The new tangible property regulations present the opportunity to expense tenant improvements if the expenditures are not required to be capitalized under the restoration, adaptation, betterment, or improvement (“R.A.B.I.”) tests. When applying these rules for our commercial property / apartment building owners, we often identify current tax deductions that exceed $100,000. In some cases, especially with large commercial / apartment buildings, the deduction can be significantly higher.
The final regulations have created guidelines for income tax treatment of tangible property expenditures and are effective for tax years beginning on or after January 1, 2014. These new regulations provide guidance on the capitalization and depreciation of capital expenditures, the treatment of materials and supplies, and expanded opportunities to write off partial asset dispositions.
There are specific rules relating to improvements made to leased property. In general, the “R.A.B.I.” test is applied to the expenditures for tenant improvements against the “Unit of Property,” i.e., the building. If the expenditures do not meet any of the “R.A.B.I.” criteria, it is treated as a currently deductible repair expense. For real estate, each building and its structural components is a single unit of property. Building systems such as HVAC, plumbing, electrical, fire protection/alarm, security, gas distribution systems; elevators/escalators; and other systems identified in published IRS guidance are separate units of property and the “R.A.B.I.” rules must be applied separately.
If you, as a landlord, make tenant improvements (TI) for a new tenant or an existing tenant, the TI's may be currently deductible because the expenditures are compared against the building (unit of property). For example, if your commercial building has 15 floors and you make TI's for one of the floors for a new tenant, those costs may be currently deductible. Or, if you own a 35 unit apartment complex and make TI's to 6 units after tenant turnovers, those costs may be currently deductible. Additionally, you may have TI expenditures incurred in prior years that would have been deductible if the final regulations were applied to those costs. There is an opportunity to claim those deductions retroactively if you properly file for a change in accounting method (Form 3115) on your 2014 tax return. Note that TI's that are put into a space for the first time do not qualify; and construction allowances under section 110 and T'Is that are substitutes for rent do not qualify.
It is important to note that these final regulations are effective for tax years beginning January 1, 2014 and the opportunity to claim prior year deductions is available on the 2014 tax return only.
This would be beneficial to many taxpayers as the repair deduction would generate tax benefits at ordinary rates while the future gain from sale would be taxed at capital gains rates with less recapture. Not all TI's will qualify to be expensed so we recommend that you discuss this opportunity with your tax advisor.
Additional articles explaining the new filing requirements and the need for Accounting Method Change requests include:
Tangible Property Regulations - New Filing Requirements for Tax Year 2014
Tangible Property Regulations - Is Form 3115 Required?
Your BPM advisor has the resources to assist you in determining how this regulation will affect your business and could result in significant tax savings.