Accounting for leasehold improvements.
It was reasonably well-settled, even before ERTA, that the cost of leasehold improvements constructed by a lessor had to be recovered over their useful lives regardless of the term of the lease. Prior law implicitly allowed two exceptions to this general rule. First, a taxpayer could prove a shorter useful life, as might be the case with special purpose leasehold improvements that could benefit only the current lessee when the lease term is shorter than the useful life of the asset. Second, a taxpayer could prove a useful life cut short by obsolescence--as might occur with such special purpose leasehold improvements when the lease is unexpectedly cut short. In such a case, the unrecovered cost could be written off at that time.
The enactment of the accelerated cost recovery system (ACRS) system in 1981, followed by its modification (to the MACRS system) in 1986, effectively eliminated the concept of "useful life" in determining the period over which the cost of leasehold improvements could be recovered. The Grinalds court held that (1) the statutory recovery period, rather than the useful life, controlled for purposes of recovering the cost of leasehold improvements; and (2) the term of the lease was irrelevant, even if the improvements were special purpose and of use to no one following termination of the lease.
While the first conclusion is widely acknowledged, many practitioners still cling to the apparently logical notion, in the case of special purpose improvements that will become worthless at the conclusion of the lease, that the period of the write-off should coincide with the lease term. And even if scheduled percentages (rather than straight-line amortization) were used, many practitioners believe the remaining basis could (or at least should) be written off at the conclusion of the lease.
ACRS regulations proposed in 1984, but still not finalized (no proposed regulations have been issued under MACRS), indicate that the unadjusted basis of a building's structural components must be recovered as a whole (Prop. Regs. Sec. 1.168-2(e)(1)), the same recovery period and method must be used for all structural components, and such components must be recovered as constituent parts of the building of which they are a part. Prop. Regs. Secs. 1.168-2(1)(1) and -6(b) also provide that the term "disposition" does not include retirement of a structural component of a building and that retirement of a structural component is not an appropriate occasion to recognize loss or reduce basis.
Accordingly, under the proposed regulations, the cost of tenant improvements, if considered to be structural components of the building, would continue to be recovered over the scheduled period even if demolished. In a General Information Letter dated Sept. 17, 1992, the IRS confirmed the view that the cost of tenant improvements that constitute structural components must continue to be recovered over the recovery period of the building--even after their demolition.
The Grinalds case, unfortunately, did little to change this position. However, footnote 2 suggests that when leasehold improvements are demolished by a new lessee to make way for his own occupancy, the unrecovered cost of the demolished leasehold improvements should be deducted over the term of the new lease. (At least this is the position the Service took in its Grinalds brief.)
Since Grinalds was argued and decided subsequent to the issuance of those proposed regulations, one is left to wonder about the significance, if any, of the IRS position. Note that the Service disallowed the claimed loss not on the basis that the unrecovered cost must continue to be recovered under the ACRS schedule, but that the unrecovered cost was part of the cost of acquiring another amortizable asset (a lease) over which the unrecovered cost was to be recovered. This construction may not always benefit the landlord, as for example when the remaining recovery period is shorter than the new lease's term.
It is unclear whether the IRS took this position because it considered the landlord's transfer of the improvements to the new lessee and demolition by the new lessee a "disposition" within the meaning of the proposed regulations, or whether the Service was rethinking the concept put forth in its proposed regulations. It is more likely that the former proposition is true.
Accordingly, it appears that landlords may have a choice when it comes to recovering the undepreciated cost of their tenant improvements that do not constitute structural components. If the term of the new lease is less than the remaining recovery period, space (including the old tenant improvements) can be transferred to the lessee together with enough money to cover the lessee's cost of demolition. Under the theory of the Grinalds footnote, the unrecovered cost of the old improvements and the amount of the payment would be treated as a lease acquisition cost and written off over the term of the new lease. On the other hand, if the term of the new lease exceeds the remaining recovery period, the results obtained by a literal reading of the proposed regulations can be followed and the landlord can demolish the obsolete improvements, continuing to recover their cost over the relevant recovery period.
The IRS has not issued any final authoritative guidance in the area; hopefully, the logical proposition, that the unrecovered basis of tenant improvements remaining at the conclusion of a lease may be written off, will ultimately prevail.
From Howard Levinton, CPA, J.D., Baltimore, Md.
|Printer friendly Cite/link Email Feedback|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1995|
|Previous Article:||Using the cash method of accounting.|
|Next Article:||Accounting for client out-of-pocket expenses.|