Summary: You are renting a new office or store and are negotiating an allowance for improvements, and planning for the costs you will incur on fitting out the space. How can you maximize deductions from leasehold improvements and other costs that you are likely to incur?
Costs to Acquire Your Lease
Brokerage commissions, legal fees, and other costs that you incur as a tenant with 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 that 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 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 will be 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 incurs 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.
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.