Tips And Tricks For Navigating The Tax Implications For Legal Spaces
In addition to being the biggest user of DC trophy office space, law firms are also some of the most complex tenants. With countless firms popping up every day and clients increasingly "in the driver's seat," many firms are trying to find a space that impresses, but doesn't break the bank.
As such, law firms can require unique build-outs, heavy renovations, high technical and IT capabilities, and many other changes.
These requirements aren't only a huge headache for the law firms, but for developers, landlords and brokers as well, as was discussed at Bisnow's Sixth Annual Real Estate Strategies for Associations and Law Firms.
Perhaps the most complex challenge for legal tenants is the tax implications that come with these spaces. With all the required changes and renovations, figuring out how these are exempted and paid for takes a sharp eye and brilliant mind.
Bisnow: What are some general considerations and tax laws that law firms have to keep in mind when it comes to their real estate and amenities?
Bill: As with most tenants, law firms negotiate a tenant improvement allowance from the landlord when signing a new lease, or renewing the lease, to outfit their space. When doing that, the lease improvements have to be amortized under the current law over a 15-year period. But then, certain things can be amortized or depreciated over, say, five or seven years. So law firms, in many cases, would prefer to take advantage of the five- or seven-year assets.
Bisnow: For clarity, what are some concrete examples of five- to seven-year assets compared to 15-year ones?
Bill: Many times, when a law firm leases a space, it's an unfinished space with no walls, amenities, nothing. So when the landlord is going to improve that space for the law firm, they’re going to put in walls, wiring, lighting, a drop down ceiling—there may or may not be sufficient HVAC in there.
All of those improvements are assets that they can depreciate. If all you do is spend $1M to up-fit the space and call it all "leasehold improvements," then it will all be depreciated over 15 years.
On the other hand, you can take the plans for building and break that down into more reasonable divisions. You may be able to say that the walls are permanent and are thus 15-year assets, but there are also certain types of wall pieces that are movable and can be considered seven-year assets. Then, there's certain types of cabling and technology that can change over time, and will be considered five-year assets, along with carpeting and various other items.
Bisnow: What are some factors that law firms are considering when it comes to these five- to seven-year assets?
Bill: When a law firm receives a tenant improvement allowance from the landlord and then they simply pay for everything themselves, two things happen.
First, the firm may be forced to pick up that improvement allowance as income in the year they receive it, because they did receive the cash.
Second, they will not be able to experience the full benefit from the depreciation of those leasehold improvements until years down the road. They’d be taking it over a 15-year period.
What we suggest firms do is have a cost segregation study done. This is an engineering study that looks at the plans and breaks out the components of the construction into the different categories. Then the landlord can pay the contractor directly for as many of the 15-year assets as possible, and the landlord will be the owner of those assets as they depreciate. The firm will own more of the five- or seven-year assets and get to depreciate those over the shorter time frame.
Bisnow: And the second?
Bill: This one, admittedly, is more particular. So prior to a few years ago, leasehold improvements had to be amortized, and would depreciate over 39 years, instead of 15.
A lot of law firms that are 12 or 15 years into their leases and are now looking to renew may be sitting on leasehold improvements on their books that were 39-year assets when they started. So they may still have substantial balances of unamortized leasehold improvements left on their books. This could be as much as a couple of million dollars for large firms. And since these large firms in particular publish their profits per partner every year and really rely on that as a recruiting tool, they don't particularly want to write off several million dollars of abandoned leasehold improvements in one year because it could severely impact their bottom line. There are provisions in the IRS regulations that firms may be able to use to avoid this treatment.
Bisnow: Will the new FASB leasing standards—which would have all improvements, lease agreements, and all liabilities on the books—affect law firms or these law firms are just specifically for different markets?
Bill: Well, that’s a good question and that's one of the things that now will make law firms a much more attractive tenant to a lot of these landlords. If you read the FASB rules, it applies to firms that keep their books on a GAAP basis. These "generally accepted accounting principles" aren't the same as the tax accounting rules, as they require you to treat various transactions differently for GAAP purposes than you do for tax purposes. Most law firms do not use GAAP. Most use modified cash basis accounting for their books.
With cash-basis accounting, you only pick up income when you actually receive the cash, and will only record an expense when you actually pay the cash out for the expense. With this kind of accounting, most law firms would not be subject to the rules under the FASB.
Bisnow: Do you find that law firms stick around in office spaces longer than other tenants do and that’s why they choose longer lease terms?
Bill: Because the cost of up-fitting the space is relatively expensive and landlords generally tend to want longer-term leases, we tend to see smaller law firms likely to only have five-, seven- or 10-year leases. The larger firms—which generally will have a little bit more elaborate outfitting—tend to have longer-term leases simply because landlords need the longer terms to recoup costs for what they did to the space and the kind of tenant improvement allowance they’re giving.
Bisnow: With tax day in the rear-view mirror, what are some considerations that law firms of any size should be considering for next year?
Bill: The biggest thing I think—which, admittedly, isn't directly related to the real estate—is personal property tax. Many firms have to pay personal property tax on all of their non-real estate holdings. This includes their furniture, fixtures and equipment and things like that they have in their office, and you’re allowed to depreciate them. But DC, for example, never lets you fully depreciate all your personal property.
So even if it’s something you’ve had for 20 years, there’s still some residual value that you have to pay personal property tax on, and we’re constantly reminding our clients to clean up their personal property tax records and make sure that if they don’t use it anymore, they get it off their books. We constantly find that many firms are still paying personal property taxes and, although it’s often a small amount, it adds up if they have a lot of assets or a lot of things that they don’t even have anymore but are still on their books.
To learn more about our Bisnow partner, click here.