New Rules for Writing Off Leasehold Improvements

For the past seven years, leasehold improvement rules have been undergoing changes that can improve your bottom line.  That’s what this article is about: improving your cash realization from leasehold improvement write-offs.

Whether you are the landlord or the tenant, you need to know the leasehold rules.  New developments increase your ability to write off leasehold improvements at the end of the lease term and allow you to use much shorter depreciation periods.

Not knowing the rules is not an option, unless you want to throw money in the trash can.  The good news is that the rules are easy to understand and have a certain logic embedded in them.  We predict that you will smile as you read about these very beneficial rules.

Rules That Apply to the Leasehold Improvement Write-Off Period

Rule 1.  Whether you are the owner or the tenant, improvements you make to a business property are depreciated over the statutory recovery period for the improvement type.

Example 1.  You enter into a five-year lease to rent office space.  The lease gives you an option to renew for an additional five years.  To make the building more functional, you build interior walls and countertops at your expense.  You depreciate the cost of the walls and countertops over their five-to-seven year recovery periods.

Example 2.  You build an office on land you lease from Irma Smith.  Because you have read this article, you know you can use cost segregation on this building to separate the components and depreciate

?  the personal property components over their three-, five-, and seven-year class lives, and

?  the real property over its lengthy 39-year statutory period. 

Rule 2.  If the improvement is made in lieu of rent, the law deems the improvement rent paid by the tenant to the owner.

Example.  You replace the air-conditioning and heating system in your office building.  The landlord agrees that you can deduct the cost of this new equipment from your rent check.  You treat the cost of the new equipment as deductible rent.  The landlord treats the cost of the equipment as

?  rental income, and

?  the acquisition of equipment, which the landlord then depreciates as if he had purchased the                     equipment himself.

Planning tip.  If you are the landlord, have the tenant make improvements at the tenant’s expense with no reduction in rent.  If you arrange this properly, your money happily sits on the sidelines and watches as your tenant makes improvements that make your property more valuable but do not create taxable income for you.

Rules That Apply at Lease Termination

As either the tenant ot the landlord, it is possible that you will not have fully depreciated the leasehold improvements by the time the lease expires.  Here are the rules that apply.

Lease termination write-off rule for the tenant.  I f the improvements have no value to the tenant at the end of the lease, the tenant may write off the un-depreciated cost remaining at the termination of the lease.

Example:  You built interior walls and countertops in a building that you leased for five years with an option to renew for another five years.  At the end of the first five-year rental period, you move out of this building to a new space.  At the termination of the five-year rental period, you may deduct the remaining un-depreciated basis of the interior walls and countertops.  Should the lease require that you put the property back into its original shape, excluding normal wear and tear, you also may deduct the cost of removing the walls and countertops.

Lease termination write-off rule for the landlord.

If the building owner makes the improvements to accommodate the tenant and those improvements are worthless at lease termination, the owner may write off the remaining un-depreciated improvement costs.

Example.  You, the owner, construct interior walls and build various counters for a tenant who signs a four-year lease with an option for a second four years.  At the end of the fourth year, the tenant moves out and you find a new tenant, but the tenant does not want any of the walls or counters.  You tear them out and return the space to its original condition.  At this time, you write off

?  the un-depreciated basis of the interior walls and counters, and

?  the cost of removing the walls and counters.

New Developments That Shorten the Leasehold Improvement Write-Off Period

The faster you can get a tax deduction, the more valuable that deduction is.  Why?  Deductions put cash in your bank account, where it can compound and grow.  Say you have two choices:

?  Put all the money in the bank during the next five years, or

?  Put the money in the bank in equal amounts over 39 years.

The bank does not pay interest on potential deposits-you want to get that money into the bank as quickly as possible.

When it comes to your leasehold improvement write-offs, you’ll be happy to know that you now have a little more control over the time-value of your money.  Both the courts and the IRS have recently approved the segregation of building and improvement costs into real and personal property classifications.

Real property is depreciated over 39 years, entirely too long to make your time-value-of-money buildup happy. 

Personal property is depreciated over periods as short as three, five, or seven years; a substantially shorter period that plants a smile on your time-value-of-money buildup.

Say you install decorative molding in your property.  With no knowledge of the cost segregation rules, you would treat the molding as personal property and depreciate it over five years.

Many taxpayers, realizing the importance of the new cost segregation possibilities, have filed amended returns for improvements made on existing buildings.  The lure of immediate cash is a very big draw.

We will not discuss amended returns in this article, but we do want to point out the importance of getting your leasehold improvements right.  Most build-outs consist entirely of personal property, meaning that, because you know about the cost segregation rules, you will get your deductions much more quickly.

Here are four events that contribute to the use of cost segregation studies to break a building into its personal and real property parts:

1. The IRS agrees that federal law, not local law, controls the classification of property as real or personal for income tax purposes.
2. The Hospital Corp. of America court case, combined with the IRS acquiescence, gave the green light to the cost segregation of a building into its personal and real property components.
3. The IRS recognizes cost segregation as a viable method of separating assets in these publications:

?  Field  Directives on Planning and Examination of Cost Segregation Issues in the Restaurant Industry (12/27/04).

?  Planning and Examination of Cost Segregation Issues in the Retail Industry (12/16/04).

?  Planning and Examination of Cost Segregation Issues in the Biotech/Pharmaceutical Industry (11/28/05).

?  Cost Segregation Audit Technique Guide (4/30/04).

4.  The significant time-value-of-money difference between 39-year straight-line depreciation and 5-year double-declining-balance depreciation makes cost segregation desirable for those who want to improve cash flow.