Improvements are changes made to your property that add value (whereas repairs are changes made to your property that restore it to its original condition). Repairs can be deducted from your taxes in the year they’re made. Meanwhile, improvements add value to your property for years to come, so their tax deduction, known as depreciation, happens yearly.
However, thanks to 100% bonus depreciation, one of many tax deductions landlords might not know about, you can immediately deduct the eligible items’ cost. 100% bonus depreciation is expiring in a few years and, on the way to expiration, won’t cover 100% of the improvement’s cost. There’s also Section 179 deductions, which are similar to 100% bonus depreciation, but with important distinctions.
Let’s take an in-depth look at these valuable deductions.
What’s the difference between an improvement and a repair?
“Is it a repair or an improvement?” can be a hard question to answer, but you’ll need to be able to answer correctly to help identify items eligible for depreciation. The two easiest ways to tell the two apart is:
- Improvements add value to your rental property.
- Repairs return your property to its original condition.
Here are three examples highlighting the nuance that can separate a repair from an improvement.
- A new roof is an improvement but patching your roof is a repair.
- New windows are an improvement, but windows you need to install so your property is up to code are a repair.
- Replacing a broken sink with a newer model because the original model is discontinued is a repair. Replacing an old sink with a newer model when the original model is available is an improvement.
To help identify the difference, you can also use the acronym BAR: betterment, adaptation, restoration.
Is the change a solution to a problem that existed before your purchase? Does the change make the property bigger or better
Is your property going to be used in a way other than its intended use when it was purchased?
Are your changes going to make your property “like new”? Has the disrepair already cost you money?
If you answered yes to these questions or your change fits into one of these categories, then you’ve performed an improvement and may qualify for 100% bonus depreciation.
What is 100% bonus depreciation?
The Tax Cut and Jobs Act of 2017 (TCJA) doubled bonus depreciation to 100%. The TCJA also permitted certain used items to qualify for 100% bonus depreciation. The deduction will be available until 2023, at which point it will be decreased by 20% every year until 2027, at which point it will cease to be unless Congress legislates otherwise.
How does 100% bonus depreciation work?
Bonus depreciation works by allowing you to deduct a percentage of your improvement’s cost basis at the time of its purchase. It only applies to improvements that have a useful life of 20 years or less (useful life being the amount of time the IRS has determined an item can be used as part of a business’s operation).
So, if you claim bonus depreciation on an improvement that’s worth $100,000, then you would take 100% of the deduction in that year. For an item that’s $100,000, that would be 21%, so you’d be able to deduct $21,000.
Bonus depreciation is applied in the year that the improvement is placed into service using Form 4562. The deduction is applied automatically. Although, a business can opt-out of bonus depreciation. One reason may be that they believe regular depreciation would serve them better.
Bonus depreciation is an all or nothing deduction when it comes to the type of asset you’re deducting. That means that if you bought ten computers, you either depreciate all of them or none of them. But if you purchased ten computers and ten office chairs, whether or not you depreciate the ten computers does not affect the office chairs.
Do I have to pay depreciation recapture on 100% bonus depreciation?
Depreciation recapture is a tax you pay on the total amount you depreciated an item at the time of your property’s sale. Since bonus depreciation is a type of depreciation, you will have to pay depreciation recapture.
How does 100% bonus depreciation work with used property?
Thanks to the TCJA, bonus depreciation now applies to used property so long as:
- The property owner filing the deduction has used the property for 90 days or less.
- The property was not acquired using tax-exempt means (meaning that it was not the result of a tax-free acquisition or transferred by someone with a connection to the property owner, like a friend or relative).
What qualifies for bonus depreciation?
Some examples include:
1. Property with a useful life of 20 years or less:
- Not land or buildings (including accessory dwelling units)
- Computer software
2. Some property that’s used for both business and personal purposes so long as it’s used for business at least 50% of the time:
What is the Section 179 deduction?
Section 179 is often discussed in the same breath as bonus depreciation because they both allow you to deduct a percentage of a depreciable item's cost in the year that it's put into service. They’re also both filed using Form 4562.
As explained on the official website of Section 179, only cars, office equipment, business machinery, and computers are eligible. As of 2020, the deduction is capped at $1,040,000 for a property valued at $2,590,000 at purchase.
What are the differences between a Section 179 deduction and 100% bonus depreciation?
Bonus depreciation can be used even if your business isn’t profitable, whereas a Section 179 deduction requires profitability. Your business’s profitability imposes a cap when it comes to section 179. So, if your business makes only $20k and your improvement cost $30k, then you’ll only be able to apply Section 179 to $20k.
There are two ways to depreciate a purchase using Section 179 if you can’t claim 100% of the item’s cost in the year that it’s put into use.
- The remainder can be claimed using regular depreciation.
- You can deduct the remaining sum the following year using Section 179.
Additionally, if your item is eligible for bonus depression, regular depreciation, and Section 179, then the order in which the three deductions are to be applied are.
- Section 179
- Bonus depreciation
- Regular depreciation.
You don't have to recapture the Section 179 deduction unless you use it under 50% or less in the year in which the deduction is applied. In that case, the recapture amount is included as ordinary income.
What qualifies for the Section 179 deduction?
This is an excerpt from the full list of Section 179 deduction eligible items
- Office furniture
- Office equipment
- Large manufacturing tools and equipment
Bonus depreciation is a valuable deduction that makes real estate investment much easier. Take into consideration bonus depreciation’s expiration date so that you can decide whether or not you want to make rental property updates that attract high-quality tenants sooner rather than later. You can also make changes that make for easier rental property turnover.
If you do make improvements because of bonus depreciation, consider making some of them while you still have tenants since allowing your current tenants to make use of those improvements is one of many gestures that show tenant appreciation and can drive increase lease resigning.