Depreciation and Changes in Use of Real Property
For income tax purposes, taxpayers that own rental property with gross receipts from residential or nonresidential uses should heed the rules on accounting for depreciation. This item discusses the distinction between residential and nonresidential property, depreciation, and the application of the change-in-use regulations if a rental property changes from residential use to nonresidential or vice versa.
Dwelling-Unit and Gross-Receipts Tests
Sec. 168(e)(2) defines residential rental property as any building or structure from which 80% or more of the gross rental income for the tax year is from dwelling units. Nonresidential real property is Sec. 1250 property that is not residential rental property or that does not have a class life of less than 27.5 years.
In determining whether a property meets the 80%-gross-receipts test to qualify as residential rental property, taxpayers may include in gross rental income the rental value of any portion of the building that they occupy. For hotels, motels, and other establishments, the 80%-gross-receipts test is disregarded if more than 50% of the dwelling units are used on a “transient basis.”
For purposes of defining residential rental property, “dwelling unit” means a house or apartment used to provide living accommodations in a building or structure, but it does not include a unit in a hotel, motel, or other establishment in which more than 50% of the units are used on a transient basis. Former Regs. Secs. 1.167(k)-3(c)(1) and (2), which were removed in 1993, provided that 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 tax year, it was occupied by a tenant or series of tenants, each of whom occupied the unit for less than 30 days. If a dwelling unit was occupied subject to a sublease, the taxpayer looked to the sublessee to determine whether the dwelling unit was used on a transient basis.
The definition of dwelling units indicates that, under the right circumstances, properties such as nursing homes, retirement homes, and college dormitories can qualify as residential rental property as long as they do not run afoul of the transient-basis requirement. This assumes the 1993 definition of “transient basis” still applies, as the term still appears in Sec. 168(e)(2)(A)(ii)(I), which defines “dwelling unit.” In CCM 201147025, the Office of Chief Counsel cited Regs. Secs. 1.167(k)-3(c)(1) and (2) in determining that a taxpayer’s assisted-living facilities qualified as residential real property. Assuming a vacation home is subject to the transient-basis rules, the vacation home is classified as a residential rental property if the gross rental income test is met and it is rented to each tenant more than 30 days for more than 50% of the days in a tax year it is rented; otherwise, the vacation home would be classified as nonresidential real property.
Depreciation Methods, Periods, and Conventions
Sec. 167(a) permits a depreciation deduction for the exhaustion and wear and tear of property used in a trade or business or held for the production of income. Sec. 168 sets forth the methods, periods, and conventions by which a taxpayer can depreciate tangible property as permitted by Sec. 167(a).
In the case of residential rental property and nonresidential real property, Sec. 168(b)(3) states that the applicable depreciation method is the straight-line method. Sec. 168(c) states that the applicable recovery period is 27.5 years for residential rental property and 39 years for nonresidential real property. The applicable convention to be used for both residential rental property and nonresidential real property per Sec. 168(d) is the midmonth convention.
Certain property identified by Sec. 168(g) (tangible property that during the tax year is used predominantly outside the United States and certain other property) is depreciated under the alternative depreciation system (ADS). Residential rental property and nonresidential real property subject to the ADS is depreciated using the straight-line method, a recovery period of 40 years, and the midmonth convention.
Changes in Use
Because the gross rental income test is “for the taxable year,” the 80% test needs to be calculated annually. The difference in depreciation rates for residential rental property vs. nonresidential real property can be considerable.
Example: In January 2010, taxpayer X placed in service a building in New York state that met the 80%-gross-receipts test and the dwelling-unit requirement and had no transient-basis tenants. Therefore, the property met the definition of residential rental property and was depreciated using the straight-line method at an annual rate of approximately 3.6364% (12 months ÷ [12 months × 27.5 years]). (The annual depreciation rate is different in the first and last year the property is placed in service because of the application of the midmonth convention.)
In 2011, the property failed to meet the 80%-gross-receipts test and, thus, no longer qualified as residential rental property. Therefore, since the property is now nonresidential real property, it is depreciated using the straight-line method at an annual rate of approximately 2.5641% (12 months ÷ [12 months × 39 years]). (The annual depreciation rate is different in the first and last year the property is placed in service because of the application of the midmonth convention.)
