What is Bonus Depreciation?

Understanding Bonus Depreciation and Its Role in Tax Planning

Bonus depreciation has been one of the most powerful tax incentives available to businesses and property owners in recent years. Originally designed to stimulate investment, this tax provision allows businesses to accelerate the depreciation of qualifying assets, resulting in immediate tax savings. While bonus depreciation has historically offered substantial benefits, recent changes in tax laws have introduced a phase-out period that will reduce the percentage of eligible deductions each year until it phases out completely by 2027.

For property owners, especially those involved in real estate investment, leveraging bonus depreciation in conjunction with cost segregation studies can lead to significant tax savings. By understanding how bonus depreciation works and how to optimize it, you can enhance your tax efficiency and improve cash flow.

What Qualifies for Bonus Depreciation?

Eligible Assets for Bonus Depreciation

Assets with a recovery period of 20 years or less qualify for bonus depreciation. These include equipment, machinery, furniture, and even certain types of software. However, improvements made to property, like parking lots or lighting systems, also fall into this category, making bonus depreciation a versatile tool across industries.

Depreciation Class Lives and Bonus Depreciation

Assets are categorized by class lives, which dictate how quickly they can be depreciated. Assets with shorter class lives—such as five, seven, or 15 years—are eligible for bonus depreciation, allowing businesses to accelerate deductions.

How Does Bonus Depreciation Work?

Calculating Bonus Depreciation

To calculate bonus depreciation, businesses apply a percentage to the cost of the asset in its first year of use. This percentage depends on the year the asset was placed into service, with recent changes reducing the percentage from 100% to 80% for 2023, and continuing to decrease.

Application in Different Industries

Bonus depreciation applies across multiple industries. In real estate, it’s used in conjunction with cost segregation studies to allocate portions of buildings that qualify for shorter depreciation periods, like appliances or parking areas. In manufacturing, it covers machinery and other production equipment.

Changes in Tax Law and Bonus Depreciation

2017 Tax Cuts and Jobs Act Impact

The Declining Bonus Depreciation Schedule: What You Need to Know

The Tax Cuts and Jobs Act (TCJA) of 2017 dramatically increased bonus depreciation to 100%, allowing businesses to immediately deduct the full cost of eligible assets, such as equipment, building improvements, and certain real estate assets. However, beginning in 2023, the bonus depreciation percentage has started to decrease by 20% each year:

• 2023: 80%

• 2024: 60%

• 2025: 40%

• 2026: 20%

• 2027: 0%

This phase-out means that property owners and businesses must act quickly if they want to maximize the benefits of bonus depreciation. By placing qualified assets in service before year-end, you can secure the highest possible deduction before it diminishes further.

Bonus Depreciation vs. Section 179

Key Differences and Similarities

While both bonus depreciation and Section 179 allow businesses to deduct the cost of qualifying assets, they operate differently. Bonus depreciation has no spending limit and can create a tax loss, while Section 179 has a spending cap and cannot generate losses. Bonus depreciation is typically applied to larger investments.

Which Method is Right for Your Business?

Deciding between the two depends on your business’s financial goals. If you're making substantial investments, bonus depreciation may offer more flexibility, especially for companies looking to accelerate deductions on large assets.

Bonus Depreciation in Real Estate

Role of Cost Segregation in Maximizing Depreciation

For real estate investors, bonus depreciation is most effective when paired with a cost segregation study. Cost segregation is a tax strategy that accelerates the depreciation of certain components of a property by reclassifying them into shorter asset classes, typically 5, 7, or 15 years, rather than the standard 27.5 or 39-year schedules for residential and commercial properties.

When a cost segregation study identifies which components of a building qualify for shorter recovery periods, bonus depreciation can then be applied to those components. This allows property owners to write off a substantial portion of their property’s cost in the first year, drastically reducing taxable income and freeing up capital for further investments.

Commercial vs. Residential Real Estate Impact

Both commercial and residential real estate investors can leverage bonus depreciation. While larger commercial properties often yield more substantial savings, even small residential rental properties can benefit from accelerated deductions through cost segregation studies.

Illustrating the Impact of Bonus Depreciation

To better understand the potential benefits of bonus depreciation when combined with a cost segregation study, let’s consider an example scenario.

Imagine a real estate investor who purchases a commercial building for $5 million in 2023. Without advanced tax strategies, the investor would typically depreciate the building over a 39-year period, leading to modest annual tax deductions. However, by conducting a cost segregation study, the investor is able to reclassify 30% of the property’s basis (approximately $1.5 million) into shorter asset classes, such as 5-year personal property and 15-year land improvements.

Since the property was placed into service in 2023, the investor is eligible to take 80% bonus depreciation on the reclassified assets. This results in an immediate deduction of $1.2 million (80% of $1.5 million) in the first year, drastically reducing taxable income and generating a significant tax savings of $420,000, assuming a 35% tax rate.

Benefits of Using Bonus Depreciation in Tax Planning

Maximizing Cash Flow by Acting Now

With bonus depreciation set to phase out over the next several years, there’s never been a more urgent time to take advantage of this incentive. Real estate investors who are planning to acquire new properties or make significant improvements should act quickly to maximize their tax benefits before the deduction rate drops further.

Even as bonus depreciation phases out, the value of cost segregation remains intact. The ability to reclassify assets and shorten their recovery periods continues to provide substantial tax savings, allowing investors to defer taxes and enhance their cash flow for years to come.

How CPAs Can Leverage Bonus Depreciation for Clients

CPAs play a vital role in guiding clients through bonus depreciation strategies. By identifying qualifying assets and advising on timing, CPAs help businesses optimize their tax positions and gain the most from this valuable tax incentive.

Conclusion: Capitalize on Bonus Depreciation Before It’s Gone

Bonus depreciation has been a game-changer for businesses and real estate investors alike, offering the opportunity to accelerate deductions and reduce tax burdens. As we approach the final years of this incentive, the window to take full advantage of it is closing. By combining bonus depreciation with cost segregation, property owners can unlock significant tax savings and reinvest those savings into future growth.

ThriveVista assists property owners in identifying tax-saving opportunities through cost segregation. We leverage our extensive experience in engineering, specialty tax, and market knowledge to develop practical strategies and implement customized solutions that maximize financial benefits for our clients.