How a Tenant Handles Leasehold Improvements under the U.S. Tax Code
When a business leases property, such as building space, the tenant may find it necessary to make improvements to the space to make it more suitable to its needs. These leasehold improvements can qualify for special accelerated depreciation or expensing under several provisions of the Internal Revenue Code (IRC), such as IRC §179 or bonus depreciation under IRC §168(k). This article will outline the rules applicable to leasehold improvements made to real property.
What is a Leasehold Improvement?
A leasehold improvement can qualify as “qualified improvement property” (QIP). The statute defines QIP as any improvement made by the taxpayer to an interior portion of a nonresidential building if placed in service after the building’s initial placed-in-service date. However, the term does not include expenditures attributable to the enlargement of the building, any elevator or escalator, or to the internal structural framework of the building. Examples of potential QIP include electrical additions, the addition of built-in cabinetry, or installing partitions.
Standard Depreciation Rules for QIP
QIP has a MACRS 15-year recovery period using the straight-line depreciation method and the half-year convention. However, if the remaining lease term is less than 15 years, the taxpayer will instead calculate amortization expense using the straight-line method over the remaining lease term. For example, the tenant incurs $10,000 worth of improvements but only five years remain on the lease. The tenant would therefore deduct $2,000 per year ($10,000 ÷ 5 years) as amortization in lieu of MACRS depreciation deductions.
Section 1250 Property
QIP, as real property, qualifies as IRC §1250 property. When a taxpayer disposes of IRC §1250 property at a gain it must recapture of depreciation in excess of straight-line depreciation as ordinary income; such as bonus depreciation (see below). As a result, if a transaction results in QIP-related gain to the lessee, the tenant will recognize ordinary income equal to the lesser of the excess QIP depreciation or the actual QIP gain. The remainder of the gain qualifies as IRC §1231 gain potentially subject to a lower tax rate.
The bonus depreciation provisions under IRC §168(k) apply to QIP. A taxpayer can claim bonus depreciation on 100% of the property’s cost basis through 2022. After 2022, the bonus depreciation percentage decreases by 20% each year until reaching 0% in 2027 and beyond.
IRC §179 Expensing
This deduction can apply to QIP. For 2020, the maximum deduction equals $1,040,000. The maximum deduction phases out dollar-for-dollar when the taxpayer places more than $2,590,000 of qualified assets into service. If both bonus depreciation and the IRC §179 deduction apply, IRC §179 applies first to reduce the cost basis of the qualified property.
Example 1: Humble Architecture, Inc. leases office space in the downtown area of a major U.S. city. In 2020, Humble makes $20,000 of leasehold improvements meeting the definition of QIP. These improvements include new office flooring and the building of partitions as well as other items necessary to make the office space more suitable to its needs. Humble does not elect to claim an IRC §179 deduction. Humble therefore claims bonus depreciation on the entire $20,000 cost basis of the QIP.
Example 2: Dave’s Cell Phone Depot operates a chain of cell phone stores throughout the U.S. They lease building space for their 150 locations. In 2023, they make $3 million of improvements to their leased locations. These improvements meet the definition of QIP. The 2023 bonus depreciation rate equals 80% for 2023. Dave’s begins by taking the IRC §179 deduction as follows (assuming deduction limits are the same as in 2020):
Maximum §179 deduction:
$1,040,000 (maximum) – Phase-out = IRC §179 Deduction
$1,040,000 – ($3,000,000 – $2,590,000) = $630,000
Remaining amount to expense after §179 deduction:
$3,000,000 – $630,000 = $2,370,000
After applying the IRC §179 deduction Dave’s can claim bonus depreciation at a rate of 80%:
Bonus depreciation deduction:
$2,370,000 × 80% = $1,896,000
Remaining amount to expense after bonus depreciation deduction:
$2,370,000 – $1,896,000 = $474,000
Dave’s will depreciate the remaining $474,000 of cost basis on a straight-line basis over the next 15 years assuming each lease has a remaining term of at least 15 years.
|Year||Depreciation Percentage (see page 74 of IRS Publication 946)||Depreciation Per Year|
|2024 through 2037||6.67%||$31,615.80|
Example 3: Assume the same facts as in Example 2 including the application of IRC §179 and bonus depreciation. How would Dave’s expense the remaining $474,000 of cost basis assuming all the leases had remaining terms of 10 years?
Under this scenario, Dave’s would claim straight-line amortization on the remaining $474,000 of cost basis over 10 years instead of applying the 15-year MACRS depreciation method. This would result in annual amortization expense of $47,400 (= $474,000 ÷ 10 years).
For more information on expensing leasehold improvements please contact one of our experienced CPAs or tax professionals at Kurtz & Company, P.C.
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Author Of this post: Daniel Quintana