Eli Loebenberg, Madison SPECS, LLCA key component of any commercial lease agreement is the tenant improvements and allowances which are provided by the landlord. The landlord usually provides customized alterations to a rental space in order to configure the space for the needs of that particular tenant. The costs of building out or retrofitting a space for a tenant are considered property improvements which may be eligible for shorter life treatment. The costs incurred while constructing, acquiring or remodeling real estate assets can be offset with a valuable tax deferral strategy- the cost segregation study.
A cost segregation study is a specialized tax and engineering analysis that allows owners to reclassify their real property expenditures, thereby accelerating their depreciation deductions. It is also possible for landlords to recover missed depreciation deductions from prior years. This reduction in tax liability can produce an increased cash flow.
How to Classify Expenditures?
The tax code determines how to break down the costs related to repairs or capital improvements. The IRS regulations require businesses to segregate their real property building costs into eight defined building systems. When the taxpayer is determining whether eligible improvements were made, the building structure and each building system can be analyzed as separate structural assets. Expenditures relating to each building system are evaluated both as repairs or improvements with respect to that particular system as well as with respect to the entire building as a whole.
The building is evaluated and broken out into units of property (UOP) according to eight enumerated building systems:
• HVAC systems, including motors, compressors, boilers, furnace, chillers, pipes, ducts and radiators.
• Plumbing systems, including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment and site utility equipment.
• Electrical Systems, including wiring, outlets, junction boxes, lighting fixtures and associated connectors.
• Escalators.
• Elevators.
• Fire protections systems, including sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and firefighting equipment.
• Security systems, window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, and entry and access systems.
• Gas distribution systems.
Betterment, Restoration and Adaptation
Recent IRS Regulations expand the definition of capitalization of structural property costs. The amount paid can be considered an improvement if it is made to either the building structure or one of the building systems. An improvement to a unit of property is amounts paid which result in the betterment of the property, restoration of the property, or adaption of the property to a new or different use.
Betterment of a unit of property is amending a material condition or defect that existed prior to the acquisition, expanding or extending the unit of property, or increasing the productivity and strength of the unit of property. For example, the owner of a retail building adds a stairway and loft to increase its selling space. The costs to build the stairway and loft are considered an improvement because they increase the capacity of the building structure.
Restoration of a unit of property is restoring it from a deteriorated state, rebuilding it to a like-new condition after the end of its class life or replacing a major component.
For example, the owner of a farm has several out-buildings which were not used on a regular basis and fell into a state of disrepair. The owner restores the out-buildings by shoring the walls and replacing siding, making it fully functional.
Adaptation of a unit of property is altering it to a new and different use which differs from the original use at the time the taxpayer originally placed it in service. For example, the owner of a manufacturing building modifies the building structure and systems to convert it into a showroom.
This framework for capitalization requires a detailed analysis of a taxpayer’s facts and circumstances. A thorough cost segregation study can help landlords take full advantage of these tax savings.
Eli Loebenberg, CPA, is the CEO of Madison SPECS, Lakewood, N.J.
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