Specialized Returns and Taxpayers · Rental property

Commercial rentals versus residential rentals

Two rental buildings can look identical and be depreciated over periods twelve years apart. The classification is not architectural — it is a test on the composition of the rent, applied year by year, and a building can cross the line without a brick moving.

The rule

The test (IRC § 168(e)(2)(A)(i)). residential rental property means any building or structure if 80 percent or more of the gross rental income from it for the taxable year is rental income from dwelling units (IRC § 168(e)(2)(A)(i))^TY2026 Eighty percent of gross rental income, not eighty percent of floor area and not eighty percent of units. A mixed-use building with ground-floor shops paying high commercial rents and flats above can be nonresidential even where most of the square footage is residential.

What is a dwelling unit. a dwelling unit is 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 more than half of whose units are used on a transient basis; and where the taxpayer occupies part of the building, the gross rental income includes the rental value of the occupied portion (IRC § 168(e)(2)(A)(ii))^TY2026 The transient exclusion is why a hotel and a short-stay apartment block are nonresidential real property, and the owner-occupation rule is why a landlord living in one flat of a four-flat building includes the rental value of their own flat in the test.

The residual. nonresidential real property means IRC § 1250 property that is neither residential rental property nor property with a class life of less than 27.5 years (IRC § 168(e)(2)(B))^TY2026 Nonresidential real property is defined by exclusion, so anything that is IRC § 1250 property and fails the 80 percent test lands there — provided its class life is at least 27.5 years.

The periods. residential rental property is recovered over 27.5 years and nonresidential real property over 39 years (IRC § 168(c))^TY2026 under the alternative depreciation system the periods are 30 years for residential rental property and 40 years for nonresidential real property (IRC § 168(g)(2)(C)(iii), (iv))^TY2026 the straight line method is required for nonresidential real property and residential rental property (IRC § 168(b)(3)(A), (B))^TY2026 the mid-month convention applies to nonresidential real property, residential rental property and any railroad grading or tunnel bore; everything else uses the half-year convention unless the mid-quarter convention is triggered (IRC § 168(d)(2))^TY2026

Improvements are treated asymmetrically. qualified improvement property means any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property, placed in service after the building was first placed in service — excluding expenditure attributable to enlarging the building, to any elevator or escalator, or to the internal structural framework (IRC § 168(e)(6))^TY2026 qualified improvement property is 15-year property (IRC § 168(e)(3)(E)(vii)), depreciated straight line under IRC § 168(b)(3)(G), and there is no counterpart class for improvements to a residential rental building^TY2026 There is no residential counterpart. An interior improvement to an apartment building is generally depreciated over the building’s own 27.5 years, while the same work in an office building is 15-year property eligible for bonus depreciation and, within limits, for IRC § 179 expensing.

The interest election has a cost here too. an electing real property trade or business under IRC § 163(j)(7)(B) must use the alternative depreciation system for its nonresidential real property, residential rental property and qualified improvement property — 40, 30 and 20 years respectively (IRC § 168(g)(1)(F), (g)(8))^TY2026 a taxpayer may elect the alternative depreciation system for a class of property, applying to all property in the class placed in service that year, but for nonresidential real property or residential rental property the election may be made separately for each property; once made it is irrevocable (IRC § 168(g)(7))^TY2026

Current figures

How it works in practice

Run the 80 percent test on the actual rent roll each year, not once at acquisition. The statute frames it as a test “for the taxable year,” so a building whose commercial tenancies grow can shift from residential to nonresidential. In practice the Service and taxpayers alike treat the classification as fixed at placement in service for a building whose use has not materially changed, but a genuine change in the mix — the ground floor let to a restaurant at triple the residential rate — is a change in classification and needs to be handled, generally as a change in accounting method rather than a simple re-computation.

Include the taxpayer’s own occupancy in the denominator and the numerator. IRC § 168(e)(2)(A)(ii)(II) requires the rental value of any portion the taxpayer occupies to be included in gross rental income. That usually helps — an owner living in one unit of a small block is contributing residential rental value to the numerator — but it has to be quantified rather than ignored.

For improvements, identify the building’s classification before deciding how to recover the cost. The qualified improvement property class in IRC § 168(e)(3)(E)(vii) applies only to an interior improvement to a building which is nonresidential real property. Work on an apartment building’s interior is generally an improvement to 27.5-year property, though components that are properly IRC § 1245 personal property — appliances, carpeting, removable fixtures — are separable and recovered over five or seven years, which is what makes a cost segregation study worth commissioning on a residential building.

