The Tax Consequences of
Tenant Improvements

By Robert D. Fesler and Larry Maples

Structural improvements to commercial rental property must be depreciated over a recovery period of 39 years rather than amortized over the life of the lease. This and other aspects of the tax code often lead to conflicting positions between landlord and tenant as well as with the IRS.

Commercial landlords with vacant buildings frequently make structural changes to their property to attract tenants. The way expenditures are structured is crucial, because tax rules have changed and costs often exceed 25% of the rents received over a lease term.

Prior to 1986, the IRC allowed amortization of the costs of structural improvements over the term of the lease. Since then, these improvements are depreciated under the Modified Accelerated Cost Recovery System (MACRS). Statutory changes and conflicting tax, business, and legal interests between landlords and tenants are compelling reasons to consider the tax consequences of tenant improvements. Several questions are relevant when dealing with the structural capital improvements to leased property. How are repairs and capital expenditures distinguished? Can the landlord avoid having improvements designated as structural building components, thereby clearing the way for much more immediate tax benefits? Under what circumstances are repair-type expenditures required to be capitalized as part of a general reconditioning program? When can a landlord classify costs as lease acquisition costs with the attendant tax advantages? How does a landlord treat improvements paid for by the tenant? What tax challenges and opportunities exist when a landlord buys property with an existing lease? From the tenant's prospective, what are the tax consequences of tenant expenditures and landlord advances to cover such expenditures?

Statutory Framework

The 1993 Revenue Reconciliation Act requires all leasehold improvements, whether owned by the lessor or the lessee, be depreciated via MACRS which currently prescribes a recovery period of 39 years for commercial real estate. Lessor arguments to write off improvements over much shorter lease terms are now foreclosed since MACRS rules provide no special exception for property built for a lessee. IRC Sec. 168(I)(6) explicitly indicates that for all additions and improvements to property, the same recovery period applies as would apply to the underlying property.

The IRC also does not allow write off of any basis remaining at the end of the lease term. Where improvements are not demolished, the theory is they will continue to generate rent revenue. Even when improvements are demolished, IRC Sec. 280B(a)(2) prohibits a deduction. Instead, remaining basis is capitalized as land cost. The issues need to be examined from the perspective of the landlord and the tenant. First to be considered is the landlord.

Expenditures Currently Deductible

If landlords or tenants can establish an expenditure is a current expense, statutorily prescribed recovery periods are avoided. Unfortunately, neither the courts nor accounting profession have devised a foolproof method of distinguishing current expenses from capital costs. General criteria such as ordinary and necessary [IRC Sec. 162(a)] and the 10th Circuit's one-year rule of thumb apply. Under the latter rule, expenditures benefitting more than one year are capitalized. But the 10th Circuit cautions against a literal application of this rule in every circumstance. That the rule is "intended to serve as a mere guidepost" is evidenced by the established practice of expensing costs such as painting and window and door repairs that obviously benefit more than one year.

Of special interest to landlords is how this reasoning was applied and extended in the North Carolina National Bank case, [North Carolina National Bank, 82-2 USTC 9469, 684 F.2d 285 (CA-4, 1982, aff'g DC-NC, 78-2 USTC 9661)]. Citing a Second Circuit decision, the Fourth Circuit declared:

It is a long-recognized principle of tax law that expenditures for the protection of an existing investment, the continuation of an existing business, or the preservation of existing income from loss or diminution are ordinary and necessary business expenses within the meaning of IRC Sec. 162.

Many landlord improvements are for these very reasons.

In Moss, [87-2 USTC 9590, 831 F.2d 833 (CA-9, 1987, rev'g 51 TCM 742)], a lessee had allowed an airport hotel to deteriorate. In obtaining a new tenant, approximately $2 million was spent on repainting, repapering, and replacement of hotel equipment and furniture. The Ninth Circuit, in reversing the Tax Court, ruled that painting and papering costs of $260,000 could be expensed. The court pointed out that although several periods might be benefitted, the expenditures were necessary for the hotel to remain competitive and in first-class condition. Thus, these expenditures were more like repairs than capital improvements. As discussed under the Rehabilitation Doctrine below, however, circumstances sometimes require capitalization of the cost of such items.

