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Depreciation Tax Planning

Our Services - Tax Planning

Depreciation Tax Planning

Depreciation Issues

  1. Depreciation is one of the most commonly misunderstood areas of 1031 exchanges. In addition, computation of depreciation is the most common error for property owners. The solution imposed by the IRS is simple. There is only one correct way to compute depreciation deduction and it is their way.
  2. It was the long held position of the IRS that if a taxpayer computed depreciation incorrectly, that the taxpayer must request a change of accounting method to switch back to the correct method. The only problem with this was the IRS kept losing in court on this issue. So the IRS changed tactics and put the requirement into an administrative announcement.
  3. The IRS ruled in Revenue Ruling 90-38, 1990-1 CB 57 that if a taxpayer uses an erroneous method of accounting for two or more years, the taxpayer has adopted a method of accounting. This includes a material item on the tax payer's return and would include an erroneous computation of depreciation.
  4. Revenue Procedure 2004-23, 2004-16 provides that if a taxpayer is on an erroneous method of accounting the exclusive method for correcting that method is a change of accounting method, using Form 3115.
  5. For purposes of determining gain or loss from the sale of a depreciable asset, the taxpayer must reduce its original tax basis of the asset by the depreciation taken in earlier years.
  6. Depreciation on real property taken over a period equal to or in excess of 27.5 years is subject to recapture upon sale at a rate of 25% plus state taxes.
  7. Depreciation on real property taken over a period less than 27.5 years, including ACRS depreciation, for property purchased between 1980 and 1986 as well as other improvements such as land and building improvements depreciated over a period less than 27.5 years is recaptured at ordinary income rates, which cannot exceed 35% under current federal law plus state taxes.
  8. For taxpayers who realize that they have been depreciating their property erroneously after they have sold the property, Revenue Procedure 2004-11, 2004-3 IRB 311 allows the taxpayer to make a change in accounting method for depreciable property after its disposition.
  9. Finally, the key behind understanding depreciation within the context of 1031 exchanges is as follows:
    1. The depreciation that the taxpayer was taking on the relinquished property continues as though the property was never sold.
    2. If the purchase price of the replacement property exceeds the sale price of the relinquished property, the difference may be treated as new property placed in service on the date of the purchase and depreciated under the rules in place as of the date of the purchase.
    3. The appreciation which is not subject to tax due to the provisions of Section 1031 cannot be depreciated.

Depreciation Methods and Tenant Allowances

Federal tax law provides that [MACRS] depreciation deduction for any tangible property is determined by using the applicable depreciation method, the applicable recovery period, and the applicable convention. There are three specified methods, ten general recovery periods, and three specified conventions. Which method, recovery period, and convention to apply to a particular item of property depend, for the most part, on the recovery class to which the property belongs. Generally, the names of the recovery classes of property are tied to recovery periods.

Furthermore, there is only one way to depreciate property, the IRS way. Taxpayers who erroneously compute their depreciation will be forced onto the correct method by a change of accounting method. Taxpayer’s who think that they can fool the IRS are in for a rude awakening.

Non-residential real estate includes any building or structural component that is not residential rental property and realty with a class life of 27.5 years or more. This property is depreciated over 39 years if placed in service after May 12, 1993.

Residential rental property includes any building or structure, including a mobile home, for which 80% or more of the gross rental income for the tax year is rental income from dwelling units. If any part of the building or structure is occupied by the taxpayer, the gross rental income includes the fair rental value of the part the taxpayer occupies. A dwelling unit is a house or an apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis (generally, for periods of less than 30 days). Residential rental property is depreciated over 27.5 years.

Depreciation of Leasehold Improvements

A taxpayer must own a depreciable interest in property (which could include the lessee in a capitalized lease) to be entitled to depreciation deductions. Similarly, if both landlord and tenant remain unchanged throughout the lease term, either the landlord or the tenant, but not both, should depreciate each particular asset.

Where a lease calls for the landlord to make the required tenant improvements, the following tax issues may arise.

