The American Jobs Creation Act was signed into law by President Bush on October 22, 2004. Among the provisions in the bill is one that allows commercial property owners to depreciate certain leasehold improvements completed for tenants over 15 years rather than the current 39 years. Only improvements placed in service or use after October 22, 2004 and before January 1, 2006 qualify for the accelerated depreciation allowance. The tax savings a landlord could enjoy by moving tenants in prior to January 1, 2006 could be significant.
Assume a landlord and tenant enter into a lease the term of which will commence January 1, 2005. Assume that the landlord and tenant agree that the landlord will construct $250,000 worth of improvements to the leased premises. If the landlord completes construction of the improvements and the tenant moves in by January 1, 2005, the landlord will be entitled to 11.5 months of depreciation in 2005 (under a “mid-month convention,” the depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, and property placed in service at any time during a month is treated as having been placed in service in the middle of the month). Under the new tax law, the landlord will be entitled to a depreciation deduction of $15,972.22 in 2005 and a depreciation deduction of $16,666.66 thereafter ($250,000 divided by 15 years). Under the old tax law (which will revive on January 1, 2006), the landlord would be entitled to a depreciation deduction of only $6,143.16 in 2005 and a depreciation deduction of $6,410.25 thereafter ($250,000 divided by 39 years).
There are some caveats. Among the caveats are: (1) the building in which the tenant is leasing space must have been place in use for more than 3 years; (2) only those portions of the improvements that do not affect the internal structural framework of the building and do not benefit a common area qualify for the accelerated depreciation allowance; (3) the improvements must remain the property of the landlord at the end of the lease term; and (4) for restaurant properties, no improvements will qualify for the accelerated depreciation allowance unless more than 50% of the building’s square footage is devoted to the preparation, seating and consumption of prepared meals.
The text of the accelerated depreciation allowance provisions appears below. You can find a full explanation of the provisions on pages 24 through 26 of the “Joint Explanatory Statement of the Committee of the Conference” (i.e., the U.S. House and Senate Conference Committee Report).
“SEC. 211. RECOVERY PERIOD FOR DEPRECIATION OF CERTAIN LEASEHOLD IMPROVEMENTS AND RESTAURANT PROPERTY.
(a) 15-YEAR RECOVERY PERIOD- Subparagraph (E) of section 168(e)(3) (relating to classification of certain property) is amended by striking `and’ at the end of clause (ii), by striking the period at the end of clause (iii) and inserting a comma, and by adding at the end the following new clauses:
`(iv) any qualified leasehold improvement property placed in service before January 1, 2006, and
`(v) any qualified restaurant property placed in service before January 1, 2006.’.
(b) QUALIFIED LEASEHOLD IMPROVEMENT PROPERTY- Subsection (e) of section 168 is amended by adding at the end the following new paragraph:
`(6) QUALIFIED LEASEHOLD IMPROVEMENT PROPERTY- The term `qualified leasehold improvement property’ has the meaning given such term in section 168(k)(3) except that the following special rules shall apply:
`(A) IMPROVEMENTS MADE BY LESSOR- In the case of an improvement made by the person who was the lessor of such improvement when such improvement was placed in service, such improvement shall be qualified leasehold improvement property (if at all) only so long as such improvement is held by such person.
`(B) EXCEPTION FOR CHANGES IN FORM OF BUSINESS- Property shall not cease to be qualified leasehold improvement property under subparagraph (A) by reason of–
`(ii) a transaction to which section 381(a) applies,
`(iii) a mere change in the form of conducting the trade or business so long as the property is retained in such trade or business as qualified leasehold improvement property and the taxpayer retains a substantial interest in such trade or business,
`(iv) the acquisition of such property in an exchange described in section 1031, 1033, or 1038 to the extent that the basis of such property includes an amount representing the adjusted basis of other property owned by the taxpayer or a related person, or
`(v) the acquisition of such property by the taxpayer in a transaction described in section 332, 351, 361, 721, or 731 (or the acquisition of such property by the taxpayer from the transferee or acquiring corporation in a transaction described in such section), to the extent that the basis of the property in the hands of the taxpayer is determined by reference to its basis in the hands of the transferor or distributor.’.
(c) QUALIFIED RESTAURANT PROPERTY- Subsection (e) of section 168 (as amended by subsection (b)) is further amended by adding at the end the following new paragraph:
`(7) QUALIFIED RESTAURANT PROPERTY- The term `qualified restaurant property’ means any section 1250 property which is an improvement to a building if–
`(A) such improvement is placed in service more than 3 years after the date such building was first placed in service, and
`(B) more than 50 percent of the building’s square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals.’.
(d) REQUIREMENT TO USE STRAIGHT LINE METHOD-
(1) Paragraph (3) of section 168(b) is amended by adding at the end the following new subparagraphs:
`(G) Qualified leasehold improvement property described in subsection (e)(6).
`(H) Qualified restaurant property described in subsection (e)(7).’.
(2) Subparagraph (A) of section 168(b)(2) is amended by inserting before the comma `not referred to in paragraph (3)’.
(e) ALTERNATIVE SYSTEM- The table contained in section 168(g)(3)(B) is amended by adding at the end the following new items:
(f) EFFECTIVE DATE- The amendments made by this section shall apply to property placed in service after the date of the enactment of this Act.”
Kathleen A. Lauinger joined Withrow, McQuade & Olsen, LLP in August 2001, and practices primarily Corporate and Securities Law and Commercial Real Estate Law. She is a member of the American Bar Association, the State Bar of Georgia and the Georgia Association of Women Lawyers. Ms. Lauinger received her undergraduate degree in Philosophy (B.A.), summa cum laude, from the University of Notre Dame in 1998. Upon graduation, she was elected Phi Beta Kappa. She earned her law degree from the University of Virginia School of Law in May 2001, where she served on the editorial board of the Virginia Journal of Law & Politics.
NOTE: This site does not, and is not intended to, give legal advice. Reference should be made to full text of statutes and regulations for complete analysis. Consultation with competent counsel is strongly recommended.