COMPANIES THAT SPEND MONEY upgrading office, retail and other commercial properties over the next few years may be eligible for a big tax break due to a provision buried in the economic stimulus package passed in March. The only catch: Companies that do not take action within a three-year window will miss out on this significant tax benefit.
News articles that discussed the federal economic stimulus bill — known officially as the Job Creation and Worker Assistance Act of 2002 — typically focused on sections of interest to the general public. Corporate tax breaks were rarely explained, so many companies may not realize the bill offers them a significant tax benefit for investing in interior build-outs.
The benefit, outlined in Section 101 of the act, amounts to an acceleration of the usual 39-year “straight-line” method of depreciating interior improvement costs for tax purposes. Landlords and tenants of commercial property may depreciate 30% of the cost of “qualified tenant improvements” in the first year that the improvements were placed in service. The other 70% is depreciated over the standard 39-year schedule.
Of special note: the depreciation benefit covers security expenditures, such as electronic access control systems, installed in tenant spaces as a result of heightened sensitivity to security issues in the wake of the Sept. 11 terrorist attacks.
Big Tax Savings
The biggest beneficiaries of the tax benefit are likely to be property owners that pay a large share of tenant improvement costs, either by direct payments incurred in the construction of tenant space or in the form of allowance dollars allocated to the tenant. On the other hand, a tenant that expends more than the allotted amount provided by its landlord may also accelerate its depreciation schedule. The way a lease is structured will help determine which party gains the benefit.
To understand the size of the tax savings, consider the example of an owner and tenant of a 25,000 sq. ft. space. The tenant spends $40 per square foot, or $1 million total, on improvements placed in service at the beginning of 2002.
Under the straight-line depreciation method, the first-year deduction would be $1 million divided by 39, or $25,641. Using the method permitted in the new law, the company could take an accelerated depreciation deduction of $300,000 this year, with the remaining $700,000 depreciated over 39 years. With a tax rate of 38.6%, the larger depreciation deduction reduces the recipient's 2002 tax liability by an additional $112,831 compared with the straight-line method.
Companies interested in taking advantage of the accelerated depreciation benefit are advised to work with qualified real estate/tax legal professionals. Owners and tenants should remember the following issues when considering whether to apply for the deductions:
Use It or Lose It — The 30% deduction must be taken in the first year that the improvements are placed in service.
Three-year Window — Tenant improvements must be made after Sept. 10, 2001 and before Sept. 11, 2004, in commercial space placed in service by Jan. 1, 2005, to qualify for the benefit.
No New Buildings — The accelerated depreciation method is available only on interior improvements that are placed in service at least three years after the completion of the building.
Interior Construction Only — The provision does not cover building expansions, structural repairs or improvements to common areas such as lobbies.
Leased Space — Expenditures must be in connection with a qualified lease transaction, so a building that is owned by the occupant is not eligible.
First-year Benefit is Offset Over Time — Depreciating 30% of the cost of improvements in the first year means there is less to depreciate over the remainder of the 39-year schedule. The other 70% of the cost is eligible for straight-line depreciation deductions spread over the remaining 38 years.
Whether or not this tax break prompts landlords and tenants to spend more on improving space, it is an important option for companies planning for growth during the economic recovery.
Mark Gershon is a partner at Piper Rudnick, a national law firm with one of the largest real estate practices in the country.