First, over what period should the landlord recover the cost of the tenant improvements?

Second, what happens when landlord and tenant share improvement costs? Finally, what happens to any unrecovered costs at the termination of the lease?

If the lease term is much shorter than the relevant MACRS life (typically the case for real property improvements), the tenant may be in a stronger position to write off the remaining basis at the end of the lease

If the landlord grants rent concessions to the extent the tenant makes improvements, the rent concession may represent taxable income to the landlord if the lease stipulates rents that are explicitly reduced in consideration for the tenant's expenditures for improvements.

If a rent holiday is agreed to up front, without being explicitly tied to the tenant's actual expenditures, or the negotiated rental rate reflects the fact that the tenant will be making expenditures to improve the property, then the landlord should not have to recognize taxable income from the improvements.

A rent holiday or reduced rental rate period may represent the landlord's most tax-effective way to adjust to market conditions. The landlord's detriment from the rent holiday (i.e., no or lower rent payments during the holiday) is recognized by the landlord during the holiday period in the form of reduced taxable income.

A tax motivated landlord will have a disincentive to invest in build-outs that are recovered over the 39-year period. A rent holiday gives the landlord the tax benefit (in the form of no or reduced rental income) immediately, barring the application of Section467.

Cash incentives provided by the landlord are recovered over the period of the lease.

From a tax perspective, if the lease term is under 30 years, the landlord is generally better off

  1. granting a rent holiday,
  2. making a payment to the tenant so that the tenant can make the necessary improvements, and
  3. making the real property improvements.

As the owner of the property, the landlord depreciates the building on a composite basis over the statutorily prescribed life. Under Section 168(c)(1), the mandated lives are 27.5 years and 39 years for residential rental and non-residential rental property, respectively. If the improvement qualifies as a "tangible personal property" improvement, then the shorter MACRS lives and accelerated methods are available. For real property improvements, the landlord must use the straight-line method of depreciation for both residential and nonresidential property.

Taxpayers with substantial investments in tenant improvements (either as landlords or tenants) will typically have large differences between GAAP and tax depreciation. GAAP will generally require depreciation on tenant improvements to be calculated over the shorter of the lease term (typically excluding renewal options) or the useful life of the property.

Because most tenant improvements (including fixtures) are considered real property under state law, they will be subject to the longer cost recovery periods noted above. Although some common area improvements, such as fencing, sidewalks, and surface parking should qualify as 15-year land improvements, it is less likely that a significant amount of tenant improvements will be classified as 27.5-year and 39-year land improvements. Improvement allowances may be allocated to personal property recoverable over five to seven years such as phone systems, computers, certain window coverings, and furniture.

Qualified leasehold improvement property (as defined in Section168(k)(3)) is any improvement to a part of the interior of a nonresidential building if made under a lease either by the lessee (or sub-lessee) or the lessor of that part of the building, if that part of the building is to be occupied exclusively by the lessee (or any sub-lessee), and if the improvement is placed in service more than three years after the date the building was first placed in service.

Qualified leasehold improvement property excludes a building enlargement, an elevator or an escalator, a structural component benefiting a common area, or the internal structural framework of a building

Qualified leasehold improvement property placed in service after October 22, 2004 and during the balance of 2004 may qualify for both the additional first-year bonus depreciation and the shorter 15-year recovery period.

A taxpayer may be entitled to either a 30% (under Section168(k)(1)) or 50% (under Section168(k)(4)) first-year bonus depreciation deduction.

First year bonus depreciation allows an additional first-year depreciation deduction, for both regular tax and alternative minimum tax purposes, equal to 30% of the unadjusted depreciable basis of qualified leasehold property for the taxable year in which the property is placed in service. The basis of the property and the depreciation allowances in the year of purchase and later years must be adjusted to reflect the 30% bonus depreciation. The taxpayer may elect out of the 30% bonus depreciation for any class of property for any taxable year.

