.com/sites/lynnmucenskikeck/2024/02/01/house-passes-tax-relief-act-with-a-decisive-bi-partisan-vote/?sh=1229fe92210d.
7Id.
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