REPLACEMENT TENANT IMPROVEMENTS & THE TPR’S
The enactment of the Tangible Property Regulations (“TPR”) has confused many taxpayers on how to deal with tenant improvements. The most common area of confusion is whether tenant improvements may be expensed as repairs. Though the TPR provide substantial opportunities to write off tenant improvements as repairs or maintenance, there are many traps for the unwary. The primary pitfalls are: 1) the 1245 trap; 2) the betterment trap; and, 3) the disposition trap. Taxpayers can avoid these traps by engaging experienced tax practitioners and cost segregation consultants to help navigate the Tangible Property Regulations.
Tenant Improvements: The Starting Point
“Tenant improvements” are not a tax concept. Both lessors and lessees can own improvements to a leased property. Though itself a complex topic, this is not the primary area of confusion. The confusion lies with the treatment of lessor improvements.
Under the TPR, lessors must capitalize the related amounts it pays to improve a leased Unit of Property (“UoP”). These payments may be direct or indirect using a construction allowance. Lessors must also capitalize the related amounts paid by the lessee to improve a leased UoP as a substitute for rent. Once taxpayers work through these issues to determine whether the lessor owns the improvement, taxpayers can analyze the related costs under the ten improvement tests. These tests are:
- Betterments- An expenditure is paid for a betterment if it:
- Ameliorates a material condition or defect that existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property (whether or not the taxpayer was aware of the defect at the time of acquisition or production);
- Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component to the unit of property, or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or
- Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.
- Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165-7);
- Is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component
- Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under § 165;
- Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
- Results in the rebuilding of the unit of property to a like new condition after the end of its class life; or
- Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.
- A taxpayer must capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer.
While applying these tests to possible improvement costs, taxpayers should be aware of several traps.
The 1245 Trap
Taxpayers may be familiar with classifying building components as section 1250 (long life) or section 1245 (short-life) assets as part of a cost segregation study. These classifications are based on the former Investment Tax Credit regulations found in section 1.48-1. This regulation also defines the building UoP as section 1250 building property. The problem is that many taxpayers only record a single asset on their books for each tenant suite buildout without breaking down the costs into section 1245 and section 1250 property. Identifying property as section 1245 or section 1250 is not elective. Many common improvements, (such as carpeting, demountable partitions, window treatments, or cabinetry), are section 1245 property, the replacement of which must be treated as a new asset acquisition. This is in contrast to the replacement of section 1250 property, which may often be deducted as a repair. On audit, the Service may force taxpayers to capitalize replacement section 1245 assets instead of expensing each tenant buildout as a repair. Further reading: Regulation section 1.263(a)-3(j) (3), Examples 5-8 and 22 provides examples of common section 1245 assets
The Betterment Trap
In general, taxpayers focus on the restoration rules when analyzing whether lessor improvements must be capitalized. Though this is usually the correct approach, taxpayers should not neglect the possibility that some costs are attributable to betterments, especially material additions under Test 2.
This test provides that a material addition includes a physical enlargement, expansion, extension, or addition of a major component to the unit of property. These tests apply at the level of the major component of the UoP. A major component is a part, or combination of parts, that perform a discrete and critical function in the operation of the UoP. For buildings, a major component can also include a significant portion of a major component. As the examples are currently written, the Service may consider routine tenant buildouts as betterments, such as adding or removing and rebuilding partitions. Further reading: Regulation section 1.263(a)-3(j)(3), Examples 8 and 22.
The Disposition Trap
For MACRS disposition purposes, improvements and additions placed in service after the underlying asset was placed in service are separate assets. For example, a taxpayer constructs and places into service an office building. As each tenant leases its space, the taxpayer builds out that space for that tenant. Since each suite is generally placed into service after the initial building, the assets of each buildout will be considered separate assets from the underlying building. This means that, instead of an elective partial disposition, taxpayers will often be faced with the mandatory disposition of an entire asset when the buildout is replaced. Since each lessor improvement generally is not a separate UoP from the underlying building, the taxpayer will be required to capitalize the replacement UoP components as a restoration under test 4. This forces taxpayers onto a path where each tenant buildout is always a restoration.
It is worth noting that this same trap may or may not apply to acquired properties, depending on the facts and circumstances. If an entire building is acquired and placed into service with all tenant suites fully occupied and finished out, the existing tenant improvements and building will constitute a single UoP of 1250 building property and a single asset for disposition purposes. The building will not fall into the disposition trap initially. Due to the 1245 trap and the betterment trap, later tenant buildouts may be improvements for repair purposes, which would put the taxpayer back into the disposition trap.
Further reading: Regulation sections 1.168(i)-8(c)(4)(ii)(D) and 1.263(a)-3(k)(7), Examples 1 and 24.