Bonus depreciation is a powerful tax benefit but even some of the most seasoned real estate investors have never heard of bonus depreciation. Why not?
It’s traditionally been a tax benefit reserved for developers that build new buildings. So unless you’re a developer or invest in new development, it’s probably not been on your radar.
Thanks to the Tax Cuts and Jobs Act of 2017 (TCJA), it’s no longer a tax benefit only for developers. Bonus depreciation has been expanded to include used properties as well. Additionally, the Tax Cuts and Jobs Act of 2017 doubled the bonus depreciation deduction from 50% to 100%. However, the 100% bonus depreciation can only be used for properties acquired between September 28, 2017 and December 31, 2022.
Under current law, 100% bonus depreciation will be phased out in steps for property placed in service in calendar years 2023 through 2027. Thus, an 80% rate will apply to property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026, and a 0% rate will apply in 2027 and later years.
In its simplest form, depreciation is the reduction of value of an asset over time. And we all know most things lose value with the passage of time. For these assets, the IRS typically allows businesses to take a tax deduction for that declining value. They call that tax deduction depreciation.
However, it isn’t universally true that all assets decline in value over time; some assets appreciate. And real estate is one of those assets that tend to appreciate with time.
What’s unique about real estate is that despite its history of appreciation, the IRS still allows investors to claim depreciation. And historically speaking, they allow owners of resident-occupied real estate to depreciate their property over 27.5 years.
So a property with an improvement value (excludes the value of land) of $27.5 million would yield $1 million in depreciation ($27.5 million value/27.5 years) each and every year for the next 27.5 years.
That’s straight-line depreciation and it’s a great benefit.
For those that want to front-load the depreciation benefit, they can accelerate their depreciation utilizing a cost segregation study. Cost segregation identifies all of the non-structural elements of the property along with the improvements to the land.
Instead of depreciating those items over 27.5 years, they can be accelerated over a 5, 7, and 15-year timeframe. That accelerated depreciation has the effect of giving the investor more depreciation benefit in the early years of ownership.
Bonus depreciation is a form of accelerated depreciation that allows you to take 100% of the accelerated benefit and utilize it all in year one of ownership. It’s an amazing perk, but it doesn’t last forever. The 100% full benefit only apply to properties acquired through the end of this year and ultimately gets phased out by 2027!
To better illustrate the potential impact of bonus depreciation to the right person, let me share a hypothetical example that closely mirrors the benefit that some of our investors are enjoying.
John is a Radiologist who is part of a multi-partner group that covers several hospitals and free-standing imaging centers. His earned income is derived from the work he does at one of those facilities.
However, because he’s a partner in the group, he also derives passive business income from the other facilities that he doesn’t actively work in. John has a successful practice and his total combined income is in excess of $700,000 a year.
He makes around $400,000 as earned income and another $300,000 as passive K-1 income from the business. Make no mistake; John is paid well. He also pays a ton of taxes. At least he used to.
When John learned about bonus depreciation, he started investing in apartments.
He invested fractionally in two properties in late 2017 and two more in 2018.
Because of 100% year one bonus depreciation, John received depreciation deductions of $64,325 and $57,275 on his first two properties in 2017. Combined that benefit totaled $121,600.
That meant he could claim a $121,600 paper loss (depreciation) on his taxes even though he actually made $300,000. His syndicator reported that paper loss on his year-end K-1. It’s considered a passive activity loss.
The interesting point here is that the $300,000 of income he gets from the business is considered income from a passive activity. And the IRS allows losses from passive activities to be taken against passive activity income, regardless of the source.
That’s just a long way of saying that John could use his bonus depreciation from his real estate investments to offset his passive income from the Radiology business.
Mathematically, here’s how it looks.
$300,000 passive activity income – $121,600 passive activity loss = $178,400 in taxable passive income. Assuming a 39.6% tax rate, John saved almost $50,000 in real dollars on his taxes in 2017.
That’s the difference between paying taxes on $300,000 versus paying taxes on $178,400. And bonus depreciation made it all possible.
$300,000 x 39.6% = $118,800 of tax due without bonus depreciation.
$178,400 x 39.6% = $70,647 of tax due with bonus depreciation.
Given his tax savings, it’s no surprise that John invested in two more properties in 2018. On those two properties, he received first-year bonus depreciation deductions of $73,200 and $64,550.
The previous two properties purchased in 2017 did not have any bonus depreciation in 2018. However, he still received straight-line depreciation on the structural elements of those properties in the amount of $8,000 and $6,250 respectively. He’ll continue to get that benefit each and every year for the next twenty-five-plus years.
When the depreciation deductions from those four properties are added up, John’s depreciation benefit was $152,000 ($73,200 + $64,550 + $8,000 + $6,250). That amount got subtracted out from his K-1 passive activity income of $300,000 leaving him with $148,000 of taxable passive income.
In 2018, the top Federal tax bracket fell to 37%. So his depreciation benefit allowed him to pay $54,760 in taxes on $300,000 instead of the $111,000 of tax he would have paid had he not utilized the depreciation benefit. That’s a savings of $56,240.
For most people, taxes are easily their biggest expense. Every dollar they spend in tax is a dollar they can’t use to secure their financial future.
The highly tax-advantaged nature of real estate is one of the reasons they invest in apartments. However, bonus depreciation has taken it to the next level for the right person.
You don’t have to have income as high as John’s, but you do need to have K-1 passive activity income from other sources. Earned income simply doesn’t count. The key is the K-1. So, if you invest in an apartment syndication, you receive a K-1, and therefore, a prime candidate for this benefit.
Don’t delay, this is important!
Consider what some of our investors have been able to achieve utilizing this benefit. For example, our average investor has realized 50% of their initial investment in bonus depreciation in year one.
So, people who invested $50,000 got $25,000 in depreciation. Those that invested $100,000 got roughly $50,000 of depreciation and those that invested $200,000 got a $100,000 benefit.
If not, you could be leaving tens of thousands of dollars on the table that goes to Uncle Sam instead of your bank account.
So if you’re a businessperson, someone who invests in businesses, or in group practice like doctors, lawyers, accountants, and others, it’s very possible that you receive K-1 passive activity income.
We have a lot of these people in our family of investors. And many of them are adding real estate as fast as they can. Why wouldn’t they? After all, this is a significant benefit and it’s not going to last forever.
Having a profitable investment that saves you money on taxes, pays ongoing yield, and provides back end equity growth is hard to beat.