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Tangible Property Regulations Opportunity Alert: Landlord Tenant Improvement Costs


3/5/15

Synopsis
 
Unlike recent tax alerts that applied more broadly to a larger group of taxpayers, this alert focuses on a potential opportunity for building owners that incur significant amounts for tenant improvements. Building owners that incur significant amounts for tenant improvements may have an opportunity to deduct these costs for tax purposes under certain provisions of the new Tangible Property Regulations (TPR), sometimes referred to as the Repair Regulations. 
 
Issue
 
Typical Fact Pattern

In 1980, Landlord A purchases a building with ten equal sized rental units. Landlord A eventually secures leases for all ten spaces with different terms ranging from five to ten years. As tenants move out, and new tenants move in, Landlord A demolishes prior tenant build-outs and pays for the new tenant’s improvements. This pattern typically repeats itself over the years. If Landlord A does not write-off the remaining basis of the tenant build-outs that were demolished to make way for a new tenant, there may be a position in certain circumstances to deduct the full cost of the new tenant’s improvements.
 
The cost of any tenant improvements subsequent to the first set of tenant improvements could be analyzed for potential deductibility under the TPR.
 
Technical Discussion

For depreciation purposes, a single building is the “unit of property.” However, under the Repair Regulations a building consists of designated systems (HVAC, electrical, plumbing, escalators, elevators, fire protection and alarms, security, gas distribution, and other structural components) and the building structure itself. Therefore, any analysis of building repair costs needs to be done taking into account the effect of the repair on – not only the building overall – but on the various systems.
 
The building’s structure consists of various “major components” and “substantial structural parts.” A major component is defined as a part or combination of parts that perform a discrete and critical function in the operation of the unit of property (the building in this discussion). A substantial structural part is defined as a part or a combination of parts that comprises a large portion of the physical structure of the unit of property (the building in this discussion). Taxpayers can generally deduct costs if the taxpayer does not replace a “large portion” of the physical structure of the building or a building system. The examples in the TPR suggest that an amount less than 30% is not a significant portion of the physical structure of the building. This percentage is not a bright-line test, but a level for consideration.
 
The cost of tenant improvements must be capitalized if they result in any of the following:

  • Betterment (physical enlargement; ameliorates a material condition or defect that existed when acquired or that arose during the construction: or an increase in efficiency, strength, or quality);
  • Restoration (a loss was taken on the adjusted basis of the property replaced: replacement of a “major component” or “substantial structural part” of the property, returns the property to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and no longer functions for its intended use, or rebuilds the property to a like new condition at the end of the class life), or
  • Adaptation of the property to a new or different use.
     

The TPR provides definitions and examples of what is considered a Betterment, a Restoration, or an Adaptation.
 
One of the “Betterment” rules relates to the “amelioration of a condition or defect” existing at the time the property is purchased. This rule could potentially affect the treatment of the costs of the first build-out performed by a landlord, but less so for subsequent build-outs. Similarly, if a taxpayer constructs a building, the cost of the first set of tenant improvements would be capitalized, and the subsequent ones analyzed under the improvement rules above.
 
One of the “Restoration” rules relates to when a taxpayer recovers the property’s adjusted basis in connection with a partial disposition. For example, this would occur in a situation where a landlord writes-off the net adjusted basis of an old tenant build-out when it is removed. In that case, the new build-out would be considered a capitalizable restoration.
 
Going back to the typical fact pattern, under what circumstance would Landlord A be able to deduct the cost of leasehold improvements?
 
Let’s say Landlord A replaced 20% of the tenants (based on the building’s square footage) in a single year and paid $500,000 to retrofit the spaces for new tenants. Landlord A did not write-off the remaining tax basis of the leasehold improvement costs it incurred from the departing tenants. (Note: That if Landlord A did write-off the remaining tax basis of the departing tenant’s leasehold improvements, Landlord A would have to capitalize the $500,000 as restoration costs). If Landlord A replaced 20% of various systems and/or the building structure, this would not be considered a significant portion of a major component, or a significant portion of the building systems. Accordingly, this would not be a restoration. Assuming that the new build-out did not improve the quality of any system and did not adapt the building or any system to a new or different use, the costs of this build-out would be deductible.
 
The TPR allows property owners to look-back to prior years to see if they can apply these fact patterns and write-off any leasehold improvement costs incurred prior to the current tax year if they meet the above tests. 
 
While the amount of the accelerated deduction might be somewhat limited if the Landlord treated such improvements as “qualified leasehold improvement property” with a 15-year life and subject to bonus depreciation and possibly §179, the amount of accelerated deduction could still be significant.
 
A Form 3115 could be filed to accelerate the tax deduction equal to the net (undepreciated) basis in the leasehold improvements.
 
While this may seem too good to be true, it appears to be supported by the TPR. However, this is a new law that is probably years away from being challenged. We, therefore, caution taxpayers to consider the risks of this position and their tolerance for possible future challenges.
 
What Does CohnReznick Think?
This alert is intended to inform you of a potential opportunity related to specific taxpayers. It is merely a very high-level overview of this topic and a detailed analysis of each taxpayer’s situation needs to be performed in order to quantify properly and confirm the benefit. Please consider this opportunity as you decide whether to apply Rev. Proc. 2015-20 or to file a Form 3115 to adopt the TPR.
 
If you potentially have this opportunity, please reach out to one of our technical TPR experts about your options including the possibility of filing a Form 3115 with an extended 2014 return or possibly for the 2015 tax year.
 
Certain actions in 2014 could preclude a taxpayer from taking advantage of this opportunity.For example, if a small business taxpayer was to apply Rev. Proc. 2015-20 in 2014, it would preclude the taxpayer from filing a Form 3115 in 2015 with a section 481(a) adjustment. Similarly, filing a “zero 481(a) adjustment” Form 3115 in 2014 would have the same result.
 
If a taxpayer is interested in pursuing a favorable accounting method change to recover the costs of prior tenant improvements, our TPR experts can provide guidance in analyzing the taxpayer’s costs and documenting why those costs can be deducted.

Contact

For more information, please contact Richard Shevak, director, at richard.shevak@cohnreznick.com or 862-245-5029; David Grant, partner, at david.grant@cohnreznick.com or 973-403-6905; Doug Finkle, senior manager, at doug.finkle@cohnreznick.com or 973-364-7832; or Cheryl Joseph, partner, at cheryl.joesph@cohnreznick.com or 301-280-1934.
 
To learn more about CohnReznick’s tax services, please visit our webpage.


This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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