Landlord's ability to write off discarded tenant improvements challenged by IRS.

• Author: Dupee, Daniel S.

To lease office space in today's soft rental real estate market, landlords are frequently required to offer prospective tenants certain inducements. one common inducement is the tailoring of office space to tenant specifications. Under such an arrangement, a tenant will determine office space configuration. The landlord then undertakes all necessary construction to bring the space into compliance. The construction costs are booked by the landlord as tenant improvements (a capital asset) and are usually depreciated over 31 1/2 years in accordance with Sec. 168.

Previously rented office space that is leased to a new tenant will likely require refitting to the new user's specifications. Landlords are then left with the task of removing the old improvements (such as walls, ceilings, doors and floor coverings), and replacing these items with new tenant improvements.

In many cases, landlords would recognize a loss for the undepreciated leasehold improvements because the assets had been destroyed and replaced. However, this treatment has been challenged by the IRS in a general information letter, citing as support the legislative history and presumably Prop. Regs. Secs. 1.168-2(e) and 1.168-6(b). The Service's application of these proposed regulations requires the continued depreciation of the old tenant improvements as though still in service for the remaining period of the 31 1/2-year life. The IRS takes the position that the tenant improvements are structural components of the building - broadly defined to include walls, ceilings, flooring, partitions, windows, doors, HVAC systems and other detailed items (see Regs. Sec. 1.48-1(e)).

The Service's position should not apply to the extent a tenant improvement qualifies as a "substantial improvement." Substantial improvements are treated as separate building under the proposed regulations and are defined as expenditures over a 24-month period exceeding 25% of the building's cost before the improvement. In addition, to qualify, all expenditures must be incurred three or more years after the building is placed in service.

Taxpayers may also find relief under Sec. 165. Sec. 165 sets forth the requirements that must be fulfilled to allow a taxpayer a deduction for a loss sustained during a tax year. Sec. 165(a) states that a deduction not compensated by insurance or otherwise can be used in the year the loss is sustained. Under this provision, without regard to the limitations that follow, landlords...