IRS Clarifies Capitalization of Leasehold Improvements

December 2012

 Leasehold improvements can pose some tricky tax issues for all parties involved. In a recent legal memorandum, the IRS addressed one such issue — the proper capitalization treatment of indirect costs incurred by a lessee to construct real property it then leased. This article takes a look at a case involving Internal Revenue Code (IRC) Section 263A, Capitalization and Inclusion in Inventory Costs of Certain Expenses, and IRC Sec. 263(a), Capital Expenditures, in which the lessee lost the battle.

It's a fact: Leasehold improvements can pose some tricky tax issues for all parties involved. In a recent legal memorandum, the IRS addressed one such issue — the proper capitalization treatment of indirect costs incurred by a lessee to construct real property it then leased.

The Lease Arrangement

In the matter addressed in Internal Legal Memorandum (ILM) 201220028, a lessee entered a sublease and construction agreement with a lessor. The agreement provided that the lessee would lease certain real property and its improvements. It also provided that the lessee would construct additional real property and improvements that it would lease from the lessor after construction.

Under the agreement, the lessor would own all of the real property and most of the real property improvements constructed. The lessee would own all of the personal property and some of the real property improvements constructed.

The lessee was required to pay for some indirect costs associated with construction of the real property and improvements owned by the lessor. The agreement didn't provide that the costs incurred by the lessee associated with the construction of the leased property were a substitute for rent.

The lessee relied on Internal Revenue Code (IRC) Section 263A, Capitalization and Inclusion in Inventory Costs of Certain Expenses, to capitalize indirect costs associated with the construction of the leased property to the basis of the property the lessee produced and owned. The Large Business and International (LB&I) division of the IRS, however, contended that Sec. 263A allowed the lessee to capitalize only the costs that related to the property it produced and owned. The LB&I division sought guidance from the Chief Counsel of the IRS.

Bad News for the Lessee

Sec. 263A provides that taxpayers that produce real or tangible personal property must capitalize the property's properly allocable share of indirect costs. A taxpayer isn't considered to produce property unless it's an owner of the property.

Under IRC Sec. 263(a), Capital Expenditures, if a lessee makes a leasehold improvement that isn't a substitute for rent, the lessee is generally required to capitalize the cost of the improvement.

The Office of the Chief Counsel found that the lessee's costs (including indirect costs) for the property owned by the lessor must be capitalized as leasehold improvements under Sec. 263(a), rather than capitalized under Section 263A to the basis of the property produced and owned by the lessee.

It further explained that only indirect costs that directly benefit or are incurred to produce property owned by the lessee may be charged to the basis of that property. Indirect costs incurred that relate to both the property produced and owned by the lessee and the leased property must be allocated between the two types of property.

The Bottom Line

Capitalization issues continue to confound many in the real estate industry, despite (or perhaps because of) the IRS's issuance late last year of temporary regulations on capitalization vs. expensing of costs related to tangible property. Your tax advisor can help you navigate these sometimes rough waters.

 For questions or to discuss a real estate issue, please contact Doug Collins, CPA and Partner, at dcollins@nisivoccia.com or 973-328-1825.