Electing Out of Bonus Depreciation: When It Makes Sense

Electing out of bonus depreciation means choosing to use regular MACRS depreciation instead of claiming the additional first year depreciation allowed under Section 168(k). When you elect out, qualifying property depreciates over its assigned recovery period using the applicable MACRS method (200% or 150% declining balance) rather than receiving immediate bonus expensing of a percentage of its basis in the year placed in service.

The election is made on a property class basis, not an all or nothing decision for all property. You can elect out of bonus depreciation for 5 year property while claiming bonus on 7 and 15 year property. You can elect out for personal property while claiming bonus on land improvements. This class by class flexibility allows customization based on the specific tax benefits and limitations applicable to different property types in your situation.

Opting out bonus depreciation does not change the property's MACRS classification, recovery period, or depreciation method. A component assigned to the 5 year class remains 5 year property whether or not you claim bonus. The only difference is that without bonus, the component uses regular MACRS depreciation (20% first year rate for 5 year property) instead of receiving immediate expensing under bonus depreciation rules.

The election to forego bonus depreciation is generally irrevocable once your return is filed. You cannot claim bonus in year one, then revoke the decision and elect out later, or vice versa. This permanence makes the election significant because it affects the property's depreciation for its entire ownership period. Careful analysis before filing is essential because changing the decision requires expensive and uncertain IRS consent procedures.

The primary reason to elect out of bonus depreciation is insufficient taxable income to utilize large immediate deductions. If claiming bonus depreciation would create or increase a net operating loss that provides minimal current benefit, spreading deductions over time using regular MACRS may preserve more value. This situation is common for new businesses, properties acquired late in high income years, or investors experiencing temporary income declines.

Passive activity loss limitations provide another compelling reason for electing out. Real estate investors who do not qualify as real estate professionals under Section 469 may have passive activity losses suspended if deductions exceed passive income. Large bonus depreciation deductions that create suspended losses provide no immediate benefit and may not be usable for years. Using regular MACRS instead can better match deductions with passive income over time.

Expected future tax rate increases can justify electing out to preserve deductions for years when they will offset income taxed at higher rates. If you expect substantially higher income in future years, or if tax law changes are anticipated to increase marginal rates, deferring deductions by electing out of bonus may provide better after tax outcomes. This requires accurate forecasting of both income and tax law changes.

State tax conformity issues create situations where federal bonus depreciation produces state tax problems. Some states do not conform to federal bonus depreciation, requiring addbacks that create large book-tax differences. Others partially conform with lower percentages. Electing out of bonus for federal purposes can simplify state compliance and in some cases reduce overall combined federal and state tax liability. For broader context, review bonus depreciation strategy.

Insufficient taxable income to utilize bonus depreciation deductions occurs in multiple contexts. Startup businesses often have limited income in early years as they establish operations. Property acquired late in a tax year might follow a profitable period where most income has already been realized, leaving insufficient remaining income to absorb large bonus deductions. Economic downturns or industry specific challenges can temporarily reduce income below normal levels.

When bonus depreciation would create a net operating loss, the question becomes whether the NOL carryback and carryforward provide sufficient value compared to spreading deductions over time. Current law allows NOL carrybacks to one prior year and unlimited carryforwards, but carryforwards are limited to offsetting 80% of taxable income in future years. The time value of money and limitations on carryback and carryforward usage reduce the value of NOL relative to current deductions.

Modeling the insufficient income scenario requires projecting future taxable income and evaluating when NOL carryforwards can be used. If you expect strong income growth such that NOL carryforwards will be fully utilized within 3 to 5 years, the present value of bonus depreciation creating an NOL may still exceed the value of electing out and using regular MACRS. If income recovery is uncertain or distant, electing out to preserve deductions becomes more attractive.

Properties acquired by entities with other income sources require consolidated analysis. Bonus depreciation on one property might offset income from other properties or business operations, providing full immediate benefit even if the subject property alone has insufficient income. The election decision should consider the taxpayer's overall income picture, not just the property in isolation.

