| WHO PAYS/OWNS | TENANT TAX TREATMENT | LANDLORD TAX TREATMENT | ||||
| Tenant Pays for 100% | 1. Owns improvements & takes a tax deduction for depreciation. 2. May deduct the balance of the basis in the improvements if abandoning them at the end of the lease. |
No tax consequence. | ||||
| Landlord Pays for 100% | No tax consequences. |
Landlord owns tenant improvements & takes a tax deduction for depreciation. |
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| Landlord Provides an Allowance for 100% of Cost | 1. Owns improvements & takes a tax deduction for depreciation. 2. The allowance is fully taxable as income to the tenant (could offset a net operating loss carry forward). |
1. Landlord amortizes allowance ratably over the lease term as a leasehold acquisition cost. 2. The reversion of the tenant improvements is not a taxable event for the landlord. |
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Landlord provides free rent in lieu of a TI allowance |
1. Loses rental deductions during abatement period. 2. Must fund the tenant improvements, which provides a tax deduction for depreciation. 3. May deduct the balance of the basis in the improvements if abandoning them at the end of the lease. |
Recovers contribution immediately for tax purposes through the absence of any taxable rental income from the Tenant during the free rent period. | ||||
| Tenant pays for 100% and Conveys them to the Landlord upon their completion [2] | Can amortize the full cost of the improvements over the lease term as a leasehold acquisition cost. |
1. Cost of improvements is taxable income upon receipt of the tenant improvement. 2. Takes a tax deduction for depreciation/cost recovery. |
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| Landlord borrows funds to pay for the tenant improvements and increases the rent from the tenant in an amount to cover the debt service. | Deducts payment for tenant improvements ratably over the term through tax deductions for rental payments. | 1. Depreciates the improvement 2. Deducts interest payments |
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| Landlord loans the Tenant money to pay for tenant improvements [3] | 1. Recovers the cost of the improvements. 2. Claims an abandonment loss once the tenant vacates the leased Premises. 3. Deducts the interest |
The reversion of the tenant improvements to the landlord is not a taxable event. |
With the enactment of the CARES Act, “Qualified Improvement Property” (QIP) is currently 100% depreciable in the first year of use. QIP includes interior improvements for non-residential buildings, excluding structural framework, elevators, escalators, or building expansions. Another requirement is that the building has physically already been placed in service. Essentially, the first tenant ever to occupy the building will not get qualified improvement property treatment.
Tenant improvements which qualify as QIP can be 100% depreciated in the first calendar year of use. This 100% bonus applies to QIP which is placed in service after September 27, 2017, and before January 1, 2023. Because of the new technical amendments, taxpayers that make or have made improvements to their facilities may take steps to claim the missed 2018 100% bonus depreciation. This bonus depreciation is reduced 20% per year starting in 2023, as follows. In summary, taxpayers may claim:
- 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023
- 80% for qualified property placed in service before January 1, 2024
- 60% for qualified property placed in service before January 1, 2025
- 40% for qualified property placed in service before January 1, 2026
- 20% for qualified property placed in service before January 1, 2027
After taking bonus depreciation, the “normal” tax depreciable life applies (ie, the remainder would be depreciated, straight line, over 15 years, if it qualifies as QIP). Note, this is retroactive to 2018.
The same schedule of bonus depreciation will apply to office furniture & fixtures, graphics, cabling and audiovisual assets. It will also apply to security such as cameras or interior access systems. After the bonus is applied, furniture, security, and graphics have a tax depreciable life of 7 years (MACRS) [4] and cabling & audiovisual equipment are 5 years (MACRS), if a company uses the Alternative Depreciation System (ADS). The percentage of depreciation each calendar year depends upon the quarter that the asset is “placed in service,” but assuming they are placed in service in the first quarter, the below tables from the IRS would apply.
| MACRS Depreciation for 5-Year and 7-Year Property, Mid-Quarter Convention, Placed in Service in First Quarter |
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| Depreciation Rate for Recovery Period | ||||
| Year | 5-Year | 7-Year | ||
| 1 | 35.00% | 25.00% | ||
| 2 | 26.00% | 21.43% | ||
| 3 | 15.60% | 15.31% | ||
| 4 | 11.01% | 10.93% | ||
| 5 | 11.01% | 8.75% | ||
| 6 | 1.38% | 8.74% | ||
| 7 | 8.75% | |||
| 8 | 1.09% | |||
| Total | 100.00% | 100.00% | ||
Alternatively, taxpayers can choose to use the GDS (General Depreciation System) for all assets, under which the recovery period is 10 years for office furniture, fixtures and equipment and 5 years for information systems, both on a straight-line basis. However, companies must consistently apply the depreciation system which is used.
In order to accelerate the depreciation time-table for landlords, owner/users, and tenants, it is also recommended to prepare a cost segregation study. Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets, and separating out personal assets for tax reporting purposes. According to the American Society of Cost Segregation Professionals, a cost segregation is "the process of identifying property components that are considered "personal property" or "land improvements" under the federal tax code."
A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations. Personal property assets include a building's non-structural elements, exterior land improvements and indirect construction costs. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property).
Personal property assets (5 or 7 year depreciable life) found in a cost segregation study generally include items that are affixed to the building (but do not relate to the overall operation and maintenance of the building), while land improvements (20 year depreciable life under ADS and 15 year depreciable life under GDS) generally include items located outside a building that are affixed to the land (but do not relate to the overall operation and maintenance of a building).
Reducing tax lives results in accelerated depreciation deductions, a reduced tax liability, and increased cash flow. Land improvements include:
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For tenant’s interior premises, any improvements that can be removed without significant damage, such as furniture & fixtures (cabinetry), carpet (or any floor covering installed by means of strippable adhesives), window coverings, and certain wallcoverings, can be classified as personal property and depreciated over a shorter time period. A cost segregation study serves as the supporting documentation during any IRS audit. For more information, there are two resources from the IRS to reference: Publication 946 – How to Depreciate Property and the Cost Segregation Audit Techniques Guide (see links below).
The information above is not intended to provide tax, accounting, or legal advice and should not be relied upon as such. It is expressly recommended that you consult with an attorney and accountant, including auditing advisory firm(s), in order to validate the information stated herein. No representation, warranty or guarantee, expressed or implied, as to the accuracy, completeness, or timeliness of this information or any of its contents, is made or given by Colliers International.
Resources:
https://www.irs.gov/pub/irs-pdf/p946.pdf
https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents
https://www.ballardspahr.com/-/media/files/articles/2014-05-28-7-tax-aspects-of-tenant-improvements.pdf?la=en&hash=8BDFAABCB7B233DF1D234EA56220A9FD
https://taxnews.ey.com/news/2020-0806-cares-act-adopts-technical-amendments-for-qualified-improvement-property-and-provides-broad-relief-for-many-taxpayers-including-provisions-related-to-irc-section-163j-nol-deductions-and-amt-acceleration
https://ascsp.org/
https://en.wikipedia.org/wiki/Cost_segregation_study
[1] Note, the IRS calls depreciation “cost recovery”, but we have used the term depreciation in this brief.
[2] This often occurs inadvertently when leases provide that all improvements or alterations become the landlord’s property immediately upon completion.
[3] To increase the likelihood that the IRS would respect the form of this transaction, the loan would be evidenced by a promissory note that probably would mature at the end of the lease term.
[4] Modified Accelerated Cost Recovery System.
