The real estate investment landscape is evolving quickly, prompting investors to monitor legislative changes closely. Trump’s possible return to office heightens this focus. The impending expiration of the Bonus Depreciation law concerns many investors. This law has made real estate highly appealing for those with active income.
Understanding the significance of this change and its impact on real estate investors is essential. Here’s why:
The Power of Depreciation
Taxes can significantly impact investment returns, and many investors already know that real estate offers unique tax advantages. Unlike W-2 income, where taxes are withheld automatically, real estate investments allow for strategic deductions and tax planning, making it a powerful tool for minimizing taxable income.
One of the most advantageous tax benefits of real estate investing is depreciation. When you invest in an asset that erodes over time, like property improvements, the IRS allows you to deduct a portion of the asset’s cost over its useful life, reducing your taxable income. Each asset has a different depreciation schedule that dictates how long the depreciation period lasts. For instance, residential real estate improvements generally have a 27.5-year depreciation schedule, while other components, like appliances and cabinetry, may have shorter lifespans such as 5 or 15 years.
The brilliance of real estate investing is that, despite being depreciable, real estate typically appreciates over time. This creates a powerful tax advantage, allowing investors to deduct the “wear and tear” of the building’s structure while the property value continues to rise. It’s important to note that only the improvements on the property can be depreciated, not the land itself.
For example, if you buy a $300,000 property and allocate $250,000 of that to improvements, you can claim depreciation on the $250,000, reducing your taxable income each year. Properly allocating value between land and improvements is key, as it can significantly impact your taxes. Experienced investors and their advisors maximize depreciation by allocating as much as possible to improvements within IRS guidelines, making strategic use of Cost Segregation and Bonus Depreciation a game-changer.
Cost Segregation and Accelerated Depreciation
Here’s where things get even more interesting. The IRS allows for accelerated depreciation on components of a property that don’t have a 27.5-year life span. Items like paint, appliances, and cabinets might qualify as 5- or 15-year property. This enables investors to front-load depreciation and take larger deductions sooner. This process is called a Cost Segregation Study, where a CPA meticulously documents each component of your property, assigning them to the appropriate depreciation category. While costly, these studies are beneficial for higher-value properties where the tax savings justify the expense.
The Impact of Trump’s Tax Code and Bonus Depreciation
In 2017, the Trump administration introduced a significant change: 100% Bonus Depreciation. This law allowed investors to take the entire depreciation amount of 5- and 15-year property in the first year rather than amortizing it over time. This provision dramatically shifted the math for real estate investors, making it possible to offset other active income with large, upfront deductions. The result? Real estate investment became a highly efficient tax shelter for those with substantial active income.
However, the law is gradually phasing out, decreasing by 20% each year from 100% in 2022 until it reaches 0% by 2027, and with Trump’s return to office, investors are closely watching to see if his administration will reinstate or extend Bonus Depreciation. The potential for changes in tax law is critical, as it materially affects the economics of real estate investing, especially for those who qualify as Real Estate Professionals, a status that requires dedicating at least 750 hours per year and over 50% of working hours to real estate activities. While this designation is difficult to attain, it’s invaluable for those who can prove it, making it crucial to document hours diligently in case the IRS requires evidence of active involvement.
