How does bonus depreciation change the cash-on-cash math on a CRE deal?

Modeling bonus depreciation impact on sponsor returns

This page is sponsor-POV process commentary, not tax or legal advice. Bring a CPA and tax counsel onto every transaction before relying on any of the mechanics described below.

The bonus depreciation percentage has stepped down from 100% (2017 to 2022) on a phase-down schedule. The applicable percentage in any year governs the size of the first-year deduction on qualifying short-life property. Confirm the current-year percentage with tax counsel before modeling. Congress has periodically extended or modified the schedule.

Worked illustration: a $20M acquisition with a $4M land value leaves $16M building basis. A cost segregation study reclassifies $4M (25%) to 5/7/15-year property. With bonus depreciation at the applicable rate, the first-year deduction equals roughly that percentage of the $4M reclassified basis, plus standard MACRS depreciation on the remaining $12M. The result for high-bracket investors is meaningful first-year tax shelter against passive income.

After-tax cash-on-cash: pre-tax distributable cash flow is unchanged by depreciation. After-tax cash flow improves because the depreciation deductions reduce or eliminate property-level taxable income, which means investors pay less tax on the distributions they receive. Marketing materials typically present both pre- and after-tax IRR.

Recapture at exit: §1250 recapture taxes the depreciation taken on real property at a maximum 25% rate, while §1245 recapture on personal property (the items reclassified by cost segregation) is taxed at ordinary rates. The recapture math reduces the long-run benefit relative to a 1031 exchange that defers all tax. The bigger the bonus depreciation up front, the bigger the recapture if the property is sold rather than 1031-exchanged.