Taxpayers are always on the hunt for ways to get more money back from the IRS in their annual returns, especially taxpayers who have invested their money into various properties and assets within those properties. These deductions for a given tax year can work in favor of an investor and their real estate portfolio. One of the ways businesses are getting their portfolio to work for them during tax season is through what's called bonus depreciation. Let's take a closer look at what this means for your properties, and why you as a taxpayer should capitalize on it while you can.
1. What is bonus depreciation?
As far as the tax code goes, some investors may not be aware of the benefits of bonus depreciation for their annual filing. Bonus depreciation is a tax incentive that allows businesses to immediately deduct a large percentage of the purchase price of eligible assets, rather than writing off over the "useful life" of the asset. Also known as an additional first-year depreciation deduction, this incentive has become of tremendous benefit to small business owners by allowing them to file claims on bonus depreciation for qualifying personal property used for business purposes.
Qualified property can include residential rental property and nonresidential real property that's having modifications made. However, there are specifics on that type of property that have evolved over the years. When a business makes an acquisition like machinery, the cost for tax accounting purposes has traditionally been spread out over the useful life of that asset.
Congress introduced this asset in 2002 in the Job Creation and Worker Assistance Act, allowing small businesses the ability to recover the cost of capital acquisitions. This was intended to drive an economic bounce back. Bonus depreciation must be taken in the first year that the depreciable item is placed in service, so be sure to consider the timing of the depreciation expense to make sure that it's made applicable to that given tax year.
2. What property qualifies for bonus depreciation?
Using bonus depreciation, you can deduct a certain percentage of the cost of an asset in the first year it was purchased, and the remaining cost can be deducted over a given time period using regular depreciation. If this isn't applied, it could have a long-term impact on a company’s financial statement. This could end up showing smaller profits or larger losses for the year it made the acquisition. Eligible property for the bonus depreciation deduction varies based on federal law for a depreciated asset. This was adjusted years ago for federal tax purposes to drive stimulus, especially for investors in small businesses.
Small businesses use this incentive for qualified improvement property. This refers to any improvement to a building's interior. However, this excludes improvements that are attributed to the enlargement of the building or the internal structural framework. An expansion of this law under the definition of Section 179 allows taxpayers to elect to include improvements made to roofs, HVAC units, fire protection systems, alarm systems, and security systems. Recent adjustments to the tax code have also expanded the amount of the deduction.
3. What are the current rules regarding depreciation?
Adjustments to the tax code have changed how much investors can deduct over time with bonus depreciation. The maximum deduction was raised from $500,000 to $1 million, with an increase in the phase-out threshold from $2 million to $2.5 million. For taxable years after 2018, the amounts have been adjusted for inflation. The new law has also increased the bonus depreciation percentage from 50% to 100% for qualified property acquired and placed in service after September 27, 2017, and before the new year begins. For property acquired before that time, the rate remains at 50%. Special rules will apply for longer production period property and particular pieces of equipment.
Depreciation limits have changed for particular assets with adjustments to the tax code, depending on whether or not taxpayers claim the bonus depreciation allowance. If it's unclaimed, a taxpayer can get a maximum of $10,000 for the first year. If they claimed 100% bonus depreciation, the greatest allowable depreciation deduction for that first year is $18,000. With each future tax year leading to decreasing values on that allowable deduction, it's important to recognize that the next subsequent tax year will impact the valuation on the depreciation subject. Changes to the tax codes have also removed certain equipment from the definition of listed property, such as computers and peripheral equipment. This change applies to property placed in service after December 31, 2017.
4. Why is this deduction getting phased out?
The bonus depreciation deduction will soon be a thing of the past. The Tax Cut and Jobs Act made major changes to the rules on bonus depreciation back in 2017, with the main goal of reducing the amount of time it takes taxpayers to file. However, the act is set to expire on January 1 of next year, those provisions disappearing unless Congress elects to renew. The 100% depreciation rate will deduct to 80% for 2023, then down to 60% in 2024, 40% in 2025, and 20% in 2026. After that, changes to the tax law including the bonus depreciation deduction will revert back to pre-TCJA regulations.
The reason that this phase-out is happening is primarily because of adjustments under President Biden's tax plan. This includes a proposal for a minimum corporate income tax equal to 15% of a company’s book income. This could hamper small businesses as they may not be able to fully utilize bonus depreciation. Bonus depreciation lowers taxable income, not book income, which means that certain capital-intensive businesses might not be fully eligible for these deductions.
That's why it's important to take advantage of the 100% depreciation deduction rate while you still can. Businesses should use IRS Form 4562 to record bonus depreciation, as well as other types of depreciation and amortization. Having this adjustment for an applicable period for assets could be a game-changer to saving on a piece of equipment or repairs made to your investments.
About the Author:
Annie Dickerson and her partner Julie Lam are founders of Goodegg Investments — an award-winning real estate private equity firm — and creators of the Real Estate Accelerator Mentorship Program. They are authors of the book Investing For Good and hosts of the popular Life & Money Show podcast: good egg investments