Bonus depreciation for the cost of tenant improvements just keeps getting better. First came the federal economic stimulus package in 2002 that contained a temporary provision for owners and tenants to deduct 30% of eligible non-residential leasehold improvement costs in the first year, with the other 70% depreciated over the standard 39-year schedule. Next, the U.S. Jobs and Growth Tax Relief Reconciliation Act of 2003 upped the ante to a 50% first-year depreciation deduction for new improvements placed in service by Jan. 1, 2005.
Now bills have been introduced in the U.S. House of Representatives to extend the bonus depreciation allowance temporarily or permanently. A bill introduced on July 25 by Rep. William Thomas, R-Calif., chairman of the House Ways and Means Committee, would extend the period for claiming the bonus depreciation allowance for another year, and would reduce the depreciation period of qualified leasehold improvements to 20 years. In another recent development, the IRS has released temporary regulations that took effect on Sept. 8, 2003, setting forth requirements to qualify for the bonus.
How It Works
Under the rules, the 50% first-year bonus depreciation allowance offers significant tax savings on two categories of property that are of interest to building owners and tenants. The first category is new property with a depreciation period of 20 years or less, which includes many kinds of equipment, interior decoration, landscaping and carpeting. The second category involves leasehold improvements to non-residential real estate, such as interiorin leased office and retail space.
Unlike regular depreciation deductions, which must be pro-rated to reflect that property has been in service only for a portion of a tax year, the 50% bonus deduction is allowed in full the year property is placed in service even if that date is the last day of the year.
The bonus is intended to encourage immediate new investment. Property must be acquired or constructed after May 5, 2003, and placed in service before Jan. 1, 2005. For acquisitions to be eligible, there cannot be a binding contract for acquisition of the property before May 6, 2003.
Property that an owner constructs qualifies for the 50% bonus only if construction begins after May 5, 2003. Under the regulations, construction begins when 10% of construction costs have been incurred. Furthermore, the bonus is available only in buildings that are at least three years old at the time the improvements are placed in service, so existing buildings gain an advantage over new buildings.
Without the bonus, non-residential leasehold improvements are typically depreciated over 39 years, resulting in an annual deduction of about 2.56% of costs per year. With the bonus, first-year depreciation increases to as much as 51.3%.
What's the Payoff?
To illustrate the first-year benefit of the allowance, compare an existing building owner who spends $1 million on tenant improvements to a new building owner who does the same. Assume the improvements are finished on Jan. 1, 2004, so that both the bonus and a full year of straight-line depreciation are available for 2004.
The owner of the existing building claims an accelerated deduction in 2004 of as much as $512,820 while the owner of the new building receives only a $25,641 deduction. The owner of the new building ends up paying as much as $170,513 more in federal income tax for 2004, if both owners are in the 35% tax bracket.
Landlords and tenants who understand this benefit have an edge in evaluating leasing alternatives. Lease negotiations can determine the extent of each party's depreciable interest in improvements and the bonus depreciation available to each. The bonus has greater value to the party with the higher marginal federal income tax bracket for the year qualified improvements are placed in service.
A word of caution: Subsequent year depreciation deductions are reduced to take the early bonus into account. The bonus deduction is mandatory unless the taxpayer makes a proper election not to claim it. A taxpayer can elect not to claim it or claim the 30% bonus instead.
The bonus is available for regular and alternative minimum tax purposes. In fact, no alternative minimum tax adjustment is made for any depreciation deductions with respect to property entitled to the bonus.
Owners should be aware the leasehold benefit does not cover expansions, structural repairs or improvements to common areas, nor does it apply to owner-occupied space. With those caveats in mind, the benefit of bonus depreciation is significant enough to warrant the attention of every commercial property owner.
Miriam Sheehan and Mark Gershon are partners in the Boston andoffices, respectively, of Piper Rudnick LLP, a national law firm with one of the nation's largest real estate practices.