Recently, Kelli, Dan, and I have been discussing end-of-year financial and tax planning. Depreciation always plays a big part in this conversation because it’s one of the best ways to reduce your tax liability on investment gains and earned income, depending on your personal tax situation. Depreciation is a powerful tool because it creates losses you can claim on your tax return to lower gains or income. I’m sure most of you are also preparing and getting ready. I wanted to provide a reminder and update regarding current depreciation rules that affect all of us.
Depreciation: Straight-line, Accelerated, & Bonus
Depreciation, per the IRS, is the simple reduction in the value of an asset as it ages. The IRS allows individuals to allocate the decrease in value of an asset over its life expectancy. The IRS sets life expectancy terms specific to asset types. Using the IRS life expectancy term and claiming an equal depreciation amount each year over the term is called straight-line depreciation.
Accelerated depreciation can be utilized if you get a cost segregation study done to identify the non-structural elements, land improvements, and structural elements. Structural elements still get depreciated over the IRS term, but non-structural items like flooring, fixtures and others are reclassified as personal property, which get depreciated over a shorter (typically) five- or seven-year term. Land improvements like paving, landscaping, pools, etc., get depreciated over 15 years. This way, you can front-load depreciation and get more benefit early in your ownership period.
Bonus depreciation can be utilized by having a cost segregation study done, and instead of using the accelerated method, you are able to take all the personal property and land improvement benefits in your first year of ownership to get a huge benefit early. The Tax Cut and Jobs Act of 2017 currently impacts bonus depreciation benefits. The benefit phases out by 20% per year from 2023 through 2026, so starting in 2027, you will still be able to accelerate depreciation, but you won’t be able to do bonus depreciation unless the government changes the in-place rule.
Depreciation Recapture: In the future, if you sell a property, you could owe depreciation recapture on your taxes, but you also have the opportunity to 1031 exchange and defer the taxes. The long-term strategy a lot of wealth planners and investors use to eliminate taxes completely is by always 1031 exchanging and, upon the owner’s death, having the investment property basis reset (which eliminates tax and recapture tax) when the property is transferred to an heir.
Disclaimer: This is for information purposes only. We are not providing legal, tax, financial services or investment advice of any kind. We are not your CPA, accountant, legal advisor, or attorney.
