If you own a business and have ever wondered what happens to the depreciation of the investments you made in a rented property when the lease is terminated, this case will be of interest to you. It is a recent binding ruling (V2118-24) that clarifies an important point regarding the tax treatment of these situations. Let’s take a closer look at it in detail and in simple terms.
The Case: Investment in a Rented Property
The story begins with a hospitality company that, in 2017, rented a space to turn it into a coffee shop. As is often the case, in order to convert the space (which had been a retail store) into a venue suitable for the hospitality industry, the company had to make a significant investment:
- Masonry, electrical work, soundproofing, …
- Also, the purchase of machinery and furniture necessary for its operations.
The cost of these improvements was depreciated according to tax schedules, with a 20-year depreciation period for the improvements, matching the initial term of the lease agreement. However, in 2019, the company terminated the lease because the premises were not profitable. Although some items, such as furniture and machinery, were reused at other locations, the improvements remained part of the premises, resulting in an accounting loss of 108,000 euros. It is important to note that when a company vacates a property, there are elements it cannot take with it, such as the electrical system.
This raises a tax-related question:
- Can those projects continue to be depreciated until the 20-year period is complete?
- Or do we have to write everything off in 2019, with the corresponding impact on the financial statements?
What the General Directorate of Taxes Says
The response from the General Directorate of Taxes (DGT) is clear:
- When the lease agreement is terminated, the improvements can no longer be depreciated. The reasons for this are based on accounting and tax regulations, as well as, perhaps, common sense. A fixed asset (such as improvements) must be written off when it no longer generates profits or economic returns for the company. In this case, since the improvements are tied to the premises that are no longer in use, their write-off is mandatory.
- The accounting loss resulting from this disposal must be reflected in the income statement for the fiscal year in which it occurs—that is, in 2019. This loss is tax-deductible, provided that it aligns with the carrying amount and is properly recognized.
What does this mean for businesses?
In practical terms, this means that:
- You cannot continue to depreciate investments in a leased property once the lease expires, and you must recognize the extraordinary loss in the fiscal year in which the lease is terminated. That loss is included in the corporate income tax base, which may cause the company to report a net loss for that fiscal year, with all that entails.
- For tax purposes, we will generate a negative tax base to offset future profits.
An extra tip for business owners and accountants
This case reminds us how important it is to consider the term of lease agreements and plan investments accordingly. If you’re thinking about undertaking significant renovations on a leased property, carefully assess the timing and the potential tax and financial impact if the lease is terminated early.
If you’d like to learn more about these topics, you can read Article 1
Section 1 of the Corporate Income Tax Law or the depreciation guidelines in the General Accounting Plan. You can also review other binding rulings on the Tax Agency’s website and, of course, consult with us as your tax advisors.
Frequently Asked Questions
Can you continue to depreciate the improvements if the lease is terminated?
When the lease is terminated, the improvements can no longer be depreciated.
In which fiscal year should the loss resulting from the suspension of construction be recognized?
The accounting loss resulting from this disposal must be reflected in the income statement for the fiscal year in which it occurs—that is, in 2019.
What happens to the accounting loss for tax purposes?
This loss is tax-deductible, provided that it corresponds to the book value and is properly recognized.
What impact might this have on corporate income tax?
That loss is included in the corporate income tax base, which may result in the company reporting a net loss for that fiscal year, with all that that entails.
What can be done with the negative base that is generated?
For tax purposes, we will generate a negative tax base to offset future profits.
Conclusion
Conclusion: Repay Your Loan Wisely
In short, if you terminate the lease, you’ll need to crunch the numbers and adjust your taxes for that year, recognizing the corresponding loss. Although it hurts to lose investments, these types of tax adjustments in the form of tax loss carryforwards will be there to offset future profits.
