Building new construction is financially appealing for many reasons. As we remain in a competitive seller’s market with low vacancy rates for rentals, developers are reaping the benefits of new construction. This blog focuses on another lucrative perk of new construction: real estate bonus depreciation. Read on to see how this powerful tax tool can help you expand your portfolio.
Depreciation in Real Estate, an Unlikely Ally
Unlike cars, equipment, or other assets that have a clear line of depreciation throughout their “useful life”, real estate tends to appreciate over time, making it a safe and lucrative investment. Interestingly, even though real estate tends to appreciate, the IRS still allows taxpayers to claim depreciation on the asset for the purpose of lowering taxes. The typical “useful life” of real estate used in depreciation calculators is around 27.5 years, but we know that single-family residences, apartments, townhomes, and other developments maintain value far past the 30-year mark.
In short, new construction benefits you, the developer, because you’re able to utilize bonus depreciation in your first year in service, and you can count on steady appreciation in value if you choose to maintain ownership beyond your first year.
How Bonus Depreciation Benefits Developers in 2022
To fully understand the benefits of bonus depreciation, let’s investigate the scope of current bonus depreciation limits. Real estate bonus depreciation, also known as “additional first year depreciation deduction” is a tax benefit that allows investors to deduct a percentage of their asset’s depreciation in the first year in service.
The new real estate tax laws increased the bonus depreciation benefit from 50% to 100% for the remainder of 2022. We have the Tax Cuts and Jobs Act (TCJA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) to thank for this increase. This generous deduction privilege is extremely advantageous for builders. The current rate of bonus depreciation (100%) is unprecedented and will likely slowly decrease for bonus-eligible construction after 2022. In short, that means that 2022 is an excellent time to break ground on your next construction project.
The taxpayer or its predecessor didn’t use the property at any time before acquiring it.
The taxpayer didn’t acquire the property from a related party.
The taxpayer didn’t acquire the property from a component member of a controlled group of corporations.
The taxpayer’s basis of the used property is not figured in whole or in part by reference to the adjusted basis of the property in the hands of the seller or transferor.
The taxpayer’s basis of the used property is not figured under the provision for deciding the basis of property acquired from a decedent.
Also, the cost of the used property eligible for bonus depreciation doesn’t include the basis of property determined by reference to the basis of other property held at any time by the taxpayer (for example, in a like-kind exchange or involuntary conversion).
Utilizing bonus depreciation for your new construction can allow you to defer paying current year taxes for several years which can allow you to stabilize your investment. Taking advantage of accelerated depreciation gives you wiggle room to find the most competitive buyer and turn a profit.
Bonus Depreciation for Land Improvements and Building Costs
Good news- all improvements made to raw land can be included in bonus depreciation filings. Everything from buildings, driveways, sidewalks, parking lots, garages, swimming pools, etc count. During your first year of construction, this can be extremely beneficial as you work to stabilize your investment.
Depreciation Recaptures- What You Need to Know
When you sell an asset that previously offset your taxable income, the IRS is then able to collect taxes on that sale. This is known as Depreciation Recapture. Depreciation Recapture is only assessed if the sale price of your asset is higher than the adjusted cost basis (ACB). The ACB is the change in value for your asset after you have completed improvements, sold it, or accepted a payout. In 2022, the Depreciation Recapture rate is capped at 25%.
If you’re curious how depreciation recapture rates are calculated, the IRS uses a depreciation schedule to account for expected wear and tear done to the building and structures, but not the land, each year after it is built. This anticipated schedule gives taxpayers a good idea of the percentage their assets will depreciate each year. If your asset is sold for more than the anticipated depreciation value, that difference is the depreciation recapture amount.
Capitalizing Costs vs Expensing Costs
Capitalization allows you to categorize a large expense over time, rather than as one large debt on your profit & loss statement. By capitalizing costs as appropriate, you are essentially reporting it based on the value it adds to your business. Even though you have paid for that item (such as building a swimming pool), you are insinuating that the pool will add value to your construction project as a whole by increasing the value potential buyers place on your project.
How does this relate to depreciation? The expense you are capitalizing, in this example your swimming pool, will gradually appear on your statements over the course of the property’s expected useful life and is classified as a depreciating asset.
Other examples of expenses that can be capitalized in construction projects include: the cost of materials, labor and overhead to complete your project. Building permits, architectural fees, blueprints, specifications and land excavation are also expenses you can capitalize.
It is wise to create and adhere to a consistent policy to decide what expenses are well suited for capitalizing. For guidance, refer to the FASB, or IRS standards. From there, ensure that your policy applies to your tax reporting strategy as well, so that you can benefit from the depreciating asset.
As you’re expanding your real estate portfolio, one of the most helpful strategies for financial security is strategically lowering tax bills. Taking advantage of bonus depreciation rules with your new construction project is an excellent way to save substantially on your taxes, opening the door for continued investment and growth.