Tenant Severance Payments – Immediate Expense from Rental Income

The classification of expenses incurred in connection with the acquisition and renovation of a building can frequently become a matter of dispute with the competent tax office. The issue concerns repair and modernization measures under § 6 Abs. 1 Nr. 1a EStG. According to this provision, the production costs of a building also include expenses for repair and modernization measures carried out within three years of the building's acquisition, provided that such expenses, excluding VAT, exceed 15 percent of the building's acquisition costs (production costs incurred close to acquisition). How this legal basis applies to severance payments for existing tenancies is explained below on the basis of a court case.

The Dispute

The plaintiff in this case is a GbR whose corporate purpose is the letting of real property. In the 2016 assessment period, it acquired four residential units in a listed building. The purchase price was EUR 1.2 million. In order to bring the units up to a higher technical standard, the plaintiff carried out extensive renovation work on the rental apartments between 2016 and 2018. For the sake of simplicity, severance payments totalling EUR 35,000 were made to the existing tenants to induce them to move out early. The renovation could also have been carried out with the tenants remaining in place, but this would have been considerably more cumbersome. The GbR claimed the severance payments as immediately deductible income-related expenses in its separate and uniform determination of profits. Following a tax audit, however, the competent tax office decided to classify the tenant severance payments as repair and modernization measures under § 6 Abs. 1 Nr. 1a EStG. The FG Münster, which had jurisdiction over the underlying action, agreed with the tax office in its ruling and classified the severance payments as repair and modernization measures under § 6 Abs. 1 Nr. 1a EStG.

BFH Ruling: Tenant Severance Payments – Immediately Deductible

Contrary to the tax office and the FG Münster, the BFH ruled in favour of the GbR. According to the BFH, the scope of repair and modernization measures is limited to structural measures on the building itself. Accordingly, expenses that are only indirectly connected with repair and modernization measures do not automatically fall under § 6 Abs. 1 Nr. 1a EStG. Such expenses include severance payments for previously existing tenancies. Furthermore, the timing of repair and modernization measures under § 6 Abs. 1 Nr. 1a EStG must also be considered. The relevant point in time for such measures is the commencement of construction. The commencement of construction can be considered either the filing of a building application or, in the case of projects not requiring a building permit, the submission of the construction documents (§ 52 Abs. 16 Satz 8 EStG i.d.F. des StÄndG 2003). Tenant severance payments are often made in advance and, in terms of timing, are therefore not attributable to the repair and modernization measures. The BFH further explains that § 6 Abs. 1 Nr. 1a EStG is in any event intended to simplify matters, in that repair and modernization measures undertaken in the context of a building acquisition need not be considered in isolation (Senatsurteil in BFHE 254, 246, BStBl II 2016, 996, Rz 16; Schindler in Kirchhof/Seer, a.a.O., § 6 Rz 70). However, if expenses do not belong to the repair and modernization measures, a separate assessment is generally required. Taking these points into account, the BFH classified the tenant severance payments as immediately deductible income-related expenses against income from letting and leasing (§ 21 EStG).

Note: Demolition and New Construction

It should be noted, however, that the building underlying this dispute is a listed building, so that complete demolition and new construction would not have been possible. By contrast, it should be noted that the demolition of a building in order to erect a new building on the same site naturally results in production costs. In such a case, severance payments for an existing tenancy would also be subject to these costs and would therefore qualify as subsequent acquisition and production costs (cf. BFH-Urteil vom 01.10.1975 – I R 243/73, BFHE 117, 153, BStBl II 1976, 184).