When you buy a substantial business asset, you typically have to depreciate it over a number of years, which means you can only subtract a fraction of the value of the purchase as an expense each year. Bonus depreciation is one of the ways you can choose to instead subtract all or most of the expense of a purchase as an expense in the year that you buy it.
Bonus depreciation is actually called “special depreciation” in the tax code and IRS forms, and it is defined in IRC code 168(k). It has been around in various forms since 2002, offering deductions of anywhere from 50% to 100% as it was offered by various tax bills over the years.
The current version of bonus depreciation was put into law in the Tax Cuts and Jobs Act of 2017. It offered bonus depreciation of 100% until the 2022 tax year. In 2023, it is now 80%, and it is scheduled to be reduced each year until it is eliminated in 2027. At least that’s the current law. It may change at any time. If history is any indication, Congress may bring back bonus depreciation again before it expires.
Note: There is currently a law that is working its way through Congress that may restore bonus deprecation to 100%, retroactively including 2023. It’s still unclear whether it will be approved or not. https://www.congress.gov/bill/118th-congress/house-bill/7024
The current bonus depreciation can apply to new or used property. Previously, bonus depreciation could only be applied to new property that didn’t have a previous owner. So if you bought a house that wasn’t new construction (it had a previous owner) before September 28th, 2017, you can’t use bonus depreciation with a cost segregation study to deduct existing components of the house. But you can use it for improvements that you added more recently.
| Date Placed in Service | Bonus Depreciation Offered |
|---|---|
| Before September 28th, 2017 | 50% (only for new property, not used) |
| September 28, 2017 to December 31st, 2022 | 100% |
| 2023 | 80% |
| 2024 | 60% |
| 2025 | 40% |
| 2026 | 20% |
| 2027 | 0% |
For example, if you make a business purchase and put an item into service in 2023, you can use bonus depreciation to deduct 80% of the cost of it for your 2023 taxes. The other 20% is depreciated over the normal depreciation schedule for that type of item.
Qualifying for Bonus Depreciation
For an item to qualify for bonus depreciation, it must meet all of these criteria all of these criteria:
- It must be for business use (which includes rental properties). Most types of assets can be divided up into a percent for personal and business use. An exception is “listed property”, which includes passenger vehicles under 6000 pounds and various types of entertainment / recreational / photographic equipment. Listed property must be at least 50% business use and the use must be documented, otherwise it’s not eligible for bonus or section 179 depreciation.
- It must be “placed in service” (put in use) for the business during the tax year.
- You must have bought the property, it can’t be inherited.
- It can’t be property acquired in a 1031 exchange.
- The item must be owned, not leased.
- The item can’t be purchased from a related party if it is a used item.
- It must have a MACRS depreciation life of 20 years or less. That means real estate and buildings don’t qualify for bonus depreciation. So you can use it for some rental expenses, but not the entire buildings themselves. If you do a cost segregation study, you can use it for 5-15 year items.
- Property in foreign countries doesn’t qualify.
Recapture
When you take any type of depreciation, including bonus depreciation, you will be subject to “recapture” if you later sell the property. That means it saves you taxes when you make use of the depreciation, but it adds to the amount of tax you pay when you sell the property. Most investors consider that to be an acceptable trade-off because they would rather have the tax savings sooner to make use of those funds now rather than later (the “time value of money”).
You can also further delay the recapture if you do a 1031 exchange with the property. Alternatively, you can avoid recapture entirely by holding the property until your death, and it is inherited by your heirs. So it is particularly adventitious to use bonus depreciation on property that you plan to pass on to your heirs.
Difference Between Bonus Depreciation and Section 179
Section 179 is another way to expense the cost of items in the current tax year, and in a lot of ways it can be used to do that same thing as bonus depreciation. But a major difference is that section 179 can’t be used to generate a loss if your net taxable income is negative, but bonus depreciation can. There are also some minor differences in the types of items that can be used for section 179 compared to bonus depreciation.
Applying Bonus Depreciation for Assets Placed in Service in a Prior Year
The process to apply bonus depreciation is simplest if you do it starting with the first tax year that you put the property into service (when you first make it available to rent). The actual study can be done anytime before you file your tax return and applied to that tax return.
It is more complicated to make the adjustment if it isn’t the first year you put the property in service, as long as it was placed in service. In that case, you have to file form 3115 and do a 481(a) adjustment as a DCN 7 accounting method change. So there is some added complexity to your tax return, and it’s generally something you would need to have a tax professional do (TurboTax won’t do it).
If you bought the property many years ago and you’ve already taken most or all of the depreciation, then it may not be worth it. Also, bonus depreciation may not be available depending on the date it was placed in service (see the chart above).
Opting Out of Bonus Depreciation
Bonus depreciation is applied to by default unless you elect to opt-out (on form 4562 Depreciation and Amortization).
You may want to opt out of bonus depreciation if your net taxable rental income is already negative, and you don’t qualify to offset your other income. Or you may want to opt out if you expect to be in a higher tax bracket or have more rental income in future years, and you want to have more expenses to deduct against that income in the future.
If you elect to opt-out, that election applies to all assets in the same class. The class of the property is the depreciation period (5 year, 7 year, 15 year, etc.). You can’t choose to opt out of bonus depreciation for some items but not others if they are the same class of property. The amount of bonus depreciation you are using is entered on form 4562 line 14.
Deducting the Loss Against Other Income
Be aware that even if bonus depreciation results in negative net income for your rental for the year, you may not necessarily be able to deduct that negative income against your other job, business, or investment income. In order to do that, you would need to qualify for one of the exceptions that allows you to deduct your rental losses against your other income.
