Can expenditures to refresh tenant improvements (TIs) be deducted by building owners? Your first reaction is probably “Of course not, TIs have to be capitalized.” But under the final tangible property regulations (commonly referred to as the R&M regulations) the answer is not as straightforward as you might think. In the right circumstances, landlords may be able to deduct certain costs to refresh leased space for existing tenants, or turn over floors for new tenants. The answer depends on the nature and extent of the work, the size of the building, and the impact of the disposition rules included in the final regulations.
R&M rules for tenant improvements
An expenditure that results in an improvement to a unit of property must be capitalized. Generally, a building and its structural components—not an individual tenant space—is the unit of property. A TI refresh project must be capitalized if the work results in a material increase in the efficiency or quality of the building (a betterment), the replacement of a major component or substantial structural part of the building (a restoration), or a change in use of the building from its original intent (an adaptation).
As noted above, under the R&M rules a building, its structural components, and the tenant improvements are all part of the same unit of property. Therefore, to determine if the costs to refresh or renovate TIs must be capitalized, the taxpayer must analyze if the nature and extent of the work results in an improvement to the building as a whole (not just to the specific tenant space).
Disposition rules for tenant improvements
When a landlord physically abandons or completely destroys a TI at the end of a lease, the general rule is that a loss (equal to the adjusted basis at the time of the disposal) must be recognized in the year of the disposal. However, if a landlord renovates or replaces less than 100 percent of an existing TI, loss recognition is optional. Under the partial disposition rule, the taxpayer can elect to write off the remaining adjusted basis of the disposed portion of the TI, or continue to depreciate the remaining basis over the original recovery period. This flexibility can be very beneficial for landlords in certain situations.
Caution! There may be a point where a partial disposition of a TI will be viewed by the IRS as crossing the line to a complete disposition. For example, assume a taxpayer demolishes 95 percent of an existing TI but leaves a few non-structural partitions in place. Technically, the original TI has not been completely disposed, so the taxpayer is not required to write off the remaining basis of the original improvement. But for all practical purposes, the IRS may argue that the TI has been completely disposed and force the taxpayer to write off the remaining basis, thus precluding a deduction for repairs to the leased space.
As we go to press, the IRS currently is studying the interaction of the R&M rules and the disposition rules to tenant turnover situations in the real estate industry. We would not be surprised to see additional guidance on this issue in the coming months.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
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