Senior housing in full-service communities is residential rental property under Sec. 168

Internal Legal Memorandum 201147025

An IRS Internal Legal Memorandum (ILM) concludes that buildings used to provide housing to seniors in communities that offer a range of services (e.g., from independent to assisted living to nursing care) as well as housing are properly classified as residential rental property for depreciation purposes. Thus, the buildings may be depreciated over a 27.5-year recovery period, rather than the 39-year period that applies to nonresidential rental property.

Background. Depreciation deductions are computed under the modified accelerated cost recovery system (MACRS) rules of Code Sec. 168, which prescribe the depreciation method, recovery period, and applicable convention for various types of property. Under the general depreciation system, residential rental property is assigned a 27.5-year recovery period, while nonresidential rental property is assigned a 39-year recovery period. (Code Sec. 168(c))

Under Code Sec. 168(e)(2)(A)(i), residential rental property is defined as any building or structure if 80% or more of the gross rental income from the building or structure for the tax year is rental income from dwelling units. Under Code Sec. 168(e)(2)(B), nonresidential real property is defined as Code Sec. 1250 property that is not residential rental property or property with a class life of less than 27.5 years. Code Sec. 168(e)(2)(A)(ii)(I) provides that a dwelling unit means 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 one-half of the units in which are used on a transient basis.

Facts. A taxpayer we'll call Sunset operates a number of senior retirement communities, all of which fall into one of two categories. Type One communities offer independent living housing units, with a sliding scale of care depending on the senior's needs. With the passage of time and as needs arise, seniors may go from independent living to assisted living, memory support care, and skilled nursing care, as well as back to more independent living as health improvements may allow. Type One community residents don't buy a residence, nor do they enter into a lease. Instead, Sunset and the resident enter into a continuing care agreement. The resident pays a substantial entrance fee (a portion of which is refundable if a resident moves out or dies) and a substantial monthly fee. Services covered by the monthly fees include maintenance of building and grounds, weekly light house cleaning, and laundering of bed linens. Sunset does not characterize any portion of the monthly fees as rent, and in reporting income, Sunset describes the monthly fees as life care services income (and not as rent).

Sunset's Type Two communities are similar to the Type One Communities, but no upfront entrance fees are charged and residents sign renewable annual leases. Type Two communities offer services that are similar to those provided by Type One communities, except that residents must pay on a monthly fee basis additional charges for any onsite assisted living, personal care, or Alzheimer's disease care.

Recovery period issue. Sunset depreciated its Type One and Two facilities over a 27.5-year recovery period, but the auditor examining its returns questioned whether this was correct.

RIA observation: Evidently, the auditor thought a 39-year recovery period would have been more appropriate because he thought Sunset's buildings generated income from providing services, not housing.

Taxpayer-favorable guidance. The ILM concludes that Sunset properly depreciated its Type One and Two facilities over a 27.5-year recovery period. Residents of both types of communities use the residential units in them as living accommodations, and part of the benefit they receive is the right to occupy and reside in a particular residential unit. Although residents may move between Sunset's facilities as their needs change, and therefore between residential units, they nonetheless may generally expect to retain the same residential unit continuously until such time arises. This right is one of several rights that the resident obtains and pays for under the service agreement with Sunset. Consequently, the ILM says, some allocable portion of the monthly amount received by Sunset is payment for the use of, or the right to use, a dwelling unit, and is rental income from that dwelling unit for purposes of applying the 80% gross rental income test under Code Sec. 168(e)(2)(A)(i).

The fact that residents in Type One communities occupy residential units without a formal lease is not dispositive, the ILM says, pointing out that Code Sec. 168(e)(2)(A) does not require a landlord-tenant relationship or the existence of a lease, but only that income is received from the rental of dwelling units.

Also not dispositive was the fact that Sunset characterized all of the income it receives from residents as income from life care services and not as rent. The ILM said this subjective characterization did not dictate whether the property is residential rental property for Code Sec. 168 purposes.

The ILM concludes that the various types of residential units (independent living, assisted living, memory care, and skilled nursing care units) within the buildings that comprise Sunset's Type One and Two communities are used to provide living accommodations, and are not units in an establishment more than half of which are used on a transient basis. Sunset didn't receive non-residential rental income from third parties, or conduct commercial activities in a significant enough portion of these buildings to cause it to fail the 80% gross rental income test. Thus, the ILM determines that the buildings used to provide living accommodations to residents in both Sunset's Type One and Two communities are residential rental property under Code Sec. 168(e)(2) and may be depreciated over a 27.5-year period.

RIA Research References: For residential rental property defined for MACRS purposes, see FTC 2d/FIN ¶ L-8211; United States Tax Reporter ¶ 1684.02; TaxDesk ¶ 266,211.
Source: Federal Tax Updates on Checkpoint News tab 12/1/2011

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