CCA 1049026: An adult home care house qualifies as residential rental property

Plain-English summary

This Chief Counsel Advice considers whether a house used for an adult home care business qualifies as residential rental property for depreciation purposes. The residents lived in the house full-time, and the taxpayers provided supervision, care, and other services. The advice concludes that the house qualifies as residential rental property under IRC § 168(e)(2) because the residents' bedroom apartments and associated common areas were dwelling units and the building met the applicable rental-income test. The portion leased as dwelling units may generally use a 27.5-year recovery period, or a 40-year period if the alternative depreciation system applies, but the owner-occupied portion is excluded. The advice does not address whether § 280A limits deductions for using part of the residence for business.

Ruling snapshot

• Question: Does a house used for an adult home care business qualify as residential rental property under IRC § 168(e)(2)?
• Outcome: advice given
• Key authorities: IRC §§ 167(a), 168(a), 168(e)(2), and 280A; Rev. Rul. 79-209.

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201049026
       Release Date: 12/10/2010
       CC:ITA:B07:BPHarvey                      Third Party Communication: None
       POSTN-126540-10                          Date of Communication: Not Applicable

UILC: 168.20-00

date: September 23, 2010

 to:   Associate Area Counsel - Seattle
       (Small Business/Self-Employed)
       Attn: Melanie Senick

from: Branch Chief, Branch 7
(Income Tax & Accounting)

subject: Adult Home Care Business as Residential Real Property
POSTN-126540-10

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       ISSUES

       Whether a house used to operate an adult home care business that cares
       full-time for adults who cannot live on their own qualifies as residential rental property
       for purposes of § 168(e)(2) of the Internal Revenue Code such that the owners of the
       house are entitled to depreciate the house using a 27.5 year recovery period, under the
       general depreciation system of § 168(a).

       CONCLUSIONS

       The house qualifies as residential rental property for purposes of § 168(e)(2). Thus, the
       owners should determine depreciation for the portion of the house leased as dwelling
       units by customers of the adult home care business (but not the portion of the house
       that is owner-occupied) using a 27.5 year recovery period (or a 40 year recovery period
       if the alternative depreciation system of § 168(g) applies).

       FACTS

       Taxpayers own, and have operated out of their house, an adult home care business
       since 2005. They provide general care for adults who cannot live on their own

POSTN-126540-10 2

("residents"). The residents live full-time in the taxpayers' house. On average, the
taxpayers have three to four residents living with them at any time. The majority of
residents stay in the house on a non-transient basis. The taxpayers provide 24 hour
supervision and care for the residents, laundry service, maid service, upkeep of the
house, landscaping, transportation, and other services. The residents each pay
$3,000.00 per month to the taxpayers. Approximately $1,000.00 of this amount is
allocated by the taxpayers to the rent of a bedroom and the right to use the bathroom,
kitchen, and living room. Approximately $2,000.00 is allocated to the services that the
taxpayers provide for their residents.

The taxpayers allege that their house qualifies as residential rental property under
§ 168(e)(2) and have depreciated the house using the 27.5-year recovery period. Upon
examination, the Internal Revenue Service determined that the taxpayers' house did not
qualify as residential rental property and that the taxpayers were required to depreciate
the house using the 39-year recovery period for nonresidential real property.

LAW AND ANALYSIS

Section 167(a) generally allows as a depreciation deduction a reasonable allowance for
the exhaustion, wear, tear, and obsolescence of property used in a trade or business.
Section 168(a) provides that the depreciation deduction provided by § 167(a) for any
tangible property placed in service after 1986 must be determined using the applicable
depreciation method, the applicable recovery period, and the applicable convention.
Only the applicable recovery period is at issue in this case. Section 168(c) assigns
recovery periods of 27.5 years and 39 years to residential rental property and
nonresidential real property, respectively, for purposes of the general depreciation
system of § 168(a).

Under § 168, the applicable recovery period is determined by the property's
classification under § 168(e). In general, § 168(e) classifies real property as either
residential rental property or nonresidential real property. Section 168(e)(2)(B) defines
nonresidential real property as § 1250 property that is not residential rental property or
property with a class life of less than 27.5 years.

Section 168(e)(2)(A)(i) defines residential rental property as any building or structure if
80 percent or more of the gross rental income from such building or structure for the
taxable year is rental income from dwelling units. If any portion of the building or
structure is occupied by the taxpayer, the gross rental income from the building or
structure includes the rental value of the portion occupied by the taxpayer. Section
168(e)(2)(A)(ii)(II).

Section 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 half of the units in which are
used on a transient basis.
POSTN-126540-10 3

Prior to the enactment of the Omnibus Budget Reconciliation Act of 1990,
§ 168(e)(2)(A) provided that the term “residential rental property” has the meaning given
such term by § 167(j)(2)(B). See also section 3.02(2) of Rev. Proc. 87-57, 1987-2 C.B.
687, 689. Section167(j) and (k) (stricken by the Omnibus Budget Reconciliation Act of
1990) contained definitions of the terms "residential rental property" and "dwelling unit"
substantially identical to the definitions in § 168(e)(2). Former § 167(j)(2)(B) defined
residential rental property as a building or structure of which 80 percent or more of the
gross rental income for the building or structure is rental income from dwelling units
within the meaning of former § 167(k)(3)(C). The definition of dwelling unit in former
§ 167(k)(3)(C) is the same definition given that term in § 168(e)(2)(A)(ii)(I). According to
GCM 35648, (Feb. 4, 1974), the authors of former § 1.167(k)-3(c)(1) of the Income Tax
Regulations intended that the term “dwelling unit” encompass nursing homes, old age
homes, and college dormitories. The housing arrangement described in the instant
case is the same or similar to the “old age homes” discussed in GCM 35648.

