Having worked in depreciation and fixed assets for many years we see many issues due to incorrect understanding of the tax law. Unfortunately depreciation is one of the biggest areas of confusion related to taxes. Since depreciation law is heavily court case driven it is sometimes hard to dive into the details.
Over the coming months we will be issuing a series of articles dealing with some of these confusing areas. Some of the areas we see issues include:
- The Use of 27.5-Year Depreciation
- When is ADS Required
- Handling of Land Preparation Costs
- Handling of Demolition of Structures
- Use of Qualified Leasehold Improvements (Prior to the new tax law)
- Handling of ACM and other Decorative Exterior Panels
- Why Cost Segregation is Important after the Tangible Property Regulations
The point of these articles will be to allow professionals to dive into some of the more confusing areas and to clarify areas of confusion. Please let us know if there are other areas of confusion that you would like to see us cover.
Use of 27.5-Year Depreciation:
To kick off these articles we wanted to start by discussing the 27.5-year depreciation for long term residential real estate. This may seem pretty self-explanatory. MACRS depreciation requires that “Non-Residential” Property be depreciated over 39-years while “Residential” gets 27.5 years. However we often see taxpayers splitting buildings into residential and non-residential portions. This is the incorrect way for a taxpayer to handle.
Under Sec. 168(e)(2) residential rental property is a structure with 80% or more of the gross rental income coming from long term residential rental. This is calculated over the entire building, not portions of it. This means that if a building derives 10% of the income from retail space, that space is still depreciated over 27.5 years. Conversely if a property is mixed use and derives 50% of the income from office space and 50% from residential the entire building is non residential.
Now that then brings up the question as to when a property is residential rental and when it is “transient”. 168(e)(2)(A)(ii)(I) states that hotels and motels do not qualify if more than ½ of the units are used on a transient basis. But what qualifies as transient for this definition. Under 1.167(k) of the Regs, the IRS defines transient as a unit which “for more than on-half of the days in which the unit is occupied on a rental basis during the taxpayers taxable year, it is occupied by a tenant or series of tenants each of whom occupies the unit for less than 30 days.”
This definition will become even more important in coming years if Congress fixes the issues surrounding Qualified Improvement Property (“QIP”). Under the Tax Cuts and Jobs Act of 2017 QIP was supposed to be bonus eligible, however due to an error it was left out of the final bill. If this becomes law the defining line between residential and non-residential becomes even more important as residential is not eligible for QIP treatment.
We look forward to delving into these topics in greater detail in the months to come.