The Investor's Guide to the Section 179 Deduction: Rental Property Benefits

Section 179 of the Internal Revenue Code might change the way you view your rental property expenses.

Traditionally, the cost of tangible property used in your rental business is recovered over time through depreciation. However, Section 179 allows for an immediate deduction of the full cost of qualifying property in the year it's placed in service, potentially accelerating your tax savings.

This article explores Section 179 specifically for landlords. We'll identify the types of property that qualify for deductions, explain exclusions, and discuss the rules and considerations that apply to the rental real estate sector.

You can potentially leverage the Section 179 deduction for any portfolio size, even if you're managing just one single rental unit. Knowing your options can help shape your approach to managing your rental business's finances.

What is Section 179?

Section 179 of the Internal Revenue Code allows businesses to deduct the full cost of qualifying property in the year it's placed in service. Rental property businesses can use this code to expense the cost of property rather than the traditional method of depreciating the asset over its useful life.

Taking the deduction upfront allows you to see immediate tax savings rather than waiting years to recoup the full cost of your investments.

Property deductions under 179

Here are the types of deductions the IRS allows for landlords under Section 179:

• Tangible personal property: This includes machinery and equipment purchased for business use. For landlords, this might mean maintenance equipment or appliances provided in rental units, such as refrigerators, washers, and dryers.
• Computer software: You can deduct software that you buy for your business under Section 179. This could include property management software used by landlords to manage rental properties.
• Qualified improvement property: This involves making interior upgrades, such as installing new flooring or remodeling the interiors of commercial rental property, after the building's initial use. Elevators, escalators, and the building's core structure do not qualify.
• Specified property: This includes certain types of property designated by the IRS, such as qualified leasehold improvement property and qualified retail improvement property. These designations allow specific improvements in leased spaces, restaurants, and retail spaces to qualify for deductions.
• Roofs, HVAC, fire protection, alarms, and security systems: Recent changes to the tax law have expanded Section 179 to include these items when installed on non-residential property. This expansion is particularly beneficial for landlords of commercial properties looking to upgrade or replace these essential components.

What doesn't count under Section 179?

Understanding what doesn't fall under Section 179 can help landlords and business owners plan their purchases and investments more effectively. Here's a list of property types that Section 179 does not apply to:

• Real property: Physical property, like residential rental property buildings, is not deductible under Section 179 because it's considered permanent and immovable.
• Land improvements: Specific improvements to land, such as landscaping, outdoor lighting, or paving parking areas aren't deductible. Despite their role in enhancing property value and utility, they're treated as part of the real estate and don't qualify.
• Permanent structures: These include buildings and structural components like detached garages. This category also includes durable fixtures like security gates and outdoor signs attached to the property.
• Leased property: If a landlord leases equipment or other tangible personal property to tenants (for example, office equipment in a commercial building), that leased equipment typically doesn't qualify for a Section 179 deduction.
• Property purchased from related parties: Purchases made from related parties, such as family members or controlled entities, do not qualify. This means if a landlord buys property from a related party, those purchases are not eligible for deduction. This rule prevents tax avoidance through intra-family or closely held business transactions.
• Property outside the United States: Property outside the U.S. does not qualify.
• Mixed-use property: To qualify for Section 179 deductions, you must use your property for the rental business more than 50% of the year. This requirement means tenants must pay rent to you, distinguishing the property's use as primarily for your business rather than for personal purposes.

Considerations of Section 179

Besides understanding which expenses for your residential real estate business qualify, there are a few additional rules and factors to be aware of. These include:

Annual deduction limit

For 2023, the maximum deduction is $1,080,000, subject to phase-out starting at $2,700,000 in total property placed in service. These limits are adjusted annually for inflation.

For example, let's say you upgrade your rental real estate with qualifying equipment under Section 179. You purchase new appliances, office equipment, and property management software, totaling $1,500,000 in costs. You can apply $1,080,000 of this amount under Section 179, and the remaining $420,000 might be eligible for depreciation deductions in future years, following IRS guidelines.

Business income limitation

The total amount deducted under Section 179 cannot exceed the business's taxable income. The good news is that you can carry forward deductions beyond this to future years.

Suppose you earn $100,000 from your rental activities in one year and spend $150,000 on qualifying items like new appliances. Because the total amount deducted under Section 179 can't exceed the business's taxable rental income, you can only deduct $100,000 of their $150,000 expense in that tax year, matching your taxable income.

The remaining $50,000 isn't lost, though, because you can carry this excess amount forward to future tax years. This flexibility allows for strategic planning around taxable income and investment in qualifying property.

Election

The deduction under Section 179 is not automatic. You must make this election by completing Part I of IRS Form 4562 and attaching it to your return.

Rental business

If you want to take advantage of Section 179 deductions, be sure your rental activities count as a business by tax standards. You can't take Section 179 deductions if you own rental property only as an investment.

Here's what makes your rental activities qualify as a business in the eyes of the law:

• Direct involvement: You can self-manage or hire help like property managers or agents, but you need to be directly involved in decision-making and oversight. This could involve setting rental policies, approving tenants, or planning major renovations.
• Consistent and ongoing efforts: Your rental business should involve regular, continuous, and substantial efforts to turn a profit. This includes activities like marketing your properties, maintaining or improving the properties, and managing tenant relationships.
• Trade or business criteria: Your rental operations must meet the tax definition of a "trade or business." This means actively steering the direction and performance of your rental properties, not just passively owning them for income.

