Substantial New Tax Benefits on Horizon for Tenant Work

Real estate owners may have a few new options to depreciate tenant improvement work in their properties, and even to extend the tax benefits to site work like infrastructure and utilities. But not many of them know about it.

By Mark de Stefanis

Many of you probably remember when an owner could depreciate tenant improvements over the life of a lease. In 1993, that all changed with the majority of the improvements being depreciated over 39 years.

A lot of that may be about to change. To owners' benefit, they may soon be able to recover qualified leasehold improvements over 15 years instead of 39 years. But the regulations are only temporary, and to qualify, owners must place the property in service before January 1, 2006.

The change agent here is the American Jobs Creation Act "AJCA" of 2004, which President Bush planned to sign into law at the end of this year. A key depreciation provision in this act is the accelerated depreciation allowed for qualified leasehold improvements, or tenant improvements. The majority of tenant improvements are considered structural components of the building, recoverable over a 39-year period under Code Sec. 168(1)(8)(A). The temporary regulations, as outlined under the pending act, provide the lessor or lessee the ability to significantly decrease the recovery period for tenant improvements down to 15 years. This regulation will be in effect from when the bill is signed until December 31, 2005.

Generally, such leasehold improvements consist of interior work to nonresidential real estate. With respect to office buildings, retail establishments, and warehouses, this applies to tenant improvement work that would not be classified as personal property, and is available to landlords and tenants that fund their own tenant improvements. Typically, most office tenant improvement work is classified as section 1250 property, or realty, making it depreciable over 39 years. The change would allow depreciation of such qualified leasehold improvements using the straight-line method in 15 years.

The taxpayer paying for the improvements can receive a significant tax benefit from using accelerated depreciation. For example, let's suppose that there is 50,000 sq. ft. of tenant improvement work constructed at a cost, both direct and indirect, of $35 per sq. ft. or $1,750,000. Using the previous 39-year recovery period, this would provide a present value tax benefit of $140,000 over 10 years using a combined federal and state tax rate of 43 percent. However, with the pending rules in effect, the present value tax benefit would be $358,000, or an impressive increase of $218,000.

In order to leverage the benefit of the new act, the property must meet various regulatory criteria for qualified leasehold improvements. Once qualifying, the taxpayer should try to gain the maximum deduction possible by properly allocating the appropriate share of general condition and indirect costs as well. Within this context, the extra general condition costs alone - for security, management, expediting, etc. - will significantly increase the depreciable basis, and therefore the tax benefit when properly allocated.

This latest tweaking of the depreciation rules is just one of many changes enacted over the last few years that benefit the real estate industry. For this reason, cost segregation techniques are increasingly becoming a part of a real estate owner's tax planning strategy.

In addition to the benefits for qualified leasehold improvements, many property owners have substantial site work and other improvements that can qualify for shorter recovery periods. Few owners realize that they can also depreciate site work - such as paving, curbing, sidewalks, and utilities - over 15 years instead of 39 or 27.5 years for non-residential and residential property purchased after 1987 regardless of its age. But most taxpayers are not availing themselves of the tax benefits provided by these cost segregation techniques.

Keith Misciagna is business representative for the International Brotherhood of Electrical Workers Local 164 of Paramus, N.J.