The Tenant and Capital Expenditures

Updated: Sep 12, 2019

What are they and why am I paying for them?

By Anna Woodworth, Esq.

Senior Auditor

A Quick Note: you may be familiar with the term “capital expenses,” but for the purposes of this discussion, we will refer to costs associated with capital items as capital expenditures. We do so because combining the terms “capital” and “expense” can often lead to confusion. As we explore the topic of capital expenditures herein, the reason for making this distinction will become clear.

Tenants should consider many options when negotiating a commercial lease, especially because there can be lots of costs beyond just how much a tenant pays for rent. Capital expenditures are big ticket items that a tenant may get stuck paying for if they are not discussed beforehand. There are provisions that can be negotiated to lessen or eliminate these potentially unnecessary burdens for the tenant.

The lease has provisions for which specific operating expenses or capital expenditures may be passed through to the tenant. Ordinary expenses include the maintenance costs and ordinary repairs necessary to keep the building in working condition, as opposed to a capital expenditure typically representing a substantial investment by the building owner. Some people like to think of the difference in terms of “keeps” and “puts.” For example, if the expenditure “keeps” the asset in an ordinary or efficient operating condition, it would be considered an operating expenditure. On the other hand, if the expenditure improves the asset, or “puts” it in a better operating condition, then it could be considered a capital expenditure.

For illustration, a cost that “keeps” the HVAC system in its ordinary operating condition would be an ongoing maintenance expense such as biannual check-ups. The system was working in its ordinary operating condition before the checkup and continues to work in its ordinary operating condition after the checkup. A cost that “puts” the HVAC system into a better operating condition is an expenditure that substantially improves or extends its useful life, an expenditure the landlord could amortize beyond one year, such as replacing the chiller. Repair v. replace is another way to view the difference between ordinary and capital expenditures.

Tenants should negotiate carefully in order to not get stuck with a large bill in the years to come.

Leases can exclude capital expenditures entirely, and tenants can and should negotiate to exclude some or all capital improvements. For example, it is very common for a lease to narrow the allowable capital expenditures to only those which are “required by law” or that “produce documented energy savings” over the life of the capital project. When Landlords insist on including capital projects in the payment of operating expenditures, tenants should negotiate to amortize those expenditures, and include those expenditures in the Base Year if there is one.

Standards Defined in the Lease

When tenants negotiate a commercial lease, they should pause to consider the standards being implemented in the lease to define the scope and character of the terms. This can be especially important when big ticket items are in play, i.e. who pays for capital projects in the building.

Landlords can capitalize large projects or expense them. Whether a Landlord capitalizes these expenditures for its own accounting and tax purposes is only partially related to whether it can pass those costs onto tenants. The lease language determines whether the tenant will be obligated to pay for those costs.

When the costs are passed through to tenants, they can be expensed in the year they are paid or amortized over a period of years. The standard laid out in the lease determines the definition of capital expenditures and who pays for them.

The IRS, GAAP, BOMA, and Other Standards

According to the Internal Revenue Service (“IRS”), capital costs are those amounts paid to acquire, produce, or improve a unit of property (“UOP”). A UOP for a building is comprised of the building and its structural components, including building systems. Building systems are defined to include:

· HVAC systems

· Plumbing systems

· Electrical systems

· All escalators

· All elevators

· Fire and alarm systems

· Security systems

· Gas distribution systems

· Systems identified in published guidance