September 2002

How to Stimulate Depreciation on Leased Practice Property
What You Need to Know Before You Sign on the Dotted Line
By Mark E. Battersby

In the rush to get the paperwork signed, it’s not uncommon for chiropractors to reach lease agreements that are not as profitable for the doctor - or the building’s owner - as they could be. One of the most misunderstood areas of those lease negotiations is related to who will pay for improvements to the leased property.

The depreciation deduction is an allowance for the wear and tear, the natural deterioration, or the technical obsolescence of the assets and property used in a chiropractic practice. Surprisingly, the depreciation deduction is also available for business property that is leased or rented.

That’s right - many chiropractors routinely utilize the depreciation rules to deduct the cost of improvements made to “leased” property. In fact, the depreciation deduction may be available whether it’s rented practice premises or special equipment that is modified by the chiropractic practice leasing it.

And now, our lawmakers have gone one step further in creating a unique first-year “bonus” depreciation deduction that applies to improvements made to leased property.

Stimulating the Depreciation Deduction
Thanks to the Job Creation and Worker Assistance Act of 2002 (H.R. 3090), chiropractic practices are now entitled to an additional first-year depreciation deduction equal to 30% of the adjusted basis of qualified property. And, best of all, property eligible for the special treatment includes leasehold improvements.

Generally, those leasehold improvements must have been made after Sept. 10, 2001, and before Sept. 11, 2004, in order to qualify for the new bonus depreciation. Original use of the property must commence with the chiropractic practice on or after Sept.11, 2001, and the property must be placed in service generally before Jan. 1, 2005. The basis or book value of the property and the depreciation allowances in the year of purchase and in later years must be adjusted to reflect the additional first-year depreciation deductions.

For example, say the improvements a chiropractic practice makes to the clinic it leases cost $200,000, and that the improvements were placed in service on June 1, 2002. The chiropractic practice may claim a first-year depreciation bonus of 30% of the property’s adjusted basis. That’s a $60,000 deduction. What’s more, the chiropractic practice’s remaining basis in the property, $140,000, is recoverable over the life of those leasehold improvements - usually three, five, or seven years. The write-offs start with the 2002 tax year and use the normal Modified Accelerated Cost Recovery System (MACRS), which is the standard, no-questions-asked depreciation system.

Under these depreciation rules, a chiropractic practice can recover the full amount spent to acquire business property. The flexibility of the depreciation system arises when the owner or manager decides whether the chiropractic practice would benefit more from the bonus depreciation and larger first-year depreciation deductions, or whether smaller depreciation deductions over a longer period would be more beneficial to the bottom line. Larger, first-year write-offs admittedly help reduce the out-of-pocket costs for acquiring business assets.

A start-up or unprofitable chiropractic practice expecting increased income in future years might be better served by depreciation deductions in those more profitable years.

Leasehold Improvements
Under the tax rules, leasehold improvements made by a lessee or lessor are depreciated under the MACRS system. The party who owns the improvement claims the tax deductions. As many chiropractors are already aware, the majority of leasehold improvements are considered structural components and are depreciated in the same manner that the building itself would be depreciated if the building were placed in service when the structural component was placed in service.

A good illustration of this would be a case in which a chiropractic practice leases a commercial building for 20 years, and decides to construct a wall to divide an open space into two sections in January 2002. The wall is a structural component of the building. Since the building would be 39-year nonresidential real property if placed in service in January 2002, the wall is depreciated as nonresidential real property placed in service in January 2002, using the straight-line method and a 39-year recovery period. The fact that the lease term is only 20 years is irrelevant.

Certain types of improvements, such as removable partitions, flooring, or carpeting, may be considered personal property rather than structural components. Generally, the principles of the former investment tax credit rules apply for purposes of determining whether an improvement is personal property or a structural component (real property). Improvements that are classified as personal property are depreciated under MACRS using accelerated depreciation methods and shortened recovery periods that are usually related to the property class that the personal property is assigned to under MACRS.

The Bonus
Although the 30-year, bonus first-year depreciation is allowed only for MACRS property with a recovery period of 20 years or less, an exception is made for qualifying leasehold improvements. Qualified leasehold improvement property is any improvement to an interior portion of nonresidential real property made under or pursuant to a lease by the lessee, sublessee, or lessor.

The improvement must be placed in service more than three years after the date the building was first placed in service. Fortunately, the law does not say that three years must pass after the building was first placed in service by the “taxpayer.” The requirement appears aimed a newly constructed buildings.

Expenditures for: the enhancement of a building; any elevator or escalator; any structural component that benefits a common area; or the internal structural framework of a building are not considered qualified leasehold improvement property.

What’s more, the lease may not be between related persons. That rules out many transactions in which the chiropractic practice sells its office or clinic building or equipment to the practice’s principal, who in turn leases it back to the chiropractic practice.

Abandoned But Not Forgotten
Any lessor who disposes of a leasehold improvement (made by the lessor or by the lessee) may suffer a legitimate loss if the improvement is irrevocably disposed of or abandoned by the lessor at the termination of the lease. If, for example, the leasehold improvement is destroyed or abandoned, the lessor may claim an ordinary loss in the amount of the improvement’s remaining adjusted basis.

If the entire building is demolished, however, the unreported cost of the improvements is included in the basis of the land. A similar rule applies to lessees who abandon their improvements at the end of the lease.

Opt Out
The new bonus depreciation must be claimed unless a chiropractic practice makes an “election out.” The election out is made at the property class level. Furthermore, that election out applies to all property in the class or classes for which the election out is made that is placed in service for the year of the election.

A chiropractic practice’s principal may, for example, make the election out for all three-year property placed in service in that tax year. The election out cannot be made for some, but not all, three-year property placed in service during the tax year. Similarly, the election out may be made for all qualifying software or all leasehold improvements placed in service during a tax year.

Construction Allowances
The additional first-year bonus depreciation allowance reduces the after-tax cost of making leasehold improvements. Naturally, there are times when such benefits may be wasted. A start-up or an unprofitable chiropractic practice, for example, may not benefit from current tax deductions against its low or nonexistent tax bill.

In fact, it may often be better for a chiropractor/lessee to negotiate to have the improvement or “build-out” constructed by the lessor. In other words, a tenant that receives cash or rent reductions from the landlord or lessor with respect to a short-term (i.e., 15 years or less) lease (after Aug. 5, 1997), is not required to include that amount in gross income if the amounts are used for qualified construction or improvements to the rented space.

Finally, since the amendments apply to property placed in service after Sept. 10, 2001, in tax years ending after that date, many chiropractic practices can qualify for the bonus depreciation - depending on the tax year and depreciation conventions used - on their 2001 tax year return. In many cases, amended 2001 returns will need to be filed.

Leasehold improvements have long been - or should have been - a depreciable item on the tax returns of many chiropractors and their practices. The options the average chiropractor has to weigh remain constant: Will the chiropractic practice benefit more from large, up-front write-offs for those leasehold improvements, or would longer write-offs help offset higher tax bills in later years?

Another factor has been added to that equation in the form of the new 30% bonus depreciation. However, the question remains: How can those expenditures for leasehold improvement best be used to produce the lowest cumulative tax bill for the chiropractic practice?

Understanding the depreciation rules is the first step to answering those questions. As always, it pays to do your homework before you sign on the dotted line.

Mr. Battersby is a tax and financial advisor, freelance writer, and columnist based in Ardmore, Pa. He writes a syndicated weekly column focusing on tax issues for small businesses. He can be reached at mebatt12@earthlink.net or 215-747-7082.