Bonus depreciation on residential rental property improvements

Taxpayers can take bonus depreciation on residential rental property improvements but not on the actual rental property. There are qualified improvement properties that are eligible for bonus depreciation, thus, allowing taxpayers to deduct a large percentage of the cost of the qualified improvement property.

Claiming this special depreciation deduction for qualified improvement property impacts owners of real estate and leaseholders by lowering their cost of capital. It accelerates the depreciation of qualified improvement property and defers payment of tax on income, thus, lowering the pre-tax rate of return. In this article, we will discuss how bonus depreciation on residential rental property improvements works with examples of the kinds of improvements that are eligible for deduction.

Related: How to calculate bonus depreciation

Bonus depreciation explained

Bonus depreciation is a tax incentive that allows business taxpayers to write off a huge percentage of the cost of an eligible asset in the first year that it was purchased while the remaining cost of the asset can be deducted using regular depreciation over multiple years until it completely phases out. When it comes to rental properties, bonus depreciation is one of the biggest and most important deductions for real estate investors. This is because it helps reduce taxable income without reducing cash flow.

In real estate, the land is never depreciated. Hence, several landlords aim to allocate a large percentage of the purchase price of the property to the building value in order to maximize the depreciation expense. However, bonus depreciation on a residential rental property only applies to improvements and not to the actual rental property because residential rental properties have a useful life of more than 20 years.

For real estate investors, claiming bonus depreciation on residential rental property improvements delivers far more tax savings benefits than the straight-line or declining-balance depreciation methods for property improvements.

Compared to the straight-line and declining-balance depreciation methods that stretch out depreciation deductions over multiple years, bonus depreciation permits taxpayers to deduct 100% of the cost of a qualifying improvement in the first year of its use. This means that improvement expenses are treated the same as maintenance and repair expenses which are deductible in the tax year incurred.

See also: What qualifies for bonus depreciation?

Understanding bonus depreciation on residential rental property improvements

By claiming bonus depreciation, business taxpayers can deduct the entire cost of an eligible property in the first year that the property is put into service. However, when it comes to rental property, they cannot take bonus depreciation on the property itself because for an asset to be eligible for this special depreciation deduction, it has to have a useful life that is less than 20 years.

Therefore, since residential rental properties have a minimum depreciation period of 27.5 years, taxpayers can only claim bonus depreciation on residential rental property improvements and personal property that are used within the rental property. In order to claim bonus depreciation on residential rental property improvements, you have to write off the bonus depreciation percentage of the improvement on Form 4562, which you file along with your business tax return. You report the calculated bonus depreciation on form 4562, where businesses report depreciation and amortization, under Part II, Line 14. 

Bonus depreciation allows accelerated tax write-offs for qualifying residential rental property improvements and according to the Internal Revenue Service, these improvements include any improvement to the interior of a building. As stated by the IRS, qualifying improvements do not include the internal structural framework of a building, enlargement of a building, an elevator, or an escalator, rather, they include interior improvements like plumbing, drywall, insulation, and electrical fixtures.

Residential rental property improvements will qualify for bonus depreciation if they improve, restore or result in the betterment of the rental property. Bonus depreciation can be claimed on such improvement as far as it has a useful life of 20 years or less. Expenses made on a residential rental property that results in the betterment of the property, restore the property, or adapt the property to a new or different use are categorized as qualified residential rental property improvements.

Betterments

Expenses that may result in the betterment of a residential rental property include expenses for:

• Fixing a pre-existing defect or condition
• Enlarging or expanding the property
• Increasing the capacity, strength, or quality of the property

Such improvements add to or change the rental property and qualify for bonus depreciation. A typical example is adding a bedroom in order to increase the monthly rent price and the amount of rentable square footage.

Adaptation

You can claim bonus depreciation on expenses that may be for adaptation. Such improvements include expenses for altering a property to be used for something else that isn’t consistent with the intended ordinary use of the property when it was initially up for rent. Such improvement changes part of the rental property to a new or different use. A typical example of such residential rental property improvements would be converting an attic into a studio apartment or probably renovating a basement into a separate living unit.

Restoration

You can claim bonus depreciation for residential rental property improvements that replaces a major property component. This includes expenses that may be for restoration such as replacing a window, or roof or an installation of a new central HVAC (heating, ventilation, and air conditioning) system.

Read also: Adjusting Entry for Depreciation

Rules for bonus depreciation on residential rental property improvements

1. Bonus depreciation can be claimed for both new and used property improvement items.
2. The bonus depreciation percentage on residential rental property improvements is 100% for qualified improvements acquired and placed in service between September 27, 2017, and January 1, 2023.
3. From 2023, the bonus depreciation percentage on residential rental property improvements is 80% and deduces by 20% each year till 2027 (i.e 60% for 2024, 40% for 2025, 20% for 2026, and 0% for 2027)
4. Bonus depreciation allows the deduction of a large percentage or full cost of capital improvements in the same tax year that the expense is incurred.
5. For a residential rental improvement to qualify for bonus depreciation, it must have a useful life of 20 years or less and must be purchased from an entity or individual that the taxpayer is not related to.
6. According to IRS Publication 527 (2022) for Residential Rental Property, examples of residential rental property improvements that are eligible for claim bonus depreciation include:

Additions	Lawn & Grounds	Miscellaneous	Interior Improvements	Heating & Air Conditioning	Insulation	Plumbing
Bedroom Bathroom Deck Garage Porch Patio	Landscaping Driveway Walkway Fence Retaining wall Sprinkler system Swimming pool	Storm windows or doors New roof Central vacuum Wiring upgrades Satellite dish Security system	Built-in appliances Kitchen modernization Flooring Wall-to-wall carpeting	Heating system Central air conditioning Furnace Duct work Central humidifier Filtration system	Attic Walls, floor Pipes, duct work	Septic system Water heater Soft water system Filtration system

Read also: Is Accumulated Depreciation an Expense?

Last Updated on November 2, 2023 by Nansel Nanzip Bongdap