A Practical Guide to Depreciating Improvements Under Section 178
As all accountants, CPAs, tax lawyers and other tax professionals should know, tangible business and investment property may be depreciated over the course of its useful life to provide relief to owners for the wear and tear associated with its ownership.
Tangible assets, such as real estate and business vehicles, allow for depreciation deductions to owners, and the expectation is that such deductions will offset the decreasing value of the asset as measured against its original acquisition cost. Intangible assets, such as improvements made by lessees to leased property, on the other hand, do not allow for depreciation deductions, but are instead amortized over the course of their useful lives.
In practical terms, these concepts are very similar, but technically, intangible assets cannot depreciate, as they have no physical substance that deteriorates in value over time. Improvements made during a lease are considered intangible assets because the lessee does not actually own them but possesses the right to use them while they hold the lease.
In this post, we will take a look at the amortization provisions of Section 178 of the IRC. Section 178 refers to improvements made by lessees (or tenants, the persons holding the leasehold) on leased properties and lays out specific rules for amortizing improvements made during the course of a lease.
One note before we begin: These rules can actually be quite complex, so the scope of this article will only allow for a brief introduction. This overview should be useful, however, for practitioners needing to point their clients in the direction of a specialist in this area or who would like a starting position from which to learn more and ultimately develop expertise.
Let’s start with a very brief overview of leasehold interests as distinguished from fee simple interests and then proceed with a breakdown of the basic provisions of Section 178.
A fee simple interest, sometimes referred to as “fee simple absolute”) is the highest form one can have when it comes to property. It gives a person not only the ability to control the use of their property during the course of their own lives, but it also grants the ability to determine the fate of it after their death.
So, a fee simple owner can determine which person will acquire the property after them, and it also means they can decide whether to pass down the property in fee simple or another, lower-tier interest. They can even transmit an interest of lesser quality to an acquirer if they so choose.
Leaseholds, on the other hand, merely represent the right to use a property for a specified period of time for specified compensation. In certain cases, such as in the context of Section 1031 transactions, leaseholds may be treated as equivalent to fee simple interests in real estate, but, generally, they represent a lower-tier interest in property.
Now, suppose a person signs a long-term lease to use a piece of commercial real estate. Let’s further suppose this individual then makes a number of substantive improvements to the property. If the lessee or individual holding the leasehold were not able to write off some portion of the cost associated with erecting these improvements, we can see they would be placed in an unfair financial situation and would consequently be deterred from constructing improvements during the lease. To avoid this situation, the code allows for amortized deductions of this sort, and Section 178 provides rules as to the exact amounts allowable for deduction.
As mentioned, technically, even though the lessee may construct improvements, he or she does not actually own them, so an issue may arise as to the correct schedule according to which amortization deductions are taken. This is one issue Section 178 addresses.
Suppose a lessee constructs a commercial building on leased property and that building would normally be depreciated over the course of 39 years (the current depreciation timeline for commercial real estate). Let’s also assume the building was constructed in the fifth year of a 30-year lease that has two renewal options of 10 years each.
Ordinarily, if the lessee held the property in fee simple, he or she would have a simple depreciation schedule of 39 years. But the term of the lease has only 25 years remaining. How does this matter get resolved?
In this hypothetical scenario, the 60 percent rule found in Section 1.178-1(b)(1)(i) would not apply, because 25 years (the remaining term on the lease) is greater than 60 percent of the normal depreciation schedule for commercial real estate. And so, in this example, the lessee would simply amortize the cost of the commercial building over a 25-year period rather than 39 years.
Special rules would come into play if the commercial building had been constructed in the tenth year of the lease because then the 60 percent rule would apply. If the 60 percent rule applies, then the renewal options would be included in the remaining term of the lease, but this can also change if the lessee can present compelling evidence that the renewal options should not be counted toward the remaining lease term.
As is always the case in the world of tax and accounting, Section 178 provides rules for almost every conceivable contingency. In the future, we will come back and give a more in-depth coverage of Section 178 and its various provisions. For now, the above should serve as a useful practical introduction.
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Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.