Expenditures for Structural
Components of a Building

Commercial landlords frequently expend significant amounts repartitioning buildings to new tenant specifications. Usually, new walls, doors, etc., are structural components of a building and are subject to the 39-year recovery period for nonresidential real estate. According to Reg. Sec. 1.48-1(e)(2), structural components of a building include--

...such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings thereof such as paneling or tiling, windows, and doors . . . and other components relating to the operation or maintenance of a building.

For moveable partitioning, the taxpayer may prevail in classifying the partitioning as depreciable personal property, with a recovery period of seven years. In Minot Federal Savings & Loan Association, [71-1 USTC 9131, 435 F.2d 1368 (CA-8, 1970)], office building partitions were not structural components since they were easily moveable and gave tenants flexibility in developing a floor plan. In McManus v. US, [88-2 USTC 9623, 863 F.2d 491 (CA-7, 1988, aff'g DC-Wis., 87-2 USTC 9618)], partitions were ruled structural components since they were bolted to steel piers like other walls, were necessary to protect airplanes from inclement weather, and added to the strength and operation of the structure. Taxpayer arguments that the doors and partitions were easily removable, could be sold separately, etc., were unsuccessful.

The Rehabilitation Doctrine

In Seahill, (23 TCM 408, TCM 1964-56), items that would normally qualify as repairs were required to be capitalized. Repair work done as part of an overall program of rehabilitation and conditioning for a new tenant were treated as a cost of acquiring the lease with the new tenant and had to be capitalized. Thus, when ordinary repairs and capital improvements are made at the same time, courts may invoke the rehabilitation doctrine. Under this doctrine, the distinction between repair and capital improvements may disappear when such expenditures combine to change an asset's use, value, or life. Furthermore, characterization of an expenditure as a deductible repair or as a capital improvement depends on the context in which the expenditure is made. If it is made as a part of a general plan of rehabilitation, modernization, or improvement of the property, the expenditure must be capitalized even though, standing alone, the item would be currently deductible. In making the determination as to whether such a general plan exists, courts attempt to appraise all surrounding facts and circumstances such as the purpose, nature, extent, and value of the work done, whether it was done to suit the needs of an incoming tenant, to adapt the property to a different use, or to generally enhance the property's value.

In the Stoeltzing v. Commissioner case, [59-1 USTC 9444, 266 F.2d 374 (CA-10, 1959, aff'g 17 TCM 567)], capital improvements and ordinary repairs made simultaneously prompted the court to draw an analogy between building a new building and rehabilitating an older one. The court reasoned that during building construction, expenditures associated with carting away trash, painting windows, or even washing windows could not meaningfully be separated from other building costs and should be capitalized. Thus, when a rehabilitation plan meets the criteria outlined above, expense items cannot meaningfully be separated from capital items and must therefore be capitalized.

The rehabilitation doctrine has been ruled inapplicable to situations where a taxpayer is simply trying to maintain an ongoing productive capacity or quality of facilities (see Moss). In addition, the doctrine is seldom invoked absent substantial repairs and capital improvements to a specific asset, normally a building in significant disrepair. Nevertheless, landlords making massive renovations should realize that under the rehabilitation doctrine, expenditures normally deductible may have to be capitalized and depreciated over the applicable MACRS life.

Lease Acquisition and
Inducement Costs

Tax treatment of lease acquisition costs differs significantly from that for structural improvements. The landlord amortizes lease acquisition costs over the lease term including all renewal options, according to new IRC Sec. 178. For example, L spends $25,000 renovating a store building for a specialty retailer and pays the broker who located the tenant $4,000. The structural improvements would be depreciated over a 39-year MACRS recovery period. The broker's fee is a lease acquisition cost amortizable over the term of the lease with the retail tenant. A recent case, (Grinalds, 65 TCM 1971, TCM 1993-66), suggests that a cash advance from the landlord to enable a new tenant to demolish the previous tenant's structural improvements would be a lease acquisition cost amortizable over the life of the new lease.

Lease inducements can be classified as lease acquisition costs for tax purposes. For example, rather than making structural improvements for the tenant, a landlord could make a cash payment to a tenant and have the tenant use the advance to pay for structural improvements. The landlord would amortize the payment over the lease term, including renewal options. Usually this will be a significantly shorter time frame than the MACRS 39 years, resulting in a significant tax break for the landlord. The tenant, however, must recognize the payment as current income. The tenant's basis in the improvements made will be the amount of income recognized. The tenant in this arrangement is the one stuck with the MACRS 39-year recovery period. Nevertheless, any remaining basis in the improvements can be deducted by the lessee when he or she vacates the premises. If the improvements revert to the landlord at the termination of the lease, IRC Sec. 109 provides an income exclusion for the landlord.

