The Benefits of Bonus Depreciation for Passive Real Estate Investors

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Are you an investor looking to maximize your potential returns? 

In the world of passive real estate investing, there is a game-changing benefit that can significantly boost your bottom line—bonus depreciation. This powerful tax strategy is not only a goldmine for investors but also a secret weapon for building long-term wealth.

The Three Kinds of Depreciation in Real Estate

Before diving into the benefits of bonus depreciation, we must understand how depreciation works. 

Depreciation is simply an accounting method used to allocate the cost of a tangible or physical asset over its useful life. You see, the IRS (Internal Revenue Service) is aware that tangible and physical assets break down over time. Since the IRS understands that these assets will eventually need to be replaced, they allow the business owner to recoup the cost of replacing the asset over a specified period. 

And since real estate assets (i.e., buildings and improvements) count as tangible and physical assets in the investment, depreciation also applies to real estate!

But of course, there are different types of depreciation, and they all affect the ability to allocate the cost of a tangible or physical asset’s useful life in different ways.

Straight-line Depreciation

Straight-line depreciation is the simplest method for calculating how tangible or physical assets will break down over time. With this method, the same amount of depreciation is deducted from the asset’s value for every year of its useful life. Timelines differ for assets. For residential assets such as multifamily, the useful life of a multifamily building is 27 1/2 years, whereas the useful life of a self-storage building is 39 years.

For example, you purchase a residential multifamily property for $1M, and $200,000 of that purchase is the land value. The IRS states that the useful life of that property is 27 1/2 years since it is a residential asset. Using straight-line depreciation, the first-year tax write-off would be $29,000 ($800,000 / 27.5 years).

Accelerated Depreciation

Accelerated depreciation allows greater depreciation to be taken in the earlier years of the life of an asset. The simplest way to determine what can be accelerated forward is to perform a cost segregation analysis. The goal of a cost segregation analysis is to identify any components of the real estate asset that depreciates in 20 years or less (according to the IRS) and claim (or accelerate) as much of that depreciative loss to the first five years of the hold of the asset.

Taking our same multifamily purchase above, you purchase the building and decide to do a cost segregation analysis. In the analysis, the engineer identified that $200K in components on the asset would depreciate in 20 years or less. Therefore, they could be accelerated forward to years one to five of the hold. Instead of taking a straight-line depreciation of $29,000 in year one, you could take a write-off of $69,000 year (or more) in years one to five ($200,000 / 5 = $40,000, $40,000 + $29,000 = $69,000).

Bonus Depreciation

Bonus depreciation is not a change in the depreciation accounting method. It is a tax incentive that allows a business to deduct a sizable percentage of the purchase price of eligible assets immediately. Rather than writing them off over the useful life of that asset, the company can take that entire write-off in year one. The 2017 Tax Cuts and Job Act (TCJA) increased bonus depreciation from 50% to 100% (yes!). However, this increase will phase out in the next three years. But for 2023, bonus depreciation is still 80%, so back to our multifamily purchase example, instead of taking the additional $200,000 write-off over five years, you could effectively take 80% of that in year one as long as the asset closes in 2023 (that is at $160,000 write off!).

Why Is Bonus Depreciation Important for Passive Investors and How It Works?

Now that we know what bonus depreciation is, let us understand how it plays into a larger investment strategy. Bonus depreciation incentivizes real estate investors to reinvest their profits into their businesses by purchasing new properties or upgrading existing ones. This helps to create jobs and spur economic activity, which is good for everyone (hence why the IRS allows bonus depreciation to be an incentive). 

But how does bonus depreciation apply to you as a passive investor? Well, your personal tax is one of the largest expenses for most accredited investors. To compound the issue, every dollar you spend on taxes is a dollar you cannot invest. When you invest in passive real estate (like a syndication), the tax write-offs from depreciation can pass through to you (aka passive losses).

Furthermore, these passive losses can offset the passive income generated not only on the asset you initially invested in, but you can also use those passive losses to offset passive income and passive gains generated by other assets in your portfolio. 

As a passive real estate investor, bonus depreciation provides a significant tax advantage. Writing off a larger percentage of your initial investment in the first year gives you significant tax savings, especially in the first year of ownership, when the investment is typically the most expensive. Ultimately, the true power of all depreciation (especially today’s 80% bonus depreciation) is it allows you to accelerate the time value of money.

How Bonus Depreciation Will Change Going Forward

If you are an investor in passive real estate deals, bonus depreciation can be a great opportunity to save more on taxes today. However, bonus depreciation is currently being phased out and will drop from 80% in 2023 to 60% in 2024. This sunsetting was designed when the 2017 Tax Cuts and Jobs Act was signed into law. To be clear, this does not mean there is less depreciation to be taken for the investment. It just means you get to take less depreciation in year one of ownership. For example, if you invested with an accelerated depreciation loss of $200K in 2022, you could have taken 100% of that as a loss in year one. In 2023, you can take 80% (or $160K) of the loss in year one and must spread the remaining 20% ($40K) over the next five years. Still not shabby! However, starting in 2024, you can only take 60% ($120K) as a year-one loss. 

Therefore, if you plan to take advantage of the deduction, you must be more strategic and invest before the end of the year to lock in your losses today.

Wrapping Up

Bonus depreciation is an essential tool for you as a passive investor looking to maximize your profits, as it helps you recoup more of your initial investment in year one. Although bonus depreciation can be complicated to navigate, taking advantage of this tremendous financial incentive may very well be your secret weapon to growing your long-term wealth.