The tantalizing subject of tax deductions may not be dominating the conversation at your holiday party, but with 2022 drawing to a close, it’s important to remember that several changes will affect property organizations in this year’s tax returns. Real estate professionals only have a few weeks left to decide whether or not to claim the bonus depreciation deduction before it gradually begins to wind down forever.
One of the many benefits of investing in real estate is that the income stream is a vehicle for tax deductions. Owners and investors can write off costs that are directly related to the upkeep, management, and operation of a property. That’s because real estate presents a positive paradox: the value of a real estate investment generally increases over time, while the value of the building itself loses value. Foundations crack, HVAC systems putter out, plumbing systems rust, you get the idea. In the federal government’s eyes, all investment properties lose value every year, so the IRS permits the depreciation of that investment to be deducted from the taxable income that property yields each year.
However, one of the key methods that owners and investors use to significantly reduce their tax burden is on its way out. Bonus depreciation, otherwise known as the Additional First Year Depreciation Deduction under Section 168(k) of the Internal Revenue Code, allows owners and investors the ability to deduct the entire cost of some capital improvements to a qualifying property. It often gets confused with Section 179, which allows a taxpayer to expense up to $1 million of the total cost of qualified depreciable assets. But the bonus depreciation deduction is not limited to an annual dollar amount, which is exactly what made it the golden goose of real estate tax deductions.
Seizing the means of deduction
Congress had initially enacted bonus depreciation in 2002 in an effort to spur the economy after the fallout from 9/11. The deduction was folded into the Job Creation and Worker Assistance Act amid extended unemployment assistance and tax exemptions for areas that had received the brunt of the damage dealt by the terrorist attack. It was initially intended to be a temporary write-off that would fade away from the tax code once the economy bounced back. But even then, that deduction only allowed a 30 percent write-off of the depreciation of qualifying investments. As the years passed, both sides of the aisle opted to increase the deduction to 50 percent, but bonus depreciation became the magic bullet for real estate accountants in 2017 with the passage of the Tax Cuts and Jobs Act (TCJA). Under the new act, the bonus depreciation deduction jumped from 50 percent to 100 percent, albeit with some legislative hiccups as Congress literally forgot to add a clause that included buildings with a cost-recovery period of 15 years (a casualty of a hasty redraft of the bill minutes before the final vote).
Still, extending the bonus depreciation deduction was a huge win for the real estate industry. Before the TCJA was put into effect, the deduction could only be applied to brand-new constructions or properties that were placed into service for the very first time. Under the TCJA, taxpayers could suddenly expense 100 percent of an existing building, so long as it met some baseline requirements; the building had to be owned (not rented) by a taxpayer, it had to have a determinable useful life (which is the IRS’ way of saying “will eventually perish over time”), it had to be intended for business or investment purposes, and the building needed to be in fair enough condition that it would last longer than twelve months. That was it.
By using the post-2017 bonus depreciation deduction, the depreciation expense of a qualifying property would often cancel the property’s income on paper, meaning that properties could generate income while showing a loss on the tax return. Because the deduction can have a sizable impact on taxable net income, bonus depreciation became one of the biggest advantages of owning a rental property in need of repairs. An investor could use the money saved from the lessened tax burden and put it towards investing in upgrades that would boost rental income and cash flow for years to come.
But even though the deduction had been expanded, it was always meant to be a temporary stimulus, and the TCJA carved out the expiration date. Starting January 1st, the bonus depreciation deduction will phase out by 20 percent each subsequent year. Properties acquired in 2023 can only use the deduction to cover 80 percent of capital expense. By 2024, properties can only benefit from a 60 percent deduction. The bonus depreciation deduction will fizzle out completely come 2027.
2022 is the final year that real estate professionals can place property into service and take advantage of the full extent of the bonus depreciation deduction. Even though it’s on its way out, it’s still a powerful tax benefit.
Last call for a full deduction
Given the shrinking timeline for the bonus depreciation deduction, we might expect owners and investors to frontload some of their capital expenditures now to benefit from high depreciation rates. Owners can also offset the uptick in their tax burden by raising rent rates in the long-run, but justifying those rent rates by making targeted repairs that are funded by the money saved by the bonus depreciation deduction in the short-term.
It’s crucial to understand that bonus depreciation in real estate only applies to upgrades, not to the actual rental property, and that’s because buildings have a finite shelf-life. The IRS deems the shelf-life of a residential dwelling to be 27.5 years, whereas a commercial property lasts around 39 years. Land improvements (think sidewalks and curbs) last only 15 years. But remember, it’s the building, not the land, that depreciates in value.
By taking advantage of bonus depreciation while the deduction is still in play, owners and investors can reduce setup expenses because they can deduct more money from your taxes in the initial years of property ownership. But bonus depreciation can still pack a big tax punch as it phases itself out over the next five years. Even if buying a property wasn’t on the 2022 agenda, real estate players might want to consider moving any anticipated future purchases ahead by a few years for some significant tax savings. Another advantage of real estate bonus depreciation is that you can claim larger deductions all at once rather than having to spread them out over a number of years. This will lower the year-end tax burden, allowing more money in a portfolio to grow.
Bonus depreciation has advantages, but there are also reasons why you might decide against using it. If you use bonus depreciation, depreciation recapture may apply when you sell the asset. This implies that you can be required to reimburse a portion of the original value that was subtracted, so run this by a certified tax professional if you haven’t already.
There’s no word from Congress to suggest that the bonus depreciation’s demise will be halted, and without any legislative change, the bonus depreciation dedication will disappear for good. But don’t think the erasure of this tax perk is a harbinger of doom for investing in real estate. The 1031 Exchange is an attractive tax option as it allows for the deferment of capital gains tax, which frees up more money for a replacement property. And again, bonus depreciation won’t dissolve from the tax code entirely come New Year’s Day. Still, the phase-out of this desirable deduction means that owners and investors need to be on their toes about their future tax liability.