Depreciation of tenant improvement costs.

Commercial property owners and tenants should consider taking advantage of an accelerated depreciation provision in the newly enacted U.S. Jobs and Growth Tax Relief Reconciliation Act of 2003 that could result in significant tax savings on property acquisitions and leasehold improvements.

Rather than depreciating newly acquired equipment and interior space buildout costs over traditional depreciation periods, the new law allows 50 percent of eligible costs to be depreciated in the first year, with the other half to be depreciated over the normal depreciation schedule.

If this accelerated depreciation benefit sounds familiar, it's because a similar deal for 30 percent first-year depreciation was offered in 2002 as part of the post-9/11 economic stimulus package. Because that effort did not bring about a decisive turnaround in the general economy or the commercial real estate business, Congress recently upped the ante to 50 percent first-year depreciation.

As before, the bonus is intended to encourage immediate new investment. New property must be acquired or constructed after May 5, 2003, and placed in service before January 1, 2005 (certain property with longer production periods gets a 2006 date). For property acquisitions to be eligible, there cannot be a binding contract for acquisition or construction of the property before May 6, 2003.

While the bonus applies to several categories of property, two are of particular interest to building owners and tenants. The first is newly acquired property with a depreciation period of 20 years or less, a category that includes many kinds of equipment, interior decoration, landscaping and carpeting. The second is "qualified leasehold improvement property"."

Without the bonus, leasehold improvements are typically depreciated over 39 years, resulting in an annual deduction of about 2.56 percent of costs per year. With the bonus, first-year depreciation increases to as much as 51.3 percent. While regular depreciation deductions must be pro-rated to reflect that property may have been in service only for a portion of a tax year, the 50% bonus depreciation amount is available in full even if property is placed in service on the last day of the year.

Landlords and tenants who understand this benefit may have an edge in negotiating tenant allowances over the next several months. Lease provisions will determine the extent of each party's depreciable interest in personal property and leasehold improvements. Typically, landlords will provide tenants with a fixed dollar allowance to fund the cost of fitting up newly leased space and treat these improvements as landlord owned property for depreciation purposes. The tenant is then responsible for funding the cost of leasehold improvements in excess of this allowance. Some leases treat the tenant funded portion of the improvements as additional rent to the landlord with the landlord again retaining the depreciable interest in the property. In this context, the landlord would claim the bonus for 50% of the full cost of the leasehold improvements. Other leases treat the tenant funded portion of the improvements as tenant owned property with the tenant instead holding the depreciable interest in the improvements to the extent of its funding. In this context then, the tenant would claim the bonus on the portion of the improvements it funded. In leases which contemplate both landlord and tenant funding, lease provisions will often specifically identify the property to be funded by each party. For tax purposes, one party may be more interested in allocating its funding to property such as interior decoration or equipment with shorter depreciation periods.

Tax, as well as other business considerations, will influence parties' decisions on how to fund leasehold improvements. The bonus may have greater value to the party in the higher marginal federal income tax bracket. Given that it is only available for improvements placed in service before January 1, 2005, the bonus puts pressure on parties to close deals. Consider for example a landlord in the 35% tax bracket and a tenant operating at a taxable loss who are negotiating about the amount of the landlord funded tenant improvement allowance. Each $100 funded by the landlord and placed in service prior to January 1,2005 results in a current tax deduction for the landlord of at least $50, while the tenant is unable to take advantage of the deduction until its income again becomes positive. If the improvements are placed in service in 2005, the landlord loses access to the accelerated depreciation provided by the bonus.

Because the bonus is available only in buildings that are at least three years old, existing buildings gain an advantage over new buildings. To illustrate, compare an existing building owner who spends $1 million on tenant improvements to a new building owner who does the same. Assume the improvements are finished on January 1, 2004 so that both the bonus and a full year of regular straight-line depreciation are available fur 2004. The owner of the existing building claims an accelerated deduction in 2004 of as much as $512,820 while the owner of the new building receives only a $25,641 deduction, in 2004, a difference of $170,513 in federal income tax for 2004 if both owners are in the 35 percent tax bracket.

Technical requirements for any tax rules require careful analysis by a qualified professional, but in general, the bonus depreciation deduction is available both for regular tax and alternative minimum tax purposes. The IRS has indicated that a book/tax difference created as a result of the bonus will not be a "tax shelter" item subject to new disclosure and list maintenance rules.

Unless a properly filed election is made to claim the bonus, the bonus, whether or not actually claimed by a taxpayer, will reduce depreciation in subsequent years. Many unhappy taxpayers were unaware of this in filing 2001 tax returns and failed to claim the 30 percent bonus. The IRS recently issued special relief for them if they file amended returns by the end of 2003. It's better to be aware of the new rules than to count on the Service granting relief again.

Given the economy and low interest rates, some businesses may conclude that it is to their advantage to elect not to claim the bonus, or to take the 30 percent bonus in lieu of the 50 percent bonus. Guidance that may influence this decision in the form of regulations is expected in the near future.

Owners should also be aware the leasehold benefit does not cover building expansions, structural repairs or improvements to common areas such as lobbies, nor does it apply to owner-occupied space. With those caveats in mind, the benefit of accelerated depreciation is significant enough to warrant the attention of every commercial property owner.

As this article goes to press, there is indication that the 50% bonus provisions of the U.S. Jobs and Growth Tax Relief Reconciliation Act of 2003 may not be the last word on depreciation this year. On July 25, 2003 Rep. William Thomas, R-California, Chairman of the House Ways and Means Committee, introduced a bill that would extend period for claiming the bonus depreciation allowance for an additional year and would reduce the depreciation period of qualified leasehold improvements to twenty years.

Pamela Westhoff and Miriam Sheehan are partners in the Los Angeles and Boston offices, respectively, of Piper Rudnick LLP.