How to maximize deductions
When your business rents space, you’ll probably have to prepare that space for your use. It might need new carpeting or lighting, for example. More extensive outlays may be necessary for new walls, upgraded restrooms, etc.
Loophole: Knowing the rules can help you deduct your expenses rapidly.
Trap: Missteps in this area can result in your company picking up unwelcome taxable income or having deductions spread out over decades.
INCOME AND ALLOWANCE
- Income from improvements. In some cases, landlords will provide “building standard improvements” for their tenants. A landlord might classify these outlays as costs of acquiring a tenant.
Trap: Deals may be set up so that the improvements are owned by your company, the tenant. While the landlord will amortize the costs of your improvements over the lease term, you will have to recognize taxable income up front and depreciate the improvements over a period of 39 years.
For you, this is the worst possible tax result.
Strategy: When you are negotiating a lease, be sure that your company is not the owner of any improvements paid for by the landlord. This is typically done in a lease clause saying that all real property improvement belongs to the landlord.
- Adapting the allowance. Rather than pay for improvements, your landlord may provide an allowance—cash up front to be used for improvements.
Trap: This allowance may be considered taxable income to your company.
Strategy: Again, negotiate the lease so that the improvements are owned by the landlord. The allowance won’t be taxable income to you, and when you spend the money, it is for landlord-owned improvements.
Loophole: The Tax Code includes a provision to assure “retail” tenants that an allowance from a landlord will not be taxable. For this purpose, retail space is so broadly defined that professional offices, such as those used by a CPA or an attorney, can qualify.
Required: The lease must be for 15 years or less.
With this 15-years-or-less lease term, any rent concessions or cash allowances used to pay for improvements can be excluded from the tenant’s income. That will be the case up to the amount that your company actually pays for improvements in its tax year.
Example: Your company takes retail space this year on a 15-year lease and spends $20,000 on improvements. If you received an allowance up to $20,000, you won’t have taxable income from it. However, if the allowance you received was $25,000, your company would pick up $5,000 in taxable income for the tax year.
Tax treatment: Assuming that you qualify for the retail exception, the cost of the improvements will be depreciated by the landlord.
Both the tenant and the landlord must attach a statement to their income tax returns for the years involved. Each statement must include the name, address, and tax identification number of both the landlord and the tenant, the amount of the allowance, the amount of the allowance that is qualified (meaning actually spent on improvements), and the property’s location. Note: The lease should stipulate that the landlord will do all required filing.
SPEEDY RECOVERY
In some cases, your company will spend its own money on improvements, over and above any landlord outlays and allowances.
General rule: Your company must depreciate such leasehold nonresidential commercial real estate improvements over 39 years, under the rules for real estate.
Loophole: Some leasehold improvements that were completed before 2008 qualify for a special favorable 15-year depreciation period. The sooner you get the tax savings from depreciation deductions, the more valuable they will be.
Required: To get the 15-year schedule, improvements must have been made to the interior of a nonresidential building. They must have been made by an unrelated (by family or business) landlord or tenant who has signed a lease and is using the space. The building had to first be used by tenants at least three years before the improvement.
Costs to enlarge a building for an elevator or for a structural component, such as ceilings, beams, walls, and roofs, don’t qualify.
Note: Starting in 2008, you may qualify for bonus depreciation for leasehold improvements.
Strategy: No matter when they were completed, some tenant improvements may be depreciated more rapidly than 39 years.
Some items you install, for example, may be depreciated over five or seven years.
Required: To qualify for rapid write-offs, money must be spent on components that are tangible, personal (as opposed to real property), movable—and not part of the base building.
Exception: Components that pass the above tests but that are related to the operation and maintenance of the building—such as doors—must use 39-year depreciation.
Examples: Nonstructural components and personal property that can qualify for five- and seven-year recovery include movable partitions, removable air-conditioning, phone equipment and wiring, kitchen piping, plumbing fittings, removable carpets, signs and ornamentation, furniture, and equipment.
If your accounting firm can’t produce a detailed component depreciation analysis for your improvements, it probably can refer you to a consulting firm that can prepare one.
FIVE- OR SEVEN-YEAR DEPRECIATION
As mentioned, some leasehold improvements qualify for five- or seven-year depreciation.
Loophole: In many cases, you won’t even have to spread deductions over five or seven years. Instead, outlays for these improvements can provide a first-year write-off.
Limits: In 2008, the maximum amount of property a business can “expense” (deduct in the first year of use) is $250,000. This deduction is reduced, dollar for dollar, for expenditures over $800,000.
Example: Including improvements to leasehold property, your company spends $850,000 this year on equipment. That’s $50,000 over the $800,000 threshold.
Therefore, only $200,000 can be written off in 2008 ($250,000 minus $50,000).
The other $650,000 of equipment purchased ($850,000 minus $200,000) must be depreciated on the appropriate multiyear schedule.
Trap: The amount that you can deduct is limited to the purchaser’s taxable income for the year, before the expensing deduction.
Therefore, if you run your business as a C corporation and “zero out” corporate income by paying bonuses to owner-employees, no expensing deduction will be allowed.
Strategy: Before paying yourself a taxable bonus, leave enough income in the company to be offset by the expensing deduction.
Note: Under the new “stimulus package,” a company can depreciate an additional 50% of the cost of an asset bought in 2008, in addition to the 100% expensing deduction described above.
