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You are renting a 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 are likely to incur?

Costs to Acquire Your Lease

Brokerage commissions, legal fees, and other costs incurred by you in negotiating and acquiring a lease are generally treated as an asset (capitalized), i.e., 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 determination is based on facts and circumstances, the results are unclear. Tip: Have a broker give you a written opinion stating 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 the 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 standard building 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 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” (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 expend the allowance on improvements that 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 leasehold improvements over 39 years, 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 three years earlier. Costs to enlarge a building, or for an elevator or structural component do not qualify.

Distinguishing Real from Personal Property

A key to maximizing deductions for tenant improvements is to characterize the property purchased properly as to whether it is personal property (e.g., equipment) that qualifies for more favorable tax benefits (faster depreciation over five or seven 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 the Checklist on pages 7 and 8.

Code Sec. 179 Deduction

If you purchase business property such as equipment, that will last for a number of years, it generally has to be written off over a specified period, e.g., five-seven 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 Economic Stimulus Act of 2008 increased the Section 179 expensing limit to $250,000 and the phase-out to $800,000 for 2008. It also authorizes 50% bonus depreciation for qualifying property acquired and placed in service in 2008. 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.

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. There have been a host of updates, so please check with your tax professional.

Checklists

The cost of a real property leasehold improvement generally has to be depreciated over a 39-year recovery period. However, if expenditures can be properly classified as tangible, personal, movable, non-real estate property, they may qualify to be deducted currently. This can provide tremendous tax benefits.

The analysis used to determine which costs can be classified as personal property, rather than real property, is referred to as “component depreciation” analysis. The foundation for this is based on the law that had applied years ago for the determination of what property qualified for the investment tax credit under prior law Code Section 48. Hospital Corp. of America & Subs. v. Comr., 109 T.C. 21 (1997). Structural components of a building (components that relate to the operation and maintenance of a building) do not qualify for more rapid depreciation or Section 179 expensing. Treas. Reg. Sec. 1.48-1(e). These include:

• Land;
• Inherently permanent structures;
• Walls;
• Doors and door locks. Treas. Reg. Sec. 1.48-1(e)(2); FSA 200203009;
• Windows;
• Floors, such as permanent tiling;
• Acoustical ceilings. Metro Nat'l Corp. v. Comr., 52 T.C.M. 1440 (1987); Central air conditioning and heating systems;
• Fire escapes;
• Stairs;
• Sprinkler systems;
• Basic affixed electrical wiring, wall outlets and general lighting;
• General Lighting; and
• General plumbing.

Non-structural components and personal property can qualify for more favorable tax benefits. Structural components that do not relate to the operation and maintenance of a building may also qualify. These qualify for five- or seven-year recovery periods, rather than 39 years, and the potential for immediate deduction under Section 179. These can include:

• Movable partitions. Rev. Rul. 75-178, 1975-1 C.B. 9;
• Equipment and machinery used to maintain temperature or humidity requirements (e.g., for food preparation);
• Removable air-conditioning equipment. Scott Paper Co., 74 T.C. 137;
• Computers and peripheral equipment and wiring;
• Smart board and related wiring and equipment;
• Special removable lighting;
• Removable kitchen equipment and furnishings;
• Telephone equipment and wiring, including wiring related to intercom, dictation and call systems. Hospital Crop. Of America v. Comr.;
• Special electrical wiring and plumbing hook-ups relating to particular equipment or function. This would include electrical loads for particular items of business equipment;
• Kitchen piping, plumbing connections, dishwashers, etc.;
• Costs that relate to the provision of services rather than building functions;
• Removable carpeting. Rev. Rul. 67-349;
• Vinyl wall covering;
• Removable floor tiles, or other floor coverings that are not an integral part of the floor itself;
• Removable ceiling treatments;
• Signs and ornamentation;
• Furniture and equipment; and
• Removable shelving.

A number of factors can be considered in determining whether property qualifies for the more favorable treatment:

• Manner in which the property is attached to the building. It should not be permanently attached;
• The property is inherently moveable;
• Size, weight and construction of the property;
• The type of equipment and number of people required to move the property;
• The property or similar property has been moved in the past;
• Facts support that the property may not stay in place permanently;
• The property was not designed to stay in place permanently. L.L. Bean, Inc. v. Comr., T.C. Memo 1997-175, aff'd 145 F.3d 53 (1st Cir. 1998);
• The cost, time and difficulty of moving the property;
• Little damage will be done to the property when moved;
• Little damage will be done to the building when the property is removed; and
• The property could readily be re-used if moved.

To secure your write-offs, you need to corroborate the allocation. You might use an engineering and cost analysis of construction records, engineering and cost estimation (when actual records are not available), survey of contractor data, or other estimates.

Martin M. Shenkman, CPA, MBA, JD, is an estate planner in New York City and Teaneck, NJ. His Web site, www.laweasy.com, has information on matrimonial, investment and related matters.

