Bonus Depreciation for Commercial Real Estate

What Is Bonus Depreciation for Commercial Real Estate?

Bonus depreciation, codified under Section 168(k) of the Internal Revenue Code, allows commercial real estate investors to deduct a significant percentage of the cost of qualifying property in the first year it is placed in service. Instead of spreading depreciation deductions over 5, 7, 15, or 39 years using standard schedules, bonus depreciation front-loads the tax benefit, creating immediate and substantial tax savings.

For commercial real estate investors, bonus depreciation applies primarily to personal property and land improvements identified through a cost segregation study. Building components like HVAC systems, electrical wiring, carpeting, parking lots, and landscaping can qualify for accelerated first-year deductions rather than being depreciated over the building's 39-year recovery period.

The Tax Cuts and Jobs Act (TCJA) of 2017 expanded bonus depreciation to 100%, allowing investors to deduct the entire cost of qualifying assets in year one. However, Congress included a phasedown schedule that reduces the allowable percentage by 20% each year starting in 2023, eventually eliminating the benefit entirely after 2026.

Bonus depreciation remains one of the most powerful tax planning tools available to commercial property owners. A $5 million multifamily acquisition might yield $1 million to $1.5 million in first-year bonus depreciation deductions when combined with a cost segregation study, potentially offsetting taxable income from other sources. Understanding how this provision works and how to plan around the phasedown is essential for maximizing after-tax returns on commercial real estate acquisitions.

How Does the Bonus Depreciation Phasedown Schedule Work?

The bonus depreciation phasedown follows a clear, legislated timeline. Under the TCJA, 100% bonus depreciation was available for qualifying property placed in service from September 28, 2017, through December 31, 2022. Beginning in 2023, the percentage decreases by 20 points annually.

Here is the complete phasedown schedule:

• 2022 and prior: 100% bonus depreciation (full first-year deduction)
• 2023: 80% bonus depreciation
• 2024: 60% bonus depreciation
• 2025: 40% bonus depreciation
• 2026: 20% bonus depreciation
• 2027 and beyond: 0% bonus depreciation (unless Congress acts)

The "placed in service" date determines which percentage applies, not the purchase date or closing date. A property purchased in December 2025 but not placed in service until January 2026 would only qualify for 20% bonus depreciation rather than 40%. This distinction matters significantly for investors timing their acquisitions and renovations.

For longer-lived property like commercial buildings, the placed-in-service date typically aligns with when the property is ready and available for its intended use. For renovations, each component's placed-in-service date corresponds to when that specific improvement is completed and operational.

The declining percentages create urgency for investors to act. At the current 40% rate in 2025, a qualifying $500,000 cost segregation allocation still generates a $200,000 first-year deduction. By 2026, that same allocation would yield only $100,000. After 2026, investors lose bonus depreciation entirely and must rely on standard depreciation schedules.

What Property Qualifies for Bonus Depreciation?

Not all commercial real estate components qualify for bonus depreciation. The IRS limits the benefit to specific categories of property with recovery periods of 20 years or less. Understanding what qualifies helps investors accurately project their tax savings.

Qualifying property includes:

• Personal property (5-year, 7-year, and 15-year classes): Appliances, carpeting, decorative fixtures, signage, specialty lighting, window treatments, and removable partitions
• Land improvements (15-year recovery): Parking lots, sidewalks, landscaping, fencing, outdoor lighting, drainage systems, and retaining walls
• Qualified Improvement Property (QIP): Interior improvements to nonresidential buildings placed in service after the building was first placed in service, including updated flooring, ceilings, interior doors, fire protection, and security systems

Property that does NOT qualify:

• The building structure itself (39-year recovery for nonresidential, 27.5 years for residential rental)
• Structural components like foundations, exterior walls, and roofing
• Land (not depreciable at all)
• Property used predominantly outside the United States

Qualified Improvement Property deserves special attention. The CARES Act of 2020 corrected a drafting error in the TCJA, retroactively classifying QIP as 15-year property eligible for bonus depreciation. This means interior renovations to existing commercial buildings, such as tenant buildouts or lobby upgrades, qualify for accelerated deductions.

