How Bonus Depreciation Can Reduce Your Tax Bill
Tax time is upon us once again. This month we thought it would be timely to go through one enormous potential tax benefit of investing in real estate. For a very long time the U.S. tax code has played favorite to real estate owners and investors. We want to key in on one specific item in the tax code, Bonus Depreciation.
The IRS recognizes real property improvements (think buildings, parking, etc) as having a useful lifespan. This is why the tax code allows for residential building owners to depreciate their property over a 27.5 year lifespan. This ability to depreciate the asset over time helps to offset tax liabilities on profits made during ownership. Savvy investors understand this benefit and recognize their real estate profits could be taxed at a lower effective rate than other investments. For simple math, utilizing what is known straight line depreciation, one million dollars of improvements depreciated over 27.5 years would allow for a $36,363 loss (1,000,000 divided by 27.5.) If that property had $50,000 in profit its tax burden would only be $13,637 ($50,000 minus $36,363.)
Bonus Depreciation is an accounting method allowed by the IRS that allows businesses to depreciate assets with a recovery period of twenty years or less in the first year of ownership (IRS News Release). How does this affect real estate owners? Well the IRS does not consider everything on and/or inside of a property to be considered real property. In fact many improvements to a property can be depreciated over the five year or fifteen year schedules. Bonus Depreciation allows for five and fifteen year improvements to be expensed in year one. Depending on the situation this strategy could offset tax liabilities on cash flow generated by your asset in the first years of ownership. Some examples of five year property include residential appliances, carpeting, vinyl floors, and cabinetry. Fifteen year property includes retaining walls, sheds, asphalt paving, pools and site lighting. One of the best ways to benefit from these tax rules is to hire a cost segregation expert to analyze your specific property and provide a breakdown of five year and fifteen year property at your building.
It is important to note however, there is a tipping point to whether or not using Bonus Depreciation is beneficial depending on the specific property and investment hold period. Additionally, the depreciation taken during the investment hold period decreases your basis in a property and is recaptured at a higher rate upon sale. Two ways to protect against the recapture are to 1031 exchange your property into a new property at sale (which will defer all gains on the real estate) or simply invest into a new property where you can again get Bonus Depreciation. To learn more about the specifics of Bonus Depreciation, click here.
Now for a real life example. DXE Properties recently closed on a $16 million purchase in Atlanta, GA. Through a cost segregation analysis and bonus depreciation we are able to depreciate $3.1 million of the project in the 1st Year. For a $100,000 investor the loss reported in year one is approximately $40,000. These paper losses can be used to offset other passive income (think stock gains, other real estate gains) OR be carried forward to next year to offset future passive income. Depending on your tax bracket and ability to offset real estate losses with other gains, this could mean SIGNIFICANT tax savings for an investor.
Want to learn more about how real estate investments could help your tax situation? We’d be happy to speak with you.
Conversely, if you currently own a property and have a large profit, DXE could help place you into a 1031 exchange, which could defer 100% of your taxable gain on your property sale!