Accounting for leasehold improvements.

Since the Economic Recovery Tax Act of 1981 (ERTA), there has been some uncertainty as to the proper period over which to recover the costs of tenant improvements when the term of the lease is shorter than the property's useful life or recovery period. In Grinalds, TC Memo 1993-66, the Tax Court held that the statutory recovery period controls. A footnote to the case, however, offers a possible escape for leasehold improvements that qualify as personal (as opposed to structural) components.

It was reasonably well-settled, even before ERTA, that the cost of leasehold improvements constructed by a lessor had to be recovered over their useful lives regardless of the term of the lease. Prior law implicitly allowed two exceptions to this general rule. First, a taxpayer could prove a shorter useful life, as might be the case with special purpose leasehold improvements that could benefit only the current lessee when the lease term is shorter than the useful life of the asset. Second, a taxpayer could prove a useful life cut short by obsolescence--as might occur with such special purpose leasehold improvements when the lease is unexpectedly cut short. In such a case, the unrecovered cost could be written off at that time.

The enactment of the accelerated cost recovery system (ACRS) system in 1981, followed by its modification (to the MACRS system) in 1986, effectively eliminated the concept of "useful life" in determining the period over which the cost of leasehold improvements could be recovered. The Grinalds court held that (1) the statutory recovery period, rather than the useful life, controlled for purposes of recovering the cost of leasehold improvements; and (2) the term of the lease was irrelevant, even if the improvements were special purpose and of use to no one following termination of the lease.

While the first conclusion is widely acknowledged, many practitioners still cling to the apparently logical notion, in the case of special purpose improvements that will become worthless at the conclusion of the lease, that the period of the write-off should coincide with the lease term. And even if scheduled percentages (rather than straight-line amortization) were used, many practitioners believe the remaining basis could (or at least should) be written off at the conclusion of the lease.

ACRS regulations proposed in 1984, but still not finalized (no proposed regulations have been issued under MACRS), indicate that the unadjusted basis of a building's structural components must be recovered as a whole (Prop. Regs. Sec. 1.168-2(e)(1)), the same recovery period and method must be used for all structural components, and such components must be recovered as constituent parts of the building of which they are a part. Prop. Regs. Secs. 1.168-2(1)(1) and -6(b) also provide that the term "disposition" does not include retirement of a structural component of a building and that retirement of a structural component is not an appropriate occasion to recognize loss or reduce basis.