Commercial build-out costs represent a significant investment. However, within those investments lie opportunities for substantial tax savings. Understanding the nuances of the tax code, specifically regarding depreciation, energy-efficient building incentives and cost segregation, can unlock these savings and enhance your bottom line.
This article will delve into the strategic tax planning opportunities associated with commercial build-outs. By the end, you'll have a clear understanding of how to leverage these concepts to optimize the return on your investment.
Important Definitions
Before we dive into specific strategies, let’s outline some basic terminology. Tenant improvements (also called leaseholder improvements) are the customizations that you or your tenant make to your rental space to meet the tenant’s needs. Examples include:
- Constructing partitions or private offices
- Installing specialized equipment or fixtures
- Upgrading flooring, lighting or other finishes
Structural improvements, on the other hand, are changes made to the core building itself. Examples of these include:
- Roof replacements
- Major plumbing or HVAC upgrades
- Modifications to the building's foundation or exterior walls
The Role of Depreciation
The distinction between tenant and structural improvements directly impacts how they are treated for tax purposes—specifically, depreciation. Depreciation lets you spread the cost of an asset over its useful life, taking deductions each year. This distinction is especially important for landlords.
Most tenant improvements have a class life of 15 years whereas structural improvements have a class life of 39 years. This means that it takes well over twice as long to fully deduct the cost of structural improvements as it does for tenant improvements. But why is this?
As far as the IRS is concerned, the goal of depreciation is to accurately reflect the decreasing value of an asset. The types of assets that make up structural improvements typically last a long time. For example, you probably won’t have to replace your roof again for many decades. But tenant improvements are different. The assets that fall under this category, like carpeting, specialized fixtures and decorative lighting, will likely need to be replaced much sooner, and new tenants often prefer their own finishes to maintain the appeal and functionality of the space.
Optimizing Your Tax Benefits: Bonus Depreciation
Typically, you'd deduct the cost of tenant improvements over their 15-year class life. However, there's a powerful incentive for real estate investors called bonus depreciation that can accelerate these deductions. In the past, bonus depreciation allowed you to deduct the entire cost of qualified improvements (such as tenant improvements) in the first year they were placed in service. While the percentage offered by bonus depreciation has decreased in recent years, it remains a significant tax advantage.
Unlocking Further Savings With Cost Segregation
While bonus depreciation provides a substantial upfront deduction, the remaining improvement costs are still depreciated on the standard schedule. This is where cost segregation studies come in. A cost segregation study analyzes your property and identifies components that qualify for shorter depreciation periods (like five or seven years). By accelerating the depreciation of these components, you can unlock more tax savings even after taking advantage of bonus depreciation.
Bonus depreciation can sometimes make cost segregation unnecessary, but there are certainly cases where it’s still a good idea. As a general rule of thumb, you should consider cost segregation if the improvements made to your property cost $200,000 or more and if they are a mix of both structural items and interior build-outs.
The Value of Improvement Studies
Cost segregation studies that focus specifically on property improvements are often called improvement studies. To illustrate their value, let’s take a look at a common landlord-tenant scenario:
The Scenario
You own a strip mall and lease sections to various businesses under a triple net lease. One of your tenants, a restaurant, invests heavily in customizing their space with tenant improvements. After a few years, the restaurant closes, and per the lease agreement, the tenant improvements they made now become your property.
The Challenge
While you now own these valuable improvements, you may not have clear records of their original costs or know how to optimize their depreciation.
How an Improvement Study Helps
There are several ways that an improvement study can help solve this challenge:
- Focus on acquired improvements: An improvement study concentrates on analyzing tenant improvements that have transferred ownership to you.
- Establishing fair market value: The study determines the fair market value of the acquired improvements at the time of ownership transfer, establishing your depreciable basis.
- Asset classification: Each improvement is meticulously analyzed and classified into its appropriate depreciation category.
By accelerating the depreciation of eligible components, you could gain significant tax advantages.
Important Note: Even if you originally purchased the property with tenant improvements already in place, a cost segregation study done at the time of purchase can establish these elements for optimal tax treatment going forward.
179D Deductions for Structural Build-Outs
In addition to the strategies discussed above, building owners should also be aware of the 179D tax deduction. This deduction was designed to encourage energy-efficient improvements in commercial buildings. If you fund structural build-outs that include upgrades to lighting, HVAC or the building envelope, you could potentially qualify for a substantial tax deduction. The 179D deduction can reach up to $5.00 per square foot for projects that meet specific energy efficiency standards.
179 Expensing for Tenant Improvements
Section 179 expensing offers another significant tax advantage, particularly for tenants who invest in qualifying property. Under Section 179, businesses can deduct the full purchase price of qualifying equipment and certain types of improvements, up to specified limits, in the year they are placed in service.
To qualify for Section 179 expensing, the improvements must meet the following criteria:
- Used in your trade or business: The improvements cannot be for personal use.
- Tangible property: Items like furniture, machinery and certain off-the-shelf software often qualify.
- Non-structural: Section 179 cannot be applied to structural improvements to the building itself.
- Not for residential rental property: Section 179 only applies to improvements used in commercial settings.
If you're a tenant funding improvements to your leased space, Section 179 expensing can provide a major tax benefit by allowing you to deduct a significant portion of the costs upfront.
Conclusion
Tenant improvements offer a valuable opportunity for tax savings. By understanding the distinctions between tenant and structural improvements, and strategically applying tools like bonus depreciation and cost segregation studies, you can significantly reduce your tax burden and boost your investment returns.
Remember, tax laws can be complex and are subject to change. To fully assess your potential tax benefits from tenant improvements, contact the experts at Engineered Tax Services. Our team will develop a customized strategy that perfectly aligns with your specific property investments and circumstances.