For investors pursuing value-add strategies, this is particularly valuable. Renovation costs allocated to QIP and personal property through a cost segregation study can generate significant first-year deductions, improving the cash-on-cash return profile of repositioning projects.

How Does Cost Segregation Interact with Bonus Depreciation?

Cost segregation and bonus depreciation work together as a powerful tax savings combination. A cost segregation study identifies and reclassifies building components into shorter recovery periods, making them eligible for bonus depreciation. Without a cost segregation study, most of a building's cost would be depreciated over 39 years with no bonus depreciation available.

How the process works:

1. You acquire or construct a commercial property
2. A qualified cost segregation engineer conducts a detailed study of the building
3. The study reclassifies 15% to 40% of the building's cost into 5-year, 7-year, and 15-year property categories
4. Bonus depreciation applies to all reclassified components at the current year's percentage rate
5. The remaining building cost continues depreciating over 39 years using straight-line depreciation

Example: $4 million multifamily acquisition in 2025

Consider an investor who purchases a $4 million apartment building (excluding land value of $800,000, leaving $3.2 million in depreciable basis). A cost segregation study identifies $960,000 (30%) as qualifying property.

Without cost segregation: The investor claims approximately $82,051 in standard depreciation ($3.2 million divided by 39 years) in year one.

With cost segregation and 40% bonus depreciation in 2025: The investor claims $384,000 in bonus depreciation ($960,000 multiplied by 40%) plus standard depreciation on the remaining $2.24 million, totaling approximately $441,436 in first-year deductions.

That additional $359,385 in first-year deductions could save a high-income investor $130,000 to $145,000 in federal taxes alone. When you factor in state income taxes, the savings increase further.

Cost segregation studies typically cost between $5,000 and $25,000 depending on property size and complexity. Talk to our team about connecting with vetted cost segregation firms that specialize in commercial properties. The return on investment is often 10:1 or higher for properties valued above $1 million. For investors financing acquisitions through permanent loans or refinancing existing properties, the tax savings from a cost segregation study paired with bonus depreciation can meaningfully improve overall investment returns.

To explore how depreciation strategies fit within your broader tax plan, review our comprehensive guide on tax deductions for commercial real estate.

What Tax Savings Can Investors Expect from Bonus Depreciation?

The actual tax savings depend on several factors: the property's depreciable basis, the percentage of costs reclassified through cost segregation, the applicable bonus depreciation rate, and the investor's marginal tax bracket. Running realistic projections helps investors make informed acquisition and timing decisions.

Key variables that determine your savings:

• Depreciable basis: Purchase price minus land value. Land typically represents 15% to 30% of total acquisition cost depending on location and property type.
• Cost segregation allocation: Studies typically reclassify 15% to 40% of depreciable basis. Multifamily properties tend toward the higher end due to more personal property. Office and industrial properties vary based on tenant buildout and site improvements.
• Bonus depreciation rate: 40% in 2025, 20% in 2026, then 0% starting in 2027.
• Marginal tax rate: Federal rates of 24%, 32%, 35%, or 37% for individuals. State taxes add 0% to 13.3% depending on jurisdiction.

For a practical illustration, consider three investors purchasing identical $3 million commercial properties in different years:

• Investor A (2024, 60% bonus): $720K qualifying amount, $432K bonus deduction, approximately $159,840 federal tax savings at 37%
• Investor B (2025, 40% bonus): $720K qualifying amount, $288K bonus deduction, approximately $106,560 federal tax savings at 37%
• Investor C (2027, 0% bonus): $720K qualifying amount, $0 bonus deduction, $0 additional first-year savings

The difference between Investor A and Investor C in first-year tax savings exceeds $159,000 on the same property. This gap underscores why timing matters and why investors should consider accelerating acquisitions while bonus depreciation percentages remain meaningful.

Use our DSCR calculator to model how tax savings from bonus depreciation affect your effective debt service coverage and cash-on-cash returns.

Who Can Claim Bonus Depreciation on Commercial Property?

