The IRS uses different tax rules for individuals and businesses. The government taxes nearly everything individuals and couples earn in a given year. In fact, you generally pay taxes at both the state and federal levels, which can significantly reduce the amount of money left for personal needs.
Companies calculate taxes based on a separate set of rules and regulations. They earn money through revenues and then deduct qualified business expenses to determine profitability. Business costs are further broken down into operational and capital expenditures. The company can deduct 100% of operating costs but must depreciate capital expenses, defined as property lasting more than a year.
Capital expenses can include anything from computers to business vehicles to buildings. Depending on the asset, the deprecation schedule will last anywhere between three and 39 years.
Do Investments Fall Under the Business or Personal Tax Laws?
How the IRS taxes your investments depend on the type of investment and its structure. Purchasing stocks and bonds in a personal account will follow the IRS rules for individual income.
However, if appropriately structured, real estate and other alternative ventures can often utilize business tax rules. Your accountant can ensure qualified investments follow IRS rules allowing you to reap more tax benefits.
When Does Depreciation Apply to Investors?
Traditional stocks and bonds incur taxes at the time of the sale. You typically subtract the cost, the tax basis, and pay taxes on gains. Investments held for more than 12 months enjoy lower taxation at the capital gains rate. Accounts offering tax benefits, like 401ks, generally don’t tax contributions. Therefore, you pay taxes on the total amount as ordinary income, regardless of how long you held the investment.
Real estate not only allows you to deduct all qualified business expenses but lets you depreciate the asset as a capital expense.
Choosing How to Depreciate Capital Assets
Currently, there are three ways to depreciate assets purchased for business purposes:
- Straight-line depreciation
- 179 deductions
- Bonus depreciation
Straight-Line depreciation depreciates an asset over 3 to 39 years, depending on the type of property and its average life. Real estate purchases typically depreciate over 27.5 years.
179 deductions allow you to subtract a capital asset’s total cost immediately. To meet IRS qualifications, the property must be tangible (like a computer or office furniture), used by the business more than 50% of the time, and not purchased from someone related to you.
Intangible assets like patents and copyrights do not qualify, nor do buildings and land. It is subject to an annual dollar limit and limited to annual business profits.
Bonus depreciation was introduced in 2015 and expanded in the Tax Cuts and Jobs Act. Congress increased bonus depreciation to 100% of the purchase price for qualified assets bought after September 27, 2017, and before January 1, 2023. After January 2023, the maximum bonus depreciation allowed tapers off by 20% per year until 2027 when it goes to 0% bonus depreciations, when the provision ends.
When is Bonus Depreciation Applicable?
Bonus depreciation applies to all long-term assets placed in service before the prescribed deadline. The property must be in service by December 31, 2022, to qualify for 100% depreciation. Property must also meet the following qualifications:
- Purchase new or used qualified property with 20 years or less useful life.
- A relative does not sell you the property.
- According to the IRS rules, if the property is “listed” (based on the IRS list), it must be used more than 50% for business purposes. (Automobiles are an example of listed property).
- There is no annual dollar limit, and it is not limited to business profits.
How Bonus Depreciation Impacts Real Estate Purchases
Bonus depreciation can significantly reduce taxable income because you can deduct the entire cost of most capital improvements in the year you incur the expense. You may also claim the bonus on real estate purchases if you conduct a cost segregation study. The study breaks the property into depreciation components, allowing you to gain more significant depreciation in the first year of ownership.
If you are ready to learn more about multifamily investing and how you can reduce taxable income through bonus depreciation, click here to schedule your free call with me.
This article does not offer legal or accounting advice and is only meant for informational purposes. For specific tax questions seek the advice of an industry professional.