Depreciation is a crucial concept in real estate investing that can significantly impact an investor’s tax liabilities and overall investment returns. In this article, we will explore the concept of depreciation in real estate, the history and meaning of bonus depreciation, how accelerated bonus depreciation works, and what bonus depreciation recapture entails. We will also provide examples with numbers to help illustrate these concepts. In our next article, we will delve deeper into bonus depreciation recapture.
Disclaimer: The information provided in this article is for educational purposes only and should not be considered financial, tax, or legal advice. The author is not a Certified Public Accountant (CPA), and the content presented here is not intended to serve as professional advice or services. Investors are strongly encouraged to consult with their own CPA or financial advisor before making any decisions related to real estate investments or taxes.
What is Depreciation in Real Estate?
Depreciation is a tax deduction that allows real estate investors to recover the cost of income-producing property over a predetermined period. The Internal Revenue Service (IRS) recognizes that buildings and other physical assets deteriorate over time, reducing their value. Therefore, depreciation allows investors to allocate the cost of the property over its useful life, lowering taxable income and potentially saving money on taxes.
How Does Depreciation Work in Real Estate?
Depreciation in real estate is calculated based on the property’s cost basis and useful life. The cost basis includes the purchase price, plus any improvements made to the property, minus the value of the land. The useful life, also known as the recovery period, is the number of years the IRS determines a property should last. For residential rental property, the recovery period is 27.5 years, while commercial property has a recovery period of 39 years.
To calculate annual depreciation, divide the property’s cost basis by its recovery period. For example, a residential rental property with a cost basis of $275,000 and a recovery period of 27.5 years would have an annual depreciation of $10,000 ($275,000 / 27.5).
What is Bonus Depreciation?
Bonus depreciation is a tax incentive that allows businesses, including real estate investors, to deduct a substantial percentage of the cost of qualifying assets in the year they are placed in service. This provision accelerates the depreciation deductions and can lead to substantial tax savings in the short term. The Tax Cuts and Jobs Act of 2017 (TCJA) increased the bonus depreciation rate from 50% to 100% for qualifying property acquired and placed in service after September 27, 2017, and before January 1, 2023.
How Accelerated Bonus Depreciation Works?
Accelerated bonus depreciation allows investors to deduct a larger portion of an asset’s cost basis in the early years of its useful life, decreasing taxable income and providing an immediate tax benefit. It is important to note that bonus depreciation applies only to qualifying property, which includes tangible personal property with a recovery period of 20 years or less, such as appliances, carpeting, and certain improvements made to real estate.
Let’s say an investor purchases a commercial property for $1 million, with $200,000 allocated to land and $800,000 to the building. The investor also spends $100,000 on qualifying improvements, bringing the total cost basis to $900,000.
Under the 100% bonus depreciation rule, the investor can deduct the entire $100,000 for improvements in the first year, resulting in a taxable income reduction of $100,000. The remaining $800,000 can then be depreciated over the 39-year recovery period for commercial property.
What is Bonus Depreciation Recapture?
Bonus depreciation recapture occurs when a property is sold, and the IRS requires the investor to “recapture” any depreciation deductions previously taken, essentially paying back the tax savings. The recaptured depreciation is taxed as ordinary income, up to a maximum of 25%, depending on the investor’s tax bracket.
How Bonus Depreciation Recapture Works?
When a property is sold, the investor must calculate the total depreciation taken on the property, including any bonus depreciation. This amount is then subtracted from the property’s adjusted cost basis to determine the taxable gain. The portion of the gain attributable to the recaptured depreciation is taxed as ordinary income, while any remaining gain is generally taxed at the more favorable capital gains tax rate.
Using the previous example, let’s assume the investor sells the commercial property after five years for $1.2 million. Over the five-year holding period, the investor claimed $100,000 in bonus depreciation and $102,564 in regular depreciation (5 years x $20,513 annual depreciation), totaling $202,564 in depreciation deductions.
The adjusted cost basis is calculated as follows:
Original cost basis: $900,000
Total depreciation taken: -$202,564
Adjusted cost basis: $697,436
The taxable gain on the sale is then calculated:
Sale price: $1,200,000
Adjusted cost basis: -$697,436
Taxable gain: $502,564
Of the $502,564 taxable gain, $202,564 is attributable to the recaptured depreciation and taxed as ordinary income. The remaining $300,000 gain is taxed at the capital gains tax rate.
Understanding bonus depreciation and its recapture is crucial for real estate investors looking to maximize their tax savings and overall returns on investment. The ability to deduct a large portion of an asset’s cost basis upfront can provide significant short-term tax benefits, while being aware of the potential tax implications upon sale can help investors better plan for their long-term financial goals. In our next article, we will explore bonus depreciation recapture in greater detail, offering insights and strategies to help you make informed decisions in your real estate investment journey.
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