The contents of this article are not to be considered as tax advice and individuals should consult their own tax advisor as to tax advice. Recipients of the information contained in this article agree that MLG Capital, its affiliates and respective partners, members, employees, officers, directors, agents, and representatives shall have no liability for any misstatement or omission of fact or for any statement expressed herein.
Starting in 2023, the powerful tax benefits of bonus depreciation that were provided by the Tax Cuts and Jobs act in 2017 will begin to phase out by 20% each year, for 5 years, until they reach 0% in 2027. As this benefit begins to phase out this year, individuals from all backgrounds should understand what this means for their current investment, future investments, and personal financial plan.
This article will discuss what depreciation is, how it’s used in real estate to create tax efficiencies, and how the bonus depreciation phase out will potentially impact the real estate investing landscape in the coming years.
Real Estate Depreciation 101:
The IRS allows owners of real estate to deduct specific costs associated with buying and improving an asset from the owners’ income taxes, this practice is commonly referred to as depreciation1, thus creating a tax efficiency for the owners. The concept of depreciation stems from the idea that a real asset, such as a real estate asset and all the many components of said asset, will decrease in value over time.
The time period that an asset can be depreciated over changes depending on how the asset is classified. Many residential properties and their various components have 5/15/20/27.5-year lives, and commercial assets have 5/15/20/39-year lives2.
Net rental losses, a benefit of depreciation, are typically passed through to owners of real estate partnerships, these losses are usually treated as passive loss on an owner’s tax return.
It is important to note that not all investment opportunities can pass depreciation benefits down to investors, and that not all investment opportunities produce the same amount of depreciation benefits.
Before we dive into the different types of depreciation, it’s crucial to understand what a cost segregation study is and what role it plays in real estate depreciation practices.
Cost Segregation Studies are performed to categorize components of a real estate into buckets based on their estimated useful lives, or the amount of time than an asset can be depreciated over. The categories for cost segregation studies are as follows:
- Personal Property, such as furniture and carpeting, has a useful life of 5-7 years.3
- Land Improvements, like landscaping, have a useful life of 15 years.4
- Structures and buildings have a useful life of 27.5 years for residential properties, or 39 years for commercial assets.5
- Lastly, land assets, which are not depreciated at all.6
Ultimately, by using a cost segregation study and separating the costs of the asset down into these categories with different useful lives, an owner may produce passive loss benefits than could be accomplished through straight line depreciation.
At MLG Capital, we utilize the Modified Accelerated Cost Recovery System (“MACRS”) Alternative Depreciation System (“ADS”) within our MLG Capital Private Fund structure via the Real Property Trade or Business Election made popular by the Tax Cuts and Jobs Act Section 163(j).
Modified Accelerated Cost Recovery System (MACRS ADS) effectively allows owners to depreciate assets over a straight-line life based on the various depreciation tables set forth in IRS Publication 946. After a cost segregation study is completed, an owner can categorize certain components of their asset into their appropriate depreciable lives. Depending on the type of fixed asset of the investment, it may have a 5-, 7-, 15-, or 27.5-year life. For instance, if the investment has $1,000,000 of appliances, which are depreciated over 5 years instead of 27.5, the annual depreciation benefit is now $200,000 / year for 5 years assuming no bonus depreciation.
Bonus depreciation, in comparison allows owners to write off the allowable percentage of the cost basis in the first year for assets with less than a 20-year life in the year of purchase7. The chart here shows an example of 2022 bonus depreciation which allowed 100% write-off of 5-year property in year 1.
After a cost segregation study is completed and the components of an asset are categorized appropriately, an owner may use bonus depreciation to recognize the depreciation benefit quicker than they would through straight-line MACRS ADS depreciation.
Using the same example as above (an investment that has $1,000,000 of appliances which are typically depreciated equally over 5 years) Bonus Depreciation would allow an owner to recognize all $1,000,000 of depreciation in year 1.
Bonus Depreciation Phase Out:
This year, 2023, is the first year of the Bonus Depreciation phase out, which will reduce the impact of bonus depreciation by 20% each year for the next 5 years.
The example below compares $1,000,000 of assets in an apartment building with a 15-year depreciable life depreciated using (1) full year 1 bonus depreciation, (2) the 5-year phase out bonus depreciation and (3) MACRS ADS depreciation. By displaying a 15-year depreciation schedule below we can clearly see the impact of bonus depreciation in comparison to accelerated depreciation.
As bonus depreciation phases out over the next 5 years, the bonus depreciation schedules will more closely resemble what can be accomplished through MACRS ADS depreciation.
What does this mean for private real estate owners?
As bonus depreciation is phased out, the rate at which the depreciation benefits can be used will shift. Instead of most of the depreciation benefit occurring in the first year of an investment, it will now be spread out over the course of the investment.
Since bonus depreciation was introduced, our series of MLG Capital Private Funds has historically provided investors with a passive loss benefit, achieved through bonus depreciation practices, recognized in the same tax year that the investment was made8.
As bonus depreciation is phased out, the amount of passive loss an owner receives in Year 1 may drop, but the total amount of depreciation received by an owner over the useful life of the asset will likely remain the same, though will be depending on the hold time of the asset. After the dust settles and bonus depreciation is entirely phased out, we estimate that the series of MLG Capital Private Funds will still be able to produce a substantial passive loss benefit for our investors. However, this benefit will likely be spread over the life of the investment rather than recognized entirely in year 1 like we have seen in recent years.
Depending on an investor’s personal financial picture, this could have significant impacts to their tax plan and greater financial picture. We recommend that investors discuss these items with their CPA or financial advisor to create a plan to optimize tax efficiency in their personal portfolio.
As outlined in a prior blog, Cash Flows vs Taxable Income, repeatedly investing in our series of MLG Capital Private Funds over multiple years can provide an investor with a steady stream of both passive income and losses. This investment strategy creates a cycle that can help investors offset income with losses year after year.
Have questions about our series of MLG Capital Private Funds or anything real estate related?
 IRC Section 1.167(a)
 IRC Section 1.168(c)
 IRS Publication 946 Table B-1 (Asset Class 00.11)
 IRS Publication 946 Table B-1 (Asset Class 00.3)
 IRS Publication 946, Appendix A, Chart 2
 Per IRS Publication 946: “You cannot depreciate the cost of land because land does not wear out, become obsolete, or get used up.”
 IRC Section 1.168(k)(2)(A)(I)(l)
 Past performance is not indicative of future results. Contact MLG Capital for details on actual passive loss benefit received by Private Fund Investors.