Weigh the IRC § 163(j)(7)(B) election as a long-term commitment. It escapes the business interest limitation, and it puts every building the business holds onto the alternative depreciation system — 40 years for commercial, 30 for residential, 20 for qualified improvement property — irrevocably. On a heavily leveraged commercial portfolio the interest relief usually wins; on a lightly leveraged one it rarely does.

How this has changed

The 39-year period for nonresidential real property dates from the Omnibus Budget Reconciliation Act of 1993, which lengthened it from 31.5 years for property placed in service after 12 May 1993. The 27.5-year residential period has been unchanged since the Tax Reform Act of 1986. A building placed in service between 1987 and 1993 may still be running on 31.5 years, which matters when computing recapture on a sale.

Qualified improvement property was the subject of the best-known drafting error in recent tax legislation. Pub. L. 115-97 § 13204 consolidated three predecessor categories into one and intended a 15-year period, but the statutory text omitted it, leaving qualified improvement property at 39 years and outside bonus depreciation. The Coronavirus Aid, Relief, and Economic Security Act corrected it retroactively to property placed in service after 31 December 2017, and taxpayers who had capitalised over 39 years in the interim were able to change method.

The alternative depreciation period for residential rental property was shortened from 40 years to 30 by Pub. L. 115-97 § 13204(a)(3), and the Consolidated Appropriations Act, 2021 extended the 30-year period to residential property placed in service before 2018 and held by an electing real property trade or business. That correction mattered a great deal to leveraged residential portfolios making the IRC § 163(j)(7)(B) election.

Bonus depreciation was restored to the full rate and made permanent by Pub. L. 119-21 § 70301, which also repealed the phase-down schedule. For a commercial landlord that makes the qualified improvement property classification more valuable than at any point since 2017.

Exam focus

Know the 80 percent gross rental income test and that it is income-based. Know the dwelling unit definition and the more-than-half-transient establishment exclusion.

Know the four periods as two pairs: 27.5 and 39 under the general system, 30 and 40 under the alternative system. Know that both classes use straight line and the mid-month convention.

Know that qualified improvement property exists only for nonresidential buildings, that it is 15-year property, and that the IRC § 163(j)(7)(B) election forces the alternative system on every building the electing business holds.

Check yourself

1. A building’s rent roll is $210,000 from flats and $60,000 from a ground-floor shop. Which class?

Answer: Nonresidential real property, 39 years. Rental income from dwelling units is $210,000 out of $270,000, or about 77.8 percent, which is below the 80 percent that IRC § 168(e)(2)(A)(i) requires. The building is therefore not residential rental property despite the flats supplying most of the rent. The arithmetic is close enough to be worth doing rather than eyeballing, and this fact pattern is designed to punish the eyeball.

2. A landlord occupies one of five identical flats in a building he owns and lets the other four. There are no commercial tenants. Does his occupancy affect the classification?

Answer: It affects the computation but not the outcome. IRC § 168(e)(2)(A)(ii)(II) requires the rental value of the owner-occupied portion to be included in gross rental income from the building. Here that value is itself rental value of a dwelling unit, so it enters both the numerator and the denominator and the ratio stays at 100 percent. Residential rental property, 27.5 years.

3. An owner spends $250,000 replacing the lift in an office building. Is it qualified improvement property?

Answer: No. IRC § 168(e)(6)(B)(ii) excludes any improvement attributable to an elevator or escalator from the definition. The lift is a structural component of the building and is recovered over the building’s 39 years. The same result follows for enlargement work and for anything touching the internal structural framework.

4. A real property trade or business makes the IRC § 163(j)(7)(B) election. It holds an office building, an apartment block and recently completed interior improvements to the office. What periods apply?

Answer: 40 years for the office building, 30 years for the apartment block and 20 years for the qualified improvement property, all under the alternative depreciation system by operation of IRC § 168(g)(1)(F) and (g)(8). The election is irrevocable, so those periods apply for as long as the business holds the assets.

5. A twelve-unit building has seven units let nightly to tourists and five on annual leases. Which class?

Answer: Nonresidential real property, 39 years. Seven of twelve units are used on a transient basis, which is more than half, so IRC § 168(e)(2)(A)(ii)(I) takes the whole establishment out of the dwelling unit definition. Rental income from dwelling units is nil, the 80 percent test cannot be met, and the five long-let units do not save it.