Depreciating Residential Rental and Commercial Real Property

When you own rental property, depreciation is your best friend.

One reason depreciation is so valuable is that, unlike deductible rental property expenses such as interest and maintenance, you get to claim depreciation year after year without having to pay anything beyond your original investment in the property. Moreover, rental real property owners are entitled to depreciation even if their property goes up in value over time (as it usually does). The basic idea behind depreciation is simple, but applying it in practice can be complex. Indeed, the annual depreciation deductions for two properties that cost the same can be very different.

For example, if 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). If you own an apartment building with a $1 million basis, your depreciation deduction is $36,360.

Why the difference? A motel and apartment building are both rental real estate. Shouldn’t they be depreciated the same way? Not according to the tax law. An apartment building is a residential rental property, while a motel is a commercial rental property. There are different depreciation periods for commercial and residential property: it takes far longer to depreciate commercial property fully. For this reason, you should always make sure you correctly classify your property as commercial or residential. Such classification can be more challenging than you might think, especially for mixed-use properties. If you rent to residential and commercial tenants, the tax code classifies the building as residential only if 80 percent or more of the gross annual rent is from renting dwelling units.

Even properties rented only for residential use may have to be classified as commercial if a majority of the tenants or guests are transients who stay only a short time. This rule can adversely impact the depreciation deductions for property owners who rent their property to short-term guests through Airbnb and other short-term rental platforms. 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 IRS Form 3115 to fix depreciation errors more than two years old.

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Takeaways

If you keep the property for 40 years, the total depreciation deductions are the same for both residential and non-residential real property. The difference is you get your deductions 42% faster with property classified as residential rental property (39 divided by 27.5). Given the time value of money, this is a valuable benefit of owning residential rental property.

For depreciation, residential property is a building or other structure for which 80% or more of the gross rental income for the tax year is from dwelling units. How much space the dwelling units take up in the building is irrelevant; all that matters is how much money you earn from them. If you live in any part of the building, the gross rental income includes the fair rental value of the part you occupy.

If a building changes from a residential rental property to a non-residential rental property due to the 80% rule, you switch to the non-residential rate of depreciation on the first day of that year.

Likewise, if the non-residential real property becomes residential real property, you switch and depreciate over a 27.5 year recovery period for residential rental property instead of the 39-year period.

The definition of the dwelling unit for purposes of depreciation is more expansive than what you might find with vacation homes. For example, the vacation home rules state that the dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities. For 27.5-year residential rental property depreciation, you don’t need the kitchen. The 30-day transient rule applies not only to hotels, motels, and nursing homes but to short-term Airbnb-type rentals as well.