Owners can reap tax benefits of tenant improvements with new law.

On March 9, the president signed into law the Job Creator and Workers Assistance Act of 2002. A key depreciation provision in this act is the accelerated depreciation allowed for New York City's new "Liberty Zone." The New York Liberty Zone is defined as that area located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with East Broadway) in Manhattan. Essentially, that area significantly impacted by the devastation of the WTC.

More specifically, a portion of this Act pertains to "qualified leasehold improvements," which were placed in service after Sept. 10, 2001 and before Jan. 1, 2007. Generally, such improvements consist of interior work to nonresidential real estate. With respect to office buildings and retail establishments, this would be tenant improvement work and other various interior improvements that would not be classified as personalty. Typically, most office tenant improvement work is classified as section 1250 property (realty) and depreciated over 39 years. Now, such qualified leasehold improvements can be depreciated much more quickly over five years straight-line. This tax benefit is available to landlords and tenants that fund their own tenant improvements.

For a landlord or tenant, the taxpayer who paid for and owns the improvements, the present value tax benefit from using this accelerated depreciation could be substantial. For example, let's suppose that there is 20,000 SF of tenant improvement work constructed at a cost (both direct and indirect) of $35/SF or $700,000. Using the previous 39-year recovery period, this would provide a present value tax benefit of $58,000 over 10 years using a combined federal, state and city tax rate of 48%. However, if the new Liberty Zone depreciation rules are used, the present value tax benefit would be $229,000, which is an increase of close to 400%.

This Liberty Zone Leasehold Improvement tax benefit (the 5-year recovery) cannot be applied in addition to the Liberty Zone's extra 30% first year bonus allowance deduction applied to nonresidential and residential realty, which is available for such improvements that rehabilitate damaged realty or replace realty destroyed or condemned as a result of the WTC attack. Such property is referred to as qualified Liberty Zone "property." However, qualified Liberty Zone "leasehold improvements" are not considered qualified Liberty Zone "property." But, having Liberty Zone leasehold improvements eligible for a 5-year recovery does not preclude the taxpayer from conducting a cost segregation study to re-classify certain non-bonus applicable section 1250 property to section 1245 property so as to take advantage of 5 and 7-year recovery periods.

"It is important for the taxpayer to not only correctly identify and re-classify the specific qualifying leasehold improvements, but to gain the maximum deduction possible by properly allocating to such costs their appropriate share of general condition and indirect costs as well," says Mark de Stefanis, president of Construction Cost Recovery, Inc. "Within the Liberty Zone, the extra general condition costs alone for security, management, expediting, etc., will significantly increase the depreciable basis and therefore the tax benefit when properly allocated."

This latest tweaking of the depreciation rules is just one of many depreciation-related changes that has been enacted over the last few years that benefit the real estate industry. For this reason, cost segregation techniques are increasingly becoming a part of real estate ownership's tax planning strategy. For many property types, especially those with substantial site work or with improvements that can be re-classified to shorter recovery periods, the tax benefits are significant.

According to de Stefanis, "Few of our potential clients realize that most site work (paving, curbing, sidewalks, utilities, etc.) can now be depreciated over 15 years instead of 39 or 27.5 years for non-residential and residential property, respectfully, and that this is now available for any property purchased after 1987 regardless of its age. Most taxpayers are not availing themselves to the tax benefits provided by these IRS's approved and promoted cost segregation techniques. It's like free money."