While former § 167(j) and (k) does not apply to property placed in service after
November 5, 1990, the guidance issued under former § 167(j) and (k) remains
informative for determining whether a building or structure qualifies as residential rental
property under § 168(e)(2)(A).

Former § 1.167(j)-3(b)(2)(i) provided that the term “gross rental income” means,
generally, the gross amounts received from the use of or the right to use real property.
The gross amount attributable to the furnishing of services that are usually or
customarily attributable to the use of or the right to use real property constitutes gross
rental income from the building. However, the gross amount attributable to the
performance of significant services for the occupant that are other than those usually or
customarily rendered in connection with the mere rental of rooms, such as maid service,
does not constitute gross rental income from the building. See former § 1.167(j)-
3(b)(2)(iii).

In accordance with former § 1.167(j)-3(b)(3), gross rental income from a building is
gross rental income from a dwelling unit in such building only if it is attributable to or
ordinarily associated with the use of, or the right to use, such unit as a living
accommodation. If a portion of the building is used for a drugstore, grocery store,
commercial laundry, or other commercial operation, the rent paid for such portion
(including any amount paid for services in connection with such a commercial operation)
is not rental income from a dwelling unit. Similarly, if pursuant to the terms of a lease or
other agreement, a portion of a house or apartment is used as office space, such as a
doctor’s office, the rent paid for that portion is gross rental income from the building but
is not rental income from a dwelling unit.

If any portion of a building or structure is occupied by the taxpayer, former § 1.167(j)-
3(b)(4)(iii) provided that the fair rental value of that portion is included in gross rental
income in determining whether the building or structure qualifies as residential rental
POSTN-126540-10 4

property. The examples in former § 1.167(j)-3(b)(6) showed that if a building or
structure is used to provide living accommodations on a rental basis and if any portion
of that building or structure is occupied by the taxpayer, the fair rental value of the
portion occupied by the taxpayer as a residence is treated as gross rental income from
the building and as rental income from a dwelling unit, and that the fair rental value of
the portion occupied by the taxpayer for a commercial activity (such as operating a
store) is treated as gross rental income from the building but not as rental income from
a dwelling unit.

Revenue Ruling 79-209, 1979-2 C.B. 97, concerned a taxpayer who owned a duplex
consisting of two units of comparable value. The taxpayer leased one unit, and
occupied the other unit. In applying the 80-percent test, the ruling states that both the
rental unit and the owner-occupied unit are dwelling units, and so all rental income from
the duplex (actual income from the leased unit, and implied income from the owner-
occupied unit) was income from dwelling units. As a result, the leased unit (but not the
owner-occupied unit) could be depreciated as residential rental property.

Section 168(e)(2)(A) defines property as a residential rental property by reference to a
“building or structure,” not to a dwelling unit or a portion of a dwelling unit. For a
building or structure to be residential rental property, it must contain at least one
dwelling unit that is actually rented to provide living accommodations. If the building or
structure satisfies this threshold test, then the 80 percent of gross rental income test is
applied.

In the facts in this advice, the rental units are bedroom apartments used to provide living
accommodations within a building, and are not units in an establishment more than one-
half of the units in which are used on a transient basis. Therefore, the rental units are
dwelling units for purposes of § 168(e)(2). All units and associated common areas in
the building, including the portions occupied by the taxpayers, are dwelling units, and no
portion of the building is rented or used for commercial purposes outside of the
taxpayers' adult home care business. Consequently, 100 percent of the gross rental
income from the building is rental income from dwelling units, even after taking into
account the use of the dwelling unit by the taxpayers. In applying the 80-percent test in
this case, the $2,000.00 per month allocated to the services that the taxpayers provide
for their residents does not constitute gross rental income from the building because the
services (24 hour supervision and care for the residents, laundry service, maid service,
transportation) are other than those usually or customarily rendered in connection with
the mere rental of rooms1. Thus, in this case, the building is residential rental property.

1
Upkeep of the house and landscaping are services customarily rendered in connection of the rental of
rooms, and a portion of the monthly $2000 charge must be allocated to these services and included in
both gross rental income from the building and rental income from dwelling units. The exclusion of
charges for services other than those usually or customarily rendered in connection with the mere rental
of rooms is relevant in the application of the 80 percent test only in the case of a building or structure
containing both rental dwelling units and commercial rental space other than dwelling units. In the case
of a building or structure comprised solely of dwelling units and associated areas (such as the instant
POSTN-126540-10 5

case), it is unimportant whether a particular cost for services is included in rental income or not, as 100
percent of gross rental income from the building is necessarily rental income from dwelling units.

Under § 168(e)(2), and the taxpayers should determine depreciation for the portion of
the house leased as dwelling units by the residents (but not the portion of the house that
is owner-occupied) over a 27.5 year recovery period (or a 40 year recovery period if the
alternative depreciation system of § 168(g) applies).

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This Chief Counsel Advice does not address whether § 280A limits the taxpayers'
deductions for the use of a portion of their residence for business purposes.

In addition, the term "dwelling unit" is defined differently under § 280A(f)(1) than under
§ 168(e)(2)(A)(ii)(I). The conclusions in this Chief Counsel Advice concerning whether
the bedroom apartments used in the taxpayers' business are dwelling units are limited
to the analysis under § 168, and no inference should be drawn from this Chief Counsel
Advice that these bedroom apartments are dwelling units for purposes of § 280A.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 622-4930 if you have any further questions.

                                      By: _____________________________
                                          Kathleen Reed
                                          Branch Chief, Branch 7
                                          (Income Tax & Accounting)