Whether you manage a rental property or you are a personal property owner, understanding how rental property bonus depreciation works is something that is vital to consider. Bonus depreciation is a very important concept in the real estate industry because it allows rental property owners to minimize their set-up costs by taking greater tax deductions during the first year of property ownership. This means that by claiming bonus depreciation they can take higher deductions upfront instead of having to spread deductions over a couple of years, thus, reducing their end-of-year tax bill.
In this article, we will discuss how rental property bonus depreciation works and how to claim bonus depreciation on rental properties.
Related: How to calculate bonus depreciation
Bonus depreciation explained
Bonus depreciation is a tax incentive that allows an immediate deduction of a large percentage of the purchase price of a qualifying asset in the first year that it was put into service, rather than writing it off over time. This special tax deduction can be very useful for expensive machinery or other costly business purchases including rental property.
Unlike with Section 179 deduction, in real estate, bonus depreciation is not limited to an annual dollar amount. That is, there are no dollar limits on the total bonus depreciation deduction that a taxpayer can take each year. A taxpayer can take his full deduction even if it exceeds his income for the year, which results in a net operating loss.
This special depreciation deduction involves deducting a very large depreciation in the first year and then deducting smaller amounts in the following years. For instance, if you spent $5,000 to upgrade kitchen appliances and flooring in a rental property, by claiming bonus depreciation, you can expense the cost right away instead of depreciating it over a number of years. This tax incentive was first enacted by Congress’ Job Creation and Worker Assistance Act of 2002 and then, following the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, there were major changes to the rules for bonus depreciation.
One of the most notable changes was that the TCJA approved 100% bonus depreciation, which allowed the immediate write-off of 100% of the cost of an eligible property that was purchased and placed in service between Sept. 27, 2017, and Jan. 1, 2023, which was 50% before the TCJA. However, this 100% bonus depreciation expires in 2023 as the percentage for bonus depreciation decreases every year by 20% till it phases out in 2027. That is, the percentage for bonus depreciation will be 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% in 2027.
Also, for a property to qualify for bonus depreciation there are certain criteria that must be met. For instance, the property must be owned by the taxpayer rather than rented, used for business or investment purposes, and have a determinable useful life of 20 years or under. The property must not have been used before the taxpayer acquired it and the taxpayer must not acquire it from a relative.
Bonus depreciation can be very useful for landlords and rental property investors. However, in the case of real estate, there are certain laws and regulations surrounding how landlords can claim bonus depreciation on their rental property.
See also: Adjusting Entry for Depreciation
Can you take bonus depreciation on rental property?
In real estate, bonus depreciation can be a powerful tool that an investor can use to significantly reduce his taxable net income because it permits taxpayers to deduct the entire purchase price of a qualifying asset in the first year that the asset is put into service. However, when it comes to rental properties, you can not take bonus depreciation on the actual rental property. This is because rental properties have a minimum depreciation period of 27.5 years and as a result, are not eligible for this special depreciation deduction.
As earlier said, 20 years is the maximum depreciation period for a property to be depreciated using bonus depreciation. Due to this rule, you can’t claim bonus depreciation on a rental property. However, there are several other ways that you can take bonus depreciation on rental property.
Instead of depreciating the rental property itself, landlords and investment property owners can claim rental property bonus depreciation by depreciating other assets in the rental property. Since the rental property has a minimum depreciation period of 27.5 years, rental property owners can only take advantage of this tax incentive on a rental property by claiming bonus depreciation on rental property improvements and personal property that are used within the rental property.
In order to claim bonus depreciation on rental property improvements or any personal property that is used within the rental property, the taxpayer has to write off the bonus depreciation percentage of the improvement or personal property on Form 4562, which he will file along with his business tax return. He will then, report the calculated bonus depreciation on form 4562, under Part II, Line 14 where depreciation and amortization are reported.
Read also: Is Accumulated Depreciation an Expense?
Understanding how rental property bonus depreciation works
Bonus depreciation is an accelerated depreciation method that rental property investors use to substantially reduce their taxable net income. By claiming bonus depreciation for rental property, rental property owners are permitted to deduct the full cost of capital improvements in the same tax year that the expense is incurred. As a matter of fact, many of them were delightfully surprised to know that they can claim 100% bonus depreciation on rental property appliances or improvements that were purchased between 2018 and 2022.
In real estate, the most straightforward way is to claim bonus depreciation for any improvements made to the property. You can even claim both bonus depreciation and Section 179 on rental property improvements. Some investors, in order to optimize how much they can deduct using bonus depreciation, have cost segregation studies done on their rental properties.
Since the rental property has a minimum depreciation period of 27.5 years, which is more than the maximum of 20 years depreciation period required to qualify for bonus depreciation, a cost segregation study can be used. This divides the value of a purchased rental property between the relevant components.