Bonus depreciation is available to any taxpayer who owns qualifying property used in a trade or business or held for the production of income. However, specific ownership structures and investor profiles determine how the deduction flows through and whether it provides immediate benefit.

Individual investors and partnerships: Bonus depreciation deductions pass through to individual tax returns. Real estate professionals (those who spend 750+ hours per year materially participating in real estate activities) can use these deductions to offset ordinary income, including W-2 wages and business income. Non-real estate professionals face passive activity loss limitations, meaning bonus depreciation deductions can only offset passive income from other rental properties or investments.

S-Corporations and LLCs: Deductions pass through to shareholders and members based on their ownership percentages. The same passive activity rules apply at the individual level.

C-Corporations: Bonus depreciation directly reduces corporate taxable income at the 21% federal corporate rate. There are no passive activity limitations for C-Corps.

Important limitations to understand:

• Used property now qualifies: Before the TCJA, bonus depreciation only applied to new (original use) property. The 2017 law expanded eligibility to include used property acquired by the taxpayer, making acquisitions of existing buildings eligible when combined with cost segregation.
• Anti-churning rules: You cannot claim bonus depreciation on property acquired from a related party. The IRS applies attribution rules to prevent investors from selling property to related entities solely to generate new deductions.
• Election out: Taxpayers can elect out of bonus depreciation for any class of property in any tax year. This might make sense if you have net operating losses to carry forward or expect to be in a higher tax bracket in future years.
• AMT treatment: Bonus depreciation is allowed for Alternative Minimum Tax purposes, reducing both regular tax and AMT liability.

What Planning Strategies Work as Bonus Depreciation Phases Out?

With bonus depreciation declining to 20% in 2026 and disappearing in 2027 (absent new legislation), investors should implement proactive strategies to maximize remaining benefits and prepare for the post-bonus depreciation environment.

Strategy 1: Accelerate acquisitions and improvements. If you are considering a commercial property acquisition or major renovation, completing the transaction while bonus depreciation remains available creates meaningful tax advantages. A property placed in service in 2025 at 40% generates twice the first-year deductions as the same property in 2026 at 20%. Contact our team to discuss financing options that align with your timeline.

Strategy 2: Maximize cost segregation allocations. Work with experienced cost segregation engineers who use detailed, engineering-based approaches rather than estimate-based methods. A thorough study often identifies 5% to 10% more qualifying property than a cursory analysis, directly increasing your bonus depreciation deductions.

Strategy 3: Consider partial asset dispositions. When renovating or replacing building components, the IRS allows you to claim a loss on the remaining basis of the disposed component. Replacing an HVAC system lets you write off the remaining undepreciated value of the old system while claiming bonus depreciation on the new one.

Strategy 4: Time improvements strategically. If you are planning phased renovations on a value-add property, prioritize completing improvements with the highest qualifying percentages in earlier years when bonus depreciation rates are higher. Push structural and non-qualifying work to later phases.

Strategy 5: Evaluate Section 179 as a complement. Section 179 allows businesses to deduct up to $1,250,000 (2025 limit, adjusted annually for inflation) of qualifying property in the year placed in service. While Section 179 has income limitations that bonus depreciation does not, it can supplement your accelerated depreciation strategy, particularly for personal property and equipment within commercial buildings.

Strategy 6: Monitor legislative developments. Congress has extended or modified bonus depreciation multiple times. Bipartisan support exists for maintaining accelerated depreciation provisions. The Tax Relief for American Families and Workers Act proposed restoring 100% bonus depreciation retroactively, though it had not passed as of early 2025. Investors should maintain flexibility in their tax planning to capitalize on potential changes.

Strategy 7: Structure deals for maximum benefit. When financing acquisitions through permanent loans or acquisition financing, consider how loan structure affects your ability to use depreciation deductions. Higher leverage can amplify tax benefits of bonus depreciation relative to your equity invested, improving after-tax returns.

What Are the Risks and Limitations of Bonus Depreciation?

While bonus depreciation offers significant tax advantages, investors must understand the potential drawbacks and limitations to avoid unexpected tax consequences.

