Market Insight: Guest Articles
Depreciation Benefits Under the Jobs and Growth Tax Relief Reconciliation Act of 2003: Leasehold Improvements and Office Furnishings
by James Ullakko of Odenberg, Ullakko, Muranishi & Co. LLP
September 2003
Leasehold Improvements
The cost of leasehold improvements whether paid for by the landlord or the tenant is required to be depreciated over 39 years even though the related lease is for a much shorter period.
In 2002, in response to the tragic events of September 11, 2001 the Job Creation and Worker Assistance Act of 2002 gave businesses an opportunity to significantly increase their first-year depreciation deductions. The 2002 law introduced, for a limited time, an additional first-year depreciation “bonus” equal to 30% of the cost of qualified property. To qualify under the 2002 law, the property must generally be new property acquired after September 10, 2001 and before September 11, 2004. In addition, the property must be:
- Property with a recovery period of 20 years or less,
- Eligible computer software, or
- Qualified leasehold improvement property.
The bonus depreciation is available for both regular and alternative minimum tax purposes, is not mandatory, and doesn’t preclude the regular deduction for first-year depreciation. However, the bonus depreciation is subtracted from the property’s adjusted basis when figuring the regular depreciation deduction.
The 2003 Act expands and modifies the bonus depreciation provisions. Under the 2003 Act, the additional first-year depreciation has been expanded to 50% for qualified property. Qualified property is defined in the same manner as under the 2002 law except the time period for acquisition is different. The original use of the property must commence with the taxpayer after May 5, 2003, and the property must be acquired by the taxpayer after May 5, 2003, and before January 1, 2005, and be placed in service before that latter date.
Qualified leasehold improvement property is any improvement to an interior portion of a building that is nonresidential real property, provided certain requirements are met. The improvement must be made under or pursuant to a lease either by the lessee (or sublessee) of that portion of the building, or by the lessor of that portion of the building. That portion of the building is to be occupied exclusively by the lessee (or any sublessee). The improvement must be placed in service more than three years after the date the building was first placed in service.
Qualified leasehold improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building.
Example—Leasehold Improvements
For example, if a tenant builds out a space at a cost of $600,000 and receives a $300,000 reimbursement from the landlord, then 50% of the net cost of $300,000, or $150,000, represents a deduction in the year the improvements are placed in service, with the balance of $150,000 being depreciated over 39 years.
Office Furnishings
The cost of office furnishings generally must be depreciated over 7 years.
Small businesses can take advantage of the election under Section 179 of the tax code to expense the cost of office furnishings in the year of acquisition, within tax law limits.
Under Section 179, a taxpayer may elect to deduct, up to a dollar limit ($25,000, under pre-2003 Act law), the cost of qualifying property placed in service during the tax year. The dollar amount is phased out dollar-for-dollar as the taxpayer’s cost of qualifying property for the year exceeds $200,000. The amount that can be expensed each year cannot exceed the taxpayer’s taxable income derived from the active conduct of a trade or business for the year (without taking into account the effect of Section 179). Thus, the expensing election is most beneficial to profitable smaller businesses that make small annual capital investments.
Property qualifying for the election must generally be tangible personal property, like equipment, vehicles, machinery, office furnishings, etc. Under pre-2003 Act law, off-the-shelf computer software did not qualify.
The 2003 Act increases the maximum dollar amount that may be deducted under Section 179 to $100,000 for property placed in service in tax years beginning in 2003, 2004, and 2005. In addition, for phaseout purposes, the $200,000 annual investment limit described above rises to $400,000 for property placed in service during those years. The dollar limits will be indexed for annual inflation for tax years beginning after 2003 and before 2006. And off-the-shelf computer software qualifies for the Section 179 election, for tax years beginning in 2003, 2004, and 2005. After tax years that begin in 2005, the expensing election rules go back to the way they were prior to the 2003 Act.
Example—Office Furnishings
For example, if the tenant referred to in the above example following the buildout of space spends $150,000 on new furnishings, then depreciation on the $150,000 would be computed as follows:
| Total Cost | $150,000 | |
| 179 deduction | (100,000) | $100,000 |
| 50,000 | ||
| 50% bonus | (25,000) | 25,000 |
| $25,000 | ||
| Regular depreciation (half year) | 3,571 | |
| Total depreciation in year of acquisition | $128,571 |
Powerful Combination
The increased Section 179 election and the newly expanded additional first-year depreciation bonus can be a powerful combination when it comes to writing off new asset purchases, especially given the significantly higher Section 179 annual asset investment limit.
The combined depreciation deduction in the above two examples is as follows:
| Total leasehold improvement cost after landlord reimbursement | $300,000 | |
| Current year deduction | $150,000 | |
| Total office furnishings | 150,000 | |
| Current year deduction | 128,571 | |
| Total cost | $450,000 | |
| Total deduction | $278,571 |
For state tax purposes the news won’t be as good since it is doubtful that most states will adopt conforming legislation.
Summary
The new law provides an incentive for a limited period of time to deduct a large part of the cost of space buildouts that would otherwise be depreciable over longer periods. Because of the lengthy lead times required in connection with negotiations and buildouts, time will be of the essence in order to satisfy the January 1, 2005 placed-in-service requirement. Also, since the rules are complex, advice from your professional tax advisor is critical.
It may be advantageous for tenants to finance buildout costs and trade construction cost allowances for other concessions. The new depreciation benefits could make the difference between renewing existing leases or seeking out new space and making a move.
Depreciation benefits for leasehold improvements could be further enhanced provided cost segregation techniques are employed to allocate buildout costs to shorter lived assets, i.e., tangible personal property buried in the overall cost of the buildout. This may be possible through a review of blueprints and construction documents by someone experienced with cost segregation techniques.