Passive activity loss rules under Section 469 create one of the strongest cases for electing out of bonus depreciation. Real estate rental activities are passive for most investors, and passive losses can only offset passive income unless the taxpayer qualifies as a real estate professional. Large bonus depreciation deductions that create passive losses provide no immediate benefit if the investor has no passive income and does not qualify for the REP exception.

Suspended passive losses carry forward indefinitely and can be used when passive income is generated in future years or when the property is disposed of in a taxable transaction. However, the uncertainty about when suspended losses will be usable and the time value of money reduce their value compared to current deductions. Electing out of bonus to use regular MACRS can create a more balanced stream of deductions that better matches passive income over time.

The passive loss limitation analysis requires projecting passive income and losses across all activities over multiple years. If you have other passive income sources that can absorb the losses created by bonus depreciation, claiming bonus remains attractive. If you are consistently in a suspended passive loss position with no near term path to using the losses, electing out of bonus may provide better economic outcomes.

Real estate professional status under Section 469(c)(7) eliminates passive loss limitations for qualifying individuals. If you can satisfy the material participation and time requirements to qualify as a REP, passive loss limitations do not apply, and the argument for electing out of bonus weakens significantly. The REP qualification analysis should be completed before making the bonus depreciation election decision because it fundamentally changes the value of immediate deductions.

State tax conformity with federal bonus depreciation varies significantly across jurisdictions, creating complexity for multi-state property owners and situations where state tax consequences can justify electing out of federal bonus. States fall into three categories: full conformity (adopting federal bonus rules), partial conformity (adopting lower percentages or limited eligibility), and non-conformity (requiring full addback of federal bonus).

Non-conforming states require taxpayers to add back federal bonus depreciation when computing state taxable income, then claim state depreciation using regular MACRS or state specific rules. This creates book-tax differences that must be tracked over the property's life. For properties in non-conforming states with high state tax rates, the federal benefit of bonus may be partially or fully offset by increased state tax liability.

Partial conformity states adopt federal bonus at reduced percentages or with limited eligibility. Some states conform to 30% or 50% bonus even when federal law provides 100%. Others limit bonus to specific property types. The state limitation creates federal-state differences that complicate return preparation and may reduce combined tax benefits. Electing out of federal bonus can eliminate these differences and simplify compliance.

The combined federal and state analysis requires modeling tax liability under both scenarios: claiming federal bonus versus electing out. For properties in high tax non-conforming states, the state tax cost of bonus may approach or exceed the federal benefit, particularly when combined with passive loss limitations or AMT exposure. Multi-state portfolios require property by property analysis because state rules vary and may justify different elections for properties in different jurisdictions. For related depreciation considerations, see TCJA depreciation rules.

To opt out of bonus depreciation properly, you make the election by not claiming bonus depreciation on the property class when filing your original tax return (including extensions). There is no separate form or checkbox for the election. You simply compute depreciation using regular MACRS methods instead of claiming bonus depreciation. The return should include adequate documentation to support the election and identify the property classes for which it is made.

The election must be made on a timely filed original return, including extensions. Elections made on amended returns are not valid without IRS consent. This timing requirement makes the decision deadline the extended due date of your return, not the original filing deadline. If you file your return without extension before the due date, that return establishes your election even if you later wish to amend it.

Best practice includes attaching a statement to the return identifying the property classes for which bonus depreciation is being declined. The statement should clearly indicate the election is being made and specify the applicable property classes by recovery period (for example, 5 year property, 7 year property). This documentation creates a clear record and reduces potential confusion if the return is examined.

For properties subject to cost segregation, the election interacts with the cost segregation study by determining depreciation method for each component class. The cost segregation study identifies components and assigns them to appropriate recovery periods. The bonus depreciation election determines whether those components receive bonus expensing or regular MACRS. A single property can have different elections for different classes of components.

