Depreciation is your best fried, when you own rental property. 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 in depreciation?
Answer: recovery periods.
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 property. 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.
The tax code assigns a certain amount of time—called the recovery period—over which you depreciate all business assets that last more than one year. The longer the recovery period, the less you deduct each year. As you might expect, real property, such as a building, has a longer recovery period than personal property, such as a car. But this is tax law, so the recovery period is not the same for all types of real property.
- The recovery period for residential rental real property is 27.5 years.
- The recovery period for non-residential real property— that is, commercial rental and business property—is 39 years.
What Is Residential Rental Property?
Not all property you might think of as residential qualifies as such for depreciation purposes. For depreciation, residential rental property is a building or other structure for which 80 percent or more of the gross rental income for the tax year is from “dwelling units” (IRC Section 168(e)(2)(A)(i)). How much space the dwelling units take up in the building is irrelevant; all that counts 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.
What Is a Dwelling Unit?
The definition of a dwelling unit for purposes of depreciation is more expansive than what you find with vacation homes. For example, the vacation home rules state that a dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities (Prop. Reg. Section 1.280A-1(c)(1); IRS Pub. 527, Residential Rental Property (2020)). Note that for 27.5-year residential rental property depreciation, you don’t need the kitchen.
When defining the dwelling unit for residential rental property depreciation, the tax code states that the term “dwelling unit” means a house or apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, or other establishment in which more than one-half of the units are used on a transient basis, and if any portion of the building or structure is occupied by the taxpayer, the gross rental income from such building or structure shall include the rental value of the portion so occupied.
What Is Transient Use?
Before 1993, the IRS stated this on transient use: “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.”
Although the IRS withdrew this regulation, the 30-day average occupancy definition has stood the test of time, still exists in the investment credit regulations, and is considered informative by the IRS.
What about Airbnb and Other Short-Term Rental?
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.