Certain leasehold improvements qualify for increased first-year depreciation amounts.
The Jobs and Growth Tax Relief
Reconciliation Act of 2003 provides a number of tax breaks and
incentives to the commercial real estate industry. One particular
benefit is the increased bonus depreciation amount, which creates an
even greater tax incentive than the previously adopted bonus
depreciation rules. Landlords can use this new benefit to significantly
improve cash flow in the years they lease property.
2002 Congress passed the Job Creation and Worker Assistance Act, which
implemented special bonus depreciation rules for certain leasehold
improvements among other items. (To read about the 2002 act, see "Job
Creation Act Increases Tax Savings for Commercial Property Owners," CIRE,
July/August 2002.) Under the previous act, landlords can take an
additional first-year depreciation, or bonus depreciation, equal to 30
percent of qualified property's depreciable basis. The new act
increases this depreciation bonus to 50 percent.
Bonus Depreciation Requirements
Special bonus depreciation rules apply to qualified leasehold
improvement property, or any improvement to a non-residential
building's interior if made by the landlord or tenant under the lease's
terms. Leases between certain related parties, such as two entities
owned by the same person, do not qualify for the bonus depreciation.
30 percent bonus depreciation is available only for leasehold
improvements made after Sept. 10, 2001, and before Jan. 1, 2005. The
new 50 percent bonus depreciation is available only for improvements
placed in service after May 5, 2003, and then only if no binding
agreement, such as a signed lease, was in effect before May 6, 2003. If
the improvement has a recovery, or depreciation, period of more than 10
years and it cannot be completed by Jan. 1, 2005, it may nonetheless
qualify for bonus depreciation as long as it is placed in service
before Jan. 1, 2006. However, in that case, only the pre-Jan. 1, 2005,
expenditures are eligible for the bonus depreciation in keeping with
the bonus depreciation expiration date.
depreciation rule applies only to the part of the building the tenant
occupies exclusively and only if the improvement's original use begins
with the taxpayer. Moreover, the improvement must be made more than
three years after the date the building is first placed in service.
This generally refers to the date the building is ready for use or when
a certificate of occupancy is issued and the tenant occupies the space.
For example, a taxpayer cannot claim bonus depreciation in 2003 for an
improvement to a commercial building built in 2002.
types of leasehold improvements are excluded from the new rules,
including elevators, escalators, building enlargement, and common area
and certain internal framework structural improvements.
Last September, the U.S. Department of Treasury issued regulations
describing how to implement the bonus depreciation rules, which can be
found online at www.irs.gov /businesses. A number of twists and turns
complicates the process.
example, the bonus depreciation's original-use rule is satisfied if a
taxpayer originally acquires new property for personal use and then
converts it to a trade or business use. However, if a taxpayer acquires
a property for personal use, and then a different taxpayer acquires it
for a trade or business use, the original-use requirement is not
satisfied. Or, the original-use requirement is met if a taxpayer
reconditions or rebuilds property he originally acquired, but the
reconditioning or rebuilding costs do not satisfy the act's
Special rules apply if a
written binding contract for a property's acquisition was in effect
before Sept. 11, 2001 (for the 30 percent bonus depreciation) or May 6,
2003 (for the 50 percent bonus depreciation). Self-constructed property
also may qualify. For example, the regulations state that the property
acquisition requirement is met if a taxpayer manufactures, constructs,
or produces qualified property or 50 percent bonus depreciation
property for its own use.
A Case Study
The following example illustrates how the bonus depreciation rules might work for a qualified leasehold property.
accordance with lease terms, a landlord has agreed to build out a
tenant's space. The lease is signed on Oct. 1, 2003, so it qualifies
for bonus depreciation. The leased property is ready for occupancy in
January 2004, so the property meets the pre-2005 placed-in-service
requirement. One of the leasehold improvement's components costs
$100,000, which, under normal depreciation rules, would be depreciated
over five years.
Under the new rules, in 2004 the
landlord can deduct $50,000 for the component's expenditures (50
percent of the component's costs). The remaining $50,000 is depreciated
over five years, using normal depreciation methods.
happens if the property's landlord cannot use the depreciation? This
situation could arise if a landlord has accumulated net operating
losses and thus determines the bonus depreciation is not valuable to
him. In such an instance, the landlord can elect out of the bonus
depreciation on the Internal Revenue Service's depreciation and
amortization form 4562.
Finally, what happens if the
landlord sells the property? Any depreciation taken early reduces the
property's basis and increases the sale's gain. However, the bonus
depreciation reduces taxes at ordinary income tax rates (for
individuals, currently a 35 percent maximum rate), but the gain either
is recognized as capital gains (taxed at 15 percent) or, at worst,
subject to the recapture rate (25 percent).
most landlords, the new bonus depreciation rule creates a powerful
incentive in tenant negotiations. Consult a tax professional for more
information on applying the bonus depreciation benefits and the special
rules and circumstances under which they may be used