How Landlords Can Increase Tax Deductions and Tax Benefits – February 2016
Landlords in the past have been able to reduce their taxes by accelerating deductions from leased real property, and by not recognizing income on monies and property improvements which they receive from their tenants. The recently enacted Protecting Americans From Tax Hikes Act of 2015 (known as the “PATH Act”) has enhanced landlord’s tax deductions.
Landlords Under the PATH Act are Able to Further Accelerate Their Deductions for Tenant Improvements.
The general tax rule requires that landlords capitalize and then amortize their constructed tenant improvements on a straight line basis over the real property’s long tax recovery period (which is 39 years for commercial property and 27.5 years for rental residential property). Fortunately, there are exceptions to this rule as described below.
a. First-Year Bonus Depreciation.
The PATH Act has extended first-year 50% bonus depreciation through 2017. In 2018 the first-year bonus depreciation amount is reduced to 40% and in 2019 it is reduced to 30%. Landlords can utilize first-year bonus depreciation deductions for qualifying tenant improvements.1 One way for landlord’s to receive this first-year bonus depreciation deduction is to have the improvements reclassified as personal property with a recovery period of twenty (20) years or less (such as cabinetry, carpeting, and specialized tenant systems) or fifteen (15) year land improvements (such as irrigation systems, roads, and parking areas) for tax purposes.2
Additionally, the first-year bonus depreciation rules also apply to qualified leasehold improvement property (see description of qualified leasehold improvement property below). For qualified restaurant property and qualified retail improvement property to qualify for the first-year bonus depreciation the property must also be “qualified leasehold improvement” property.
Note that California tax laws do not conform to the federal tax laws’ first-year depreciation rules.
b. Landlords Can Expense Certain Property.
Landlords can take advantage of Section 179 which allows landlords to expense certain amounts of personal property placed in service in an active trade or business. For the 2016 tax year the aggregate cost which may be deducted under Section 179 is $500,000. Accordingly, for 2016 landlords and other taxpayers are permitted to expense up to $500,000 of the cost of qualifying property under Section 179, reduced (dollar for dollar) by the amount which the taxpayer’s qualified investment exceeds $2 million. Additionally, for tax years beginning after December 31, 2015 the expensing of qualified real property for “qualified leasehold improvement” property, “qualified restaurant” property, and “qualified retail improvement” property can be treated as eligible for expensing under Section 179.
The Section 179 expense deduction is subject to a phase out for taxpayers that put in service more than $2 million of depreciable property during the year. The $500,000 amount and the $2 million amount are indexed for inflation after the 2015 tax year.
c. Classifying Tenant Improvements as “Qualified Leasehold Improvement” Property to Deduct Over Fifteen (15) Years.
The PATH Act makes permanent the fifteen (15) year MACRS depreciation for qualified leasehold improvements (as well as qualified restaurant property3 and qualified retail improvement property4.
For the tenant improvements to be “qualified leasehold improvement” property the leasehold improvements must, among its other requirements, be constructed by the landlord or the tenant in a nonresidential property, and not be tenant improvements in a new building (the improvements instead must be placed in service more than three (3) years after the date the building itself was first placed in service). For example, “qualified leasehold improvements” would not include: (i) the enlargement of the building; (ii) any elevators or escalators; and (iii) any structural components of the common areas and internal structural framework. Thus, “qualified leasehold improvements” can include electrical, plumbing, heating, ventilating and air conditioning systems that are part of the tenant improvements.
Having leasehold improvements depreciated over fifteen (15) years allows landlords to remodel their properties and to then be able to amortize those improvements over a more reasonable fifteen (15) year period of time (rather than thirty-nine (39) years).
d. Deducting of Tenant Improvements at the End of the Lease Term.
If the tenant improvements at the end of the lease term have not been fully deducted and these tenant improvements are, in fact, abandoned then the unrecovered tenant improvement costs can be deducted by the landlord under Section 168(i)(8)(B).
Energy Tax Deductions and Credits.
For property placed in service through December 31, 2016 under the PATH Act, landlords can take energy-efficient commercial building deductions under Section 179D. Section 179D enables a deduction of up to $1.80 per square foot for certain building improvements which reduce energy use (examples would be insulation, certain types of doors and windows, energy efficient heating, ventilating and air conditioning, and energy efficient lighting).5
There are also energy investment tax credits under the PATH Act for solar, geothermal, and wind technologies.
Landlord’s Deductions can be Increased by Performing Cost Segregation Studies on the Tenant Improvements.
Cost segregation studies, which classify some or all of the tenant improvements (and building’s improvements) as “personal property”, not only allow the landlord to use the first-year bonus depreciation, but also increase the landlord’s amortization deductions on the remaining tenant improvements’ tax basis. The tenant improvements, which are classified as personal property, can have their remaining tax basis (after applying any first-year bonus depreciation), amortized over five (5) to seven (7) years using the double declining method.6 In other words, improvements classified as personal property do not have to be written off over the long straight-line method of thirty-nine (39) years for non-residential real estate or twenty-seven and one half (27.5) years for residential real estate. Cost segregation studies can classify as “personal property” cabinetry, specialized lighting, exhaust systems, specialized equipment, electrical and plumbing items for specialized equipment, loading door levelers, emergency generators, computer wiring, storage improvements, and refrigeration equipment.7 Additionally, sidewalks, roads, driveways, parking areas, fencing, drainage, sewers, underground utilities, landscaping, irrigation, and other land improvements can be amortized over a shorter fifteen (15) year period utilizing the 150% declining balance method.8
Decide in the Lease as to Whether the Landlord or the Tenant Will Deduct the Tenant Improvement Costs.
