In our last post, we provided a practical overview of leasehold improvement depreciation under Section 178 of the IRC. This overview provided a brief introduction to the basic purpose and provisions of Section 178 and also gave examples of the types of issues involved when leasehold improvements are depreciated utilizing this section.

As we saw, one of the key issues involved in Section 178 is addressing scenarios in which the normal depreciation schedule of a given improvement is greater or less than the remaining term of a lease. Section 178 provides a system of rules which assist leaseholders in resolving this issue along with other issues which can develop as a consequence of instituting depreciable improvements.

In this post, we will cover a couple of additional issues which can turn up when leaseholders create depreciable improvements upon leased real property. Specifically, we will address the issue of the “probability test” for determining whether renewal options are includable in the remaining term of a lease. We will discuss how this test is initially applied to a given lease with a given set of circumstances, and then how it may be reapplied whenever new circumstances affect the probability of renewal options or extensions being exercised in the future.

## The "Probability Test" Issue

In our introductory post on Section 178, we made reference to the so-called 60 percent rule. This rule comes into effect whenever a leaseholder creates an improvement which has a depreciation schedule (or “useful life”) which is greater than 60 percent of the remaining term of the underlying lease. Put another way, the 60 percent rule applies whenever the remaining lease term is less than 60 percent of the useful life of the depreciable improvement (this is the way that the rule is typically expressed).

If the 60 percent rule is triggered, then the remaining term of the lease will include any renewal options or extensions. The remaining term of the lease is necessary in order to determine the precise amount allowable for deduction on an annual basis. For instance, suppose a leaseholder erects a rental property on a piece of leased real estate. Suppose that the remaining term of the lease is 10 years, and that the lease contains 3 renewal options of 5 years each. Because the remaining term of the lease is less than 60 percent of the useful life of the rental property – residential rental real estate is currently depreciated over a 27.5 year time period – the remaining term will include the renewal options, and so the rental property will actually be depreciated over a period of 25 years.

This is where the so-called “probability test” comes into play: under subparagraph 1.178-1(b)(2), the remaining term of the lease shall not include any renewal options or extensions if it can be shown that it is more probable than not that those renewal options or extensions will not be exercised. This probability test is applied separately to each renewal option or extension. This test is very important, because if a leaseholder can establish, by way of a preponderance of evidence, that any renewal options or extensions will likely not be utilized, then that leaseholder may take advantage of a shorter depreciation schedule and therefore have access to greater annual deductions.

Using the same hypothetical scenario as described above, if it were determined that the renewal options were not likely to be exercised, then the leaseholder would be entitled to depreciation deductions on a schedule of only 10 years. Clearly, this would result in much greater deductions than would be available if the renewal options were includable in the remaining term of the lease. However, the application of the probability test isn’t necessarily limited to a single inquiry for each renewal option or extension. Circumstances can often change during the course of a lease, and if circumstances change in such a way that the probability that a renewal option or extension will be exercised changes, then the probability test can be reapplied and the new outcome will then take effect.

Again, using the above scenario, suppose that an initial probability test reveals that the 3 renewal options are not likely to be used, and so the depreciation schedule is first established at 10 years. But then suppose that circumstances change and it suddenly becomes highly probable that the renewal options will in fact be utilized. In this situation, the probability test would be reapplied, the renewal options would be includable in the depreciation schedule, and the annual deductions allowable to the leaseholder would be adjusted to reflect the changed depreciation schedule. This complex application of the probability test is intended to give an accurate picture of the leaseholder’s remaining term so that leaseholders have access to deductions which are as fair as possible.

Though its provisions can be a bit complex, Section 178 is definitely a section which all leaseholders should be acquainted with, particularly those who plan to contribute depreciable improvements to their leased property at some point before their lease expires. Leaseholders who wish to maximize their financial condition are advised to consult with a qualified tax professional, such as a CPA or tax attorney, so that they can be certain that they are utilizing the provisions of Section 178 correctly. The last thing any leaseholder wants to face is an audit stemming from an incorrect application of Section 178, and so the best course of action is to take preventative measures at the outset.

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good article