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This article was written by Ashley Sullivan, Director and Roger Upton, Director of Technical Tax Issues.

Hint – it is not a simple answer. Remember, this building housed the “Central Perk” on the first floor (i.e., commercial property), while the remaining floors were apartments (residential property). 39 years vs. 27.5 years depreciation lives.

While a somewhat logical approach might be to depreciate the Central Perk floor over 39 years, and the remaining floors over 27.5 years (and we have seen depreciation schedules set up this way), this is not the correct way to write off the building.

As defined by IRS Sec. 168(e)(2), a residential rental property is any building where 80% or more of the gross rental income for the taxable year is from dwelling units. Dwelling units can be a house or an apartment that provides living accommodations. It does not include hotels, vacation homes or other establishments, which have a 50% transient basis test (which we will discuss in a separate article).

As you can see by this test, the bar is set high for property to be treated as residential. In some ways this high bar makes sense, since a residential property depreciated over 27.5 years is written off 40% faster than a 39-year commercial property. For example, the annual depreciation for a $3M apartment building is $109,090, while if it was commercial property, the depreciation would be $76,923 – a sizable difference of over $32,000 a year.

So, for most taxpayers it is usually more beneficial tax wise to be treated as residential property. However, two recent tax law changes may have tipped the depreciation scales in favor of being treated as commercial property:

1. First, starting in 2016, improvements to commercial buildings meeting the definition of Qualified Improvement Property (QIP), qualify for Bonus Depreciation treatment. QIP is defined as improvements to Commercial property that are

• Building must have been previously placed in service. This test applies to any previous ownership, not just the current owners.
• Interior only changes
• Non-structural in nature (ie, changes such as pillars, weight bearing walls, etc.)
• Not an elevator or escalator
• Not an expansion of the building

2. Second, starting in 2019, the definition of property that could be written off under Sec. 179 was expanded to include replacement of roofs, HVAC, sprinkler systems, security systems and QIP made to existing commercial property. (Remember, Sec. 179 has several other tests that need to be passed before taking the deduction)

So, now commercial property owners have two powerful depreciation tools that generate immediate deductions, that Residential property owners do NOT have.

Consider the Developer who purchased a downtown hi rise and is going to convert 2/3 of the floors to residential property. The remaining 1/3 will stay commercial. A typical situation in many cities these days. If the overall gross rent can stay at 21% or more from commercial tenants, the whole building is considered commercial property. And most of the improvements the Developer is incurring to convert the floors to apartments could possibly qualify as QIP – which means Bonus Depreciation and 15-year life! Adding to these potential savings, if the Developer has to replace the roof, or the HVAC located outside the building, those improvements qualify for Sec. 179. Tremendous tax savings for the Developer of apartments!

Two important items to remember:

1. The 80% gross rent test is applied at year end – when all the rent has been received and can be measured. However, the outcome of the 80% test is applied to the beginning of the year. This result was confirmed by the IRS Office of Chief Counsel in their July 21, 2020 webcast with the American Bar Association. So back to the above office building conversion example above, careful planning must be applied during the year to make sure the office building remains Commercial property by the end of the year, allowing all the apartment conversions to qualify as QIP.
2. Depreciation in this area can be confusing. If a property’s revenue stream changes, so that the property’s use and depreciation life changes, then here are the rules:
   1. If moving to a longer life asset (for example, 27.5 year residential to 39 year commercial), the remaining depreciable basis at the beginning of the year is depreciated over the remaining portion of the new, longer recovery period. Example – 15 years after placing residential property in service, it is now considered commercial. So, the new depreciation life is 24 years (39 years less the 15 years of previous depreciation), applied to the remaining depreciable basis. Reg. 1.168(i)-4(d)(4).
   2. If moving to a shorter life asset (for example, 39 year commercial to 27.5 year residential), the remaining depreciable basis at the beginning of the year is now depreciated over 27.5 years. It does not matter how long the taxpayer has been depreciating the building. This is the major difference between these two approaches. Reg. 1.168(i)-4(d)(3). Example – following the above example, 15 years after placing a commercial property in service, it is now considered residential property. Because the property has to change to a shorter tax life, the depreciation life is now 27.5 years (restarting your depreciation life, instead of applying 24 years like above.) So, the taxpayer’s depreciation actually is less, even though the property has a shorter depreciation life.
   3. Fortunately, the IRS recognizes that this bad tax answer can occur and allows taxpayers to elect not to follow paragraph (d)(3)(i) above. Instead “the taxpayer may elect to determine the depreciation allowance as though the change in the use had not occurred.” To make this election, the taxpayer must claim the depreciation as if the change never occurred on a timely filed (including extensions) Federal income tax return. Following the above Example, by making this election, the depreciation life changes to 24 years, applied to the remaining tax basis. There does not seem to be a formal election – just compute the depreciation on Form 4562 as if the change did not occur.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.