Depreciation and Changes in Use of Real Property

Taxpayers that own rental property with gross receipts from residential or nonresidential uses should be familiar with the rules on accounting for depreciation. Let’s see some rules about buildings or structures qualifying as residential or nonresidential property, and application of the change-in-use regulations if a rental property changes from residential use to nonresidential use or vice versa.

Gross-Receipts Tests

If 80% or more of the annual gross rental income from a mixed-use building or structure is generated from residential rental apartments (taxpayers may include in gross rental income the rental value of any portion of the building that they occupy but cannot include a unit in a hotel, motel, or other establishment of which more than half of the units are used on a “transient basis”), the entire building and its structural components will qualify as a residential rental property, which means a faster cost recovery period of 27.5 years.

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.

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 larger or smaller 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.

On the other hand, 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). A taxpayer needs only to complete Form 4562, Depreciation and Amortization, 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 bonus depreciation deductions in the year of change, Sec. 179 depreciation (which allows you to expense certain depreciable business assets and is generally not applicable to residential and nonresidential property), or Sec. 1400L (tax benefits for New York Liberty Zone property). Additionally, for purposes of determining whether the mid-quarter convention applies to other MACRS property placed in service during the year, the change-in-use property is not taken into account.

Taxpayers that own rental properties with both residential and nonresidential receipts should work with their accountant or tax advisor annually to test whether the property has changed use and the effect of the change on the taxpayers’ tax returns.