Definition
Bonus depreciation is a tax provision that allows investors to immediately deduct a significant percentage of the cost of eligible property in the first year it is placed in service, rather than depreciating it over its normal recovery period.
How It Works in Real Estate
Real estate itself (the building) is typically depreciated over 27.5 years (residential) or 39 years (commercial). However, through a cost segregation study, certain components (like appliances, flooring, fixtures, and some improvements) can be reclassified into shorter-lived categories (5, 7, or 15 years).
These shorter-lived assets may qualify for bonus depreciation, allowing a large portion of their value to be deducted in year one.
Example
An investor purchases an apartment building for $10,000,000. After allocating land value and performing cost segregation, $2,000,000 qualifies as 5- and 15-year property.
- If 80% bonus depreciation applies,
- Immediate deduction = 2,000,000 × 80% = $1,600,000
This deduction may offset taxable income from the property or other passive activities, depending on investor status.
Why It Matters
- Increases early-year tax deductions
- Improves after-tax cash flow
- Enhances projected IRR in underwriting
- Creates potential passive loss offsets
Phase-Down Considerations
Bonus depreciation percentages have been subject to legislative changes. Investors should verify the applicable percentage for the tax year and consult tax professionals when underwriting deals.
Interaction With Depreciation Recapture
Accelerated depreciation may increase future depreciation recapture taxes upon sale. While bonus depreciation boosts early cash flow, investors should evaluate the full lifecycle tax impact.
Investor Perspective
Sophisticated investors incorporate bonus depreciation into underwriting, but do not rely solely on tax benefits to justify acquisitions. The property must still meet return and risk thresholds on an operational basis.
Common Pitfalls
- Ignoring recapture taxes at exit
- Overestimating eligibility without cost segregation
- Assuming tax rules will remain constant
- Confusing tax deductions with actual cash profit