Guidelines to Property Improvements Provide Tax Deferral Strategies
By: Eli Loebenberg, CPA, CEO, Madison SPECS
A key component of any commercial lease agreement is the tenant improvements and allowances, which are provided by the landlord. The landlord usually provides customized alterations to a rental space in order to configure the property for the needs of that particular tenant. The costs of building out or retrofitting a space for a tenant are considered property improvements, which may be eligible for shorter life treatment by the IRS. The costs incurred while constructing, acquiring or remodeling real estate assets can be offset with a valuable tax deferral strategy: a the cost segregation study.
A cost segregation study is a specialized tax and engineering analysis that allows owners to reclassify their real property expenditures, thereby accelerating their depreciation deductions. It is also possible for landlords to recover missed depreciation deductions even from prior years. This reduction in tax liability can produce increased cash flow.
How to Classify Expenditures?
The Tax Code determines how to break down the costs related to repairs or capital improvements. The IRS Regulations require businesses to segregate their real property building costs into eight defined building systems. When the taxpayer is determining whether improvements made are eligible, the building structure and each building system can be analyzed as separate structural assets. Expenditures relating to each building system are evaluated both as repairs or improvements with respect to that particular system as well as with respect to the entire building as a whole.
The building is evaluated and broken out into units of property (UOP) according to the eight Enumerated Building Systems.
- HVAC systems, including motors, compressors, boilers, furnace, chillers, pipes, ducts and radiators.
- Plumbing systems, including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment and site utility equipment.
- Electrical Systems, including wiring, outlets, junction boxes, lighting fixtures and associated connectors.
- Fire Protections Systems, including sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and firefighting equipment.
- Security systems, window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, and entry and access systems.
- Gas distribution systems
Betterment, Restoration and Adaptation
Recent IRS Regulations expand the definition of capitalization of structural property costs. The amount paid can be considered an improvement if it is made to either the building structure or one of the building systems. An improvement to a UOP unit of property is the amount paid which results in the betterment of the property, restoration of the property, or adaption of the property to a new or different use.
- Betterment of a unit of property is amending a material condition or defect that existed prior to the acquisition, expanding or extending the unit of property, or increasing the productivity and strength of the unit of property. For example, the owner of a retail building adds a stairway and loft to increase its selling space. The costs to build the stairway and loft are considered an improvement because they increase the capacity of the building structure.
- Restoration of a unit of property is restoring it from a deteriorated state, rebuilding it to a like-new condition after the end of its class life or replacing a major component. For example, the owner of a farm has several out-buildings which were not used on a regular basis and fell into a state of disrepair. The owner restores the out-buildings by shoring the walls and replacing siding, making it fully functional.
- Adaptation of a unit of property is altering it to a new and different use which differs from the original use at the time the taxpayer originally placed it in service. For example, the owner of a manufacturing building modifies the building structure and systems to convert it into a showroom.
This framework for capitalization requires a detailed analysis of a taxpayer’s facts and circumstances. A thorough cost segregation study can help landlords take full advantage of these tax savings.
Eli S. Loebenberg, CPA, Chief Executive Officer, Madison SPECS LLC, has 27 years of broad-based tax experience. In 2006, he partnered with Madison Commercial Real Estate Services to form Madison SPECS, LLC, providing expert cost segregation and fixed asset review services.
Mr. Loebenberg started his career with Deloitte and Touche in 1996, focusing on real estate, banking and securities. In 2000, he joined IDT Corporation, a publicly-traded multi-billion dollar telecom company, primarily responsible for high-level M&A tax planning and tax minimization for the consolidated entity. From 2001-2004, Mr. Loebenberg was with KPMG in their Federal Solutions Group. As a senior manager in the group, he handled research and experimentation credits, cost segregation studies and embedded cost reviews. In 2004, Mr. Loebenberg joined Grant Thornton, focusing on cost segregation studies for clients, including The New York Times, Wolfson Group, Reuters, King Kullen Group and Edison Properties.
Mr. Loebenberg has a BA in Accounting and Business Administration from the University of Maryland, Baltimore County and is a licensed CPA. He is a member of AICPA.
Madison SPECS, LLC (Specialized Property Engineering & Cost Segregation) performs cost segregation studies of residential and commercial real estate properties. These specialized engineering and tax analyses have the aim of segregating assets that qualify for accelerated depreciation resulting in a reduction to taxable income, thereby generating improved cash flow. It is estimated that for each $1 million of reclassified assets Madison SPECS can generate approximately $150,000 to $200,000 of tax benefit.
Pat Anarumo, Vice President of Sales
Madison Commercial Real Estate Services
56 West 45th Street, Floor 12, New York NY 10036
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