Tenant Improvements: Tax Bennies

Summary:

You’re renting new office or store and are negotiating
an allowance for improvements, and planning for the costs you’ll incur on
fitting out the space.  How can you
maximize deductions from leasehold improvements and other costs you’re likely
to incur?

Costs to Acquire Your
Lease

Brokerage commissions,
legal fees, and other costs incurred by you as a tenant in negotiating and
acquiring a lease are generally treated as an asset (capitalized), not deducted currently. Treas. Reg. Sec.
1.263(a)-4(c) and (d). These costs, once capitalized, are then deducted ratably
(amortized) over the
lease term. Treas. Reg. Sec. 1.162-11(a); 1.263(a)-4. You have to determine the
length of the lease term. This is not always obvious with the many possible
renewal provisions and other lease terms.
Generally, you must include a renewal option in the “lease term” for
amortization purposes if less than 75% of the costs are attributable to the
base lease term.  Treas. Reg. Sec.
1.1.78-1. Since this is a facts and circumstances determination, the results
are unclear. Tip: Have a broker give you a written opinion that based on market
conditions it is unlikely that you will exercise the options.

Costs of obtaining a
sub-lease are capitalized and then amortized over the lease term. If you
purchase a lease, the payments will generally have to be amortized over the
term remaining in the lease purchased. However, it may be possible to argue
that you can allocate some of the costs to improvements and depreciate
(recover) that portion of the payments according to those rules discussed
below. Rev. Rul. 61-217. If you purchase the lease along with the property the
cost allocable to the lease becomes part of the cost of the realty and must be
depreciated over what is usually a longer period. Treas. Reg. Sec.
1.197-2(c)(8).

Tax Consequences of
Tenant Improvements and Allowances

Landlords often will
provide building standard improvements and then you, as the tenant, will pay
for any above standard finishes, e.g., better carpet, a kitchen, and more. You
must depreciate (recover) these improvements over the time periods required for
depreciating real estate. Tenants can no longer amortize improvements over the
lease term. IRC Sec. 168(i)(8).  Improvements
the landlord pays for and owns must be capitalized and depreciated under rules
called the “Modified Accelerated Cost Recovery System” or MACRs. If instead the landlord structures the payment as
a lease acquisition cost with improvements owned by the tenant, the landlord
will amortize the costs over the lease term, but the tenant will recognize
income, and depreciate the improvements. This is the worst possible tax result.

Avoid Income on Receipt
of an Allowance

If you as the tenant
expend the allowance on improvements which are owned by the landlord, the
allowance is not taxable income to you. Another approach which has also been
used by tenants to avoid income taxation of allowances is to argue that
landlord payments are non-taxable contributions to capital and excluded from
income. IRC Sec. 118; Elder-Berman Stores, Corp. Finally, the tax laws include a provision to
assure retail tenants that an allowance will not be taxable. IRC Sec. 110. When
a retail tenant receives rent concessions or a cash allowance to use to pay for
improvements, for a short term lease (15 years or less) for retail space
(broadly defined so that professional offices of a CPA or attorney are deemed
retail), the amount is excluded from tenant income to the extent paid in that
tax year for improvements. The cost of the improvements is treated as
non-residential real property improvements owned by the landlord that the
landlord then depreciates (recovers). Treas. Reg. Sec. 110-1(b)(5). The IRS
view is that payments not spent on improvements are income to the tenant. AM
2007-003 1/24/07. The tenant and landlord must each attach a statement to their
income tax returns for the years involved. Treas. Reg. Sec. 1.110-1(c). This
must include: name, address and tax ID number of landlord and tenant, amount of
the allowance, amount of the allowance that is qualified, and the property’s
location.

15 Year Special
Depreciation.

The general rule is that
you must depreciate (recover) leasehold improvements over 39 years, the using
the rules prescribed for real estate. However, qualifying leasehold
improvements completed before 2008 qualify for a special favorable 15-year
recovery period. IRC Sec. 168(e)(6).  These improvements must be to an interior of a nonresidential
building, made by an unrelated landlord or tenant under a lease, to a building
that had been completed at least 3 years earlier. Costs to enlarge a building,
or for an elevator or structural component doesn’t qualify.

Distinguishing Real
from Personal Property.

A key to maximizing
deductions for tenant improvements is to properly characterize the property
purchased as to whether it is personal property (e.g., equipment) that qualifies
for more favorable tax benefits (faster depreciation over 5 or 7 years), or
real property (walls and structural components) that must generally be
recovered over the 31.5 (or longer) recovery periods (unless the special 15
year rule above applies). See Checklist article.

Code Sec. 179 Deduction.

If you purchase business
property that will last for a number of years, such as equipment, it generally
has to be written off over a specified period, such as 5-7 years. However,
these costs may qualify to be deducted immediately under a special tax rule
contained in Code Section 179. The holy grail of leasehold improvement tax
planning is to qualify expenditures for this benefit instead of the 39 year
recovery for real property.

The maximum amount of
property you can deduct in any year is $125,000. This limit is reduced to
$25,000 in 2010. Your deduction is also reduced by expenditures in excess of
$500,000 for qualifying property. The amount you can deduct is also limited to
your taxable income for the year, before the  Section 179 deduction. When a partnership, limited liability
company or S corporation incur qualifying expenses the entity must file a
statement with the IRS to claim the deduction. This is done on Form 4562. The
property cannot be purchased from a related person, and it must be used more
than 50% in an active trade or business.

Trusts and estates are not
eligible for the Section 179 benefit. So if a trust or estate  is a partner in a partnership (or a member
in a limited liability company) the amount of Section 179 deduction that would
pass through to the trust or estate will have to be capitalized and then
depreciated. It might be possible to avoid this adverse result by allocating
179 deductions to partners who are not trusts or estates, and allocating
depreciation deductions to the partners who are trusts or estates.

Conclusion.

Planning for tenant improvements can
substantially enhance tax deductions. This requires a coordination of tenant
allowances, documenting expenditures to corroborate the maximum amounts that
can be treated as depreciable personal property instead of real estate, and
taking advantage of the Section 179 deduction.