What Landlords and Tenants Need to Know about the New Depreciation Regulations
In continuance of our series of analyses of the new regulations for deduction vs. capitalization, this section highlights the rules for landlord and tenant expenses related to leased buildings. Although fairly similar, the capitalization rules differ in how they apply to lessees and lessors. Please note – this is a separate issue from the proposed lease accounting changes that we expect to see resolved by the end of 2012.
Improvements Paid for by Lessee
In general, a lessee must capitalize the aggregate of related amounts that it pays to improve a unit of leased property. There are two situations, however, in which capitalization is not required:
- A construction allowance is received
A tenant excludes from income any amount received in cash or as a rent reduction if the amount is (a) received under a short-term (15 years or less) lease of retail space; and (b) is made so the tenant can build or improve qualified real property. In this case, if the tenant excludes the construction allowance from income, it does not capitalize the improvements made.
- Improvement is a substitute for rent
If the lessee makes improvements to real estate that are a substitute for rent, the costs are treated as rental income to the lessor. Although the regs do not specifically address what amounts are deductible by the lessee in this situation, several court cases have held that the tenant may deduct the full rent due even though part of it was never paid directly as rent but as improvements.
The prior rules allowed a lessee to depreciate leasehold improvements over the shorter of the estimated useful life of the improvement or the remaining period of the lease. These new regs amend this rule and provide that both lessee and lessor must depreciation leasehold improvements under the applicable cost recovery provisions of the Internal Revenue Code, without regard to the term of the lease or estimated useful life of the improvement.
Improvements Paid for by Lessor
A taxpayer that is a lessor is required to capitalize the aggregate of costs:
- Paid directly to improve a unit of leased property;
- Paid indirectly through a construction allowance to the lessee; or
- Paid by the lessee where the lessee’s improvement constitutes a substitute for rent.
Any amounts capitalized by the lessor under these rules cannot be capitalized by the lessee. In a situation where both the landlord and tenant finance a realty improvement, both parties are treated as having separate units of property.
For more information on the new depreciation regulations contact an Anders advisor.