Depreciation is a non-cash deduction real estate investors use to reduce or sometimes completely eliminate taxable net income from a rental property.
In most cases, an investor must depreciate improvements over their useful life of between 5 and 27.5 years. By claiming bonus depreciation, the entire cost of some improvements can be deducted in a single year instead of waiting for years to recover the expense.
However, investors may wish to move fast, because 2022 is the last tax year to claim 100% bonus depreciation.
- Bonus depreciation was increased to 100% by the Tax Cuts and Jobs Act of 2017.
- 100% bonus depreciation allows a real estate investor to deduct the entire cost of some improvements made in 2022.
- A cost segregation study can be conducted to calculate how much of a newly purchased rental property may be subject to bonus depreciation.
- After this tax year, the amount of bonus depreciation gradually decreases until being phased out in the 2026 tax year.
What is bonus depreciation?
Bonus depreciation allows an investor to deduct the entire cost of an improvement with a useful life of 20 years or less in the year the cost is incurred. For example, if $5,000 is spent to upgrade kitchen appliances and flooring in a rental property, the cost can be expensed right away instead of being depreciated over a number of years.
When the Tax Cuts and Jobs Act (TCJA) was passed in 2017, the bonus depreciation expense for improvements was increased from 50% to 100%. However, investors may wish to act fast, because the 100% bonus depreciation is only available through the end of the 2022 tax year. After that, this bonus deduction gradually decreases until it expires at the end of 2026.
Note that the depreciation schedule of 27.5 years for residential rental property remains unchanged, even when bonus depreciation is entirely phased out.
Bonus depreciation versus normal real estate depreciation
Bonus depreciation is arguably one of the biggest benefits of owning a rental property in need of repair, because the deduction can have a significant impact on taxable net income. By reducing taxes owed, an investor may be able to have extra money to make improvements that can increase rental income and cash flow for years to come.
Let’s assume an investor spends $5,000 to upgrade appliances in the kitchen and to replace worn-out carpeting. Normally appliances and attached carpeting are depreciated over a useful life period of 5 years, even if they last several years longer. By claiming bonus depreciation, an investor may claim the entire expense in a single tax year.
The following example compares bonus depreciation to normal depreciation in a $120,000 single-family rental (SFR) property:
|Normal depreciation||Bonus depreciation|
|Gross rental income||$18,000||$18,000|
|Taxable net income||$1,637||$0|
Residential rental property is depreciated over 27.5 years, and appliances and flooring over 5 years, as shown in the normal depreciation column above.
However, by claiming bonus depreciation and deducting the entire cost of the appliances and flooring in a single year, an investor is able to reduce taxable net income to $0 and may be able to carry forward the loss of $9,363 to use as a deduction in future tax years.
How to claim bonus depreciation on a new rental property investment
Many investors are pleasantly surprised to learn that they may be able to claim 100% bonus depreciation on a rental property that is purchased in 2022. Bonus depreciation on a new rental property investment can be claimed by conducting a cost segregation study and classifying a property into depreciation components of 5, 7, 15, and 27.5 years.
To illustrate, let’s say an investor purchases an SFR property listed for sale on Roofstock for $120,000, which includes a lot value of $10,000. One way to calculate the depreciation expense is simply to divide the property value by 27.5 years. Because land doesn’t depreciate, the straight-line depreciation expense would be $4,000:
- $120,000 rental property value – $10,000 lot value = $110,000 cost basis for depreciation
- $110,000 cost basis for depreciation/27.5 years = $4,000 annual depreciation expense
However, by conducting a cost segregation study, an investor may be able to claim bonus depreciation on a property that was recently purchased. For example, assume that the SFR home in this example has the following depreciation components based on a cost segregation study:
|Total value (excluding lot)||$110,000||$5,522||$18,455|
As illustrated above, an investor in this example may be able to increase the annual depreciation expense from $4,000 per year to $5,522 per year simply by conducting a cost segregation study.
But, by combining the power of bonus depreciation with a cost segregation study, the investor in this example is able to claim a total depreciation expense of $18,455 in the year the property is purchased.
Bonus depreciation is being phased out
The benefit of 100% bonus depreciation is effective until the end of the 2022 tax year, after which bonus depreciation is gradually phased out. Improvements with a useful life of 20 years or less may be depreciated 100% this year, and will be gradually phased out over the next 5 years:
|Tax year||Bonus depreciation|
|2027 and beyond||0%|
Improvements made to a rental property this year may be deducted 100%. But, the longer an investor waits, the lower the bonus depreciation benefit is.
Repairs versus improvements in a rental property
One of the keys to claiming bonus depreciation is understanding the difference between a repair and an improvement.
For tax deduction purposes, the cost of a repair is generally deducted from gross rental income the same tax year the cost was incurred. Repair expenses include work that keeps a rental property in good condition, such as painting a room, fixing a leaky sink, or cleaning the carpet in between tenants.
By contrast, an improvement is something that betters, adapts, or restores a property. A good trick for understanding the difference between a repair and improvement is the BAR acronym:
Materially adds to or changes a rental property, such as adding a bedroom to increase the amount of rentable square footage and the monthly rent price.
Changes part of a rental property to a new or different use, such as renovating a basement into a separate living unit or converting an attic into a studio apartment.
Replaces a major property component, such as installing a new central heating, ventilation, and air conditioning (HVAC) system or replacing a roof.
Understanding the BAR acronym also helps you understand what work can and can’t be claimed as bonus depreciation. Provided an improvement has a useful life of 20 years or less, bonus depreciation may be able to be claimed. However, an improvement that is added to the structure, such as an HVAC or roof, generally does not qualify for bonus depreciation and must be depreciated over 27.5 years.
Bonus depreciation recapture
When a rental property is sold, bonus depreciation is recaptured and taxed the same way that other forms of depreciation are. Recaptured depreciation is taxed as regular income, but only up to a maximum rate of 25%. In other words, if an investor is in an upper income tax bracket of 32% or more, depreciation recapture tax is capped at 25%.
To illustrate how depreciation recapture works, assume an investor purchased a $120,000 SFR property and decides to sell. The annual depreciation on the house is $3,455 and the 100% bonus depreciation based on a cost segregation study is $15,000. If an investor in an upper tax bracket decides to sell 2 years from now, the depreciation recapture and tax might be:
|Item||Depreciation recapture||Tax liability|
Based on this example, the potential tax liability from bonus depreciation recapture and normal depreciation recapture would be $5,478. However, because every investor’s tax situation is different, an investor may wish to consult with a tax professional or CPA to better understand tax liability when selling a rental property.
Making improvements to a rental property can help you increase gross rental income, annual cash flow, and property value. Bonus depreciation allows an investor to make improvements and deduct the entire expense in the same tax year, rather than recovering the cost over a number of years. By claiming bonus depreciation, a real estate investor may be able to reduce or eliminate taxable net income and carry forward any unused loss to upcoming tax years to offset future income.