Real estate owners, tenants get tax break. (An Advertising Supplement).

Companies that spend money upgrading office or retail space in the next three years may be eligible for a big tax break due to a provision buried in the economic stimulus package passed in March. The only problem is that many companies are unaware of the opportunity.

News articles that discussed the federal economic stimulus bill--known officially as the Job Creation and Worker Assistance Act of 2002-typically focused on sections that were of interest to the general public, including the 13-week extension of unemployment benefits and the allocation of $5 billion to rebuild downtown New York. To the extent that corporate "tax breaks" were discussed, they were rarely explained. The result is that companies may not know the bill offers them a significant tax benefit for investing in interior build-out of new and existing office and retail space.

The benefit, outlined in Section 101 of the Act, amounts to an acceleration of the usual 39-year "straight-line" method of depreciating interior improvement costs for tax purposes. For the next few years, landlords and tenants of commercial property may depreciate 30 percent of the cost of "qualified tenant improvements" in the first year that the improvements were placed in service. The other 70 percent is depreciated over the standard 39-year schedule. This accelerated depreciation schedule represents a significant benefit to any company or real estate owners facing the substantial cost of constructing new, high quality tenant interiors.

One reason this provision was included in the law is that it provides an incentive for companies to invest in their work environment, which has the effect of creating jobs and helping to speed up the economic recovery. In theory, companies are more likely to prepare for growth by upgrading their office space, and retailers are more likely to invest in stores to attract customers, if there is an economic incentive to making these improvements now instead of five years from now. Because the bill was designed to stimulate economic activity in the short-term, however, the 30 percent depreciation is available for a limited time only. Companies that do not take action within the three-year window mandated by Congress will miss out on this significant tax benefit.

To understand the size of the tax savings, consider the example of a 25,000-square-foot tenant that spends $40 per square foot building out space that is placed in service at the beginning of 2002. Although this is a medium size lease and a conservative cost per square foot for interior construction, the $1 million price tag represents a major expense. Under the straight-line depreciation method, the first-year deduction would be $1 million divided by 39, or $25,641.02. Using the method permitted in the new law, the company could take an accelerated depreciation deduction of an additional $300,000.00 this year, with the remaining $700,000 depreciated over 39 years. Assuming a federal tax rate of 38.6 percent, the larger depreciation deduction translates to an additional reduction of tax liability of approximately $100,000.00 in the first year compared to the straight-line method.

Companies interested in taking advantage of the accelerated depreciation benefit are advised to work with qualified real estate/tax legal professionals to ensure that their expenditures are eligible for the 30 percent first-year deduction. In general, however, interior improvements are likely to be considered eligible for the benefit under the following conditions:

Use it or lose it--The 30 percent deduction must be taken in the first year that the improvements are placed in service, unless the tenant or owner chooses the standard depreciation method.

Three-year window--Tenant improvements must be made after September 10, 2001 and before September 11, 2004, in commercial (including retail) space placed in service no later than January 1, 2005, to qualify for the benefit.

No new buildings--The accelerated depreciation method is available only on interior improvements that are placed in service at least three years after the completion of the building.

Interior construction only--the provision does not cover building expansions, structural repairs or improvements to common areas, such as a lobby renovation in a multi-tenant office building or escalators in a shopping mall.

Leased space--Expenditures must be in connection with a qualified lease transaction, so a building that is owned by the occupant is not eligible for the accelerated depreciation deduction.

First year benefit is offset over time--Depreciating 30 percent of the cost of improvements in the first year means there is less to depreciate over the remainder of the 39-year schedule. The other 70 percent of cost basis is eligible for straight-line depreciation deductions spread over the next 39 years, but because the benefit is front-loaded in the first year, depreciation deductions in subsequent years will be marginally lower than if the company chose the traditional straight-line depreciation method..

Special rules for NYC--Property within the "Qualified New York Liberty Zone" may be depreciated over five years rather than 39 years, but it does not qualify for the 30 percent depreciation deduction.

The biggest beneficiaries of the tax benefit are likely to be owners of existing office buildings, who pay a large share of tenant improvement costs, either by direct payments incurred in the construction of the tenant space or in the form of allowance dollars allocated to the tenant for the construction of its space. Since property owners typically pay for a large portion of the tenant improvements constructed in the space, they receive the accelerated depreciation benefit of those "qualified tenant improvement" dollars. On the other hand, a tenant that expends more than the alloted amount provided by its landlord may also share in the benefit of the accelerated depreciation. The issue of which party receives the depreciation benefit depends on how the lease terms are negotiated with respect to the characterization of the tenant improvement allowances, ownership of the improvements and other related issues.

Whether or not the 30 percent depreciation deduction prompts landlords and tenants to spend more on improving office and retail environments, the 30 percent first-year depreciation benefit is an important consideration for companies that are planning for growth during the current economic recovery.

Jeffrey Rosenfeld is a partner of the Los Angeles office of Piper Rudnick, a national law firm with one of the largest real estate practices in the country.

Mark Gershon is also a partner at Piper Rudnick with extensive experience in the approval, development and financing processes of local and regional developments, and on issues important to the real estate community including tenant improvement depreciation.