Bonus Depreciation on Inherited Property: What You Need to Know

Bonus depreciation can provide significant tax savings by allowing businesses and investors to deduct a large portion of an asset’s cost upfront. However, inherited property follows different tax rules that determine whether bonus depreciation applies. Understanding these rules is important for anyone inheriting real estate or business assets. Tax laws change frequently, so knowing what qualifies and how to claim deductions properly can prevent costly mistakes.

Determining the Property’s Adjusted Basis

When inheriting property, the adjusted basis is generally its fair market value (FMV) on the date of the original owner’s death. This “step-up in basis” can reduce future capital gains taxes if the property is later sold. For example, if a decedent bought a building for $200,000 but its FMV at inheritance is $500,000, the new owner’s basis is $500,000, eliminating unrealized gains before the inheritance.

An estate can elect an alternate valuation date, six months after the date of death, if it lowers both the estate’s overall value and tax liability. If the property’s value declines in that period, using the alternate valuation can reduce the adjusted basis, affecting future depreciation. For rental real estate, depreciation deductions must be based on this adjusted basis rather than the original purchase price.

Asset Classification for Depreciation

Depreciation depends on how an inherited asset is classified, which determines the recovery period and deduction method. The IRS categorizes assets based on their nature and useful life. Real property, such as buildings, falls under the Modified Accelerated Cost Recovery System (MACRS), which assigns residential rental property a 27.5-year recovery period and commercial property a 39-year period. Land is not depreciable.

If an inherited building is converted into a rental property, it qualifies for depreciation under the appropriate class life. Structural components, such as roofs, HVAC systems, and plumbing, are depreciated over the same period as the building. Non-structural improvements, like appliances or carpeting, may have shorter recovery periods—typically five or seven years.

A cost segregation study can accelerate depreciation by identifying portions of a property that qualify for shorter recovery periods. For example, electrical systems dedicated to specialized equipment may qualify for a five- or seven-year recovery period instead of the building’s 39-year schedule. This strategy increases early deductions, benefiting investors looking to maximize tax savings.

Criteria for Bonus Depreciation

For an inherited asset to qualify for bonus depreciation, it must meet the requirements of Internal Revenue Code 168(k). The property must be “qualified,” meaning it has a recovery period of 20 years or less. This generally excludes real estate structures but may include certain improvements, such as equipment or land enhancements.

Bonus depreciation applies primarily to newly constructed or first-use property. Since inherited property is not newly placed in service by the decedent, it typically does not qualify. However, substantial improvements made after inheritance are considered separate assets for depreciation purposes and may be eligible. For example, if an heir installs a new electrical system or repaves a parking lot, those upgrades may qualify for bonus depreciation if they meet the recovery period requirement.

Claiming Bonus Depreciation

To claim bonus depreciation, the asset must be placed in service in the tax year the deduction is taken. If an inherited property is improved with eligible assets, such as a new security system or upgraded lighting, the installation date determines the tax year for the deduction. Proper documentation, including invoices and proof of service dates, is necessary.

Bonus depreciation interacts with other deductions, such as Section 179 expensing, which allows an immediate deduction for certain asset costs. Section 179 has annual deduction limits and taxable income restrictions, making it a better option in some cases. Comparing both options helps maximize deductions while maintaining flexibility for future tax years.

Depreciation Recapture Considerations

Depreciation recapture is a tax consequence when selling an inherited asset that has been depreciated. If an heir claims depreciation deductions, including bonus depreciation on qualifying improvements, the IRS may tax a portion of the gain at ordinary income rates instead of the lower capital gains rate.

For real estate, Section 1250 of the Internal Revenue Code governs recapture rules. If a depreciable building is sold for more than its adjusted basis, the portion of the gain attributable to depreciation deductions is taxed at a maximum rate of 25%, rather than the long-term capital gains rate of 15% or 20%. For personal property or land improvements under Section 1245, the entire amount of depreciation claimed is recaptured as ordinary income. Using a like-kind exchange under Section 1031 can defer these taxes when reinvesting in similar property.

Reporting on the Tax Return

Depreciation deductions for inherited property are reported on IRS Form 4562, which details the type of asset, recovery period, and deduction method. If the property is used for rental purposes, these deductions flow through to Schedule E, where rental income and expenses are reported. Business owners who inherit depreciable assets may need to include depreciation on their business tax return, such as Form 1120 for corporations or Schedule C for sole proprietors.

If bonus depreciation is claimed, it must be documented on Form 4562 in the year the asset is placed in service. Some states do not conform to federal bonus depreciation rules, requiring separate calculations. If depreciation recapture applies upon sale, the gain must be reported on Form 4797 to ensure the correct tax rate is applied. Keeping thorough records of depreciation schedules and property improvements helps prevent errors and ensures compliance with IRS regulations.