Business use requirement

When you claim a Section 179 deduction for something you buy for your business, such as a vehicle, you have to keep using it for business at least 50% of the time for its entire depreciation period. So, if you claim a Section 179 deduction for a vehicle, which usually has a depreciation period of five years, you need to use it for business more than half the time over those five years.

Understanding recapture risk

If you fail to meet this 50% business use threshold during the depreciation period, the IRS may require you to recapture some of the tax benefits previously claimed. This means you could need to report a portion of your past Section 179 deductions as taxable income in later years, potentially increasing your tax liability.

The IRS uses this recapture mechanism to reserve the substantial tax relief provided by Section 179 for assets genuinely used in active business operations.

Depreciation periods, explained

The concept of depreciation periods is central to understanding both the business use requirement and the potential for recapture. The IRS assigns specific depreciation periods to different types of assets to reflect their expected useful life in a business setting.

Here's how some common assets are categorized:

• Office furniture and fixtures: 7-year depreciation period.
• Vehicles: 5-year depreciation period.
• Computers and office equipment: 5-year depreciation period.
• Residential rental property: 27.5-year depreciation period.
• Nonresidential (commercial) real property: 39-year depreciation period.

These depreciation periods guide how long you must follow the business use requirement to avoid recapture. They also frame the timeline over which you can spread out the tax benefits for your property under the Modified Accelerated Cost Recovery System (MACRS) if you aren't deducting the entire expense immediately under Section 179.

Bonus depreciation

In addition to Section 179, another valuable tax incentive for landlords is bonus depreciation. While Section 179 allows you to deduct the full cost of qualifying property in the year it's placed in service, bonus depreciation offers a similar benefit but with some key differences. Let's explore how bonus depreciation works and how it can complement your Section 179 deductions.

The Tax Cuts and Jobs Act (TCJA) increased the bonus depreciation percentage to 100% for property acquired after September 27, 2017, and before January 1, 2023. This means that you can deduct the full cost of qualifying property in the year it's placed in service. Starting last year in 2023, the bonus depreciation percentage decreases until it reaches 0% in 2027.

Generally, you'll first apply Section 179 to qualifying property up to the annual limit of your business's taxable income. Then, you can use bonus depreciation on any remaining cost of the Section 179 property and any other qualifying property.

Bonus depreciation offers a wider range of eligible property types compared to Section 179. These include:

• Property with a recovery period of 20 years or less.
• Qualified improvement property.
• Computer software.

One key advantage of bonus depreciation is that it's not limited by the business's taxable income. This means that even if your rental business has a loss for the year, you can still claim bonus depreciation and carry forward the loss to future tax years.

If you want to use Section 179 and/or bonus depreciation, it's a good idea to discuss your specific situation with a tax professional. Factors such as your current taxable income, expected future income, and the type of property you're investing in can all impact which deduction method is the best for your rental business.

Reporting Section 179 on Schedule E

Now that you understand how Section 179 deductions can benefit your rental business, let's discuss how to report them properly on your tax return.

As a rental property owner, you'll report your rental income and expenses, including Section 179 deductions, on Schedule E (Form 1040), Supplemental Income and Loss. Here's a breakdown of how to report these deductions on your returns:

• Part I, Line 18: Enter the total amount of your Section 179 deduction for all rental properties in the "Expenses" column.
• Part II, Line 24a: If you have only one rental property, enter the property's address. If you have multiple properties, attach a statement listing each property's address and allocating the Section 179 deduction among them.
• Part II, Line 24b: Enter the total Section 179 deduction for the property or properties listed on Line 24a.
• Part II, Line 25: Subtract the amount on Line 24b from the total expenses for each property. This is the amount of depreciation and other expenses you'll report on Line 18 of Part I.

Be sure to keep accurate records of your Section 179 deductions and allocate them correctly among your rental properties. Accounting software can help you maintain these records. If you have multiple rental properties, consider consulting a tax professional to verify proper reporting on Schedule E.

Mastering Section 179 for rental property

Section 179 offers an opportunity for landlords to strategically manage their tax obligations and potentially boost their bottom line. If you're upgrading appliances, investing in property management software, or making improvements to your commercial properties, Section 179 can help you write off these expenses more quickly.

As with any tax strategy, be sure to work with an advisor and have a clear understanding of your specific circumstances and goals. Keep in mind that Section 179 deductions are subject to certain limitations and requirements and whether you use the property primarily for business purposes. Proper record-keeping and planning can help you verify compliance and maximize the benefits of this tax provision.

Incorporating Section 179 into your rental business can also provide new opportunities to grow. By strategically timing your purchases and keeping an eye on your taxable income, you can make the most of this valuable deduction.

Section 179 deduction rental property FAQs

Can I claim 100% depreciation on my rental property?

No, you can't claim 100% depreciation on the rental property itself, but you may be able to deduct the full cost of certain qualifying property you use in your rental business. This is possible through bonus depreciation, which allows a 100% deduction for property acquired after September 27, 2017 and before January 1, 2023, and is placed in service during that time.

Can you use Section 179 on a 20 year old property?

Yes, you can take a Section 179 deduction on property with a recovery period of 20 years or less. This includes a wide range of assets used in your rental business, such as appliances, furniture, and equipment.

Is furniture a capital expense for a rental property?

The purchase price of furniture for a rental property is generally a capital expense, which means you must capitalize it and depreciate it over its useful life. However, depending on your specific circumstances and the current tax laws, you may be able to deduct the full purchase price of the furniture in the year you place it in service using Section 179 or bonus depreciation.