Residential rental property is depreciated approximately 30% (1 – [2.5641 ÷ 3.6364]) faster than nonresidential real property. The difference can amount to a significant return on an investment via tax savings, but it also can be a big issue upon audit.
Regs. Sec. 1.168(i)-4 provides the rules for determining the depreciation allowance for MACRS property when the use changes in the hands of the same taxpayer. Use changes include when property is converted from personal property to business or income-producing use and vice versa, and when the change in the use results in a different recovery period and/or depreciation method. The allowance for depreciation under this section constitutes the depreciation deductions permitted under Sec. 167(a).
A change in the use of MACRS property occurs when the primary use of the MACRS property in the tax year differs from that of the immediately preceding tax year. The primary use of MACRS property may be determined in any reasonable manner that is consistently applied. If the primary use of MACRS property changes, the depreciation allowance for the year of change is determined as though the use had changed on the first day of the year of change.
If a change in use results in a shorter recovery period and/or a depreciation method that is more accelerated than the method used before the change in use, the taxpayer has two options: (1) The taxpayer can compute the depreciation allowance using the shorter and/or more accelerated depreciation method in the year the change in use occurred, or (2) the taxpayer may elect to continue determining the depreciation allowance as though the change in use had not occurred. These options provide a planning opportunity to suit a taxpayer’s need for more or less accelerated depreciation deductions. For example, a taxpayer with excess net operating loss carryovers might not be able to use the maximum depreciation deductions permitted and may want to use the longer, less accelerated depreciation method.
If a change in use results in a longer recovery period and/or less accelerated depreciation method than before the change in use, the taxpayer must compute the depreciation allowance using the longer and/or less accelerated depreciation method in the year the change in use occurred.
A change in computing the depreciation allowance in the year of change for property subject to Regs. Sec. 1.168(i)-4 is not a change in method of accounting under Sec. 446(e). To make the election or to disregard the election, a taxpayer needs only to complete Form 4562, Depreciation and Amortization (Including Information on Listed Property), in the year of change. However, the regulations under Secs. 446(e) and 481 apply if the taxpayer does not account for the depreciation allowance in the manner set forth by Regs. Sec. 1.168(i)-4 or revokes the election to disregard the change in use. If Secs. 446(e) and 481 do apply, the taxpayer should file a Form 3115, Application for Change in Account Method, to request an automatic change.
Property affected by the change-in-use regulations is not eligible for special depreciation deductions in the year of change, as otherwise permitted in Sec. 168(k) (bonus depreciation), Sec. 179 (election to expense certain depreciable business assets (generally not applicable to residential and nonresidential property)), and Sec. 1400L (tax benefits for New York Liberty Zone property). Additionally, for purposes of determining whether the midquarter convention applies to other MACRS property placed in service during the year, the change-in-use property is not taken into account.
Regs. Sec. 1.168(i)-4 also discusses the applicability of and options to use depreciation tables in the calculation, the rules to compute the new depreciation allowance, and assets subject to ADS.
Under the former investment tax credit (ITC) rules in Regs. Sec. 1.48-1(c), as interpreted by the Tax Court in Hospital Corp. of America, 109 T.C. 21 (1997), items in a building that qualify as tangible personal property may be separately depreciated under MACRS as personal property. Furthermore, the court held that if a building component is not personal property under the former ITC rules, it is considered a structural component and may not be depreciated separately. Therefore, a cost-segregation study identifying the structural components of specific units in a building to maximize depreciation would not be helpful to the owner(s) of a building that has tenants that use separate and identifiable units for business purposes and other units as their non–transient-basis dwelling units.
Under the temporary regulations in T.D. 9564 that apply to tax years beginning on or after Jan. 1, 2012, a taxpayer may retire a structural component of a building and use any reasonable method to allocate a cost to the component disposed of with respect to the larger asset, i.e., the building.
Many tax practitioners’ clients own one or more rental properties to which the above rules apply. Tax practitioners need to communicate continually with those clients that own rental properties with both residential and nonresidential receipts and test whether the property has changed use and the effect of the change on the clients’ tax returns.