For instance, instead of valuing an entire residential rental property at $100,000, a cost segregation study will divide the value between property components, for example, $85,000 for the house, $5,000 for appliances, and $10,000 for flooring. Since appliances and flooring have less than the 20 years depreciation periods compared to the house itself, the number of appliances and flooring can then be deducted using bonus depreciation. This is a typical example of how investors claim bonus depreciation on residential rental property.
On the other hand, if the regular annual depreciation method is used, the building with a value of $100,000 will typically have $3,636 ($100,000/27.5). But, if an investor commissioned a cost segregation study and discovers that 20% of the value of the building can be reclassified as personal property or land improvements, he could claim bonus depreciation on residential rental property improvements.
Let’s say he deducts $20,000 using 100% bonus depreciation and also enjoys another $2,909 in regular annual depreciation. This means a total depreciation deduction of $22,909 will be made in the first year compared to the $3,636 in regular annual depreciation that he would have deducted through 27.5 years. However, if as an investor, you plan to use the cost segregation method to claim bonus depreciation for your rental property to cut taxes, ensure you work with a qualified tax accountant to file everything correctly.
An example of bonus depreciation for residential rental property
In order to understand how bonus depreciation on rental property works, let’s look at an example. As earlier said, bonus depreciation on a rental property investment can be claimed by conducting a cost segregation study. This means classifying the rental property into depreciation components of 5, 7, 15, and 27.5 years. Let’s say in 2022, an investor, Mr. Peter purchases a single-family residence property (SFR home) listed for sale for $120,000, which includes a $10,000 lot value. That is:
The rental property value of $120,000 – lot value of $10,000= $110,000 cost basis for depreciation
The regular way to calculate the depreciation expense would be to simply divide the value of the property by 27.5 years. This means that the straight-line depreciation expense would be $4,000. That is:
$110,000 cost basis for depreciation / 27.5 years = annual depreciation expense of $4,000
On the other hand, let’s say Mr. Peter commissioned a cost segregation study. This means, by conducting a cost segregation study, he may be able to claim bonus depreciation on the residential rental property that he purchased. For example, let’s assume that according to the cost segregated study done, the SFR home has the following depreciation components:
|Item||Value||Schedule (years)||Depreciation||Bonus depreciation (100%)|
|Total value (excluding lot)||$110,000||$5,522||$18,455|
As seen in the table above, by simply conducting a cost segregation study, Mr. Peter may be able to increase the annual depreciation expense from $4,000 per year to $5,522 per year. However, by combining bonus depreciation with a cost segregation study, he can claim a total depreciation expense of $18,455 in the year that the property is purchased.
As shown above, the Appliances, Flooring, and Fence have a depreciation period of 5, 5, and 15 respectively. According to IRS, you can take bonus depreciation on appliances for rental property and improvements made to the property. As a result, Mr. Peter is able to claim 100% bonus depreciation on the residential rental property improvements and appliances which gives a total of $18,455 that he is permitted to deduct in the first year (2022). This is a typical example of how you can take bonus depreciation on residential rental property.
What qualifies for bonus depreciation on rental property
Bonus depreciation does not apply directly to rental property. When it comes to rental property bonus depreciation, only land improvements, personal property within the rental property, and the improvements made to the rental property qualify for bonus depreciation. In this session, we will be going over all the ways that landlords and investment property owners can use bonus depreciation to their advantage and how it could be used for rental real estate properties.
Bonus depreciation can be taken on rental property for the following qualifying items:
Claiming bonus depreciation on land improvements
Bonus depreciation can be used for a rental property by claiming this special depreciation deduction on land improvements. You cannot take bonus depreciation on the rental property itself but you can depreciate land improvements since they have a 15-year depreciation period. Land improvements involve any work done on the actual land where the rental property is situated or additions (or changes) made to permanent structures on the land other than buildings. Such expenses can be depreciated with bonus depreciation.
Using bonus depreciation, 100% of the cost of land improvements can be deducted in one year from 2018 through 2022. However, for 2023, 80% of the cost of land improvements can be deducted in one year; and 60%, 40%, and 20% of the cost of the land improvements can be deducted in 2024, 2025, and 2026 respectively. Nonetheless, bonus depreciation is optional as land improvements can always be depreciated over 15 years using regular depreciation. Typical examples of land improvements that qualify for bonus depreciation include:
- Retaining wall
- Sprinkler system
- Swimming pool
- Outdoor Lighting
- Drainage facilities
Claiming bonus depreciation on personal property
Bonus depreciation can be taken on rental property by claiming a deduction on personal property. You can claim bonus depreciation on the personal property used within a rental property because a majority of such personal properties have a depreciation period that is fewer than 10 years. By using this tax incentive, you can deduct the entire price of some personal property in a rental property in only a few years.
