Are you looking to do tenant improvments (TIs) to your building? Are you aware that the Tangible Property Regulations (TPRs), i.e. repair regulations, are to your benefit as a building owner? There are specific guidelines to help building owners save money on their taxes when it comes to TIs. Many times we see that owners have capitalized items that could have been expensed. Not only is that the incorrect way to account for some items, the IRS doesn’t want you to do it that way and it’s costing you quite a bit in lost tax savings.
The words lessee and lessor in §1.162 and §1.263(a) (Tangible Property Regulations) are mentioned over 200 times. The TPRs are a dramatic change for landlord and tenants regarding the capitalization or expense deduction of tenant improvements.
There are two critical general rules under §1.263(a) for leased property and improvements.
The first general rule is that an improvement to a unit of property is NOT a separate unit of property from the building. The second general rule is if the landlord’s expenditure is NOT a restoration, adaptation, betterment, or improvement (RABI), then it is repair and maintenance.
The unit of property for a taxpayer who is the lessee of an entire building is each separate building, its structural components, and building systems.
If the lessee leases only a portion of a building (such as an office, entire floor, or specified square footage), the portion of each building and the building systems associated with ONLY the leased portion is the unit of property. If the lessee pays for the tenant improvements, the lessee must generally capitalize the related amounts, which it pays to improve the tenant space. The only exception is if §110 applies. §110 is a construction allowance received by the lessee for the sole purpose of the improvement or when the improvement constitutes a substitute for rent.
In other words, tenants who do not lease the entire building and pay for their tenant improvements have their separate unit of property, and those improvements must be capitalized under the UNICAP rules §263A.
If the landlord pays for the tenant improvements, they must be put through the RABI rules (restoration, adaptation, betterment or improvement) to determine if the tenant improvements are a repair and maintenance item or if they must be capitalized. Generally, an amount capitalized as a tenant improvement is not a separate unit of property from the building. If the landlord’s tenant improvements are not a separate unit of property from the building, the landlord can compare the expenditure against the whole building, building structures, and building systems. The result will be that most landlord tenant improvements, (beyond the initial tenant improvements capitalized for each space), will be classified as a repair and maintenance expense.
Example
The landlord owns and operates two buildings. One is a 4-story office building of 40,000 square feet with the first floor consisting of retail space. The other building is a stand-alone 10,000-square-foot retail building. The landlord has two new tenants move in 2022. Tenant A leases the first floor of the 4-story building. Tenant B leases the stand-alone building. The landlord already had prior tenants in those spaces and has tenant improvements on its books for both of those building spaces. The landlord tears out the previous tenant improvements and does extensive new tenant improvements for both tenants.
Conclusion
The landlord can expense the tenant improvements for Tenant A in the office building but must capitalize the tenant improvements for Tenant B. The reason he can expense the TIs for the office building is that the space being renovated consists of only 25% of the building. The Tangible Property Regulations allow that if you are improving less than 30-35% of the building that those costs might be able to be expensed instead of capitalized. However, we will often see that owners have indeed capitalized such items.
Regarding Tenant B, the landlord must capitalize those improvements because because it’s 100% of the property. However, they can do a partial asset disposition (PAD) and get a significant tax deduction for the removal of those previous tenant improvements that had been in the building. PADs must be completed in the tax year in which the work (improvement / renovation) was done.
So what’s the difference between these two buildings? The landlord replaced a large physical portion of the stand-alone building that B occupied but only improved 25% of the building that tenant A was to occupy.
If you are a building owner and you are doing tenant improvements, reach out to consult with me at no charge. We can discuss your situation and see if it makes sense to expense or capitalize your improvements and whether or not it might qualify for a partial asset disposition.
The original article appeared on CSSI’s website and has been updated here at Cost Seg Building.