Can You Take Bonus Depreciation on Residential Rental Property?

The short answer is: it depends. While the Tax Cuts and Jobs Act (TCJA) expanded bonus depreciation, allowing businesses to deduct a larger percentage of the cost of qualifying property in the year it’s placed in service, the application to residential rental property isn’t as straightforward as it seems. Generally, bonus depreciation is available for new personal property with a recovery period of 20 years or less. The key is understanding how specific components of a residential rental property are classified and whether they meet the eligibility criteria. Let’s dive into the nuances.

Understanding Bonus Depreciation and Residential Rental Property

Bonus depreciation is a powerful tax incentive designed to stimulate the economy by encouraging businesses to invest in new assets. Instead of depreciating an asset over its useful life, you can deduct a significant portion of its cost upfront. This can substantially lower your taxable income in the year of purchase.

However, the devil is in the details when it comes to residential rental property. The building structure itself is typically classified as real property and has a longer depreciation period (27.5 years for residential rental and 39 years for commercial). This long depreciation period disqualifies it from bonus depreciation. Therefore, you generally cannot take bonus depreciation on the entire building.

The Key: Cost Segregation and Personal Property

Here’s where things get interesting. A cost segregation study can identify components of a residential rental property that qualify as personal property rather than real property. This is where the opportunity for bonus depreciation lies.

What Qualifies as Personal Property in Rental Properties?

Certain items within a residential rental property may be classified as personal property, also known as qualified improvement property. This includes things like:

• Carpeting: Often treated as personal property with a shorter depreciation period.
• Appliances: Refrigerators, ovens, dishwashers, washers, and dryers are typically considered personal property.
• Window Treatments: Blinds, curtains, and other removable window coverings.
• Certain types of flooring: Beyond just carpet, some specialty flooring could qualify.
• Land Improvements: Fences, sidewalks, landscaping (may have a longer depreciation period, but shorter than the building itself).

The Importance of a Cost Segregation Study

A cost segregation study is a detailed analysis performed by qualified professionals (engineers, accountants specializing in tax) to identify and reclassify assets within a building. It meticulously breaks down the various components of the building to determine their appropriate depreciation class.

Without a cost segregation study, it’s difficult to accurately identify and justify claiming bonus depreciation on these components. The IRS will likely challenge unsubstantiated claims.

How Bonus Depreciation Works in Practice

Let’s say you purchased a residential rental property for $500,000. Without a cost segregation study, you’d depreciate the building over 27.5 years. However, after conducting a study, it’s determined that $50,000 of the property’s value can be allocated to personal property (e.g., appliances, carpeting) with a 5-year recovery period.

You can then potentially take bonus depreciation on that $50,000 in the year the property is placed in service, significantly reducing your taxable income. The amount of bonus depreciation you can take will depend on the year the asset is placed in service, as the percentage has been phasing down over time.

Frequently Asked Questions (FAQs)

FAQ 1: What is Qualified Improvement Property (QIP) and How Does it Relate to Bonus Depreciation?

Qualified Improvement Property (QIP) refers to any improvement to an interior portion of a nonresidential real property if that improvement is placed in service after the building was first placed in service. However, a technical correction in the CARES Act mistakenly treated QIP as having a 39-year recovery period (ineligible for bonus depreciation) before being corrected. It is now generally eligible for bonus depreciation. While technically for nonresidential property, the principles of identifying and classifying improvements as shorter-lived assets are similar in residential contexts.

FAQ 2: Is Bonus Depreciation Phasing Out?

Yes, the bonus depreciation percentage is phasing out. It started at 100% and decreases by 20% each year beginning in 2023. So, for property placed in service in 2023, the bonus depreciation rate was 80%. In 2024, it’s 60%, and so on, until it reaches 0% in 2027. This makes it increasingly important to accelerate depreciation deductions while you still can.

FAQ 3: How Does Section 179 Deduction Differ from Bonus Depreciation?

While both Section 179 deduction and bonus depreciation allow you to deduct expenses upfront, they have key differences. Section 179 has limitations on the total amount that can be deducted each year (indexed for inflation) and also limits based on taxable income. It’s often used for smaller businesses and has specific eligibility requirements related to active trade or business. Bonus depreciation has no income limitations and can often be more advantageous for larger investments.

FAQ 4: Can I Take Bonus Depreciation on Used Property?

Generally, bonus depreciation is only available for new property. However, there are exceptions. One exception is for “qualified used property” that meets specific criteria. It must be acquired by purchase, not from a related party, and the taxpayer must not have used the property before. State laws also have to align with Federal Law to be able to do it.

FAQ 5: What are the Risks of Taking Bonus Depreciation Incorrectly?

Taking bonus depreciation incorrectly can lead to penalties and interest from the IRS if your return is audited. It’s crucial to have proper documentation, including a cost segregation study, to support your claims. Underestimating the risk of an IRS audit is not a good idea. Consult with a tax professional to ensure compliance.

FAQ 6: How Do I Conduct a Cost Segregation Study?

A cost segregation study should be performed by qualified professionals, such as engineers or accountants specializing in tax. They will inspect the property, review construction documents, and analyze costs to identify components eligible for accelerated depreciation. Do not simply guess and allocate costs yourself.

FAQ 7: What is the De Minimis Safe Harbor Election and How Does It Relate to Bonus Depreciation?

The de minimis safe harbor election allows you to deduct expenses for tangible property up to a certain dollar amount ($5,000 per invoice if you have an applicable financial statement, or $2,500 without). While not directly bonus depreciation, it offers a similar immediate expensing benefit for smaller items, such as tools or minor repairs.

FAQ 8: What if I Missed Taking Bonus Depreciation in a Prior Year?

If you missed taking bonus depreciation in a prior year, you can file an amended tax return (Form 1040-X) to claim the deduction. However, there are time limitations, typically within three years of filing the original return or two years from when you paid the tax, whichever is later.

FAQ 9: How Does Bonus Depreciation Affect State Taxes?

State tax treatment of bonus depreciation varies. Some states conform to the federal rules, while others decouple, meaning they don’t allow bonus depreciation or have different rules. This can create complexity in calculating your state tax liability.

FAQ 10: Can I Retroactively Apply a Cost Segregation Study?

Yes, you can generally retroactively apply a cost segregation study to prior years by filing amended tax returns. This can result in significant tax savings if you’ve been depreciating the property using a standard method without identifying eligible personal property.

FAQ 11: What if I Sell the Rental Property After Taking Bonus Depreciation?

When you sell the rental property, the bonus depreciation you took will be subject to depreciation recapture. This means that the gain attributable to the depreciation deductions will be taxed as ordinary income rather than capital gains.

FAQ 12: Is Bonus Depreciation Available for Leasehold Improvements?

Yes, certain leasehold improvements can qualify for bonus depreciation if they meet the criteria for qualified improvement property and have a recovery period of 20 years or less. However, the specific rules can be complex and depend on the nature of the improvements and the terms of the lease.

In conclusion, while you generally cannot take bonus depreciation on the entire residential rental property building, a cost segregation study can unlock significant tax savings by identifying components that qualify as personal property. Understanding the nuances of bonus depreciation, QIP, and the phase-out rules is critical for maximizing your tax benefits and ensuring compliance with IRS regulations. Consulting with a qualified tax professional or CPA is always the best course of action to navigate these complexities.