Potential Tax Pitfalls of Tenant Improvement Allowances

By McClintock & Associates | June 13, 2017

By Traci Rutter

Landlords may offer incentives to prospective or current tenants when initiating or continuing a lease. One of the most highly sought of these incentives is the “Tenant Improvement Allowance” or sometimes called a “Tenant Construction Allowance.” The tenant improvement allowance is any amount of cash, or reduction in rent, that a tenant receives from a landlord so that a tenant can renovate the leased space.

Although a valuable economic benefit to tenants, if the allowance and terms of the lease are not structured properly, the tax consequences could be unpleasant. One tax planning strategy to ensure more favorable tax treatment is to use the tax “safe harbor” for Qualified Lessee Construction Allowances provided by Section 110 of the Internal Revenue Code.

Section 110 of the Internal Revenue Code.

As a general rule, if the Section 110 safe harbor is not used, it could require the tenant to recognize the entire amount of the allowance as immediate taxable income in the year the cash allowance or rent reduction is granted, but only allow the tenant to take depreciation deductions on the improvements placed in service from the allowance funds over 39 years. Also, generally the landlord will have lease acquisition costs that can only be amortized over the term of the lease.

A Section 110 safe harbor lease allows tenants to exclude from income any amount received in cash as a construction allowance from the owner (or treated as a rent reduction). Generally, this safe harbor exclusion applies if the allowance is:

  • Received under a short-term lease of retail space (term of 15 years or less, including options to renew), and
  • Used to construct qualified long-term real property (nonresidential real property) use in the tenant’s trade or business at the retail space.

In addition, the lessor and the lessee must attach a statement to their respective federal income tax returns to disclose general information under Section 110 regarding the parties to the lease, the location of the rental space, and the amount of the allowance.

Who is responsible?

However, if one does not meet the technical requirements of the Section 110 safe harbor, the tax treatment to the landlord and lessee of the construction allowance and resulting improvements will depend on who owns the improvements. To the extent the lessee holds the benefits and burdens of ownership of the leasehold improvements constructed with the construction allowance, the lessee has an accession to wealth and income under Section 61(a). However, to the extent the lessor holds the benefits and burdens of ownership, the lessee is acting merely as an agent of the lessor and the construction allowance is not includible in the gross income of the lessee.

If the lessee owns the improvements, the tax treatment will generally be unfavorable as described under the non-Section 110 general rule above. However, if the lessor owns the improvements, then the tax treatment will generally resemble that under the Section 110 safe harbor treatment.

The best guidance is to incorporate tax planning into the negotiation and language of the lease agreement. Please feel free to reach out to us for assistance with any questions you may have regarding Tenant Improvement Allowances.

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