Class by class election strategy takes advantage of the flexibility to elect out for some property classes while claiming bonus on others. This approach allows optimization based on the relative value of immediate deductions for different components and the taxpayer's specific situation. The strategy requires analyzing each property class separately and making independent election decisions.

A common strategy is electing out for 15 year land improvements while claiming bonus on 5 and 7 year personal property. Land improvements generate less dramatic acceleration because the 150% declining balance method produces only 5% first year depreciation without bonus. Personal property generates much more acceleration with 20% and 14.29% first year rates. If income is limited, preserving land improvement deductions while claiming personal property bonus may optimize overall benefit.

Passive loss limited investors might elect out for property classes with larger aggregate basis while claiming bonus on smaller classes. If 15 year land improvements represent $400,000 of basis and 5 year personal property represents $100,000, electing out for the 15 year class preserves more future deductions while still capturing some immediate benefit from the 5 year bonus. This balances near term and long term benefits.

State conformity issues might justify different elections for different classes based on state specific rules. Some states conform to bonus on personal property but not land improvements. Electing out of bonus for non-conforming classes eliminates federal-state differences while preserving federal bonus benefits for conforming classes. This strategy requires detailed understanding of state specific conformity rules and careful coordination with state return preparation.

Declining bonus depreciation does not eliminate the value of cost segregation. Cost segregation remains beneficial because it reclassifies components into shorter MACRS recovery periods with accelerated depreciation methods. A component moved from 39 years straight-line to 5 years 200% declining balance still generates 20% first year deduction without bonus, nearly eight times the 2.56% rate for 39 year property.

When skipping bonus depreciation, cost segregation focus shifts from maximizing bonus eligible basis to maximizing 5 and 7 year classifications. These classes provide the most acceleration under regular MACRS methods. Fifteen year land improvements become relatively less valuable without bonus because the 5% first year rate produces limited acceleration. Engineering resources should prioritize personal property identification over land improvements when bonus is declined.

The cost segregation study itself does not change based on the bonus election. The engineering analysis, component identification, and basis allocation proceed identically regardless of whether bonus will be claimed. The election affects only the depreciation calculation after components are classified. This means cost segregation studies retain value and can be commissioned even when bonus depreciation will be declined.

Properties that remain viable for cost segregation when electing out include those with substantial basis (typically $2,000,000 or more), high percentages of 5 and 7 year property (30% or more), and long expected holding periods (10-plus years). The cumulative acceleration over time can still produce attractive ROI multiples even without bonus depreciation, particularly for properties with strong fundamentals. For understanding reduced bonus scenarios, review cost segregation with lower bonus rates.

Modeling the bonus depreciation election decision requires comparing present value outcomes under both scenarios across realistic holding periods and tax assumptions. The model should project annual taxable income, depreciation deductions, tax liability, and after tax cash flow for claiming bonus versus electing out. The comparison reveals which approach produces better economic outcomes given your specific facts.

Key model inputs include projected income by year, expected marginal tax rates, passive income and loss projections if applicable, anticipated holding period, discount rate reflecting your cost of capital, and bonus depreciation percentage applicable to the property. Sensitivity analysis should test multiple scenarios because future income and tax rates are uncertain. Running high, medium, and low income scenarios reveals the range of potential outcomes.

The present value calculation discounts future tax savings to current dollars using an appropriate discount rate. Tax savings in year five are worth less than tax savings today because of the time value of money. Higher discount rates favor claiming bonus for immediate benefit. Lower discount rates reduce the advantage of immediate deductions, making regular MACRS more competitive. Most real estate investors use discount rates of 6% to 10% based on their investment return expectations.

The model should account for recapture on disposition if a taxable sale is contemplated. Both bonus and regular MACRS create Section 1245 recapture for personal property and land improvements, but the recapture amount differs. Bonus depreciation creates larger recapture because more depreciation is claimed upfront. The net present value analysis should include both annual tax benefits during ownership and disposition tax costs, discounted to present value.