It is clear that the landlord's tax advantages (shorter recovery period and exclusion of income at termination) work to the detriment of the tenant (current income and MACRS recovery period). Thus, in negotiating leases landlords and tenants should be aware that the ownership variable determines the tax consequences. Where there is tenant ownership, the detriment to the tenant is generally less than the advantage to the landlord since the tenant gets to write off unamortized improvements upon expiration of the lease. On the other hand, when the landlord owns the structural improvements, there is no write off at expiration of the lease term. Rather, the landlord keeps depreciating over 39 years.

Improvements Paid for by Lessee

The lessor's tax treatment of improvements paid for by the lessee hinges on whether the lessee improvements are in lieu of cash rental payments and a requirement of the lease agreement.

If lessee improvements are in lieu of rent, applicable costs would be currently deductible by the lessee and currently taxable to the lessor. The lessor, however, can capitalize the amounts involved and take depreciation. If the improvements are not in lieu of rent, there is no income to the lessor. The landlord is not allowed depreciation deductions when improvements are made, or at termination of the applicable lease, since the landlord would have no basis in the improvements.

If a lease provision requires the lessee to maintain property in its condition/ capacity at inception of the lease, the lessor recognizes no income and has zero basis in the lessee made improvements. In such cases, the IRS has repeatedly tried to limit the landlord's depreciation deductions arguing that the lessor suffers no economic loss or depreciation if the lessee is committed to restoring the property to its original state. Nevertheless, the courts have been sympathetic to lessors using the rationale that despite maintenance, most productive assets lose value and wear out, and that depreciation encompasses not only ordinary wear and tear, but obsolescence as well. To illustrate, a perfectly maintained 30-year-old building frequently is far less valuable than when it was new, due to changing styles for buildings, fixtures, and wiring as well as changes in the neighborhood.

Although the courts have been friendly on this issue, conflict may be minimized by a lease clause excepting ordinary wear, tear, and obsolescence from the requirement to restore the property. If the lease requires the lessee to replace rather than restore or maintain property, however, courts will allow the landlord no depreciation during the lease term.

Acquiring Property with an
Existing Lease

Suppose someone acquires property on which the existing lessee has already constructed improvements. Can the purchaser allocate some of the cost to the improvements and depreciate them? The answer is by no means clear, but chances improve considerably if the new lessor can demonstrate the recovery period of the improvements is longer than the lease term. Otherwise, the IRS, (Rev. Rul. 55-89, 1955-1 C.B. 284), will take the position that the purchaser-lessor has not acquired an interest in the improvement but only a reversionary interest in the land.

According to the IRS, (Rev. Rul. 60-180, 1960-1 C.B. 114), the amount allocated to the improvement should be the value of the improvement at the termination of the lease. If the view of the Eighth Circuit in World Publishing, [62-1 USTC 9282, 299 F.2d 614 (CA-8, 1962, rev'g 35 TC 7)] is followed, this future value will not have to be discounted.

Although a recovery period exceeding the lease term usually results in allowance of depreciation on the improvement, when the depreciation will be allowed remains uncertain. The Eighth Circuit believes depreciation should commence with acquisition of the property, but the Tax Court and the Ninth Circuit would make the purchaser wait until termination of the lease and calculate depreciation over the remaining useful life.

The most taxpayer-favorable position is that of the Eighth Circuit. This court makes no distinction between situations in which the recovery period is longer or shorter than the remaining lease term. In World Publishing, the recovery period was not greater than the unexpired lease term. Nevertheless, the company was permitted to depreciate $300,000 allocated to a tenant-constructed building. In overturning the Tax Court, the Eighth Circuit reasoned that the purchaser's right to depreciation should not depend on who constructed the building. The court posed the hypothetical situation of a taxpayer purchasing two identical properties. On one property stood a building constructed by the seller but leased to a tenant. The building on the other property had been built by the tenant prior to acquisition by the lessor. Should the lessor be able to depreciate one property but not the other? The court said the economic consequences of purchasing each property is identical; thus, the tax results should be identical.

