As seen in Crain's New York Business

The COVID-19 pandemic has accelerated the shift towards remote and hybrid work models, resulting in a surge in office vacancies across the United States. While the demand for office space has decreased, the demand for housing, especially affordable housing, has continued to increase. This has presented lawmakers and property owners with a rare common goal and unique opportunity to solve this issue through commercial to residential property conversions.

Obstacles

The primary hurdles for commercial to residential property conversion are existing dwelling laws and zoning regulations, architectural challenges, and lack of financial incentives.

There is a need to modernize decades old regulations that greatly impede conversions. In particular, allowing for conversions in more office districts, broadening residential housing types qualified for conversion, and increasing the cap on residential floor area eligible for conversion.

Architecturally, buildings with deep floor plates are challenging to convert to residential dwellings due to the requirement for tenants to have ventilated windows. This is problematic for floors in buildings with deep windowless interiors and unventilated window facades. There is also the issue of building around numerous elevator shafts and relocating and extending plumbing and gas systems for residential kitchens and bathrooms.

Without financial incentives, property owners are left to shoulder the immense cost of conversion on their own. Governmental financial assistance could provide the incentive necessary for property owners to take on the financial risk of residential conversion, which in turn would help cities create more housing stock.

Tax implications of conversion

Commercial to residential conversions carry several tax implications, such as the change to the depreciation of the converted property. Commercial property is generally depreciated over 39-40 years; however, residential property is depreciated over a shorter life, 27.5-30 years. For properties that are converted to mixed-use, buildings that generate at least 80% of gross rents from dwelling units are deemed to be residential rental properties.

If nonresidential property is successfully converted to residential property, a change-in-use is deemed to have occurred. If a change in use results in a shorter recovery period, taxpayers can compute depreciation over the shorter recovery period or elect to continue computing depreciation as though a change in use did not occur. This flexibility provides tax planning opportunities for taxpayers gauging whether to accelerate deductions.

Taxpayers should also be aware that they may be precluded from applying Sec. 168(k) bonus depreciation on qualified improvement property. Condo conversions may result in property owners attaining dealer status and the related ordinary income treatment on the sales of the condo units.

Conclusion

Conversions of real property are going to be complex challenges with significant financial implications, including related tax matters. If you have an interest in converting your property to a residential dwelling, contact Citrin Cooperman’s Real Estate Industry Practice to further discuss navigating the murky waters of commercial to residential property conversion.