Accounting for Tenant Improvements
Under the Tax Reform Act of 1986, landlords who incurred leasehold improvements were required to depreciate them over 39 years. Tenants who made leasehold improvements followed the same amortization schedule. The Internal Revenue Service (IRS) ruled that this treatment was proper, even when such improvements were retired at the end of the lease term. Thus, landlords must continue to depreciate the remaining basis even after the improvements were demolished; but tenants can write off incurred improvements abandoned at the end of the lease if they hold no continuing interest in the improvements.
As a result, landlords and tenants are treated inconsistently in this area. Both face a disproportionately long amortization life for the leasehold improvements that they make, but at least tenants have been able to take abandonment losses when their leases expire.
But statutory relief may be on the way for landlords. In August, President Clinton signed the Small Business Job Protection Act, H.R. 3448, which allows landlords to use the adjusted basis of improvements to help determine the gain or loss when they dispose of or abandon improvements after leases expire.
In the accelerated cost recovery system in Proposed Regulations Section 1.168-2(e)(1), the unadjusted basis of a building's structural components must be recovered as a whole, the same recovery period and method must be used for all structural components, and such components must be recovered as principal parts of the building. Proposed Regulations Sections 1.1682(1)(1)(1) also provide that the term disposition does not include retirement of a structural component of a building, which cannot be used to recognize loss or reduce basis.
Accordingly, under the proposed regulations, the cost of tenant improvements, if considered to be structural components of the building, would continue to be recovered over the scheduled period even if demolished.
The U.S. Tax Court supported the IRS in this position. In Grinalds v. Commissioner, (65 T.C. 1971, 1993), the tax court held that the term of the lease was irrelevant, even if the improvements were for a special purpose and of no use after the lease's termination. However, footnote two in the tax court opinion suggests that when a new lessee demolishes leasehold improvements, the unrecovered cost of the demolished leasehold improvements should be deducted over the term of the new lease. This introduced the prospect that abandoned leasehold improvements could be treated in more than one way.
Last summer, Congress passed the Small Business Job Protection Act, which may bring a small dose of reasonableness to this issue. The act includes a specific change in the accounting treatment of leasehold improvements. Improvements that constitute structural components of a building must still be amortized over 39 years. But the act provides that landlords may now take into account the adjusted basis of leasehold improvements to determine gain or loss when they irrevocably dispose of or abandon the improvements at lease expiration. This provision is effective for all leasehold improvements disposed of or abandoned after June 12, 1996.
A Mixed Blessing
Integral to a landlord's ability to deduct the unamortized leasehold improvements is the premise that these improvements can be specifically identified. The level of support and detail required to substantiate these deductions may make them elusive, since many taxpayers simply do not have the ability to track the cost of specific leasehold improvements.
To illustrate, assume landlord A spends $50,000 in improvements to induce tenant B to sign a five-year lease. This cost is for general space build-out, including placement of walls, construction of offices, painting, wallpaper, carpeting, electrical, and heating and ventilation fine-tuning. Notwithstanding the five-year lease term, the landlord must amortize the improvements over 39 years. After five years, the tenant moves out and the landlord incurs new leasehold improvements, including moving walls, recarpeting, repainting, or other decorative improvements. To support a deduction, even under the 1996 legislation, the landlord must identify the unamortized cost of the specific items being "abandoned" and continue to amortize over 39 years those costs that remain.
In this example, the landlord could deduct the unamortized cost of the original walls, carpeting, painting, and other improvements that were demolished during renovations for the new tenant. The cost of the remaining improvements would need to stay on the books and continue to be amortized over 39 years. Moreover, new expenditures in connection with the new lease also would need to be capitalized and amortized over 39 years.
The Burden of Proof
Rarely, if ever, does a tenant improvement have a true economic life of 39 years. Nevertheless, the tax rules require cost recovery over this period. The Small Business Job Protection Act provides a limited benefit by allowing lessor improvements abandoned at the end of a lease term to be written off, but this benefit is only available if landlords can specifically identify and trace the costs of the abandoned improvements. Landlords would do well to examine their accounting systems and develop procedures to help capture costs in sufficient detail to permit deduction at the earliest supportable opportunity.