Capital Appropriations and Section 183 Elections

The first thing to establish is whether or not the seller has the qualifying interest. This means that they are entitled to capital allowances. With the direct purchase and sale, the interest will automatically be transferred to the buyer. However, leases are somewhat more complex; When a lease is granted, the lessor will generally grant lesser interest and thus, by default, keep the qualifying interest.

It should be noted that there is an exception in the case of development; Let’s say a developer renovates a commercial property and leases it, the qualified interest and principal allowances would automatically pass to the lessee. This is because the developer treats the office as business shares, which of course is not eligible for capital allocations, because as far as the developer is concerned, the developments are the ‘proceeds’ rather than the ‘equity’. The lessee, on the other hand, will use the property as capital, either by leasing or renting it or by using it directly.

local election 183

As mentioned above, the lessor will not want to lose their capital allocations. To prevent this from happening, they will retain the qualified interest by awarding a lower interest to the buyer. However, the tenant can still get the capital allowances if the landlord agrees to a Section 183 election; This means that the right to capital allowances is transferred to the renter, allowing them to claim instead. There are mutually beneficial reasons to participate in an election. It may be that the renter pays taxes at a higher marginal rate than the landlord and therefore could claim more money. If the lessee agrees to compensate the lessor for the loss of his possible capital allocations, then the buyer gets to keep the difference and both parties benefit.

As an example, let’s say a lease is entered into and the lessor is a small business that pays 20% taxes and has the qualifying interest while the buyer is an individual that pays 45% taxes. The property has £10,000 of capital allowances. If the parties were to stay in the default position with the lessor retaining the rights, then the lessor would have a mutual fund of £2,000 to claim over several years, while the buyer would have nothing. However, if the buyer and lessor entered into a Section 183 election transferring the qualified interest to the buyer, then the buyer would have a joint fund of £4,500 to claim. The buyer could then compensate the lessor for the £2,000 lost and keep the remaining £2,500. Of course, when the lessor could negotiate a bigger share of the £2,500 extra profit during negotiations! The end result is that both parties will be better off (and certainly no one will be worse off).

So, to summarize, it is important to ensure that you have acquired all the necessary information prior to negotiations and to remember that by being willing to cooperate and ensuring that the other party has all the facts relevant to the capital allocations, it could be that both parties benefit.