Tax issues

Bonus Deductions

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.

In 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.

The 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.

The bonus 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.

Certain types of leasehold improvements are excluded from the new rules, including elevators, escalators, building enlargement, and common area and certain internal framework structural improvements.

Special Circumstances

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.

For 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 original-use requirement.

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.

In 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.

What 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).

Overall, for 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

Anthony Ilardi Jr., JD

Anthony Ilardi Jr., JD, is a member with Dykema Gossett PLLC's taxation and estate practice group in Bloomfield Hills, Mich. Contact him at 248.203.0863 or ailardi@dykema.com. Temporary Bonus Depreciation Rules at a Glance 50 Percent Bonus Depreciation Available for leasehold improvements placed in service after May 5, 2003, and then only if no binding agreement was in effect prior to May 6, 2003. What's Eligible? Certain improvements made to non-residential building interiors if the landlord or tenant makes the improvements under the lease terms. Exclusions Certain leasehold improvements, such as elevator, escalator, building enlargement, common area, and internal structural framework improvements, do not qualify. For complete rules and guidelines, visit the Internal Revenue Service's Web site at www.irs.gov/businesses

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