Accelerated Depreciation and Section 179 Deduction

By Jason Watson, CPA
Posted Monday, August 5 2024

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).

Section 179 lost a lot of its sexiness in 2018 once bonus depreciation hit 100% for five years, and even 80% in 2023. For 2024, bonus depreciation is 60% and as such Section 179 is back as a great rental property tax deduction and tax savings tool when appropriately leveraged. Timberlake might be bringing sexy back, but Section 179 is in the mix. Did we take that too far?

If you are reading this without an understanding of Section 1245 property and how it differs from Section 1250, please check out our section on Cost Segregation. When it comes to rental properties and certain real estate investments, identifying Section 1245 property allows for a portion of the property (asset) to be instantly depreciated, or “bonused” as some say, or deducted with Section 179. Yes, there are some exceptions when referencing Qualified Improvement Property for nonresidential property which we discuss in a bit.

Let’s run through this from a residential rental property perspective first. Then we’ll tackle the nonresidential issues with Section 179 and qualified improvement property, and how short-term rentals and transient tenants flip the narrative.

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.

To be eligible for bonus, the property’s useful life cannot exceed 20 years.

If you are reporting bonus depreciation on a pass-through entity (PTE) tax return, it will generally be mixed in with all depreciation, and listed as a deduction among other deductions. This contrasts to Section 179 which is listed as a separate item on the PTE’s K-1 issued to the members or shareholders. Why? Section 179 has personal limitations that are managed on Form 4562 of your individual tax returns (there are some other nuances with basis, but we’ll avoid that topic for now).

Bonus depreciation does not have a limit.

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 below). Rather, the presumption is that they are passive and on the opposite end of the business spectrum.

A business must have a profit motive; whether you actually earn a profit is irrelevant; it is your motivation and subsequent actions that dictate this determination. This is a critical distinction since most rental properties have a loss, especially in the early years with current market rent combined with depreciation and / or with relatively high mortgage interest, or both.

In addition to your profit motive, your participation in the business must be regular and continuous. Do not confuse this with material participation which has a series of bright line tests for short-term rental loophole or real estate professional status when viewed in the context of rental properties and real estate investments.

Armed with this knowledge, does your rental property qualify as a business?

Owning a rental property should generally qualify- profit motive, and regular and continuous participation. However, it is not a slam dunk. By using Alvary v. United States, 302 F.2d 790 (2d Cir. 1962) and Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953), the IRS and others have come up with a mini facts and circumstances checklist-

• the type of rented property (commercial versus residential property)

• the number of rental properties (volume)

• taxpayer reliance on the activity for lifestyle or income

• time and effort spent on daily operations

• the types and significance of any ancillary services provided within the activity (think short-term rental, hunting lodge, tours, etc.) the terms of the lease (for example, a short-term versus long-term lease), and

• conformity to Section 199A’s preamble

We will talk more about the Section 199A qualified business income deduction (QBID) in a bit, but here is a snippet from page 16 the final regulations which eerily looks familiar to the list above-

In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

That doesn’t really stand out as helpful or definitive either. The good news is that both the courts and the IRS have consistently found in favor of rental property owners and have allowed broad support for the profit motive including the regular and continuous requirements. Yay! However, in Grier v. United States, 120 F.Supp. 395 (D.Conn. 1954) the taxpayer lost. How?

Edgar Grier inherited a house from his mother that she had rented out for many years to the same tenant. This same tenant continued to occupy the property until Grier sold it 14 years later. Over the years, little management work was required, but Grier did take care of such details as replacing the furnace. The IRS and court found that the house was an investment, not a business for Grier. The court noted that this was the only rental property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business.

This court case can be problematic, right? The court recognized that this was Grier’s only rental. So, do you need more than one? A whole gaggle? Perhaps. Or do you just need to involve yourself more in your single rental property activity, and document the heck out of it? Doesn’t hurt. Then again, things have changed a bit since 1954.

Profit motive. Got it. Continuous and regular. Wonderful. Now what? In the past, Section 179 could not be used to deduct personal property used in residential rental property. However, the Tax Cuts and Jobs Act (TCJA) eliminated this restriction starting in 2018. This means that rental property owners can now use Section 179 to deduct the cost of personal property items they purchase for use inside rental properties. For example, kitchen appliances, carpets, drapes, or blinds, just to name a handful. See our section on rental property renovations. Fun!