You are renting a 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 are likely to incur?

Costs to Acquire Your Lease

Brokerage commissions, legal fees, and other costs incurred by you in negotiating and acquiring a lease are generally treated as an asset (capitalized), i.e., 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 determination is based on facts and circumstances, the results are unclear. Tip: Have a broker give you a written opinion stating 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 the 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 standard building 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 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” (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 expend the allowance on improvements that 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 leasehold improvements over 39 years, 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 three years earlier. Costs to enlarge a building, or for an elevator or structural component do not qualify.

Distinguishing Real from Personal Property

A key to maximizing deductions for tenant improvements is to characterize the property purchased properly as to whether it is personal property (e.g., equipment) that qualifies for more favorable tax benefits (faster depreciation over five or seven 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 the Checklist on pages 7 and 8.

Code Sec. 179 Deduction

If you purchase business property such as equipment, that will last for a number of years, it generally has to be written off over a specified period, e.g., five-seven 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 Economic Stimulus Act of 2008 increased the Section 179 expensing limit to $250,000 and the phase-out to $800,000 for 2008. It also authorizes 50% bonus depreciation for qualifying property acquired and placed in service in 2008. 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.

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. There have been a host of updates, so please check with your tax professional.

Checklists

The cost of a real property leasehold improvement generally has to be depreciated over a 39-year recovery period. However, if expenditures can be properly classified as tangible, personal, movable, non-real estate property, they may qualify to be deducted currently. This can provide tremendous tax benefits.

The analysis used to determine which costs can be classified as personal property, rather than real property, is referred to as “component depreciation” analysis. The foundation for this is based on the law that had applied years ago for the determination of what property qualified for the investment tax credit under prior law Code Section 48. Hospital Corp. of America & Subs. v. Comr., 109 T.C. 21 (1997). Structural components of a building (components that relate to the operation and maintenance of a building) do not qualify for more rapid depreciation or Section 179 expensing. Treas. Reg. Sec. 1.48-1(e). These include:

• Land;
• Inherently permanent structures;
• Walls;
• Doors and door locks. Treas. Reg. Sec. 1.48-1(e)(2); FSA 200203009;
• Windows;
• Floors, such as permanent tiling;
• Acoustical ceilings. Metro Nat'l Corp. v. Comr. , 52 T.C.M. 1440 (1987); Central air conditioning and heating systems;
• Fire escapes;
• Stairs;
• Sprinkler systems;
• Basic affixed electrical wiring, wall outlets and general lighting;
• General Lighting; and
• General plumbing.

Non-structural components and personal property can qualify for more favorable tax benefits. Structural components that do not relate to the operation and maintenance of a building may also qualify. These qualify for five- or seven-year recovery periods, rather than 39 years, and the potential for immediate deduction under Section 179. These can include:

• Movable partitions. Rev. Rul. 75-178, 1975-1 C.B. 9;
• Equipment and machinery used to maintain temperature or humidity requirements (e.g., for food preparation);
• Removable air-conditioning equipment. Scott Paper Co., 74 T.C. 137;
• Computers and peripheral equipment and wiring;
• Smart board and related wiring and equipment;
• Special removable lighting;
• Removable kitchen equipment and furnishings;
• Telephone equipment and wiring, including wiring related to intercom, dictation and call systems. Hospital Crop. Of America v. Comr.;
• Special electrical wiring and plumbing hook-ups relating to particular equipment or function. This would include electrical loads for particular items of business equipment;
• Kitchen piping, plumbing connections, dishwashers, etc.;
• Costs that relate to the provision of services rather than building functions;
• Removable carpeting. Rev. Rul. 67-349;
• Vinyl wall covering;
• Removable floor tiles, or other floor coverings that are not an integral part of the floor itself;
• Removable ceiling treatments;
• Signs and ornamentation;
• Furniture and equipment; and
• Removable shelving.

A number of factors can be considered in determining whether property qualifies for the more favorable treatment:

• Manner in which the property is attached to the building. It should not be permanently attached;
• The property is inherently moveable;
• Size, weight and construction of the property;
• The type of equipment and number of people required to move the property;
• The property or similar property has been moved in the past;
• Facts support that the property may not stay in place permanently;
• The property was not designed to stay in place permanently. L.L. Bean, Inc. v. Comr., T.C. Memo 1997-175, aff'd 145 F.3d 53 (1st Cir. 1998);
• The cost, time and difficulty of moving the property;
• Little damage will be done to the property when moved;
• Little damage will be done to the building when the property is removed; and
• The property could readily be re-used if moved.

To secure your write-offs, you need to corroborate the allocation. You might use an engineering and cost analysis of construction records, engineering and cost estimation (when actual records are not available), survey of contractor data, or other estimates.

Martin M. Shenkman, CPA, MBA, JD, is an estate planner in New York City and Teaneck, NJ. His Web site, www.laweasy.com, has information on matrimonial, investment and related matters.