Bonus Depreciation is Phasing Out: Here’s What You Should Know

When I started a dental practice, I thought the goal was to have the highest production possible. At least that’s what all the “dental gurus” were telling us to focus on.

That meant spending tens of thousands of marketing dollars annually to get patients in the chair. Next, we then had to provide top notch customer service to get them to say “Yes” to our treatment recommendations. 

Most goals early in my career were focused only on making more money, even if it was strictly taxable income. I didn’t care how hard I worked; it was all about providing the most possible for my family. 

But as I’ve gotten older and noticed the physical effects dentistry takes on our bodies, I realized something had to change. The wakeup call was a minor wrist injury while snow skiing. After this happened, I realized that I couldn’t rely on dental income forever. 

I needed to learn to work SMARTER and not harder. Luckily, I found out what an incredible opportunity real estate can provide to allow us to not only make MORE, but also KEEP more of what we earn.

Real estate investing allows you to lower your overall tax bill thus keeping more income in your pocket (where it belongs).

My favorite investment, real estate syndications, offer tremendous tax advantages versus those investing in equities via a 401k. But some of these tax benefits are starting to phase out in the upcoming years.

One of these is bonus depreciation that could allow investors to deduct the ENTIRE cost of capital improvements (via cost segregation study) in the same tax year the expense was incurred. 

In this article, we’ll look at both depreciation and bonus depreciation along with how it’s being phased out so you can develop a plan of how this could impact your investments. 

Disclaimer: I’m a periodontist and NOT a tax advisor. Take everything in this article with a grain of salt and make sure you consult with your tax professional regarding your own unique tax situation. 

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Key Takeaways

  • My personal journey in dentistry led me to realize the importance of working smarter, not harder, and the benefits of real estate investment for generating passive income and tax advantages.
  • Real estate depreciation allows investors to write off property value over time due to wear and tear, providing substantial tax benefits.
  • There are three main types of depreciation in real estate: straight-line, accelerated, and bonus depreciation, each offering different advantages for investors.
  • The Tax Cuts and Jobs Act (TCJA) significantly expanded bonus depreciation, but it is now phasing out over the coming years, affecting tax strategies for investors in real estate syndications and other asset classes.
  • Understanding the phase-out timeline and its implications is crucial for investors to adapt their strategies and maximize tax benefits.
  • As tax laws constantly change, staying informed and adapting investment strategies accordingly is essential for achieving financial independence through real estate investments.
  • Consult with a tax professional to ensure proper understanding and application of tax laws in your unique situation.

How Depreciation Works in Real Estate

Before we get into a discussion about bonus depreciation, let’s start off with a brief review of real estate depreciation in general. 

Depreciation is something the IRS gives real estate investors which allow them to write off their property over time. This allowance is due to the wear and tear and deterioration of the property.

Under current law, investors can use depreciation deductions each year from pre-tax income to recover the cost basis of a property over the calendar years in which they own the property.

What’s Makes Depreciation So Great?

There’s 4 main ways to get paid with real estate:

  1. Rental income
  2. Property appreciation
  3. Mortgage paydown (via tenants)
  4. Tax break and advantages

As previously discussed, depreciation recognizes the fact that buildings, appliances, flooring, etc. wear out and need to be replaced and the IRS allows us to write these off over time. 

Something else to consider is that once the property sells, depreciation differs in that it’s recaptured at a LOWER rate.

Related article: Depreciation Recapture – How It Works When Selling Property

When investing in a property, you’re initially able to take a maximum deduction that could be worth up to 37% on your federal return in taxes but then only must pay 25% when it’s recaptured.

This difference (arbitrage) between the rates also should make us realize that there’s a time value of money

Depending on the type of depreciation used (straight line, accelerated or bonus), you may get to save on taxes for up to 39 years before having to pay them. Plus, there’s other ways you can potentially avoid paying taxes all together via a 1031 exchange.

Once you pass on, your heirs get the step up in basis at death thus the depreciation may never be recaptured.

In real estate, there are three main types of depreciation:

3 Types of depreciation

#1. Straight-line depreciation

The IRS allows owners of residential rental property to depreciate their property over 27.5 years.

For example, the annual depreciation expense of a single-family rental home with a value of $220,000 would be $8,000 ($220,000/27.5 = $8,000).

#2. Accelerated depreciation

The next type of depreciation is accelerated depreciation. To utilize this, an engineering group is hired to perform a cost segregation study

This allows different components of a building to be depreciated over shorter time schedules of 5, 7, and 15 years by identifying all the non-structural elements along with any land improvements.

For instance, a cost segregation study identifies components, such as appliances, as having a 5-year useful life vs 27.5 years as most don’t last that long.

Accelerated depreciation creates larger paper losses in the early years the property is owned which has the effect of giving the investor more depreciation benefit upfront.

This is especially good for the passive investor as many of the real estate syndication deals (i.e. apartment buildings) have a 5-7 year hold time.

#3. Bonus depreciation

The third type of depreciation in real estate is 100 percent bonus depreciation that allows a taxpayer to front load the depreciation even more.

By utilizing this, investors and business owners are allowed to depreciate items with less than a 20-year life immediately in the first year. How bout them apples?

