Discover the Magic of Bonus Depreciation
What is Bonus Depreciation?
The IRS instituted Bonus Depreciation in September of 2017, allowing you to depreciate 20-40% of the depreciable value in the 1st year.
We go through this process on every building we purchase. This is where we found the true power of bonus appreciation. This section will outline this process and how it can significantly lower your tax liability.
Cost Segregation Study
One of the first action items will be to get a cost segregation study. The cost segregation engineering study is an advantageous tax strategy approved by the IRS in 1997. It is a concept of reclassifying the usual 27.5 years of depreciable life of real estate into “tangible personal property” that is treated as five-year property or land improvements which are treated as 15-year property. This improved tax treatment allows specific components like electrical, plumbing, mechanical systems, and others to be assigned shorter lives translating into more depreciation in earlier years and more cash in your pocket today.
“Cost Segregation Studies are a lucrative tax strategy that should be considered in almost every real estate purchase.” -United States Treasury Department.
The cost segregation studies are broken down into 9 main components. These components are divided into 5 YR, 7 YR, 15 YR, and 27.5 YR property. This is illustrated in the diagram below from our cost segregation study for our Kansas City asset.
What bonus depreciation allows you to lump the 5 YR, 7 YR, and 15 YR categories to deduct in year one.
Depreciation Loss WriteOff
The total depreciation in the above example demonstrates how we were able to write off $274,100(5YR $203,202.30 + 15 YR $40,841.41 + 27.5 YR(826,543.29/27.5=30,056.12) in year 1. We received about 57% of the initial capital infusion back in losses.
Since we bought our property towards the end of the year, we showed very little income and a significant loss due to the bonus depreciation.
Additionally, you can use these losses to offset any passive income from other properties in the same tax year. Otherwise, you can carry forward any additional losses for 20 years to offset future rental income. So eventually, you will use it up.
A Few Things To Know
Keep in mind most states do not accept bonus depreciation; they will only use the 27.5 straight-line depreciation. Therefore, we owed money on our California tax return, so we used more than half of the federal refund to pay the money owed to the state. A ton of cash stayed in our pockets that we could use to invest in other deals. They say that a dollar today is worth more than a dollar tomorrow.
Important though bonus depreciation is being phased out, as shown in the diagram below.
Here are a couple more things to keep in mind when going this route:
You will have less depreciation to write off in later years.
Depreciation recapture for the accelerated portion is taxed as ordinary income at the sale.
“Depreciation recapture is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had used to offset taxable income previously.” -Investopedia.
Another fun fact is if you have already owned real estate for some years, you can do a cost seg and recalculate the missed depreciation. This is allowed once with automatic consent without having to amend your return.
JB2 Tax Strategy
JB2ʼs strategy includes refinancing to return most of the capital tax-free and holding long-term to avoid/delay getting hit by the depreciation recapture tax.
If and when we sell, we would hold it long enough so that all tax benefits and returns would outweigh any capital gains/recapture tax. We could also implement a 1031 to defer capital gains/recapture. The other option is that once sold, we could reinvest the proceeds in another deal within the same year, apply bonus depreciation and use those losses to offset gains from the previous sale.
Ultimately this is a more sophisticated strategy yet powerful nonetheless. Now that bonus depreciation is being dialed back, the next couple of years of deals will be essential to stack up those paper losses. This means we can have more paper losses to offset rental income for years.
For educational purposes, your tax professional must review all strategies discussed.