Landlord's ability to write off discarded tenant improvements challenged by IRS.

To lease office space in today's soft rental real estate market, landlords are frequently required to offer prospective tenants certain inducements. one common inducement is the tailoring of office space to tenant specifications. Under such an arrangement, a tenant will determine office space configuration. The landlord then undertakes all necessary construction to bring the space into compliance. The construction costs are booked by the landlord as tenant improvements (a capital asset) and are usually depreciated over 31 1/2 years in accordance with Sec. 168.

Previously rented office space that is leased to a new tenant will likely require refitting to the new user's specifications. Landlords are then left with the task of removing the old improvements (such as walls, ceilings, doors and floor coverings), and replacing these items with new tenant improvements.

In many cases, landlords would recognize a loss for the undepreciated leasehold improvements because the assets had been destroyed and replaced. However, this treatment has been challenged by the IRS in a general information letter, citing as support the legislative history and presumably Prop. Regs. Secs. 1.168-2(e) and 1.168-6(b). The Service's application of these proposed regulations requires the continued depreciation of the old tenant improvements as though still in service for the remaining period of the 31 1/2-year life. The IRS takes the position that the tenant improvements are structural components of the building - broadly defined to include walls, ceilings, flooring, partitions, windows, doors, HVAC systems and other detailed items (see Regs. Sec. 1.48-1(e)).

The Service's position should not apply to the extent a tenant improvement qualifies as a "substantial improvement." Substantial improvements are treated as separate building under the proposed regulations and are defined as expenditures over a 24-month period exceeding 25% of the building's cost before the improvement. In addition, to qualify, all expenditures must be incurred three or more years after the building is placed in service.

Taxpayers may also find relief under Sec. 165. Sec. 165 sets forth the requirements that must be fulfilled to allow a taxpayer a deduction for a loss sustained during a tax year. Sec. 165(a) states that a deduction not compensated by insurance or otherwise can be used in the year the loss is sustained. Under this provision, without regard to the limitations that follow, landlords who dispose of tenant improvements without receiving any compensation should be eligible to deduct the loss.

Sec. 165 has a number of other limitations and requirements that taxpayers must satisfy prior to deducting tenant improvement costs. Sec. 165(b) sets out loss limitations. It provides that the asset's adjusted basis, as determined by Sec. 1011, is used to measure the deduction. Regs. Sec. 1.165-1(d)(1) provides that for any taxpayer to be eligible to deduct a loss, there must be a completed and closed transaction that causes the taxpayer to realize a loss. Case law further provides that this loss must be a real and measurable economic loss (J.G. Boswell Co., 34 TC 539 (1960)). In addition, Sec. 165(c) contains a trade or business or profit motive limitation aimed primarily at individual taxpayers.

The issue is whether Sec. 165 should apply to allow a landlord to immediately write off destroyed tenant improvements. If the landlord is an entity other than an individual, generally there will be no limitation on the application of Sec. 165(a); as previously noted, individual taxpayers must meet the trade or business or profit motive test. According to the U.S. Court of Appeals, the term "trade or business" constitutes extensive activity over a substantial period of time during which the taxpayer holds himself out as selling goods or services (McDowell v. Ribicoff, 292 F2d 174 (3d Cir. 1961)). Providing space to a tenant seems to be a continuous activity that would fall within this definition.

Alternatively, case law has held the pursuit of rents, where such pursuit is the primary motive of the activity, is defined as being entered into for profit. Therefore, the leasing of office space satisfies the production of income requirement (Duffy, 690 F2d 889 (Ct. Cl. 1982)).

The actual disposition of walls, tiles and so forth, that no longer have any value (since the value has been destroyed on removal), appears to be a real and measurable completed economic loss. The disposition is irreversible, and the loss is measured as the difference between the current value of the former leasehold improvements (zero or scrap value) and their adjusted basis. Furthermore, because any disposition would be motivated by the desire to further a landlord's business of renting real estate, it would clearly be a bonafide disposition.

Regs. Sec. 1.165-2 specifically discusses depreciable property. It provides that losses allowable under Sec. 165(a) for depreciable property no longer used in a trade or business are to be determined under Regs. Sec. 1.167(a)-8.

Regs. Sec. 1.167(a)-8 allows a deduction on losses incurred on the retirement, by permanent withdrawal, of depreciable property used in trade or business or in the production of income. Permanent withdrawal can be achieved in several ways, including selling or exchanging property or actual abandonment. Logic dictates that leasehold improvements removed and discarded are abandoned. Regs. Sec. 1.167(a)-8(a)(4) provides that a retirement loss brought about by abandonment will be measured by the asset's adjusted basis at abandonment.

To sustain the loss under Sec. 165, the taxpayer should have detailed records on the actual costs of the tenant improvements, as well as documentation regarding what was specifically removed in the course of the new construction. Such records should be available in lease documents and construction contracts. Assembling and retaining these records is imperative.

Conclusion

A legitimate concern for taxpayers is the presence of conflicting authority. Sec. 165 and its regulations are in conflict with the Service's position and proposed ACRS regulations. When a Code section and final regulations come into conflict with proposed regulations, the Code section and its final regulations will arguably govern the issue affected and provide substantial authority under Sec. 6662. Therefore, in this instance, Sec. 165 will control and should provide taxpayers with the ability to immediately write off a loss when the requirements of Sec. 165 are met. This should hold true at least until final ACRS regulations are issued.