“In this world, nothing is certain except death and taxes.”
These were some of Benjamin Franklin’s famous words of wisdom. And while he was unfortunately correct to an extent, there are ways to legally avoid one of those two fates. No, we aren’t alluding to the magic pill so you can skirt death. We are talking about something way more exciting… tax advantages! For example, bonus depreciation.
Bonus depreciation has been an extremely hot topic in real estate over the past few months with 2022 coming to an end. 2022 is the last year allowing 100% bonus depreciation. It is very important and one of the greatest benefits when it comes to real estate investing. As such, we felt the need to share this newsletter.
Bonus depreciation was put on center stage when the Tax Cuts and Job Act (TCJA) went into effect in 2018. This offered some incredible tax advantages that are still active, including bonus depreciation. Before the TCJA, bonus depreciation would allow 50%; however, when it became effective in 2018, it allowed for 100% bonus depreciation for investments such as commercial real estate. That being said, 100% bonus depreciation expires on December 31, 2022 and effectively compresses to 80% in 2023.
Lets walk through a quick example of bonus depreciation at 100%…It’s the year 2022, and lets say we purchased a $20m property. If bonus depreciation weren’t a thing, we would have to depreciate the real property over a 39 year period (assuming we elect to use straight-line depreciation). In addition, through cost segregation, we would separate out all business personal property items (flooring, fixtures, etc.) which we would be able to depreciate over a shorter timeline. It wouldn’t be unusual for those items to total around 25% of the property’s value which would equate to $5m.
Now, lets assume we are using 100% bonus depreciation. That full amount of business personal property ($5m) would be fully deductible in the same tax year that the property is acquired and placed in service.
Now lets assume you are a passive investor in the deal (limited partner or LP). Lets say the total equity needed to purchase the property was $6m (which would include the down payment, reserves, closing costs, etc.).
Taking the $5m discovered through the cost segregation study that qualifies for bonus depreciation, the total depreciation amount would be roughly 83% ($5m/$6m).
This means that if you invested $100,000 as a passive investor, you will be seeing a loss of roughly $83,000 on your K-1.
This is an extreme advantage if you qualify for REPS (real estate professional status). If you do qualify, you will be able to take the losses from your passive investments and apply them to your other income sources. If you do not qualify, you will still see benefits as the passive losses you receive will negate the gains you make from your investment in that asset for the years to come.
The Future of Bonus Depreciation
While it will not completely go away just yet, bonus depreciation will begin to be phased out. The timeline for bonus depreciation is as follows:
- 2022 – 100% bonus depreciation
- 2023 – 80% bonus depreciation
- 2024 – 60% bonus depreciation
- 2025 – 40% bonus depreciation
- 2026 – 20% bonus depreciation
While the current state of the economy is introducing significantly higher levels of uncertainty, there are a lot of things that we can do as investors to keep our money active and growing. Beyond that, our investment decisions can even help us to retain more of the income we are making and pay less of it to the government. There are a ton of benefits of real estate investing which we covered in a separate post, click here to read more about other great benefits!
As always, we hope this is insightful. If you’re interested in learning how to invest or discussing some of our current investment opportunities, don’t hesitate to reach out!
Mitch and Kevin