Understanding Bonus Depreciation
Bonus depreciation under IRC Section 168(k) allows taxpayers to immediately deduct a large percentage of the cost of qualifying assets in the year they are placed in service, rather than depreciating them over their useful life. The Tax Cuts and Jobs Act of 2017 expanded bonus depreciation to 100% for assets acquired and placed in service between September 27, 2017, and December 31, 2022. For real estate investors, bonus depreciation applies to personal property (5-year, 7-year, and 15-year assets) identified through a cost segregation study—it does not apply to the building structure itself (27.5-year or 39-year property). This means the carpeting, specialized electrical, landscaping, parking lots, and other reclassified components from a cost segregation study can be fully deducted in year one when bonus depreciation is at 100%. The combination of cost segregation and bonus depreciation has been one of the most powerful tax strategies available to real estate investors over the past several years.
The Phase-Down Schedule: 2023-2027
Bonus depreciation is being phased down by 20 percentage points per year. For property placed in service in 2023, the bonus depreciation rate was 80%. In 2024, it drops to 60%. In 2025, the rate is 40%. In 2026, it falls to 20%. By 2027, bonus depreciation is scheduled to be 0% unless Congress enacts new legislation. This phase-down applies to the bonus-eligible portion of assets identified in a cost segregation study. For example, if a cost segregation study on a property placed in service in 2024 identifies $400,000 in 5-year property, the bonus depreciation deduction would be $240,000 (60% of $400,000). The remaining $160,000 would be depreciated under the standard Modified Accelerated Cost Recovery System (MACRS) schedule over the remaining 5-year life. While the phase-down reduces the immediate benefit, the combined first-year deduction—bonus plus regular MACRS depreciation on the non-bonus portion—still significantly exceeds straight-line depreciation on the entire building.
Which Real Estate Assets Qualify?
Bonus depreciation applies to tangible property with a MACRS recovery period of 20 years or less. In the real estate context, this includes 5-year property (carpeting, appliances, certain fixtures and decorative elements), 7-year property (office furniture, certain machinery), and 15-year property (land improvements such as parking lots, sidewalks, landscaping, fencing, and exterior lighting). The TCJA also made Qualified Improvement Property (QIP)—improvements to the interior of nonresidential buildings—eligible for bonus depreciation with a 15-year recovery period, after the CARES Act corrected what was known as the "retail glitch." QIP includes most interior improvements such as drywall, ceiling tiles, lighting upgrades, and interior doors, but excludes elevators, escalators, and building enlargements. Critically, the building structure itself—framing, roof, exterior walls, foundation, and general-purpose HVAC, plumbing, and electrical systems—remains 27.5-year or 39-year property and is not eligible for bonus depreciation.
Timing Strategies for Maximum Benefit
Given the phase-down schedule, timing asset placement is critical. Investors planning acquisitions or major renovations should consider accelerating their timelines to capture higher bonus percentages. A property placed in service on December 31, 2024 receives 60% bonus depreciation, while one placed in service on January 1, 2025 receives only 40%—a difference that can mean tens of thousands of dollars in tax savings. For properties under construction, the "placed in service" date is when the property is ready and available for its intended use, not the acquisition date. Renovation projects should be structured so that the cost segregation study is completed and assets are placed in service in the earliest possible tax year. Another strategy involves the timing of cost segregation studies themselves—if you expect to be in a higher tax bracket in 2024 than in 2025, front-loading deductions into the higher-income year maximizes the value of each dollar of depreciation. Work closely with your CPA to model the after-tax impact across multiple years before committing to a timeline.
Interaction with Passive Loss Rules
Bonus depreciation can generate large paper losses, but the ability to use those losses depends on your tax status. If you are a Real Estate Professional with material participation, bonus depreciation losses are non-passive and can offset wages, business income, and other active income. If you are a passive investor, bonus depreciation losses are subject to the passive activity loss rules under Section 469—they can only offset passive income, with the limited $25,000 allowance for taxpayers with AGI under $100,000. Unused passive losses carry forward indefinitely and are released when you dispose of the activity in a fully taxable transaction. For investors who cannot currently use the losses, there is still value in creating them: carried-forward passive losses reduce future taxable gain on sale. The interplay between bonus depreciation, cost segregation, REPS, and passive loss rules is complex, and the optimal strategy depends on your entire tax picture. Many investors work with their CPA to run multiple scenarios—one with bonus depreciation and one without—to determine which approach produces the best after-tax outcome over the projected hold period.
