Ask an Expert
Does a tax advantage exist when paying upfront for leasehold improvement?
Expert: Lloyd Lindsay
Is there a tax advantage to paying up front for leasehold improvements or should we be adding the costs to our monthly lease payments?
Lloyd Lindsay answered:
Probably, adding the costs to your monthly lease payments is the better choice. By doing so, you obtain a full tax write-off of the improvements by the end of the lease. However, you should crunch out the numbers to determine which payment method is best for you.
ADDING THE COSTS TO YOUR MONTHLY LEASE PAYMENTS
For tax purposes, the higher monthly lease payment is fully deductible, as long as you don't split it into two amounts: one for the regular rent, and the other for the improvements. In the past, based on economic substance, Canada Revenue Agency (CRA) might have considered part of the monthly rent as a depreciable asset. However, a Supreme Court case, Shell Canada Limited vs. The Queen, indicated that it was inappropriate for CRA to change a legal rental arrangement.
PAYING UP FRONT FOR IMPROVEMENTS
When you pay up front for improvements, you acquire a depreciable asset, the cost of which you can write-off over a period of time. Tax rules call it capital cost allowance (CCA); accountants call it depreciation or amortization.
Your improvements would fall into one of the following asset classes:
1. Building – Class 1, declining balance method, rate of four per cent, six per cent, or 10 per cent, or
2. Leasehold Improvements – Class 13, straight-line method.
So how do you know into which class your improvements fall?
The tax rules say that they would fall into the building class if they were for the following:
- Erecting a building or structure on leased land;
- Making an addition to a leased building or structure, or;
- Making alterations to a leased building or structure that substantially changed the nature of the property.
In its bulletin IT-464, CRA provides some guidelines. It considers the following expenditures not to be a substantial change and so they would fall into Class 13 Leasehold Improvements: the conversion by a tenant of one room into an office, or of one room into two room; or a new store front.
However, CRA considers the following expenditures a substantial change and so they would fall into a Class 1 Building: the conversion by a tenant of a house into a duplex, apartment, offices, or stores.
BUILDING – CLASS 1: DECLINING BALANCE METHOD, RATE OF FOUR PER CENT, SIX PER CENT, OR 10 PER CENT
Under the declining balance method, you apply the rate to the undepreciated balance in the class, and this Class has three rates:
- i. 4 per cent: Standard rate;
- ii. 6 per cent: Applies to new non-residential buildings, and;
- iii. 10 per cent: Applies to new buildings used 90 per cent or more for manufacturing and processing.
LEASEHOLD IMPROVEMENTS – CLASS 13, STRAIGHT-LINE METHOD
Under the tax rules, the maximum deduction in the year is the lesser of the following: one-fifth of the cost of the improvement, and; cost of the improvement, divided by the lease term (including the first renewal option, if any).
You calculate the lease term by taking the number of full 12 month periods from the beginning of the tax year in which you made the improvement until the termination of the lease (plus the first renewal option, if any). For this calculation, the lease term is limited to 40 years.
For both Buildings and Leasehold Improvements, a Half-Year Rule applies. In the year you make an addition to these classes, the tax rules limit your deduction claim to only one-half the maximum normally allowed.
If all of the above appears complex, it is. And if the expenditures for your improvements are substantial, ask a professional accountant to help you decide using the actual numbers.
About the author
Lloyd Lindsay is a CA, a licensed Public Accountant, Chartered Professional Accountant, and a Certified Management Consultant. He completed the CICA In-Depth Tax Course in 1985 and has been in public practice for over 40 years. Also, from time to time, he teaches on a contract basis.
Lloyd is a member of the Personal Computer Club of Toronto and has hosted its Microsoft Office Special Interest Group for many years.
In addition to providing tax, accounting, and auditing services, Lloyd provides presentations on those topics and on using accounting software, PowerPoint, and MS Office programs.