That is, by claiming bonus depreciation, a rental property owner can deduct a considerable percentage of an asset’s cost in a single year, rather than depreciating the full cost of the asset over several years. The entire cost of an asset can be deducted in the year that it was purchased and put in service with 100% bonus depreciation from 2018 through 2022. However, starting in 2023, the entire cost of an asset that can be deducted in one year with bonus depreciation will be reduced by 20% per year. That is, 80%, 60%, 40%, and 20% of the cost of the asset can be deducted in 2023, 2024, 2025, and 2026 respectively.
Bonus depreciation can be used to deduct any tangible property acquired by purchase. The tangible property can be new or used, but must not have been used by the taxpayer before acquiring it. However, it is important to note that you can’t claim bonus depreciation on a property you previously used for personal use but converted for rental use. For instance, a rental property owner can’t claim bonus depreciation on his former living room couch, that he placed in a rental unit.
Furthermore, rental property owners can apply bonus depreciation for an asset that they use part of the time in their rental activity. Nevertheless, the listed property (for instance cars and light trucks) must be used at least over 50% of the time to qualify for bonus depreciation. Hence, typical examples of personal property that can qualify for bonus depreciation include:
- Automobiles (used for business purposes)
Claiming bonus depreciation on rental property improvements
You can take bonus depreciation on rental property improvements. This permits accelerated tax write-offs for qualifying rental property improvements. According to the Internal Revenue Service, these rental property improvements include any improvement done to the interior of a building such as insulation, plumbing, drywall, and electrical fixtures. They do not include improvements such as the enlargement of a building, the internal structural framework of a building, an elevator, or an escalator.
Any rental property improvements that improve, restore, or result in the betterment of a rental property qualify for bonus depreciation. You can take bonus depreciation for rental property improvements that have a useful life of 20 years or less. These rental property improvements involve any expenses made on a rental property that restore the property, result in the betterment of the property, or adapt the property to a new or different use.
According to IRS Publication 527 (2022) for Residential Rental Property, you can take bonus depreciation on rental property improvements such as:
|Miscellaneous||Interior Improvements||Heating & Air Conditioning||Insulation||Plumbing|
|– Storm windows or doors|
– New roof
– Central vacuum
– Wiring upgrades
– Satellite dish
– Security system
|– Built-in appliances|
– Kitchen modernization
– Wall-to-wall carpeting
|– Heating system|
– Central air conditioning
– Duct work
– Central humidifier
– Filtration system
-Duct work insulation
|– Septic system|
– Water heater
– Soft water system
– Filtration system
Improvements that may result in the betterment of a rental property can qualify for bonus depreciation. That is you can claim bonus depreciation for rental property improvements that:
- Fix a pre-existing defect or condition
- Enlarge or expand the rental property
- Increase the strength, capacity, or quality of the rental property
Such expenses change or add to the rental property. An example of such an improvement is, adding a bedroom in a rental property, to probably increase the monthly rent price and amount of rentable square footage.
Improvements that may be for adaptation can also qualify for bonus depreciation. They include expenses that change part of the rental property to a new or different use. That is improvements that alter the rental property to be used for something else that wasn’t the initial intended use of the rental property. An example of rental property improvements for adaptation would be renovating a basement into a living room or probably converting an attic into a studio apartment.
Improvements that replace a major property component of a rental property can also qualify for bonus depreciation. This includes improvements that may be for restoration or an installation such as replacing a roof, or window, or probably installing a new central HVAC (heating, ventilation, and air conditioning) system.
So, in conclusion, does rental property qualify for bonus depreciation? No, the actual rental property is not eligible for bonus depreciation, but landlords and investment property owners can claim bonus depreciation for personal property used within the rental property or certain improvements done to the property.
Claiming bonus depreciation for rental property improvements and personal property can be advantageous to rental property owners because it allows them to minimize their set-up costs by taking greater tax deductions during the first year of property ownership. This means that by using bonus depreciation they can take higher deductions upfront instead of having to spread deductions over a couple of years. This helps them to reduce their end-of-year tax bill and make profits sooner, instead of having to wait a few years to break even.
Nonetheless, despite the benefits that come with this tax incentive, there are certain drawbacks of bonus depreciation in real estate. There are reasons why some rental property owners may choose to opt-out. For instance, if a taxpayer claim bonus depreciation, he may be subject to depreciation recapture when he or she sells the asset. This means the taxpayer may have to pay back a percentage of the value of the asset that was deducted in the first place.
Therefore, depending on one’s growth strategy, it may not necessarily always make sense to claim bonus depreciation. Hence, it is best to always seek the counsel of your tax advisor.