Understanding Tangible Property Regulations in Landlord-Tenant Issues
The new tangible property regulations offer the opportunity to expense tenant improvements without capitalization if they pass certain tests. Different rules apply when determining the unit of property (UOP) for leased buildings, impacting how expenses are categorized. Landlords may benefit from repair deductions and potential future gains taxed at lower rates. Specific criteria and examples help clarify these regulations for effective compliance.
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Tangible Property Regulations- Landlord Tenant Issues. The new tangible property regulations present the opportunity to expense tenant improvements if the expenditures are not required to be capitalized under the restoration, adaptation, betterment, or improvement ( R.A.B.I. ) tests. Expenditures required to be capitalized create opportunity for partial asset disposition. These regulations provide a double benefit to many taxpayers as the repair deduction would generate tax benefits at ordinary rates while the future gain from sale would be taxed at capital gains rates with less recapture.
Leased Buildings UOP Lessor entire building is the UOP For multi tenant buildings, UOP is the entire building. One building built at different times is one UOP. Two or more separate buildings built at the same time are separate UOP. Lessee UOP is portion of the building subject to the lease. For multi tenant building the UOP is their space If the whole building is leased UOP is entire building Amounts paid for tenant improvements are not a separate unit of property. [1.263-3(e)(4)] This conclusion is important in the measurement comparison for RABI criteria. If the TI class life was subsequently changed, from an impermissible life to permissible lifeor as a result of a cost seg. that will create a separate UOP.
1.263(a)-3(e)(2)(v) UOP for Leased Buildings (v) Leased building (A) In general. In the case of a taxpayer that is a lessee of all or a portion of a building (such as an office, floor, or certain square footage), the unit of property ( "leased building property") is each building and its structural components or the portion of each building subject to the lease and the structural components associated with the leased portion. (B) Application of improvement rules to a leased building. An amount is paid to improve a leased building property under paragraphs (d) and (f)(2) of this section if the amount is paid for an improvement, under paragraphs (j){betterments}, (k){restorations}, or (l){adaptations} of this section, to any of the following: (1) Entire building. In the case of a taxpayer that is a lessee of an entire building, the building structure or any building system that is part of the leased building. (2) Portion of a building. In the case of a taxpayer that is a lessee of a portion of a building (such as an office, floor, or certain square footage), the portion of the building structure subject to the lease or the portion of any building system subject to the lease.
Observations and Discussion The UOP for a landlord is the whole building, building structures and/or building systems. Since tenant improvements are not a separate UOP The result will be that many landlord tenant improvements, beyond the initial tenant improvements, will be classified as repair and maintenance expense. Exception would be adaptation or betterment. Examples of TI that would be adaptation or betterment: Retail or office space to medical facility.
Example- from the regs HVAC system includes 10- roof mounted units. The roof mounted units are not connected and have separate controls and duct work that distribute the air to different spaces in the buildings interior. The entire HVAC system including all of the roof mounted units comprise a building system. 2 of 10 units replaced, even if more efficient it is not a material addition or a material increase in efficiency. Question: How are we to judge the efficiency of the old units? Comparison to new units? We need more information to make these determinations.
Additional example Large multi tenant strip mall, one building so one UOP. 25% of the sq footage is a grocery store that becomes vacant. New grocery store will lease space but wants landlord to reduce square footage to 15% of building and change layout of the store. Expenditures of $400,000 are incurred by landlord to refresh the space. What is the outcome? Would it matter if it was something other than a grocery store? Would it matter if it was a Whole Foods and higher quality upgraded materials were used?
1.263(a)-3(f) Rules for Improvements to Leased Property 3) Lessor improvements (i) Requirement to capitalize. A taxpayer lessor must capitalize the related amounts, that it pays directly, or indirectly through a construction allowance to the lessee, to improve, a leased property when the lessor is the owner of the improvement or to the extent that section 110 applies to the construction allowance.
Leases with Section 110 Sec 110 allows tenants to exclude from income any amount received as a construction allowance or a rent reduction from the owner/landlord. In making the decision to capitalize or treat as R&M check the lease for 110 language. Landlord must capitalize expenditures for TI under a 110 lease even if it is not a betterment adaptation or restoration. Recommendations to clients: Do not refer to Section 110 in the lease agreement. State that the landlord owns the improvements. Do not provide lease allowance with no obligation to spend, otherwise landlord has an intangible
Common Area Maintenance and TPR Is it a tenant paid repair or a landlord paid capital expenditure? How does the TPR affect the CAM charges to tenants? Expenditures to resurface a parking lot may be treated as repairs in the future and passed on in the CAM. Certain roof work that previously would be capitalized will be R&M, for example replacing the roof membrane. Landlord and tenant may consider amending the lease to make it clear what is to be included in CAM.
Removal Costs and Tenant Improvements Method change #21 enables a taxpayer not to have to capitalize removal costs associated with an improvement. If not done in 2014 can still do for your clients. Allows taxpayers to expense removal costs when demolishing tenant improvements. Must also have a PAD on the tenant improvements disposed of. Taxpayers should ask the contractor to break out the demolition and removal costs on the invoice. Need to ask clients more questions about work done to their property.
Partial Asset Dispositions (PAD) Prior to these regulations there was no ability to take a loss on partial asset dispositions. Late partial dispositions were permitted in tax year 2014 with significant tax savings for many taxpayers. Scrubbing of depreciation and prior partial asset dispositions, a unique opportunity for 2014 returns.
Partial Asset Disposition (PAD) and the Rule of One Taxpayers need to have one of every asset on its books, but can choose to have more than one. Example TP is a landlord and replaces all of the windows in the building TP must capitalize the new windows as it is a restoration under the new standards. TP can do a PAD for the removed windows but is not required to. If the window expenditure was not a restoration and instead a R&M expenditure no PAD can be done.
Rule of One -continued You do not have to have basis in an asset, or part of an asset, in order to have one If the tenant installs a new roof that is capitalized then the landlord can do a PAD for the original roof that is already on the landlords books. Similar outcome if a new tenant pays for and does their own tenant improvements (TI), landlord can do a PAD for the previous TI.
Partial Asset Dispositions-continued If you have a capitalized improvement you need to consider the PAD. Calculation of PAD? IRS says use any reasonable method. Cost segregation study Discount the cost of a replacement component to its placed in service year using the Producer Price Index (PPI) (not for a betterment or adaptation) Resource for finding PPI indexes: www.kbkg.com
PPI rollback- limitations Be cautious in using this method when a building component is replaced within 10 years of a buildings acquisition. This method does not account for the condition of the building component at the time of acquisition and may overstate the loss. If building was purchased at a discount or involves a basis adjustment an overstated loss may result using PPI.
Example-New windows in entire building A building was acquired three years ago. $200,000 is incurred to replace all the aluminum windows. Discounting back three years the value of the windows is $186,000. Since the windows were not new when the building was purchased a condition factor must be applied. Example given on kbkg.com website states the aluminum windows had a 20 year life and had 3 years of life at purchase, a condition factor of 27% was used reducing the PAD to $50,220. KBKG.com has a software tool that you can purchase that incorporates the condition factors and the effective age of components. Different conclusion if building was newly constructed when placed in service.
Discussion/Questions Analyze future expenditures and determine if there is an improvement to be capitalized or R&M to be expensed. Sounds simple enough. Use flowcharts to help in decision making. How will the client or the clients bookkeeper know how to classify? We will need to ask many more questions of our clients to make these decisions. Opportunities? Problems? Suggestions?