The First Circuit, in DeMatteo Construction Co. [70-2 USTC 9684, 433 F.2d 1263 (CA-1, 1970, Aff'g DC-Mass, 310 F. Supp. 1313, 1970)], would allow no depreciation unless the recovery period exceeds the lease term. This court expressly rejected the reasoning of World Publishing, pointing out that the purchaser acquires the lease, not a building, when the life of the building is shorter than the lease term.

Another variation is the position of the Ninth Circuit. It may be the most difficult to apply, however, because it provides no bright-line test. In Geneva Drive-In Theatre, Inc. [80-2 USTC 9544, 622 F.2d 995 (CA-9, 1980, Aff'g 67 T.C. 764, 1977)], depreciation was disallowed prior to lease termination despite the fact the improvements had a composite life exceeding the remaining lease term. The court reasoned that the purchaser would not suffer any loss from deterioration of the improvements until the lease expired. In addition, the improvements were not held in a trade or business or for the production of income. The court seemed to be saying the lease, not the improvements, was held for the production of income. This is true in a narrow legal sense, but should a purchaser have to sever the two?

The Ninth Circuit in Geneva also pointed out that an increase in market value of the improvement should not affect depreciability. According to the court's reasoning, the purchaser would be purchasing a lease and not an improvement regardless of the increase in the improvement's value. But even a taxpayer trying to fit under the taxpayer-friendly World Publishing decision should be prepared to show that the purchased property is more valuable than the land only. The taxpayer in World Publishing demonstrated that rents called for in the lease exceeded what the ground rents would have been on the land only. Thus, appraisals of rental values could be crucial in such situations.

Next, the perspective of the tenant is discussed.

Expenditures for Improvements

The tax treatment of many improvements made by the lessee is a function of the requirements of the lease. The Eighth Circuit has held that costs of replacements and other items that maintain leased property in the same condition as at inception of the lease are currently deductible by the lessee. This holds true even if the replacements have a useful life exceeding one year so long as the replacements do not go beyond the requirements of the applicable lease and the replacements do not make the value of the leased property more than it was at inception of the lease.

The rationale for this treatment is explored in Journal-Tribune Publishing Co., [65-2 USTC 9536, 348 F.2d 266 (CA-8, 1965, rev'g 38 TC 963)]. There, a publisher-lessee's lease required printing equipment be constantly maintained at certain production standards. Since the obligation was ongoing and continuing, the relatively large periodic expenditures were held currently deductible. In cases where the lessee makes cash payments to the lessor to restore leased property to its capacity/condition at inception of the lease, the same reasoning applies. The cash payments are currently deductible by the lessee.

Landlord Advances

As mentioned earlier, tenants will generally want to avoid ownership of structural improvements made with monies advanced by the landlord since ownership puts the 39-year recovery period on their backs. In addition, it is to the tenant's advantage to structure any landlord advances so they will not be construed by the IRS as income to the tenant. A review of some typical tenant building situations from the tenant's point of view may help clarify the issues.

Sometimes landlords offer tenants a building allowance of a certain amount per square foot. The tenant compensates the building owner for these costs in the form of higher monthly or annual lease payments, which the tenant deducts currently. The tenant works with the owner's designers, architects, and contractors in specifying improvements to be made and all improvements made become property of the landlord. With this structuring, the allowance would not be income to the tenant. Costs incurred in excess of the building allowance would be borne by the tenant and depreciated over a 39 year recovery period even though the improvements are owned by the landlord.

As an alternative, the tenant might begin by selecting the architect, designer, and contractor with the landlord's approval. The landlord may advance funds directly to the tenant or to a separate account as the work progresses. As above, the tenant compensates the landlord via higher monthly or annual lease payments that are fully deductible. The lease could specify the landlord owns all property attached to the building but the tenant owns property that can be removed without structural damage to the building.

In this second type of arrangement, the tenant is running a risk that a portion of the cost of the improvements is taxable income. The IRS argument to tax the tenant will be strengthened to the extent the landlord amortizes some of the tenant improvements over the life of the lease rather than 39 years.

Another tenant strategy to avoid income recognition is to structure any advance from the landlord as a loan. There should be separate documents for the loan and the lease. The loan should bear interest and be repaid separately from the lease payments. The tenant would be treated as the owner of the improvements and depreciate them over 39 years. The tenant would get deductions for interest and depreciation while avoiding recognizing any portion of the landlord advance as income.

To avoid tax disputes, landlord and tenant should agree up front on the tax treatment. The tenant should carefully weigh the business advantages of ownership against the tax disadvantages of current income recognition. *