It’s not your imagination – there are more and more non-profit tenants turning up in formerly retail spaces. At Capstan we are seeing many retail and office buildings bringing non-profit or government tenants into their properties. How does this impact the way depreciation rules are applied?
That’s a complicated question, and it’s a good thing that a picture – or a Capstan flowchart – is worth 1000 words. Before reading on, download your copy of our newest tool, the ADS Flowchart for Tax-Exempt Property.
Tax-Exempt property must be separated into two categories – there are rules in place for depreciating tax-exempt tangible property/land improvements and different rules in place for depreciating tax-exempt non-residential real estate. The Capstan flowchart is two-sided and color-coded, to clearly differentiate between tangible property and land improvements on the orange side, and non-residential real estate on the blue side.
Before we jump into the flowchart, let’s briefly review the basics of the Alternative Depreciation System (ADS). ADS class lives are generally longer than their MACRS counterparts, and assets depreciated using ADS are usually not bonus-eligible. Rev. Proc. 87-56 provides a table of ADS class lives based on asset and/or activity category. In general, ADS recovery periods are as follows:
- Personal Property: 9 or 12-yr SL
- Land Improvements: 20-yr SL
- Real Property (Base-Building Assets): 40-yr SL
With that review, let’s turn our attention to the orange side of the flowchart, the side representing tax-exempt tangible property/land improvements. If you have a non-profit tenant – let’s say ABC Non-Profit – in your otherwise commercial retail space, the tangible property and sometimes the land improvements associated with ABC Non-Profit must be depreciated using ADS lives. The recovery period is determined by comparing the following:
[ ADS Life from Tables ]
[ Lease Term Inclusive of Options x 125% ]
Whichever is Greater = Recovery Period
This means that a tax professional must look at the non-profit tenant’s lease, and determine the lease term, including any options to renew.
A brief example: What is the class life for the cabinets in that lone ABC Non-Profit? The cabinets are tangible property leased to that tax-exempt entity, so we know we’re dealing in ADS lives. Say ABC Non-Profit has a 5-year lease, with 2 options to renew for an additional 5 years each. So, the total lease term including those options is 5 + 5 + 5 = 15 years.
- ADS life from the IRS Tables for Tangible Property: 9 years
- Lease Term Inclusive of Options x 125%: 15 years x 125% = 18.75 years
The 18.75-year ADS life is greater, so the recovery period for those ABC Non-Profit cabinets is 18.75 years. Remember, since this is a mandatory ADS scenario, there is no bonus in play.
You can use the same exercise for the land improvements with one caveat. If parking is comingled and used by all tenants, you can use MACRS-lives for depreciation. However, if ABC Non-Profit is the sole tenant, and the parking lot is being used exclusively for tax-exempt purposes, then it must be depreciated using ADS lives. The ADS life from the IRS Tables for land improvements is 20 years, which is greater than the 18.75 years we calculated above. As such, the parking lot would be assigned and ADS class life of 20 years.
Now let’s flip the chart to the blue side and talk about non-residential real estate. This is the more exciting side, as there is potential for MACRS depreciation, bonus, and QIP, if the correct conditions are met.
First, let’s define two important terms:
Disqualified Lease: If at least one of the following is present, the lease is considered disqualified —
- Lease term of MORE than 20 years (including options to renew unless those options reset to FMV)
- Purchased with tax-exempt financing
- Agreement or option to purchase by the entity
- “Sale-Leaseback” with exempt entity
Let’s be frank — you DON’T want a Disqualified Lease. Disqualified Leases make the possibility of MACRS depreciation less likely.
Less likely, but not impossible.
And that brings us to the second important term:
35% Test: Even with a disqualified lease, if LESS than 35% of the net rentable space is occupied by the non-profit tenant, you MAY use MACRS depreciation to depreciate base-building assets.
If ABC Non-Profit only occupies 10% of an otherwise commercial plaza, why should all the base-building assets be stuck with ADS lives? The 35% Test opens the door to shorter-lived MACRS depreciation of base-building assets, bonus-eligibility, and 15-year QIP with bonus on
future improvements. Here at Capstan, we often see that the base building assets are still eligible for MACRS depreciation and QIP with bonus. Bonus-eligible QIP can be a great boon to landlords who are contributing to tenant improvements and can make a cost segregation study very beneficial. As such, it’s critical that the 35% Test be employed appropriately.
There’s one more wrinkle when it comes to non-residential real property, and we’ll talk through it with one last example. Think back to our ABC Non-Profit tenant. It still occupies 10% of the net rentable space, but now imagine that it has a much longer lease – a 10-year lease with three 5-year options to renew. The options to renew have been pre-negotiated to a certain value – they will not reset to FMV.
This is the wrinkle:
- If the options to renew reset to FMV, they don’t have to be included when determining the lease term for the base building assets.
- If the options to renew have been pre-negotiated and don’t reset to FMV, then they must be included when determining the lease term.
In this example, our lease term is 10 + 5 + 5 + 5 = 25 years. Since the options to renew have been pre-negotiated, we must include them in determining our lease term. This 25-year lease term means that our ABC Non-Profit is subject to a disqualified lease, but all is not lost. Since the non-profit tenant occupies less than 35% of the rental space, the base-building assets can still be depreciated using MACRS lives and bonus, and QIP is possible for future improvements. (Of course, the tangible property and land improvements leased directly to the ABC Non-Profit would need to be depreciated using ADS lives as described earlier.)
Determining the appropriate lives when dealing with non-profit and government tenants can be complicated. Whenever you become aware of non-profit tenants in your buildings, it’s important to share this information with your CPA and Capstan so we can assist in ensuring appropriate asset depreciation.