The party that “owns” the tenant improvements is entitled to the amortization and depreciation deductions. “Ownership” of the tenant improvements will be based not only on legal title, but will also be based on who the lease states is the owner of those tenant improvements, which party paid for those tenant improvements, and other factors. Accordingly, if the landlord has, in fact, paid for the tenant improvements and intends to take amortization deductions for those improvements, the lease should specify that the tenant improvements are, in fact, the landlord’s property.
The Landlord Does Not Have Income at the Lease’s Termination Where the Landlord Receives Improvements that the Tenant Paid for.
Where the tenant pays the costs of, and owns, the tenant improvements the tenant then amortizes its costs over the improvements’ cost recovery (which can be up to thirty-nine (39) years for commercial property). When that lease terminates the landlord may receive those tenant improvements tax-free under Section 109. Section 109 states that the landlord’s gross income does not include tenant improvements which revert to the landlord upon the lease’s termination.9 The result of this tax provision is that at the end of the lease term the landlord can receive tax-free HVAC systems, lighting fixtures, plumbing fixtures, and other improvements which were paid for by the tenant. Additionally, at the end of a ground lease the ground owner (who is the landlord) can receive tax-free potentially an entire building paid for by the tenant. To avoid these tenant-paid for improvements becoming taxed to the landlord as current rent, the lease should not state that the tenant’s payment for those improvements is an offset against rent.
How Should the Landlord Give Lease Incentives to the Tenant in Order to Maximize the Tax Benefits?
Under the tax rules where the landlord pays to the tenant a tenant improvement allowance (where the tenant then uses that tenant improvement allowance to construct and own the tenant improvements in the leased premises), the landlord must amortize the amount it paid to the tenant over the lease term (and those landlord’s tenant improvement allowance costs cannot be deducted by the landlord in the year of payment). Similarly, other landlord lease incentive items which are paid by the landlord to the tenant are amortized by the landlord over the lease term, such as landlord-paid tenant moving costs, lease signing bonuses, and buyouts of the tenant’s former lease. All of these landlord paid lease incentives become ordinary income to the tenant, which in turn the tenant deducts over the lease term or the improvements’ amortization.10 To produce a better tax result to the tenant, the landlord might instead have these landlord paid lease incentives reflected in reduced tenant rent over the lease term. The reason many landlords do not want to reduce rental costs is that the value of their real estate is directly reflective of the amount of rent that the landlord receives (after applying a capitalization rate). Thus, many landlords prefer to give out tenant lease incentives, but keep the rental amounts high.
Security Deposits Received by the Landlord are Not Included in the Landlord’s Income.
A tenant’s security deposit is not taxable to the landlord until the landlord applies that deposit to the tenant’s obligations under the lease. In order to avoid the security deposit being classified as taxable rent to the landlord, the lease should identify the payment as a security deposit and require that the security deposit be returned to the tenant (less any landlord’s use of this security deposit) upon the lease’s termination.
The Landlord Can Increase its Deductions by the Landlord Leasing the Land Rather than the Landlord Purchasing the Land.
A landlord that purchases land may not deduct nor amortize the costs of that land’s purchase. However, instead of purchasing the land the landlord could lease that land (under a ground lease) and have the landlord’s ground lease rent payments be tax deductible to the landlord. The landlord can then construct a building upon that leased land. A long-term ground lease is attractive to tax-exempt land owners (such as a university or a public charity) since the tax-exempt landowner’s receipt of ground lease rents is exempt from income taxes.
1 See Section 168(k). Note that all Code Section references are to the Internal Revenue Code of 1986, as amended.
2 Personal property and land improvements have a cost recovery of twenty (20) years or less, which is one of the requirements to receive the first-year bonus depreciation.
3 Qualified restaurant property is classified under Section 168(e)(7) as buildings placed in service between January 1, 2009 and January 1, 2010, or any improvements to a building if more than 50% of the building’s square footage is devoted to preparation of, and seating for, on-premises consumption of, prepared meals.
4 Under Section 168(e)(8) “qualified retail improvement” property is improvements to the interior portion of a nonresidential building that is open to the general public and is used in the retail trade or business of selling tangible personal property to the general public made more than three (3) years after such building was first placed in service.
5 In order to qualify for this Section 179D deduction the building’s energy system must be more efficient than certain standards specified by the American Society for Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America.
6 See Rev. Proc. 87-56 and Rev. Proc. 88-22.
7 Such cost segregation of a building’s improvements was approved by the United States Tax Court in Hospital Corp. of America, 109 TC 21 (1997). As another example, the IRS has stated that appliances, carpeting, and furniture in rental real estate can be recovered over a five (5) year period in Ann. 99-82.
8 See Section 168(b)(2).
9 Section 1019 prevents a landlord from increasing the landlord’s income tax basis in those tenant improvements the landlord receives back from the tenant.
10 See Section 178. However, for landlord improvement allowances paid to a tenant for short-term retail leases, no income is reported by the tenant and the landlord then amortizes such landlord paid retail lease improvement allowance over the improvements’ life under Section 110. To qualify for this short-term retail lease exception, the lease must be of retail space and not exceed fifteen (15) years in length.