Beware of Bonus Depreciation in NY State for Real Estate Investors

Real estate investors often get excited about bonus depreciation. They envision massive deductions that will offset their income and enable them to pay little or no income tax. While this can be true for federal tax purposes, it is not always true for state tax purposes. In certain states, the state tax liability can actually increase when bonus depreciation is claimed. Overlooking state bonus depreciation adjustments could be particularly costly in some states.

There are two items to consider when determining whether bonus depreciation should be taken: (1) who will benefit from bonus depreciation and (2) are there state depreciation adjustments to consider.

Who Will Benefit from Bonus Depreciation

Rental real estate is a per se passive activity for tax purposes. When reporting the loss activity on a tax return these passive losses can only offset other passive income until the activity is disposed of in a taxable event. Most real estate private equity fund investors are passive since they are not materially participating and are not deemed Real Estate Professionals for tax purposes. These investors often don’t have other passive income and so their losses are suspended to future tax years until they either dispose of the investment or they have other passive income.

Tax exempt investors (e.g. foundations, IRAs, pensions, institutional investors) will not benefit from bonus depreciation. In fact, bonus depreciation deductions can create more complexities for tax exempt investors which is beyond the purview of this article.   

Are There State Depreciation Adjustments to Consider

Many states do not allow bonus depreciation. Instead, many states will require a net positive adjustment (“addback”) for the difference between bonus deprecation and depreciation as if bonus was not allowed. This addback occurs even if the federal bonus depreciation deduction is limited on the federal return. This means that not only do you not get to deduct the loss in the current year, you may also have to pay tax on the bonus depreciation even though no federal benefit was derived from the deduction.

Using New York (“NY”) as an example, there are two fact patterns where bonus depreciation can increase state tax liability. One of these pertains to NY residents and the other to NY non-residents. 

Bonus Depreciation Trap for Some State Residents

Some state residents, including NY and California, are generally taxed on their federal income subject to certain adjustments, including an addback for bonus depreciation.

In NY, the top combined NY/NY City tax rate for a NY City resident could be as high as 14.776%. The top NY tax rate for a NY non-resident could be as high as 10.9% on NY source income so additions due to bonus depreciation can be very costly (and there wasn’t even a federal tax benefit derived).

Here is an example: 

This illustrates how the attractive opportunity to use bonus depreciation as a means

to “front load” losses for investors can inadvertently create the opposite effect – a large and unexpected tax bill.

Note that if the bonus depreciation increases, the loss limitation addback also increases by the same amount, which means that adjusted gross income before bonus depreciation adjustments would still be ($578,000). Even though the federal income doesn’t change by the increased bonus depreciation deduction, you are required to add it back for NY purposes as if it had been deducted. This would increase NY adjusted gross income and NY income tax.   

Bonus Depreciation Trap for NY Non-Residents

NY non-residents are typically only taxed on their NY source income. However, NY requires non-residents to recalculate their passive activity deduction to determine the amount that is allowed if the federal adjusted gross income took into account only items of income, gain, loss or deduction derived from NY sources. 

Assume a non-resident of NY had passive income from Florida sources of $1 million and a passive loss from NY sources of $1 million all generated by bonus depreciation^[5]. For federal purposes, this taxpayer would have no income. But, for NY purposes, the $1 million loss would be disallowed, and an $800,000 NY addback related to bonus depreciation would be required. This means that this taxpayer would pay NY income tax on $800,000 of income when the only NY source activity had a $1 million loss. In this example, if the taxpayer elected out of bonus deprecation, no NY income tax would be owed.

It is imperative that real estate funds and operators take these facts into consideration before deciding to claim bonus depreciation. Real estate funds, operators and their accountants should model the federal and NY State tax liability for their investors to ensure that they are not inadvertently increasing their investors’ tax by claiming bonus depreciation. 

^[1] Excludes bonus depreciation.

^[2] Assumes a $1MM five-year MACRS asset. Assumes 100% bonus depreciation. Without bonus depreciation, the depreciation deduction would have been $200,000.

^[3] Business losses are limited to $578,000 for married filing jointly taxpayers for the 2023 tax year under provisions of the Internal Revenue Code dealing with “excess business losses of noncorporate taxpayers.” Any additional loss is claimed as an NOL in the subsequent tax year. 

^[4] Assumes AGI is equal to Taxable Income for illustration purposes. Also assumes highest rate.

^[5] Assumes a 5 year MACRS asset.  Without bonus depreciation, the depreciation deduction would have been $200K.