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.
First the parties must agree on the nature, extent, and ownership of the improvements, and document their intent in the lease. If a construction allowance is part of the deal and the parties want to rely on the safe harbor, Sec. 110 can be used.
- Review all new leases with clients. If the owner is providing a construction allowance, make sure the lease contains the proper language regarding construction of qualified long-term real property and ownership of the improvements. A separate agreement may be in place but the agreement must be executed before payment of the allowance.
- To avoid any excess income recognition, the allowance can be paid in installments as costs are incurred, with a final payment at the end of the project. Or the agreement can provide that the tenant will return any unused allowance to the landlord.
- A build-out of tenant space may include both real and personal property (1245). The landlord may initially account for all the improvements as 39-year property and later perform a cost-segregation study to reclassify the personal property. Important: taxpayers need to be cautious of a potential trap in this situation. For example, assume a tenant receives a $2 million allowance, constructs and places in service $2 million of building improvements, but excludes the full amount of the allowance from income under Sec. 110. In the following year, the landlord does a cost-segregation study and reclassifies $250,000 to personal property.
The IRS could take the position that the tenant should have recognized $250,000 of income in the year the allowance was received, because the amount expended on personal property was ineligible for the exclusion under Sec. 110 in the first place.
- A strategy to avoid this trap is to include language in the agreement stating that “a certain portion of the allowance is for personal property, that the tenant is acting as the landlord’s agent with respect to the personal property, and that the landlord owns the personal property improvements”.
- Make sure the required disclosures are included with the timely filed federal income tax returns for the year the allowance is paid by the owner and received by the tenant. Failure to provide the required information may trigger penalties under 6721.
Construction Allowance Payments Outside the Safe Harbor
If the allowance does not meet the safe-harbor requirements under §110 or if the parties to a retail lease want to avoid dealing with Sec. 110 the construction allowance does not automatically trigger taxable income to the tenant.
The tax treatment of the construction allowance and resulting improvements depends on who owns the improvements. In the preamble to proposed regulations the IRS stated:
“To the extent the tenant holds the benefits and burdens of ownership of the leasehold improvements constructed with the construction allowance, the tenant has an accession to wealth and income under Sec. 61(a). However, to the extent the landlord holds the benefits and burdens of ownership, the tenant is acting merely as an agent of the landlord and the construction allowance is not includible in the gross income of the tenant”.
If the tenant owns the improvements, the construction allowance is income to the tenant in the year it is received, and the improvements are depreciated over the appropriate recovery period beginning when they are placed in service. The landlord capitalizes the amount of the construction allowance as a lease acquisition cost and amortizes it over the term of the lease.
If the landlord owns the improvements, it appears that the result is similar to the safe harbor under Sec. 110. The tenant is simply acting as an agent of the owner, and the allowance is not income to the tenant.
Note that for payments outside the §110 safe harbor, the qualified long-term real property condition does not apply, so the tenant can use the allowance for personal property as well.
Further, while the §110 disclosure requirements do not apply to allowances outside the safe harbor, the agreement between the owner and the tenant should clearly state who is paying for—and who owns—the improvements.
Authored by Kevin Jerry MST
Executive Vice President CSSI
Masters of Science in Taxation