Guest post by Mark Sutton, Plante Moran
If you work in commercial real estate, or if you own or manage significant residential rental properties, you’ve probably gotten to know your tax advisor a lot better over the last couple of years. Blame this on new IRS regulations that govern the tax treatment of costs related to “tangible property” (including real property, buildings and the component systems that make them functional and habitable). This article focuses on an opportunity for tax savings under the new rules that may apply to some landlords who’ve incurred costs for “tenant improvements,” the adaptations or modifications of a space that a lessor makes in order to support the lessee’s intended use.
Betterments, adaptations, and restorations
The new rules generally require that significant amounts spent for improvements that are considered “betterments, adaptations and restorations” be treated as capital expenditures and expensed over a specified period via depreciation. Depending on your relationship with your tax advisor and his or her personal style, you may have heard these requirements described as “the BAR test,” “the BRA test” or “the RABI test.” Or your advisor may have just said, “Give me the receipts and invoices, and I’ll explain what you can deduct and how.”
This opportunity arises for landlords that haven’t tracked tenant improvements separately in the past. If the lessor purchased a building with existing tenants and never allocated any of the purchase price to specific tenant improvements, or if the lessor constructed the building but didn’t separately allocate the cost of tenant improvements, that lessor may be able to deduct the cost of improvements made for new tenants in the year they’re incurred rather than depreciating the cost over multiple years.
If the new improvements don’t qualify as a betterment, adaptation or restoration (a determination that should be made in consultation with a tax advisor), the appropriate costs can be deducted in the year they’re incurred instead of depreciated over the life of the asset. In determining whether the cost of the improvement results in a betterment, adaptation, or restoration, it’s compared to the building structure or defined building systems. The manner in which this determination is made marks a significant change from the previous rules.
A related opportunity arises when a tenant makes an improvement that replaces all or part of a capitalized asset that the landlord is depreciating. Say a tenant moves into a building and the lease requires the tenant to replace the roof. In most cases, that roof will meet the BAR standard discussed above, and the tenant will book the amount spent on the roof as a capital asset and depreciate it over a specified lifespan.
On the landlord’s side, a portion of the value of the building has been removed—specifically, the value of the old roof that was included in the building’s basis from the time it was constructed or purchased. The landlord gets what’s called a “partial asset deduction” for the amount of remaining basis in the building that’s attributed to the old roof.
The rule of one
When you discuss these opportunities with an advisor, it’s helpful to remember “The Rule of One.” That rule holds that, in any given building, one of every component part or system that rises to the level of “capital asset” should be depreciated on someone’s books at all times. In the partial disposition example above, the landlord can expense the portion of building cost attributable to the old roof because the tenant is depreciating the new roof. If the landlord had paid for the new roof, the landlord would still get the partial asset disposition deduction for the undepreciated part of the old roof, and would then capitalize the cost of the new roof as a separate asset and depreciate it over the appropriate lifespan.
What to do now
The urgent action item for anyone who owns or manages real property that includes tenant improvements is to touch base with your tax professional as quickly as possible to make sure that this opportunity has been considered. Many rental real estate properties are owned through partnerships that may be filing their 2014 tax returns by September 15, 2015. Some of those partnerships may be considering an election for a simplified procedure under the new rules. If that election is made, the opportunities described above are no longer available to the landlord.
Mark Sutton is a partner within Plante Moran’s real estate and construction tax practice in the company’s Southfield, Michigan, office. He can be reached at email@example.com or 248-375-7337