Leasehold Improvements

The Issue

Leasehold improvements, also known as tenant improvements (TI), are the customized alterations a building owner makes to rental space as part of a lease agreement, in order to configure the space for the needs of that particular tenant. These include changes to walls, floors, ceilings, and lighting, among others. In actual practice, these customized tenant improvements usually have a useful economic life of 5 to 10 years, which spans the average commercial lease term.

Despite this, until 2004 the Internal Revenue Code required that depreciation for TI occur over the economic life of the building structure itself - 39 years, rather than over the economic life of the improvements. In 2004, tax legislation was enacted that temporarily reduced this 39-year depreciation period for TI to 15 years - a period more reflective of the true economic life of TI in the modern commercial real estate market. The current 15-year depreciation schedule for qualified leasehold improvements must be reauthorized yearly, or it automatically reverts to a 39-year depreciation schedule.

Longer depreciation periods result in higher capital costs to building owners, creating disincentives for them to upgrade and modernize space for their tenants. For example, an owner of a building making tenant improvements valued at $100,000 as part of a lease agreement with a tenant would recover that investment over 15 years by expensing nearly $6,700 annually (1/15th of $100,000). However, if depreciation is spread out over 39-years, then the owner can only recover approximately $2,600 annually of the amount spent on TI (1/39th of $100,000) - a cash flow decrease of $4,100 in one year. In other words, an owner recovers his $100,000 investment in TI at a rate 2.5 times faster under the 15-year depreciation rules when compared to a 39-year depreciation schedule.

Position

NAIOP strongly supports extension of 15-year qualified leasehold improvement depreciation, and believes the provision should be made a permanent feature of the tax code.

Status

The 15-year leasehold improvement depreciation provision was extended as part of tax legislation enacted at the close of 2010, but Congress failed to extend it at the end of 2011. NAIOP is working with Congress to ensure that the provision is included in tax extenders legislation in 2012.

Talking Points

• Leasehold improvement depreciation of 15-years much more closely reflects the economic reality of the modern commercial real estate market.
• Allowing 15-year depreciation to revert to 39 years would result in higher capital costs for tenant improvements, creating a disincentive for building owners to upgrade and modernize the space for their tenants.
• Increased investment in leasehold improvements has substantial positive impacts upon economic growth.
• Having to each year extend 15-year qualified leasehold improvement depreciation creates needless uncertainty for the commercial real estate industry, and creates disincentives for owners to upgrade tenant space.
• Congress should make permanent 15-year leasehold improvement depreciaiton, particularly if Congress pursues comprehensive tax reform to simplify and make more efficient the tax code.

Resources

• * The Contribution of the Office, Retail and Industrial Properties to the U. S. and State's Economies in 2009; by Stephen S. Fuller, Director, Center for Regional Analysis, George Mason University, January 2011.
  

Contact:
Aquiles F. Suarez
Vice President for Government Affairs
(703) 904-7100 ext. 115