Leashold Depreciation Hampers Real Estate Professionals

It is common in the commercial real estate marketplace that owners modify their leased space with up-to-date accommodations to satisfy the ever-changing business needs of their tenants. These tenant improvements are critical to businesses so that they are equipped to meet their productivity and efficiency objectives. The issue of leasehold improvements, and the manner in which they have been unfairly treated under the national tax code, is a significant point of frustration for real estate professionals and an obstruction to the industry's economic recovery.

The enactment of the Accelerated Cost Recovery System, as part of the Economic Recovery Tax Act of 1981, created the first provision regulating the method of structural depreciation. It stated that structural components of a building must be recovered over the same period that applies to the building of which the components are a part. Tax law provided a 39-year recovery period for nonresidential property, and ACRS regulations dictated that owners place their TIs on the recovery schedule of the building. Since the tenant's lease will often terminate well before the end of the 39-year recovery period, property owners found it unreasonable that they were not lawfully allowed to deduct the remaining unrecovered basis in leasehold improvements. As a result, rental income generated by the improvements, and the corresponding tax recovery of those expenses incurred to generate that income, were mismatched forcing the owner to carry an unjustified tax burden.

This burden caused a higher capital cost for leasehold improvements that tended to hamper investment in tenant-occupied spaces. Small businesses took the majority of the burden due to their dynamic growth rate and their necessity to renovate their space to coincide with their growth needs.

After several years of lobbying on Capitol Hill, and copious amounts of campaign contributions to lawmakers from real estate firms, the office-building industry reaped its first advocacy victory when Congress enacted the Small Business Job Protection Act of 1996. This legislation allowed owners to deduct the unrecovered basis in leasehold improvements provided that they dispose of or abandon the improvements once the tenant's lease is terminated. Although this was seen as a positive step, this legislation was not the comprehensive solution property owners had hoped for. While taxpayers could now write off an improvement after it goes out of service, the tax code did not address the improvements still in service since taxpayers may only deduct 1/39th of the improvement value per tax year. Limiting leasehold improvements to be depreciated over a 39-year recovery period runs counter to the reality of the marketplace, since leasehold improvements generally have an economic life substantially shorter than 39 years.

Although Congress lessened the problem for property owners when it modernized the tax code to allow owners to recover the remaining basis in leasehold improvements, many estate real estate professionals found they were still being treated unfairly by maintaining leasehold improvements on the 39-year recovery period. When President Bush signed the Corporate Tax Bill of 2004, the industry claimed another victory for their considerable advocacy efforts. The bill allowed property owners to depreciate leasehold improvements on a 15-year schedule, at least through 2005, before the provision expires. If the provision is not extended before the end of this year, leasehold improvements will fall back to the 39-year depreciation rate.

This new provision, broadly supported by the real estate industry, alleviates the growth-hampering effect that the 39-year depreciation schedule has had on the industry's productivity and is a model of good tax policy. Its effects will motivate leasing activity and will allow for renovations to leased space, generating efficient and productive business environments.

BOMA and our commercial real estate allies have initiated efforts to make the provision a permanent part of the tax code. In March, Senator Kent Conrad (D-N.D.) introduced a leasehold depreciation bill (S. 621) in the Senate that would permanently extend the reduced depreciation period of 15 years. Real estate supporters expect to have a companion bill introduced in the House soon.

Permanently including the 15-year depreciation provision into the tax code, or at least a long term extension, is essential for commercial real estate to remain a catalyst for America 's economic recovery.