There is a subtle difference between the above examples, and nonresidential rental property. Under TCJA, Section 179 expensing has been expanded to include nonresidential roofs, heating, ventilation, air conditioning, and fire / alarm protection systems. Therefore, a new HVAC system for single-family residence typically cannot be expensed with Section 179 but might be allowed for an office building.

But wait! There’s more. Always more, right? You may use Section 179 expensing on an HVAC system in a single-family home that is considered nonresidential. Nonresidential home? How does that work? See our section on Qualified Improvement Property.

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 Alvary and Gilford mini checklist is nice but the underpinnings of “trade or business” are good to review again so you can correctly couch your facts (and not end up like Grier).

The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts over time. The Supreme Court has interpreted “trade or business” for purposes of Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit. We would argue that rentals and general real estate investments fall under this auspice otherwise you wouldn’t do it. Sure, we all want that short-term tax loss to offset other income, but ultimately you want to make money.

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.

By the way, bonus depreciation and Section 179 deduction is not available on foreign property.

Section 179 Problems With Partnerships

There is a problem with IRC Section 179 when using an entity such as a multi-member LLC taxed as a partnership to hold the rental property and report its activities. Generally, Section 179 expensing cannot create a loss in the business entity. This is in contrast to depreciation which may create a loss. As such, there are scenarios where using leveraging Section 179 expensing in an entity might be limited.

The instructions for Form 4562 Depreciation and Amortization, reads-

Partnerships. Enter the smaller of line 5 or the partnership’s total items of income and expense, described in section 702(a), from any trade or business the partnership actively conducted (other than credits, tax-exempt income, the section 179 expense deduction, and guaranteed payments under section 707(c)).

What does this mean? For partnership tax returns (Form 1065), you determine the profits of the business, and then add back various things including the deduction taken for Section 179 expense including guaranteed payments.

Can I Use Section 179 Against W-2 Income?

Yes. Who wants more Form 4562 instructions?

Individuals. Enter the smaller of line 5 or the total taxable income from any trade or business you actively conducted, computed without regard to any section 179 expense deduction, the deduction for one-half of self-employment taxes under section 164(f), or any net operating loss deduction. Also, include all wages, salaries, tips, and other compensation you earned as an employee (from Form 1040, line 1). Do not reduce this amount by unreimbursed employee business expenses. If you are married filing a joint return, combine the total taxable incomes for you and your spouse.

In Bloomberg v. Commissioner, 74 Tax Court 1368 (1980), the court used the term “in the business of being an employee” and this has been pointed to often when applying Section 179 expensing against W-2 wages. Here is a common example that you’ll see all over the world wide webs-

Example: You have a business income of $10,000 and qualifying Section 179 expenses of $90,000. Your spouse has a W-2 income of $50,000. Your husband-and-wife business income limit for Section 179 expensing is $60,000 ($10,000 plus $50,000).

If you elect to expense the entire $90,000, you deduct $60,000 this year and carry the $30,000 excess over to next year, where it again enters into a Section 179 computation. You may carry over the excesses to any number of years, without limit.

While miscellaneous deductions on Schedule A are no longer permitted on your individual tax returns after the Tax Cuts and Jobs Act, Form 2106 Employee Business Expense remains a valid tax form. As such, tax law continues to support the “in the business of being an employee” as referred by the Bloomberg court above.

Some States Do Not Recognize Accelerated Depreciation

California, for example, does not recognize bonus depreciation and has different limits for Section 179 expensing. According to California’s FTB Publication 1001–

The TCJA increased the amount of the additional first-year depreciation allowance from 50% to 100% for certain qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100% allowance is phased down by 20% per calendar year for property placed in service in taxable years beginning after 2022. The additional first-year depreciation deduction is allowed for new and used property. California does not conform to this provision.

It makes sense, right? The federal government can print money. States don’t have this luxury and must balance a budget (California notwithstanding).

Accelerated Depreciation and Section 179 Recap

Some of this stuff can make you drool, and a simple net-net recap is all you need. Here we go-

• You can bonus depreciate 5-, 7- and 15-year property. This would be personal property that becomes Section 1245 property.

• You can Section 179 expense 5-, 7- and 15-year property connected with a residential property provided the activity is considered a business with regular and continuous participation with a profit motive.

• You can Section 179 expense certain items in nonresidential property that might otherwise not be eligible in a residential environment. Again, there is a cool nuance with nonresidential property that we review in our Qualified Improvement Property (QIP) section.