As the sayings go “it’s not about what you make but what you keep” and “a penny saved is a penny earned.” If you are a real estate investor or real estate professional (as defined by the IRS) and this is the first time you are reading about bonus depreciation, it may be time to find another CPA.

What follows is a discussion on the use of bonus depreciation and cost segregation studies, how they benefit real estate owners, and often overlooked considerations.

What is bonus depreciation?

Bonus depreciation is a tax incentive allowed by the IRS to immediately expense qualified property in the first year it is placed in service vs. spreading out the depreciation expense over the asset’s useful life.

• Additional First Year Depreciation Deduction (Bonus) – FAQ
• More Information on Depreciation via IRS

Residential rental-income producing properties (apartments) are depreciated over 27.5 years. However, various components make up an apartment building, and those components have shorter useful lives (5 and 15 years). Examples include flooring, cabinets, lighting fixtures, HVACs, etc. A cost segregation study can be commissioned to allocate values to those components. Through bonus depreciation, qualified property with useful lives of 5 to 15 years can be expensed in the first year (see note below on pending congressional legislation).

Bonus Depreciation Example

For example, assume a property was purchased for $10,000,000 in Dallas, TX. It was determined that the value of the land comprised 20% ($2MM) of the purchase price, and improvements made up 80% ($8MM). Note: appraisals are often used to determine the land and improvement value allocations in case the IRS comes knocking at the door.

Land cannot be depreciated, so a cost segregation study focuses solely on the $8MM of improvements. A real estate owner will hire a cost segregation (“cost seg”) expert to perform a cost seg study in order to “segregate” the components of the improvements between short-term assets vs. long-term assets.

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If we assume the cost seg expert determines 35% of the improvements are short-term assets (useful lives of 5 to 15 years), the entire value of the short-term assets can be expensed in the first year (often referred to as bonus depreciation or accelerated depreciation).

$2.8MM of depreciation can be expensed in the first year to offset rental income ($8MM x 35% = $2.8MM). Remember the other 65% of improvements would be considered long-term assets with a useful life of 27.5 years, so the annual depreciation expensed for long-term assets would be ($8MM – $2.8MM) / 27.5 years = $190,000 per year. The total Year 1 depreciation expense would be $2.99MM ($2.8MM + $190K = $2.99MM).

Had the investor chosen not to commission a cost seg study nor use bonus depreciation, the calculation for annual depreciation would simply be $8MM / 27.5 years = $291K… substantially less than $2.99MM.

Important Note on Timing: Up to December 31, 2022, 100% of the short-term assets could be expensed in the first year. The percentage decreased to 80% in 2023 and to 60% in 2024. However, as of the date of this writing, Congress is working on making 100% bonus depreciation retroactive to January 1, 2023, and through December 31, 2025.

How do bonus depreciation and cost segregation studies impact the amount of money investors keep in their pockets?

Using the example above, if we assume the property was purchased at a 5% cap rate with no debt, the Year 1 cash flow would be $500,000 ($10MM purchase price x 5% cap rate = $500,000). The $2.99MM of Year 1 depreciation expense would be more than enough to offset the entire $500,000 income thereby reducing the Year 1 tax liability to $0 vs. paying taxes on $210,000 ($500,000 – $291,000 = $209,000) . Depending on the investor’s tax bracket, the difference in tax liability could be in excess of $100,000 annually paid to Uncle Sam over the next several years vs. being reinvested.

For real estate investors, the key point regarding bonus depreciation/accelerated depreciation is deferring tax payments to a later date. Would an investor rather pay the government $100,000 now or $100,000 in 5 years? I’d rather reinvest the deferred tax payments, earn additional income, and let the time value of money work its magic.

Considerations

1. Land value allocations as a proportion of total value varies by city and state.
   • The higher the land value allocation, the lower the improvement value allocation translating to a lower amount that can be depreciated
   • Consider San Diego vs. rural Texas. $1,000,000 will go much farther in rural Texas than it will in San Diego. As a result, land value allocations tend to be much higher in coastal and dense, urban cities than less popular areas.
   • Coastal cities like San Diego and Los Angeles may have land value allocations as high as 50% of the total value vs. 5% to 10% in rural areas.
2. Bonus depreciation differs substantially by property type.
   • For example, express car washes offer some of the highest Year 1 depreciation given the nature of the construction and components. I’ve been involved in transactions with as much as 80% of the purchase price depreciated in the first year
   • Other high bonus depreciation properties include mobile home parks and gas stations
   • For a table of accelerated depreciation percentages by property type, see midway down the page at Engineered Tax Services
3. Real Estate Professional as defined by the IRS
   • If you qualify as a real estate professional, you may be able to use the losses generated by rental properties to offset non-passive income
   • The IRS has specific qualifications that define who qualifies as a real estate professional and when rental income/loss can be considered non-passive activity vs. passive activities.
   • The implications can be massive for sheltering ordinary income using depreciation generated from rental properties income (i.e. real estate commissions)
     • There is additional potential when one spouse is a real estate professional, and the couple files jointly
     • For detailed information on the real estate professional qualification and potential uses, Tony Nitti, CPA, MST at The Tax Adviser does an in depth dive into the details in his article on TheTaxAdviser.com.

While cost segregation studies offer potential benefits, they are not without controversy. The IRS sometimes challenges these studies, and some tax professionals might have concerns about their legitimacy. As with most things in life, be proactive. Consult knowledgeable tax advisors before pursuing real estate strategies that utilize bonus depreciation.

If your tax advisor approves, leveraging cost segregation studies and bonus depreciation isn’t just a short-term boost, but a strategic move that can empower you to reinvest more profits, accelerate wealth creation, and reap the benefits for years to come. Don’t let Uncle Sam keep what’s rightfully yours – explore these powerful tools to maximize your real estate investment potential.

Corto Realty Group, Inc. is a San Diego-based real estate advisory firm specializing in multifamily investing.

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