Determining Transient Use For Depreciation
When a business can make deductions against their income, it reduces their overall tax due for the year. And usually the more deductions, the better the benefits.
One type of commonly used deduction is claiming depreciation (i.e., getting to claim normal wear and tear for assets used in a business), but the Code is set up with stringent rules and limitations that can affect how much can be claimed by a taxpayer.
This is where it is necessary to determine if a facility that provides accommodations should be seen as residential or nonresidential by the IRS, because being designated as residential lets you depreciate over 27.5 years versus over 39-years for nonresidential, meaning a shorter depreciation period and a bigger the deduction each tax year.
Often it is obvious whether a place that provides accommodations is considered a residential facility or nonresidential. An example of a typical residential property would be an apartment complex that rents out to individuals through leases with set durations, and a nonresidential property would include hotels that are reserved on a short-term basis. This distinction may not mean much to the average person, but as more people get into the real estate business, it becomes important to understand the difference in terms of tax.
In order for the IRS to figure out how to treat a certain property, it lays down some tests. However, like a lot of IRS rules, application can be tricky. This is especially true when it comes to certain facilities that may have ambiguous or mixed uses.
For tax years 2018 and onward, a facility is considered a residential property if it derives 80% or more of its gross income from “dwelling units” rented out to non-transient tenants. These can include not only apartment complexes, but also dormitories, nursing centers, or senior homes if they meet the requirements.
On the flipside, places like hotels, motels, and inns, where if more than half the units are used on a “transient basis”, the facility would not qualify as residential (they would not meet the definition of “dwelling units”), but rather as nonresidential subject to a less desirable recovery period of 39-years. To decide if guests are staying on a transient basis, the occupancy will need to regularly be for less than 30 days. Be aware that these tests are applied annually.