Written by: Angela Parziale, CPA, MST
As a real estate investor or owner, you’re always looking for ways to maximize your return on investment. Staying up to date on federal tax laws can be daunting, but knowing how taxes affect your bottom line is essential for making smart real estate decisions.
One significant tax law change is coming into effect in 2023: the beginning of a gradual phase-out of bonus depreciation. This article provides an overview of the shift and discusses potential strategies for balancing cash flow and tax savings.
The History of Bonus Depreciation
Bonus depreciation has been around in some form for over two decades. The Job Creation and Worker Assistance Act of 2002 sought to incentivize companies to expand and create jobs in the wake of the September 11, 2001, terrorist attacks. It did this by providing an additional 30% depreciation deduction for qualified property placed in service after 9/10/01.
Since that time, bonus depreciation has been a constant in tax legislation, although the percentage and definition of eligible property have fluctuated.
Most recently, the Tax Cuts and Jobs Act of 2017 significantly boosted the potential value of bonus depreciation, but only for a limited duration. For September 17, 2017, through December 22, 2022, taxpayers could claim a deduction of 100% of the purchase price for qualified property in the year it was placed in service rather than depreciating smaller amounts over its useful life.
Bonus Depreciation Phase-Out
Bonus depreciation begins a gradual phase-out starting in 2023. While taxpayers can still claim 100% bonus depreciation for qualified property placed in service in 2022, the percentage drops to 80% for 2023, 60% in 2024, and so on until it’s phased out entirely by 2027 unless Congress acts to extend it.
This phase-out of bonus depreciation presents a unique challenge for real estate investors and owners. For example, commercial property owners often incentivize tenants to sign leases based on a package of leasehold improvements. These leasehold improvements sometimes amount to millions of dollars per tenant. With 100% bonus depreciation, it wasn’t unusual to see a property owner’s rental income completely sheltered by bonus depreciation.
With bonus depreciation at 80% this year and dropping over the next several years, commercial property owners will need to evaluate whether it makes sense to offer the same level of tenant improvements. If you’re still obligated to provide some incentive to get tenants through the door, it might be more beneficial—at least from a tax perspective—to scale back on tenant improvements and reduce rents instead.
Potential Tax Strategies
Real estate owners always need to consider the delicate balance between cash flow and tax savings when making decisions. Since 2017, 100% bonus depreciation has allowed commercial property owners to invest heavily in their properties, letting tax savings provide cash flow to cover expenses and debt service.
One potential strategy real estate owners and investors might consider to continue enjoying generous tax write-offs is to make an election to be an excepted real property trade or business.
Section 163(j) of the Internal Revenue Code limits the amount of deductible business interest a company can claim in a taxable year. The interest expense deduction cannot exceed the sum of:
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- The taxpayer’s business interest income for the tax year,
- 30% of the taxpayer’s adjusted taxable income (ATI) for the tax year, and
- the taxpayer’s floor plan financing interest expense for the tax year
Certain real property trades or businesses can elect to be an excepted trade or business under IRC 163(j).
However, there is a downside to electing to be an excepted real property trade or business. Any real property and qualified improvement property the taxpayer holds must be depreciated using the alternative depreciation system (ADS), and the company cannot claim bonus depreciation.
In light of the reduced bonus depreciation deduction, real property businesses should consider the cost and benefit analysis of depreciating property over a longer depreciable life versus being able to deduct business interest expense above the limitation.
Transitioning from 100% bonus depreciation can present a challenge for real estate owners. Nonetheless, it’s essential to remain aware of regulatory changes to ensure you’re making the best decisions in your lease negotiations and tax planning.
Now is the time to reach out to a knowledgeable tax professional who understands the implications of bonus depreciation on your bottom line. There are recent changes that may impact your strategy. For example, starting in 2022, the calculation with respect to a real property trade or business election for Section 163(j) will be different. Depreciation will no longer be an add-back to your tax-deductibility limits, but rather interest expense will be. This could significantly impact some taxpayers’ decision-making process with respect to this election. Get a head start and reach out so we can help evaluate these changes and find the best solution for you.