With contributions from Marcus Atherly.
The federal tax code provides significant tax benefits for lessees who improve their leased business property — bonus depreciation, expensing under Section 179, and a shorter depreciable life, for example.
To qualify, the improvements must satisfy requirements established in the federal tax code. If your improvements qualify, the tax benefits can help you to recover your costs more quickly.
To understand the potential benefits for leasehold improvements and their relevance to your situation, it’s important to first understand a few key tax-related concepts.
Section 1250 and Section 1245 Property
As a general rule, if an improvement is attached to the structure of the building in some way, it is considered real property under Section 1250 of the Internal Revenue Code (IRC).
Movable property, such as furniture and equipment, is personal property under Section 1245 of the Code.
Leasehold improvements are enhancements to a leased space that are paid for by a tenant. For example, an interior improvement such as the addition of built-in cabinetry, electrical additions or carpeting.
Qualified Leasehold Improvements (QLHI)
Leasehold improvements are considered qualified if they satisfy all of the following:
are IRC Section 1250 real property
were made by the lessee, not the building owner
were made to an area used exclusively by the lessee
were made to a building in service more than three years
building owner and lessee are not the same or related parties.
There are special rules for qualified leasehold improvement property that is also restaurant or retail property.
Qualified restaurant property is Section 1250 property with more than 50 percent of the building’s square footage devoted to meal preparation or seating for on-site consumption of prepared meals.
Qualified retail property is Section 1250 property that is open to the public and primarily in the business of selling goods (tangible personal property, not services) to the general public.
Qualified Improvement Property (QIP)
Created by the PATH Act of 2015, qualified improvement property refers to an improvement to leased nonresidential real property that is placed in service after the building was placed in service.
Similar to qualified leasehold improvements, QIP must meet many of the same requirements. However there are key differences, including the following:
There is no QIP requirement that the building must have been placed in service at least three years prior to the expenditure
The QIP improvements can be made to common areas and are therefore not restricted to areas exclusively used by the lessee.
QIP specifically excludes such things as enlargements to a building and elevators/escalators.
Qualified improvement property can also be considered qualified leasehold improvements if they meet all of the requirements.
Tax Benefits to Lessees Improving Leased Property
The primary federal tax benefits for lessees who improve qualifying business property include bonus depreciation, expensing under Section 179, and a shorter depreciable life.
|Type of Property||Straight Line Recovery Period||Eligible for Section 179||Eligible for Bonus Depreciation|
|Qualified Leasehold Improvements Property||15||Yes||Yes|
|Qualified Improvement Property||39||No*||Yes|
|Qualified Restaurant Property||15||Yes||Yes|
|Qualified Retail Property||15||Yes||No**|
|Qualified Restaurant or Retail + QIP||15||Yes||Yes|
|* Unless the property also qualifies as qualified leasehold improvement, qualified retail improvement or qualified restaurant improvement property|
|**Unless the improvement also qualifies as qualified leasehold improvement property|
Depreciable Life / Straight Line Recovery Period
Qualified leasehold improvements have a depreciable life of 15 years. This 15-year life can provide a significant tax benefit as Section 1250 property is typically depreciable over a 39-year period.
Qualified improvement property must be depreciated over a 39-year life.
Expensing under Section 179
You can generally expense qualified leasehold improvements up to $500,000 (adjusted annually for inflation) under Section 179, as opposed to depreciating them.
However, Section 179 begins to phase out when you place in service assets valued in excess of $2,000,000 in a single tax year. Currently, all qualified leasehold improvements are included in this phase-out calculation, which could eliminate Section 179 eligibility depending on the value of the assets your business places in service in a year.
Qualified improvement property cannot be expensed under Section 179 unless the property also qualifies as qualified leasehold improvement, qualified retail improvement or qualified restaurant improvement property.
Bonus depreciation provides a deduction equal to a percentage of the adjusted basis of qualifying property the first year it is placed in service. Bonus depreciation deductions phase out after 2019.
The applicable percentage through 2019 is as follows:
|2015 – 2017||50|
For federal tax purposes, qualified improvement property and qualified leasehold improvement property can accelerate substantial depreciation deductions relative to non-qualifying property.
The following table compares the potential tax benefits of each type of property over a ten-year period, assuming an investment of $1 million. There is a $372,315 accelerated tax benefit for QIP relative to non-qualifying property and a $663,430 benefit for QLHI.
|Year 1||Years 2 – 10||10 Years Cumulative|
|Qualified Restaurant Property**||$1,000,000||$762,500||$156,300||$918,800|
|Qualified Retail Property***||$1,000,000||$525,000||$312,600||$837,600|
|Qualified Restaurant/Retail QIP**||$1,000,000||$762,500||$156,300||$918,800|
|* All examples assume a 1/1/2016 placed in service date. Bonus depreciation of 50% is available through the end of 2017. In 2018, it is reduced to 40%, and in 2019 it is reduced to 30%. After 2019, bonus depreciation will not be available absent additional tax reform.|
|**Assumes no other Section 179-eligible property|
|***Assumes property does not also qualify as QLHI|
Wondering how changes to the rules for qualified leasehold improvement properties affect your taxes?
Give us a call for tax advice. We can help.