Understanding the Benefits of Bonus Depreciation for Multifamily Investors

Multifamily real estate investors have long enjoyed the tax advantages of depreciation, which helps reduce taxable income. However, with the implementation of the Tax Cuts and Job Acts (TCJA) under President Donald Trump, a key provision of the reform dramatically changed how bonus depreciation works. The impact of 100% bonus depreciation on multifamily property owners will be highlighted below, as well as an explanation about how this tax benefit can be maximized for owners’ investment portfolios.

What is Bonus Depreciation?

Bonus depreciation is a tax benefit that allows investors to deduct a large portion of an asset’s value upfront instead of spreading the depreciation deductions over several years. Typically, real estate investors could depreciate a multifamily property over 27.5 years, but bonus depreciation accelerates this process, providing immediate tax relief. 

Under the TCJA, the bonus depreciation rule was significantly expanded, allowing for 100% bonus depreciation on qualified property for properties purchased and placed into service after September 21, 2017. This means multifamily investors can write off the full purchase price of certain assets, such as improvements to the property or personal property (appliances, flooring, etc.) in the first year, rather than depreciating it over several years.

Key Aspects of 100% Bonus Depreciation for Multifamily Investors

Accelerated Depreciation Deductions

Previously, investors could only depreciate a property or assets over a set period. For multifamily real estate, land improvements, such as parking lots or landscaping, typically have a depreciation life of 15 years; however, personal property could be depreciated over five or seven years. With the introduction of 100% bonus depreciation, investors can now take immediate deductions on eligible properties and assets. This could dramatically reduce the investor’s taxable income, leading to significant tax savings in the first year after the property acquisition or improvements.

Bonus Depreciation Applies to Qualified Property

It’s important to note that not all aspects of a multifamily property qualify for 100% bonus depreciation. The tax benefit applies primarily to tangible assets, such as appliances, flooring, HVAC systems, security systems, furniture (in furnished rental units), and land improvements like sidewalks or fencing. 

Land itself, as well as certain permanent improvements to buildings, generally cannot benefit from bonus depreciation. However, when property owners do cost segregation studies to break out these eligible assets from the building structure, it opens up an avenue for greater depreciation benefits.

Cost Segregation: A Key Strategy for Maximizing Bonus Depreciation

Cost segregation is a powerful strategy that allows multifamily investors to segregate personal property and land improvements from the overall building, creating the opportunity to depreciate these components over a much shorter period (typically five, seven, or 15 years instead of 27.5 years for the building itself). This study, performed by professionals, identifies assets within a building that qualify for accelerated depreciation.

For example, if a multifamily investor purchases a property for $10 million, a cost segregation study might identify $2 million worth of assets that qualify for bonus depreciation. By applying the 100% bonus depreciation, the investor can deduct the $2 million in the first year, greatly reducing the tax liability.

Tax Deferral and Increased Cash Flow

The primary benefit of bonus depreciation is the ability to defer taxes. By accelerating depreciation, multifamily investors can significantly reduce their taxable income, leading to lower current-year tax liability. This reduction in tax obligations frees up capital that can be reinvested into additional real estate or used for other business purposes.

The immediate tax savings can also improve cash flow in the short term. For example, an investor who normally faces a large tax bill on the profits from rent payments and property sales may now experience less tax burden, due to the upfront depreciation deduction.

Impact on the Sale of the Property

While 100% bonus depreciation provides significant upfront benefits, investors should be aware of the tax implications when the property is sold. The IRS may require the recapture of some depreciation deductions upon the sale of the property, which means that the investor could owe taxes on a portion of the deductions they took during ownership.

However, the recapture rate for real property that has been depreciated using the bonus depreciation method may be less than for other types of property, which means that the investor still benefits from the accelerated depreciation strategy, even if they face recapture when selling. The key takeaway is that planning ahead with a long-term investment horizon can help mitigate any negative tax impacts.

Temporary Nature of the Provision

It’s important to note that the 100% bonus depreciation benefit is set to phase down after 2022. Under the TCJA, the bonus depreciation rate will gradually decrease, starting with 100% in 2023, 80% in 2024, 60% in 2025, and so on until it reaches 20% in 2027. Therefore, multifamily investors should consider accelerating property acquisitions or major capital improvements during this window to maximize the tax benefits.

How Does 100% Bonus Depreciation Affect Investment Strategies?

Improved ROI

The upfront tax savings from bonus depreciation can significantly enhance the ROI of multifamily properties in the first few years of ownership. Investors can use these savings to fund other investments or reinvest in improving their existing properties, increasing their income-generating potential.

Attracting Equity Partners

Bonus depreciation can also be an attractive incentive for investors looking to partner with equity investors or raise capital for future deals. The potential for immediate tax savings can be used as a selling point to attract capital from other investors who are interested in reducing their own tax burdens.

Cash Flow Optimization

Real estate investors who manage their properties for long-term cash flow may find that the enhanced depreciation benefits help offset maintenance costs or unexpected expenses, improving financial stability.

Overall Impacts

For multifamily investors, the 100% bonus depreciation provision in the TCJA offers a powerful tax-saving tool. By allowing immediate write-offs for qualifying property improvements and assets, this provision can drastically reduce taxable income, resulting in higher short-term cash flow and a stronger ROI. However, investors need to work with tax professionals and consider conducting cost segregation studies to maximize these benefits.

Given that the bonus depreciation provision will phase out over the next several years, now is an optimal time to take advantage of these generous tax benefits. Planning ahead and structuring investments in a way that optimizes depreciation can make a significant difference in a current tax strategy and long-term investment success.