Bonus Depreciation for Real Estate: What Investors Need to Know

What Is Bonus Depreciation?

Bonus depreciation allows investors to deduct a large percentage of the cost of qualifying assets in the first year they are placed in service, rather than spreading the deduction over the asset's normal recovery period. Under the Tax Cuts and Jobs Act (TCJA) of 2017, bonus depreciation was set at 100% for assets acquired and placed in service between September 28, 2017 and December 31, 2022. The provision then began phasing down: 80% for 2023, 60% for 2024, 40% for 2025, and 20% for 2026. After 2026, bonus depreciation expires entirely unless Congress extends it.

For real estate investors, bonus depreciation does not apply to the building itself (the 27.5-year or 39-year property). It applies to shorter-lived asset classes identified through a cost segregation study: 5-year property (carpeting, appliances, certain fixtures), 7-year property (office furniture, specialized equipment), and 15-year property (land improvements such as parking lots, landscaping, sidewalks, and fencing). Qualified Improvement Property (QIP), which covers interior improvements to nonresidential buildings, also qualifies as 15-year property eligible for bonus depreciation.

The Phase-Down Schedule and Its Impact

The declining bonus depreciation percentages directly affect first-year deductions. Consider a $1 million rental property where a cost segregation study identifies $300,000 in assets eligible for bonus depreciation. At 100% bonus, the entire $300,000 could be deducted in year one. At 40% (the 2025 rate), only $120,000 is deductible through bonus depreciation, with the remaining $180,000 depreciated over the applicable 5, 7, or 15-year schedules.

This phase-down creates a time-sensitive planning opportunity. Investors who are considering a cost segregation study should factor the current bonus depreciation rate into their analysis. A study that generates a strong return on investment at 60% or 80% bonus might produce a weaker (though still positive) result at 20%.

Properties placed in service in earlier years can still benefit. If you acquired a rental property in 2019 but never performed a cost segregation study, you can do a "look-back" study and claim the missed depreciation through a Section 481(a) adjustment on your current-year return. This catch-up deduction is taken in a single year, without amending prior returns.

Pairing Bonus Depreciation with Cost Segregation

Bonus depreciation is most powerful when combined with a cost segregation study. Without cost segregation, a residential rental property is depreciated as a single asset over 27.5 years. With cost segregation, a qualified engineer reclassifies building components into shorter-lived asset categories. On a typical residential rental, 20% to 40% of the building's depreciable basis may be reclassified to 5, 7, or 15-year property.

The financial impact can be substantial. On a $750,000 property (excluding land), standard straight-line depreciation yields roughly $27,273 per year. A cost segregation study reclassifying 30% of the basis ($225,000) to bonus-eligible categories produces an additional first-year deduction equal to the bonus rate times $225,000. At 40% bonus, that means $90,000 in extra first-year deductions on top of normal depreciation.

Cost segregation studies typically cost $5,000 to $15,000 depending on the property's size and complexity. The general rule of thumb is that a study makes financial sense on properties valued at $500,000 or more, though the math can work on lower-value properties if the bonus depreciation rate is high.

Passive Activity Limitations

There is a critical limitation that many investors overlook. Bonus depreciation generates passive losses for most rental property owners, and passive losses can only offset passive income under IRS Section 469. If you have $200,000 in bonus depreciation deductions but only $50,000 in passive income, the excess $150,000 in passive losses is suspended and carried forward to future years.

Two exceptions allow immediate use of these losses. First, investors who qualify as real estate professionals under IRS rules (750+ hours annually in real estate trades or businesses, with more hours in real estate than any other activity) can treat rental losses as non-passive and deduct them against W-2 income, business income, or any other income type. Second, the $25,000 special allowance permits active participants in rental real estate to deduct up to $25,000 in rental losses against non-passive income, but this allowance phases out between $100,000 and $150,000 in modified adjusted gross income.

For a broader overview of tax planning for rental property investors, see Tax Planning Strategies for Rental Property Income.