Residential Rentals, Commercial Real Property, And Depreciation
When you own property there will be specific tax laws that are in place that you may or may not be aware of. This goes true for rental properties you own as well.
Example. You own a motel with a depreciable basis of $1 million, you get to deduct $25,640 each year for depreciation (except the first and last years).
However, if you own an apartment building that also has a $1 million basis, your depreciation deduction is $36,360 a year (except the first and last years).
The difference of the $10,720 larger deduction with the apartment building may have you asking why?
The reason is due to recovery periods.
The recovery period is when tax codes assign a certain amount of time where you depreciate business assets that last for more than a year.
However since tax laws are very specific when it comes to property, the recovery period will vary.
The recovery period for residential rental real property is 27.5 years.
Commercial rental and Business Real Properties referred to as non-residential real property, have a recovery period of 39-years. This period applies to properties such as commercial rental property including office buildings, hotels, or strip malls, as well as real property you own and use in your business including an office or warehouse.
To depreciate a real property the straight-line must be used which also happens to the slowest depreciation method. Deduct the equal amount of the property basis, which usually is its cost, not including land, except for the first and last years.
So in this instance:
If your property is residential, you will deduct 1/27.5 (3.636) of its depreciable basis per year.
If your property is commercial, you will deduct 1/39 (2.564) basis each year.
For the first year that you decide to use a depreciable property, you will not receive a full year’s worth of depreciation. The reason this happens is that regardless of the day in the month you put your depreciable property into service, it will appear as being active at the midpoint of the month causing you to receive only half a month of depreciation in that month. In the tax code, this is referred to as the mid-month convention. The remaining half-month depreciation is received:
Earlier in the year, you sell the property or
The year after the last year of the recovery period
What is Residential Rental Property?
There are properties you may assume qualify as residential property, but not all properties are made equal.
In regards to depreciation, residential rental property is a building where 80 percent or more of the gross rental income is from units in which residents reside. The amount of space that is taken up by the units isn’t important, what is important is the amount of money you end up earning from them within that tax year. If you decide to live in the building the fair rental value of your unit is included in the gross rental income.
Example. Bill owns a two-story building with a $500,000 depreciable basis that consists of a storefront on the first floor and four apartments on the second floor. He receives $2,000 rent per month from the store and $8,000 per month from the four apartments.
Bill uses the speedier 27.5-year residential depreciation period for the entire building because 80 percent of his total rental income from the property comes from the apartments ($8,000 is 80 percent of $10,000). He claims an $18,180 annual depreciation deduction ($500,000 x 3.636 percent).
Property can go through changes if it is decided to change a residential rental property to a non-residential property due to the 80 percent rule, there will be a switch to a non-residential rate of depreciation on the first day of the year. This change is true for a non-residential property that converts to a residential real property. This means you change on the first day of that year with the recovery period of 27.5 years instead of the 39 year period.
Example. Bill raises the rent on the store to $3,000 per month, while leaving the rents on the apartments the same. Now, less than 80 percent of his total rental income comes from the apartments ($8,000 of $11,000 is only 73 percent). Thus, for the full year, he must use the 39-year depreciation period for non-residential rental property, which results in a $12,820 depreciation deduction for the year.
The opposite is also true if a non-residential real property converts to a residential real property, on the first day of that year when the change happens depreciation will happen over the 27.5 year recovery period as opposed to the 39-year period.
A dwelling unit for a residential rental property in the case of depreciation is defined by tax code as:
A house or apartment building used to provide living accommodations
Not included are hotels, motels, in which a unit reside but excludes establishments where more than half of its units are occupied on a transient basis
Residing in any portion of the property by the taxpayer means the gross income will be included in the rental value of the property.
The IRS defines transient use as, “A dwelling unit was used on a transient basis if, for more than one-half of the days in which the unit was occupied on a rental basis during the taxpayer’s taxable year, it was occupied by a tenant, sub-tenant, or series of tenants or sub-tenants each of whom occupied the unit for less than 30 days.” While the IRS no longer uses this definition after 1993, the 30-day occupancy is still referred to in regards to investment credit regulations.
This 30-day transient rule applies to hotels, motels, prisons, nursing homes, as well as Airbnb-type of rentals as well. Many Airbnb hosts may not be aware that under depreciation purposes they need to classify their property as commercial property. This means that they must depreciate the structure that is being used in cases such as Airbnb over the 39- year recovery period.
Example. Max rents his Chicago condominium through Airbnb to 40 different guests for a total of 180 days during the year. None of the guests stays over 14 days. He used the condominium himself for only 60 days during the year. Since more than 50 percent of the total days of use are transient (less than 30 days average use), the condominium is rented on a transient basis and should be classified as a commercial rental property for depreciation purposes.
This means Max would depreciate the condo over 39 years instead of 27.5 years. The unit has a $200,000 depreciable basis; so, he can claim only $5,128 in depreciation. Had the 27.5-year depreciation period for residential property applied, he could have claimed $7,272 in depreciation for the year.
If you’ve been using the wrong depreciation period for your residential or commercial rental property, you should correct the error by filing an amended return, or if the error is more than two years old, use IRS Form 3115.15
Likely, some people do not realize that these tax codes exist and are not taking full advantage of them. As always we suggest speaking with a professional who helps you identify improvements during tax season that will save you money.
Sources: Bradford Tax Institute