With consumer and lifestyle habits constantly changing, commercial real estate developers have had to rapidly adjust how they are presenting, marketing and utilizing the space they own. E-commerce, co-working and urbanization are only making this trend more and more common and property owners can go from a consistent tenant relationship to a vacancy in short order. E-commerce, in particular, has made a huge impact on the commercial real estate industry – with retailers small and large closing their doors, and e-commerce giants snapping up industrial space for last-minute deliveries.
It is not uncommon for a store to significantly downsize its footprint. For instance, if a tenant were to shrink from 50,000 square feet to 30,000 square feet, the building owner would then contend with 20,000 square feet of suddenly vacant space that needed to be filled. As a way to cut costs and increase efficiencies, big-box tenants of all kinds are reducing their square footage upon renewal of their lease. While it makes financial sense for the retailer, it often creates a problem for the owner of the property who is suddenly left with vacant space that needs to be occupied. Additionally, that new occupant will most likely need major renovations to make the space work best for their business – a good example would be a grocer moving into a former Toys “R” Us.
As a result, the cost to attract, sign and retain a new tenant can be hefty. But because of a mistake by Congress in the new tax law, developers could now have an even bigger problem on their hands.
Prior to the Tax Cuts & Jobs Act (TCJA), the majority of the costs incurred to build out for a new tenant were deemed “qualified improvement property”, which was eligible for a 15-year depreciable life and 50% bonus depreciation. Essentially, this allowed the owner to deduct the majority of the renovation expenses in the first year, which is certainly the most ideal financial situation.
While the intent was to keep these costs eligible for 15-year depreciable life and a potential 100% first-year bonus depreciation, the final draft of the law missed the mark badly. As a result, what was once a 15-year depreciable life, is now 39 years under the current law, and for property owners, the difference in jarring.
For example, if the owner of the building spends $1,000,000 to retrofit a vacant space for a new tenant, the new tax treatment under TCJA will put all $1,000,000 on a 39-year depreciable life, only allowing for a deduction in the first year of about $25,600. Had the law met its intentions, these costs would have been eligible for bonus depreciation and a full $1,000,000 deduction in the first year. That’s a stunning variance of $974,400 in tax deductions. It’s understandable why commercial property owners are so concerned.
Congress fully recognizes the mistake and acknowledges the error, and while this was clearly not the intent of Congress the IRS must still follow the letter of the law and cannot independently change anything in TCJA. Congress has vowed to fix it as soon as possible, but it could take some time. As a result, CRE property owners may want to consider extending their real estate business tax returns, in hopes that the law gets retroactively changed, leaving those owners with more money in their pockets.
DANIEL J. THRAILKILL, CPA is a director in Ellin & Tucker’s Tax Department. He can be reached at firstname.lastname@example.org.