Rental Property Depreciation (revisited)

By Jason Watson, CPA
Posted Saturday, September 7, 2024

This section is a mini me of our various rental property depreciation sections. Here is the collapsed summary-

Depreciation Overview

Generally, there are two ways to compress time and hurry the tax benefits when you purchase and deploy certain property- bonus depreciation and Section 179 deduction (what some people call instant expensing). To be certain, Section 179 can be viewed as a form of “accelerated depreciation” since a) you list the property on your fixed asset listing of your tax returns, and b) there is depreciation recapture should the business use fall below 50% or you sell property (either the property itself or the associated rental property).

Accelerated Depreciation with Bonus

To reiterate, certain property purchases allow for a portion of the property (asset) to be instantly depreciated, or “bonused.” What do we mean by a portion? 2022 was the last year of 100% bonus depreciation. 2023 was 80%, 2024 is 60% and 2025 is 40%. By 2027 it will hit 0% unless tax laws change.

Section 179 Deduction

Generally, Section 179 allows businesses to deduct the full purchase price of qualifying equipment and property bought or financed during the tax year. Sounds simple enough, right?

However, rental properties are not automatically considered a trade or business (see definition in our rental property as a business section). Rather, the presumption is that they are passive and on the opposite end of the business spectrum.

When to Bonus? When to use Section 179? Both?

As mentioned earlier, given that bonus depreciation is no longer 100%, Section 179 might be a better tax deduction. However, there are two issues- your rental activities must be a business.

The other issue is that Section 179 has limits. The maximum Section 179 expense deduction is $1,220,000 (for the 2024 tax year). This limit is reduced by the amount by which the cost of Section 179 property placed in service during the tax year exceeds $2,890,000.

Can you use both? Yes. You can dictate to the dollar how much Section 179 you want to use “first” and then piggyback it with bonus depreciation. Technically, Section 179 is deducted first with bonus depreciation being second. The net-net is good tax planning by a qualified real estate-minded tax professional.

Allowed Versus Allowable Depreciation

The question comes up often where a real estate investor does not want to mess with rental property depreciation for whatever reason and decides against deducting it on their tax returns. The most common reasoning is- why depreciate my rental property since I cannot deduct the rental loss on my tax returns?

Generally, if you don’t deduct rental property depreciation, when you sell the property, you will be required to recapture depreciation as if you deducted it. Yuck. However, if you didn’t deduct rental depreciation on prior tax returns, you can easily fix it with a Form 3115 Application for Change in Accounting Method and Section 481(a) adjustment.

This is called the allowed versus allowance rule. Allowed is what you claimed and deducted. Allowable is what you should have claimed and deducted.

Qualified Improvement Property (QIP)

Qualified Improvement Property is defined as any improvement made to the interior of a nonresidential building after the building is placed in service and is eligible for bonus depreciation. Improvements exclude expansion of the building, elevators and escalators (specifically called out, really?!), and changes made to a building’s internal structural framework. Oh, and let’s not forget that residential property also does not qualify.

There is also qualified improvement property that is eligible for Section 179 expensing (as opposed to bonus depreciation) on nonresidential property such as roofs, HVAC (heating, ventilation, air conditioning), and fire protection and alarm systems including security systems.

If your rental property has tenants or guests who stay 30 days or less, then they are considered transient. Subsequently, the rental property is not considered residential. As such, you might be able to immediately expense the new roof or HVAC unit under Section 179.

Sidebar: Don’t get twisted on short-term rental loophole and transient rental. Generally, short-term rentals are rentals where guests or tenants stay 30 days or less. However, for the short-term rental loophole where your rental property losses are no longer limited, the average guest stay must be 7 days or less and you must materially participate in the activity. We discuss this in detail in our short-term rental (STR) loophole section.

Partial Asset Disposition (PAD)

When you replace the air conditioning system, for example, you are replacing a part, albeit tiny, of the entire rental property. As such, and when accounting for depreciation, with a partial asset disposition (PAD) you might have a loss on the old system when you replace it. Specifically, partial asset dispositions allow rental property owners to claim a loss on the disposition of a component (structural or otherwise) of an asset without having originally identified the component as an asset before the disposition.

WCG CPAs & Advisors recommends and uses KBKG for various calculations and tools including PPI. According to their website-

The KBKG Partial Disposition Calculator is designed to make calculations as simple as possible while minimizing unnecessary work. By providing basic data, the calculator provides a PPI adjusted value while considering the condition of the respective component at the time it was acquired (accomplished by considering the component’s normal life, quality, and age).

CAUTION: Using a PPI discounting method to establish tax basis for a retired building component may grossly overstate the taxpayer’s retirement loss deduction.

If your rental property experiences a casualty loss through fire or flood, partial asset dispositions are handy for harvesting tax losses when insurance falls short. Technically, a casualty loss is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.

As stated previously, this section is a reduced version of our various rental property depreciation sections. Here is the list of the topics that we expand upon-

• Accelerated Depreciation with Bonus
• Section 179 Deduction
• Allowed Versus Allowable Depreciation
• Qualified Improvement Property (QIP)
• Partial Asset Disposition (PAD)