In order for qualified leasehold improvement property to qualify for the 30% additional first-year depreciation, the following requirements must be met:

  1. The original use must begin with the taxpayer after September 10, 2001;
  2. The taxpayer must acquire the property after September 10, 2001, and before January 1, 2005, with no binding contract for its acquisition in effect before September 11, 2001; or pursuant to a binding contract entered into after September 10, 2001, and before January 1, 2005; and
  3. The property must be placed in service before January 1, 2005. The placed-in-service date is extended to before January 1, 2006, for certain property having a longer production period. However, as to that property, only pre-January 1, 2005 basis is eligible for the bonus depreciation.

This was subsequently increased the first-year bonus depreciation rate from 30% to 50% for certain property as follows:

  1. The original use of which commences with the taxpayer after May 5, 2003;
  2. Which is acquired by the taxpayer after May 5, 2003, and before January 1, 2005, but only if no written binding contract was in effect before May 6, 2003; and
  3. Which is placed in service by the taxpayer after May 5, 2003, and before January 1, 2005, or January 1, 2006 for longer production property. A taxpayer may elect out of the additional first year bonus depreciation or elect just to take 30% in lieu of qualified 50% property.

A 15-year (instead of the 39-year) recovery period applies for certain qualified leasehold improvement property which is placed in service after October 22, 2004 and before January 1, 2006. Assets falling within this 15-year category must be depreciated using the straight-line method.

If a lessor makes an improvement that qualifies as a qualified leasehold improvement, the improvement will not qualify as a qualified leasehold improvement to any subsequent owner except in the case of (1) death; (2) a Section381 transaction; (3) a mere change in the form of conducting the business as long as the property is retained in such business as qualified leasehold improvement property and the taxpayer retains a substantial interest in the business; (4) the acquisition of the property in a Section1031, Section1033, or Section1038 exchange, to the extent that the basis of the property includes an amount representing the adjusted basis of other property owned by the taxpayer or a related person; or (5) the acquisition of the property in a Section332, Section351, Section361, Section721, or Section731 transaction, to the extent that the basis of the property in the hands of the taxpayer is determined by reference to its basis in the hands of the transferor or distributor.

A landlord is allowed to deduct the remaining basis in capitalized leasehold improvements made for a particular tenant upon termination of a lease, at least to the extent such improvements will not be used by a subsequent tenant.

Landlords availing themselves of abandonment losses must be careful to consider the impact of Section280B and its mandatory capitalization of demolition losses, and expenses. Before 1984, taxpayers could deduct demolition losses provided the property was not purchased with an intent to demolish it. The disallowed losses and expenses are to be capitalized to the underlying land. In the unusual case where the landlord abandons the entire property, the unrecovered costs of improvements are deductible currently.

Depreciation of Tenant Constructed Leasehold Improvements

The costs of leasehold improvements made to leased property and owned by a tenant are recovered in accordance with the cost recovery rules under Section168. In general, the depreciation deduction for real property leasehold improvements is determined without regard to the tenant's remaining lease term. The depreciation deduction for nonresidential real property leaseholds is computed based upon a 39 year life. The depreciation deduction for residential rental real property leaseholds is computed based upon a 27.5 year life. In both cases, the straight- line method of computing depreciation must be used. Leasehold improvements that are considered "tangible personal property" should be eligible for the shorter MACRS periods and favorable (accelerated) methods. Whether or not a leasehold is considered a "real property" addition, or a "tangible personal property" addition is problematic.

Tenant constructed qualified leasehold improvement property may qualify for either an additional 30% or additional 50% first-year depreciation deduction. In addition, certain qualified leasehold improvement property may qualify for a 15-year recovery period.

If there is any unrecovered basis upon the termination of a lease the entire unrecovered basis should be written off in the year the lease is terminated. Unless the lease is terminated, the unrecovered costs should not be written off. The continuation of the lease is enough to prevent the unrecovered costs from being written off, even where the tenant sublets the original leased space.

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