The final tangible property regulations published by the Internal Revenue Service on September 19, 2013, provide important guidance on the tax treatment of repairs made to tangible property. Prior to the issuance of these regulations, there was no definitive standard as to what constituted deductible repairs or capitalized improvements. Among the many sections that make up the repair regulations, there is one provision on the treatment of leasehold improvements that should not be overlooked . This section provides guidance as to what constitutes the unit of property for leasehold property and which party is required to capitalize costs for improvements made to leasehold property (lessor or lessee). Additionally, there are important safe harbors included in the final regulations that allow qualified leasehold improvement costs to be treated as deductible repairs rather than capitalized improvements.
Given the similarities between leasehold and non-leasehold property when it comes to applying the rules under these final repair regulations, it would be helpful to first define the unit of property.
Unit of property - Non- leasehold property:
In general, the unit of property for non-buildings is defined as the property's functionally interdependent components that make up the unit of property. The term functionally interdependent means that the placement in service of one component by the taxpayer is dependent upon the placement in service of another component. Any repairs or improvements made to a large portion of a major component is considered to be a repair or improvement made to the entire property.
The unit of property for a building consists of the building's systems and structural components. Generally, improvements or repairs made to a building's system(s) or structural component(s) are considered improvement(s) to the building as a whole. A building system is defined as the building's heating and air conditioning system (HVAC), plumbing system, elevators, escalators, fire safety and security systems and the gas distribution system. A building's structural components are the windows, doors, floors, paneling, partitions, and other structural components that make up the building.
Unit of property - leasehold property:
The unit of property for leasehold property is determined based on the portion of the building that is leased. If the entire building is leased, the unit of property will be defined as the building's systems and structures that make up the entire building. However, if only a portion of the building is leased (such as an office, floor or certain square footage) then only the portion of the building's systems or structures associated with that leased space will make up the unit of property. The unit of property for non-buildings consists of the functionally interdependent components described above, but is limited only to the property subject to the lease.
The costs associated with improvements made to a leasehold property may be capitalized either by the lessee or lessor as discussed below.
Lessor improvements - requirements to capitalize:
A lessor is required to capitalize any costs it pays or incurs to improve leasehold property. Often, lessors offer construction allowances to entice potential lessees into leasing space in their particular building. This is common in leasing retail space. Under the final repair regulations, if a lessor provides a construction allowance to the lessee to improve upon leasehold property that the lessor will continue to own, the lessor is required to capitalize those costs up to the amount of the construction allowance.
If a tenant receives funding from the landlord for an improvement to be made to the property (commonly referred to as a construction allowance), this is generally taxable income to the tenant. However, if certain criteria are met, the tenant can exclude this amount from income and the improvements will be considered to be owned by the landlord. In order for the tenant to exclude the construction allowance from income, the following criteria must be met: 1) The leasehold period must be for a period of 15 years or less and 2) the construction allowance must be used by the lessee to improve upon leased property that he/she will use in his/her trade or business.
In addition to the above capitalization requirements, a lessor must also capitalize amounts paid for improvements made by a lessee in substitution of rent.
Lessee improvements - requirements to capitalize:
Similar to lessors, a lessee must capitalize amounts paid to improve upon leasehold property unless the amounts paid arise from a construction allowance or are made in substitution of rent. Additionally, if the lessee uses the construction allowance to improve upon leasehold property, and then is required to pay additional costs to complete the project, those additional expenditures will be capitalized by the lessee.
In making improvements to leasehold property, the lessee may acquire tangible personal property to complete the construction process. The final repair regulation includes an example, in which a lessee is furnished a construction allowance to create a retail sales facility, and in the process of completing the construction, acquires and constructs partitions for fitting rooms, counters and shelving. In such a case, the lessee would be considered the owner of that property and would be required to capitalize the cost of acquiring the tangible personal property separately from the leasehold building.
If after acquiring and constructing the partitions for the fitting rooms discussed above, the lessee is required to make additional improvements to that property, the final repair regulations have special rules on how to capitalize the costs for those additional improvements. Under this rule, the lessee has the option to choose whether the additional work constitutes improvements to the entire leased building, or only the portion of the previously improved upon property. This could provide a benefit to the lessee when amortizing the leasehold improvements in future years.
Although the general rule is to capitalize leasehold improvements, there are some safe harbors included in the final repair regulations that allow for the taxpayer to treat improvements as deductible repairs. The two main safe harbors available for leasehold improvements are the small business taxpayer safe harbor and the safe harbor for routine maintenance and repairs.
Safe harbor for small business taxpayers:
The small business taxpayer safe harbor is applicable only to improvements made upon buildings. To qualify for the small business taxpayer safe harbor, the taxpayer must have average annual gross receipts of $10,000,000 or less for the previous 3 years. Gross receipts include the taxpayer's total sales and amounts received for services, as well as interest, rents, royalties and annuities received (regardless of whether those items were derived from a trade or business). Qualified property is defined as a building that has an unadjusted basis of $1,000,000 or less. For lessees, the unadjusted basis of the building is equal to the total amount of undiscounted rent paid or expected to be paid over the entire lease term, including expected renewals.
If the taxpayer qualifies for the safe harbor, the taxpayer can elect to deduct repair, maintenance, and other similar activities performed upon the eligible building that do not exceed the lesser of 2% of the unadjusted basis of the building or $10,000. If the total costs of these activities made during the year exceed the threshold amount, the safe harbor is not applicable. The taxpayer is required to make an election to utilize this safe harbor with the timely filing of its tax return (including extensions). Additionally, the taxpayer must be granted permission from the IRS to change its accounting treatment from previously capitalizing these costs to now deducting them in full.
Routine maintenance safe harbor:
The routine maintenance safe harbor allows for the deduction of routine maintenance costs incurred on a unit of tangible property. Routine maintenance is defined as repair or maintenance activity or other similar activities that are intended to keep the property in its ordinary, efficient and operating capacity; and which are recurring. Repair or maintenance activities are considered recurring if the taxpayer reasonably expects to perform the activities more than once over a 10-year period. The taxpayer can qualify for the safe harbor deduction even if the activity does not occur more than once over that 10- year period if it can be established that, at the time the property was placed in service, it was reasonable for the taxpayer to expect that the repair or maintenance would be required more than once. No election is required to utilize this safe harbor, but an accounting method change to comply with this safe harbor requires the consent of the IRS. There is no limit to the amount of costs that can be deducted under this safe harbor. However, this safe harbor does not apply to improvements that go beyond routine maintenance (such as betterments, restorations and adaptations). Additionally, it is important to note that amounts paid for improvements that can be deducted under this safe harbor must be included in the calculation to determine whether the taxpayer’s improvement costs exceed the small business taxpayer safe harbor discussed above.
The final repair regulations include detailed rules on the capitalization of leasehold improvements and provide for some important safe harbors that could be beneficial to taxpayers. Becoming familiar with these rules is important when forming tax planning strategies for leased properties. Given the complexity of these rules, it is recommended that you contact your tax practitioner for assistance in interpreting these regulations.
 Treasury Regulation 1.263(a)-3(f)