Depreciation recapture: When you sell a commercial property, the IRS recaptures depreciation deductions. Bonus depreciation accelerates deductions into early years, but it also accelerates the recapture liability upon sale. Personal property depreciation is recaptured at ordinary income rates (up to 37%), while real property depreciation is recaptured at a maximum 25% rate under Section 1250.

Phantom income risk: Large first-year depreciation deductions can create net operating losses that carry forward. In later years, when standard depreciation on the building is the only deduction available, taxable income from the property may exceed cash flow, creating "phantom income" where you owe taxes despite limited cash distributions.

Passive activity limitations: Non-real estate professionals can only use passive losses against passive income. Bonus depreciation deductions that exceed your passive income carry forward indefinitely but provide no immediate tax benefit unless you have other passive income sources.

State tax variations: Not all states conform to federal bonus depreciation rules. California, for example, does not allow bonus depreciation at all. Other states partially conform or require add-back adjustments. Investors in non-conforming states should calculate federal and state tax impacts separately.

Ready to explore how bonus depreciation fits your investment strategy? Schedule a consultation with our commercial lending team to discuss financing structures that maximize your tax advantages.

Frequently Asked Questions About Bonus Depreciation?

Does bonus depreciation apply to residential rental property?

Yes, bonus depreciation applies to qualifying components of residential rental property identified through a cost segregation study. The building structure itself (27.5-year property) does not qualify, but personal property, land improvements, and certain building systems reclassified into shorter recovery periods are eligible.

Can I claim bonus depreciation on a property I purchased in a previous year?

Bonus depreciation applies in the year the property is placed in service. You cannot retroactively claim it for prior years on property already in service. However, you can file a Form 3115 (change of accounting method) to catch up on missed cost segregation deductions from previous years without amending prior returns.

Is bonus depreciation going away permanently after 2026?

Under current law, bonus depreciation reaches 0% for property placed in service after December 31, 2026. However, Congress can extend or modify the provision. Bonus depreciation has been reinstated or expanded multiple times since it was first introduced in 2002.

How does bonus depreciation differ from Section 179 expensing?

Section 179 has an annual dollar limit ($1,250,000 in 2025) and cannot create a net loss. Bonus depreciation has no dollar limit and can create or increase a net operating loss. Section 179 applies to property used more than 50% for business. Most commercial real estate investors use both provisions strategically to maximize first-year deductions.

Do I need a cost segregation study to claim bonus depreciation?

While not technically required, a professional cost segregation study provides the documentation and engineering analysis the IRS expects during audits. For properties valued above $500,000, the cost of a study ($5,000 to $25,000) is negligible compared to the tax savings generated.

What happens to bonus depreciation if I refinance my property?

Refinancing does not trigger bonus depreciation. The deduction is claimed when property is first placed in service, not when financing changes. However, if you use refinance proceeds to fund new improvements, those improvements can qualify for bonus depreciation at the current year's rate.

Can foreign investors claim bonus depreciation on U.S. commercial property?

Yes, foreign investors can claim bonus depreciation on U.S. commercial property held through a U.S. entity, subject to the same rules as domestic investors. The property must be used in a U.S. trade or business. Foreign investors should also consider FIRPTA implications upon disposition.

Does bonus depreciation reduce my property's basis for calculating gain on sale?

Yes. All depreciation, including bonus depreciation, reduces your adjusted basis in the property. When you sell, your taxable gain equals the sales price minus your adjusted basis. Higher early deductions mean a lower basis and potentially higher gain upon sale, but receiving tax savings earlier is generally more valuable due to the time value of money.

Sources?

1. Internal Revenue Service. "Publication 946: How to Depreciate Property." IRS.gov, 2024.
2. U.S. Congress. "Tax Cuts and Jobs Act of 2017, Section 168(k)." Public Law 115-97.
3. American Institute of CPAs. "Bonus Depreciation: Current Rules and Planning Strategies." AICPA.org, 2024.
4. Cost Segregation Advisor. "Impact of Bonus Depreciation Phasedown on Commercial Real Estate." 2024.
5. National Association of Realtors. "Commercial Real Estate Tax Provisions Under Current Law." NAR.realtor, 2024.