Depreciating Residential Rental and Commercial Real Property: Avoid Surprises

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 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.

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.