Unit of Property Considerations for Landlord Tenant Improvements
There has been some misstated information circulating that landlord tenant improvements are a unit of property (U of P) separate from the building. That statement is wholly not true. It is a misinterpretation of the tangible property regulations (TPRs). A landlord tenant improvement (TI) that is required to be capitalized based upon the RABI (restoration, adaption, betterment, and/or improvement) rules is not a separate U of P than the building in which the TIs are done.
This conclusion is important in the measurement comparison application of the RABI criteria/rules. If the landlord TIs are not a U of P separate from the building in which the TIs are installed, the landlord has the ability to compare its TI expenditures against the whole building, building structures, and/or building systems. If that is the required RABI comparison, the result will be that most landlord TIs, beyond the initial TIs capitalized for each space, will be classified as a current year repair and maintenance expense. If, instead, the landlord owner has to account for its TI as separate U of Ps, all landlord TIs would be required to be capitalized. Therefore, the appropriate U of P issue for landlord TI is key for the proper application of the TPRs.
The responsive narratives after each regulation quotation of 1.263(a)-3 below provide the reasoning for the conclusion that landlord TIs are not a separate U of P, even if the TIs are capitalized in a difference class life, e.g. 15 years, than the building in which the TIs are made:
“1.263-3(e)(4) Improvements to property. An improvement to a unit of property generally is not a unit of property separate from the unit of property improved. For the unit of property for lessee improvements, see also paragraph (f)(2)(ii)) of this section.”
The general rule is that an improvement to a U of P is not a separate U of P. Also, note that the statement above uses the word “improvement.” If the landlord expenditure is not an “improvement”, but is, rather not a RABI (restoration, adaption, betterment, and/or improvement), then it is a R & M (repair and maintenance) in any case. Landlord TIs are subject to the same RABI rules as any other taxpayer improvement effort on a U of P.
“1.263(3)(e)(5) Additional rules—(i) Year placed in service. Notwithstanding the unit of property determination under paragraph (e)(3) of this section, a component (or a group of components) of a unit property must be treated as a separate unit of property if, at the time the unit of property is initially placed in service by the taxpayer, the taxpayer has properly treated the component as being within a different class of property under section 168(e) (MACRS classes) than the class of the unit of property of which the component is a part, or the taxpayer has properly depreciated the component using a different depreciation method than the depreciation method of the unit of property of which the component is a part.”
This regulation section may be where the idea was created that landlord TI, if required to be capitalized, are a separate U of P, if the TI capitalized are in the 15 year class life instead of the 39 year class life. Note that this rule, however, is trumped by the 1.263(a)-3(f) rules (see below) due to the statement in those 1.263(a)-3(f) rules that “this paragraph (f) provides the exclusive rules for determining whether amounts paid by a taxpayer are for an improvement to a leased property.”
“Regulations on Unit of Property for Leased Property from 1.263(a)-3(f):(f) Improvements to leased property—(1) In general. Except as provided in paragraph (h) of this section (safe harbor for small taxpayers) and under §1.263(a)-1(f) (de minimis safe harbor), this paragraph (f) provides the exclusive rules for determining whether amounts paid by a taxpayer are for an improvement to a leased property and must be capitalized.” [emphasis added by author]
Note the important phrase above… that “this paragraph (f) provides the exclusive rules for determining whether amounts paid by a taxpayer are for an improvement to a leased property.” As such, the rules in this section trump the rule from 1.263(a)-3(e) that a different class life provides for a different U of P for TI.
“1.263(a)-(3)(f) Lessor improvements—(i) Requirement to capitalize. A taxpayer lessor must capitalize the related amounts, as determined under paragraph (g)(3) of this section, that it pays directly, or indirectly through a construction allowance to the lessee, to improve, as defined in paragraph (d) of this section, a leased property when the lessor is the owner of the improvement or to the extent that section 110 applies to the construction allowance. A lessor must also capitalize the related amounts that the lessee pays to improve a leased property, as defined in paragraph (e) of this section, when the lessee’s improvement constitutes a substitute for rent.”
The words of 1.263(a)-3(f)(3)(i) paragraph, in reference to 1.263(a)-3(e) state that a landlord must capitalize expenditures it pays for TI if it meets the RABI rules. The next paragraph from 1.263(a)-3(f)(ii) talks about the landlord U of P rules.
“(ii) Unit of property for lessor improvements. In general, an amount capitalized as a lessor improvement under paragraph (f)(3)(i) of this section is not a unit of property separate from the unit of property improved. See paragraph (e)(4) of this section. However, if a lessor improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under paragraphs (e)(2)(i) and (e)(2)(ii) of this section.”
Let’s also double check the regulation references quoted in this 1.263(a)-3(f)(ii) paragraph: (a) 1.263(a)-3(f)(3)(i) states that a landlord must capitalize amounts paid “to improve as defined in paragraph [1.263(a)-3](d), which again are the RABI rules, so supports these statements, and (b) paragraph 1.263(a)-3(e)(4) states “(4) Improvements to property. An improvement to a unit of property generally is not a unit of property separate from the unit of property improved.” Therefore, these other regulation sections also support the conclusion that a TI is not a U of P separate from the U of P improved if the expenditure is a required capitalized item based on the RABI rules.
The TPRs present a new opportunity/requirement to write off the net remaining tax basis of duplicate previously capitalized TIs as a current year 481(a) adjustment, in a proper IRS Form 3115 filing. If the landlord taxpayer misses this opportunity or misinterprets the TPRs in the application of the TPRs, the taxpayer faces the real risk that large future depreciation deductions for these TIs will be permanently disallowed by the IRS.
Copyright© 2015, Eric Wallace, LLC