November 2007 VOL. 2

Tax Strategies - Accelerated depreciation for leasehold improvements

A valuable tax provision that temporarily allows leasehold improvements to be depreciated over 15 years will be available only until the end of this year unless Congress agrees to extend it or make it permanent.

Commercial real estate owners who want to take advantage of this deduction need to get leases finalized and leasehold improvements done by Dec. 31, 2007. Any improvements completed after that date are scheduled to revert back to the standard 39-year depreciation schedule.

"The basic argument for this provision is that leasehold improvements typically don't last longer than 15 years before they're replaced," says Carl Staiger, a partner with Meyer, Unkovic & Scott LLP, a Pittsburgh, Pa.-based law firm.

Consider this example: if an owner makes $100,000 of leasehold improvements in 2007 and is subject to a 36 percent tax rate, the 15-year depreciation schedule allows for $6,700 in deductions annually. In comparison, an owner can only deduct $2,600 per year over 39 years, which is considered the life of an asset, according to tax laws.

The additional depreciation helps the bottom line by decreasing the amount of taxable income.

Because the cost recovery period for real estate is currently so long, the rate of return for investors is diminished. A shorter recovery period for real estate would improve rates of return for assets. In addition, investment in real estate would be more economically viable for potential investors. Shorter depreciation periods do, however, increase the amount of gain on sale that is subject to depreciation recapture taxes of 25 percent.

"It's a cash flow issue," explains Labry Welty, a corporate and finance shareholder with Dallas-based Munsch Hardt Kopf & Harr P.C. "With the 15-year depreciation, owners end up having more cash flow over the life of the improvements. It helps with the overall return on investment."

Depreciation rules

Almost $250 billion is invested in commercial real estate improvements annually, and $15 billion of that investment goes directly to leasehold improvements, which are also known as tenant improvements. They include changes to walls, floors, ceilings, lighting, and plumbing to meet the needs of a new or existing tenant.

Since the leasehold improvement depreciation provision was signed into law by President Bush in 2004, it has decreased tax revenues by roughly $2 billion annually, according to the Real Estate Roundtable, a Washington D.C. non-profit organization that lobbies for the commercial real estate industry.

"There is no limit on the amount of money an owner can spend on leasehold improvements, which means that there's no limit to the amount he can depreciate," notes Harvey Berenson, senior director of tax services for The Schonbraun McCann Group, a New York-based real estate advisory firm. "A small building owner with only one tenant can take advantage of the accelerated depreciation schedule just like the owner of a large complex with several tenants."

The 39-year depreciation life was enacted in 1993, and the 39-year depreciation life applies to properties placed in service on or after May 13, 1993. Before 1981 tenant improvement costs were amortized over the life of the lease.

Not all leasehold improvements qualify for accelerated depreciation, so owners need to be especially careful when they evaluate their expenditures and prepare their tax documents. For example, improvements must be related to a lease - either a new lease or the modification and renewal of an existing lease - and the owner has to make the investment to take advantage of the depreciation. If the tenant makes the improvements, the tenant is allowed to use the accelerated depreciation rather than the owner. In other words, who ever pays gets to write it off.

Common area improvements such as elevators or new carpet in the lobby don't qualify for accelerated depreciation, either. Moreover, the leasehold improvements must be to the interior portion of the building (plumbing and mechanical systems are included) - expansions to the building are excluded from accelerated depreciation.

Additionally, all buildings must be at least three years old before any leasehold improvements qualify for accelerated leasehold depreciation. An owner of a new building, for example, must depreciate so-called first tenant improvements over 39 years.

Finally, leasehold improvements must be "placed in service" before Jan. 1, 2008, to qualify for the accelerated depreciation. Simply put, placed in service is a formal tax term that means that the improvements and leased space must be ready for occupancy and usable.

There are loopholes to leasehold improvement depreciation, however. Specifically, if a tenant leaves before the end of its lease term, the owner can recognize a tax loss for the expense that wasn't depreciated, regardless of whether it was on a 15-year or 39-year depreciation schedule, according to Bryan Funk, a senior tax manager with Weaver and Tidwell.

For example, let's assume that you, as an owner, leased space to a dental clinic for 10 years and spent $300,000 building out the space to accommodate this practice. Because the improvements were completed and placed into service in 2007, you began depreciating the $300,000 on a 15-year depreciation schedule. But, the dental clinic wasn't filling enough cavities and had to move out three years into its lease. At that point, you would be able to take a deduction for the full amount of the remaining expense in the year the dental practice moved out.

"A lot of owners end up leaving these expenses on their books when they could be deducting them," Funk notes.

Political pressures

Although no official efforts are in place to extend the accelerated depreciation provision, the Real Estate Roundtable reports that Senate Finance Committee Chairman Max Baucus (D-MT) is working on a plan. His plan not only extends the 15-year recovery life for leasehold improvements for one additional year (through 2008), it also proposes 15-year depreciation for new restaurants and owner-occupied retail space. (Currently, new restaurants and owner-occupied retail space are exempted from the accelerated depreciation.)

However, Baucus has not introduced a bill for debate. Meanwhile, Senators Kent Conrad (D-ND) and Jon Kyl (R-AZ) introduced a bill in mid-May that would amend Sec. 168 of the Internal Revenue Code of 1986 and permanently extend the 15-year depreciation. If signed into law, Senate Bill 1361 would be known as the Leasehold Improvement Depreciation Act of 2007.

But, there is considerable uncertainty that this bill will ever make it to law. "This provision, like so many provisions that provide tax breaks to business, is highly political," Staiger says. "The U.S. is already incurring the loss of billions in tax revenue from the Small Business Tax Act and that may work against passing yet another tax law."

Moreover, our Democratic Congress has vowed to comply with so-called pay-go rules, which require Congress to offset increases in spending or decreases in revenue with other spending decreases or revenue increases. The Republican Congress waived pay-go requirements, but that approach has drawn criticism and fallen out of favor. If Congress adheres to pay-go rules, it would have to enact budget cuts to offset the lost revenues from accelerated depreciation, making it less likely for them to extend the provision or agree to a new tax law.

"The reversion to the old rules will be quite stunning," warns Michael Solomon, partner-in-charge of Jenkintown, Pa.-based Goldenberg Rosenthal LLP's Tax Department. "It's a huge adjustment from 15-year depreciation to 39-year depreciation."