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What is a Capital Expenditure?

(This is the second in a series of articles that address new regulations from the IRS related to capital expenditures.)

The IRS recently issued temporary regulations which clarify the tax rules relating to repairs and maintenance vs. capital improvements; these regulations apply to leased property as well..

The temporary regulations did not change the rule that a taxpayer can amortize the cost to acquire leasehold (not a leasehold improvement) over the term of the lease.

What the temporary regulations did clarify (which has been the rule since 1986) is that a taxpayer must amortize leasehold improvements under the cost recovery provisions of the Internal Revenue Code applicable to the improvements without regard to the term of the lease.

Therefore, if you make an improvement to your leased property and you have a 5-year lease, you must amortize the improvement over 15, 27.5 or 39 years, depending on what life is stated in the Code at the time. As we know from recent history, the IRS has changed lives for amortizing leasehold improvements several times from 39 years for commercial property and 27.5 years for residential property to 15 years.

The following are some very important and significant changes the IRS made to leased property improvements.

A lessee improvement involves the acquisition or production of a new and distinct interest in property, and this interest is often different from the underlying leased property. This means that the improvement is a new unit of property separate and distinguishable from the leased property being improved, rather than an improvement to the building.

In the case of a lessee, the unit of property is the portion of the building leased (such as office, floor or certain square footage). For example:

Lessee rents one floor in an office building that houses one HVAC system. After 2 years in the space, the lessee needs to replace the compressor to the HVAC system. Since the HVAC system for lessee's space is a unit of property and since the compressor is a major component to the HVAC system, the lessee must capitalize the costs of the new compressor.

What about the lessor? A lessor must capitalize all amounts paid directly or indirectly through a construction allowance to the lessee to improve a unit of leased property where the lessor is the owner of the improvement for tax purposes. In addition, a lessor must capitalize all amounts paid by the lessee to improve a unit of leased property where the lessee's improvement constitutes a substitute for rent. This requirement merits special attention when writing your leases.

A lessor improvement, however, is treated as any other owner improvement and therefore is not a new unit of property. In the hands of the lessor, the unit of property is the building and its building systems.

By Marc Wieder, CPA Anchin, Block and Anchin LLP
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Author:Wieder, Marc
Publication:Real Estate Weekly
Date:Oct 16, 2013
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