Tenant construction allowances are an integral part of commercial real estate leasing transactions. The concept is simple: Landlords need to attract tenants, and tenants need to modify space for their business.
The construction allowance is an important negotiated term of the lease that helps both parties get the deal done.
One way to plan for the tax treatment of tenant allowances is to use the qualified-tenant-construction-allowance safe harbor provided by §110.
A misstep under §110 could mean immediate taxable income for the tenant and depreciation deductions spread over 39 years.
110 allows tenants to exclude from income any amount received in cash as a construction allowance from the owner (or treated as a reduction in rent).
This safe-harbor exclusion applies if the allowance is received under a short-term lease of retail space and used to construct qualified long-term real property for use in the tenant’s trade or business at the retail space.
- A short-term lease is a lease with a term of 15 years or less, generally including options to renew. Two or more successive or related leases are treated as one lease.
- Retail space means real property leased, occupied, or otherwise used by the tenant in its trade or business of selling tangible personal property or services to the general public. Retail has a very far-reaching meaning and includes everything from auto dealers, retailers, restaurants and professional service providers.
- Qualified long-term real property is nonresidential real property that is part of the retail space and that returns to the landlord at the termination of the lease. Qualified long-term real property does not include Sec. 1245 property. In addition, the lease must state unambiguously that the allowance is for the construction of qualified long-term real property used in the tenant’s trade or business (Regs. Sec. 1.110-1(b)(3)). Although the regulations do not require the lease to state that the entire allowance is for constructing or improving qualified real property, if the tenant does not spend the full amount on qualified improvements, the excess is included in income (Rev. Rul. 2001-20).
As a side note, A separate agreement is also considered a provision of the lease agreement, if the agreement is executed before payment of the construction allowance.
The allowance must be expended in the tax year received. However, the regulations provide some flexibility; an allowance amount is deemed expended in the tax year received if
The tenant expends the amount within 8½ months after the close of the tax year received or the allowance amount is a reimbursement for amounts previously expended by the tenant ONLY IF the tenant did not claim any depreciation on the improvements.
From the landlord owner’s perspective, qualified long-term real property constructed or improved by a tenant and excluded from the tenant’s income under §110 is owned by the landlord. The owner must treat the entire amount of the construction allowance as fully used unless the tenant notifies the owner otherwise in writing. The owner can begin depreciating the qualified long-term real property when the property is placed in service.
Finally, both the landlord and the tenant must disclose certain information with their tax returns for the year in which the allowance is received. This information includes:
Name and address;
Employer identification number;
Location of the property; and
The amount of the construction allowance that qualifies under Sec. 110.
Authored by Kevin Jerry MST
Executive Vice President CSSI
Masters of Science in Taxation