Brief Bonus Depreciation History Lesson

Under Internal Revenue Service Code Section 168(k), the Tax Cuts and Jobs Act (TCJA) significantly expanded bonus deprecation.

Previous law

Under Pre-TCJA law, businesses could claim a depreciation deduction of 50% of the basis of new assets (vehicles, office furniture, machinery, software, computers, etc.) placed in service in 2017. Used assets did NOT qualify for the deduction.

Also, 50% bonus depreciation could be claimed for qualified improvement property (QIP). This is defined as any qualified improvement of a nonresidential building’s interior if placed under service AFTER said building was placed in service. 

QIP costs did NOT include costs for:

  • building enlargement
  • escalator
  • internal structural framework
  • elevator 

TCJA changes (New law)

After the TCJA went into effect, investors could then take a 100% first-year bonus depreciation deduction on assets such as commercial real estate (i.e. syndication investments) placed in service between September 28, 2017 and December 31, 2022.

It also had to fall within the definition of a “qualified property”.

In other words, the 100% first-year bonus depreciation benefit was set up to be temporary in nature.

How Bonus Depreciation Works

In a nutshell, Congress wants to stimulate the economy as it spurs growth and more importantly to them, taxes. This is one of the main reasons they developed bonus depreciation. 

It encourages business owners to purchase assets as they can accelerate depreciation to write off MORE of the cost in the year, they began using it.

Here’s a breakdown of 3 steps to take advantage of bonus depreciation:

#1. Purchase qualified business property

This includes:

  • Qualified improvement property – as stated above, includes improvements to interiors of “nonresidential real property” (i.e. commercial building), as long as the improvement is made after the building is open for business.
  • Property with a useful life of 20 years or less. Examples include equipment, vehicles, furniture, fixtures, and machinery. It doesn’t include buildings or land.

  • Computer software

  • Some listed property. This includes property that tends to be used for both business and personal use, such as vehicles. To qualify for bonus depreciation, it has to be used for business at least 50% of the time.

  • Costs of qualified film or television productions and qualified live theatrical productions

#2. Place property in service

This means you must start using the asset in your business.

For example, if you’re a dentist and purchase a new x-ray machine in December 2022, but don’t start using it until January 2023, you’d have to wait until you file your 2023 tax return to claim bonus depreciation on it.

#3. Claim bonus depreciation on your tax return

You can write off up to 100% of the cost of the asset on Form 4562, which gets filed along with your business tax return.

Bonus Depreciation Phase Out Timeline

As previously mentioned, 2022 is the last year investors can take full advantage of 100% bonus depreciation.

Here’s the phase-out threshold schedule:

  • 2017 to end of 2022: 100% bonus depreciation
  • 2023: 80% bonus depreciation
  • 2024: 60% bonus depreciation
  • 2025: 40% bonus depreciation
  • 2026: 20% bonus depreciation
  • 2027: 0% bonus depreciation

As a passive investor, any investments made by December 31, 2022, are eligible for 100% bonus depreciation.

Of course, Congress could pass legislation to extend or revise any of these phase out rules.

Bonus Depreciation Example

Dr. B decides to make a capital investment of $100k in a multifamily syndication located in Georgia. The deal closed in the same current tax year at that time (2022). In March of 2023, he was sent a K-1 which showed a paper loss of $80k. In this scenario, this represents 100% bonus depreciation. 

If he’d invested in the same asset a year later (2023), he’d received a K-1 in 2024 which would show a 80% bonus depreciation. His paper loss would be $64k vs $80k. 

Here’s a list of implications for each year of his investment from 2022 -2026 (assuming the same asset + cost segregation/depreciation potential:

  • 2022: 100% bonus deprecation = $80k paper loss
  • 2023:  80% bonus deprecation = $64k paper loss
  • 2024:  60% bonus deprecation = $48k paper loss
  • 2025:   40% bonus deprecation = $32k paper loss
  • 2026:   20% bonus deprecation = $16k paper loss

In this example, Dr. B’s depreciation would be $64k LOWER in 2026 vs investing in 2022. For the same investment, his paper loss for 2026 taxes would include a fraction of the depreciation for the same asset applied to his taxes. 

The phase out of bonus depreciation could mean a substantial shift to your overall tax burden if you’re able to apply passive losses to other passive income streams. Also, lower bonus depreciation means you’ll have less depreciation carried forward in the future which means an overall higher tax liability. 

If you’re uncertain about your situation, make sure you check with your tax professional.

What Happens Next?

Tax laws are constantly changing and if we don’t change with them, we’ll get left behind. Each time something like this happens, the IRS basically passes new laws which help guide us in where we should invest our money. 

For instance, they’ll give tax breaks to business owners and real estate investors. Why? New businesses and people investing in real estate create jobs and a place for people to live.

The IRS doesn’t want to own a bunch of businesses or deal with tenants, so they offer tax advantages for others to do it for them. 

This is something that Robert Kiyosaki’s CPA, Tom Wheelwright, discussed when we sat down for an interview below:

Whether bonus depreciation stays around or not, the fundamentals of real estate investing stay the same. You’re still able to create passive income streams, hedge against inflation, and continue receiving great tax advantages.

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