Tax Court Addresses Leasehold Improvements as a Substitute for Rent

By Andrew J. Pitt, Holtz Rubenstein Reminick, LLP, Melville, NY

Editor: Stephen E. Aponte, CPA

In a U.S. Tax Court case published on May 19, 2009, Hopkins Partners, Cleveland Airport Hotel Limited Partnership, Tax Matters Partner, T.C. Memo. 2009-107, the court held that:

  • A lease agreement under which a lessor accepted predetermined and explicitly stated eligible leasehold improvements as substitutes for rent credits from a lessee was the intention of both parties;
  • The lease had economic substance and was not drafted to evade taxes;
  • The partnership’s treatment of the eligible improvements as a substitute for rent did in fact clearly represent income;
  • Deducting the cost of the eligible improvements in lieu of rent credits as an alternative to depreciating the improvements was not a change of accounting method; and
  • The partnership properly deducted the cost of the eligible improvements as a rent expense in the year the eligible improvement was credited against rent.


Hopkins Partners, an Ohio general partnership, operates the Sheraton Cleveland Airport Hotel, which is owned by the city of Cleveland, Ohio. The partnership has the leasehold right to operate the hotel and the attendant parking facilities through November 13, 2048.

During the mid-1980s, the hotel was in poor condition and needed to be renovated. The partnership believed that the rent under its lease agreement from the immediate predecessor in interest was unjust and significantly above the prevailing market rate. The partnership had projected it would lose $500,000 a year through 1997 but was looking for a way to make a profit. The city was concerned about the appearance of the hotel and wanted it renovated. The city went as far as intimidating the partnership by saying it would allow the construction of a second hotel on the airport premises if renovations were not completed.

The partnership did not have the money to make the improvements the city wanted and could not get a mortgage to pay for the cost of the improvements. The lender, American Real Estate Group, said the land rent was significantly above the market rate and stipulated that it would not provide funds for the cost of the improvements unless there was a large reduction in the land rent.

In 1987, the partnership made it known to the city that it could not get a mortgage to pay for the improvements. As an alternative, the partnership proposed a modification to the terms of the lease, requesting that the minimum annual rent increase to $300,000 and the annual percentage rent decrease. The proposal would decrease the overall rent.

Ultimately, the partnership and the city came to an agreement. As an alternative, the partnership was allowed a rent credit for the cost of eligible improvements against the annual rent in excess of $300,000 toward the payment of the annual percentage rent. Over the course of a few more years, additional amendments to the lease were made, but the overall concept remained the same. Rent credits would be allowed against the annual percentage rent for eligible leasehold and land improvements for the annual rent in excess of a specific amount and up to a specified limit.

At the beginning of each year, the city held the right to accept or reject planned improvements. At the end of the year, the partnership and the city had to agree on the improvements that qualified as eligible improvements that could be used as rent credits. The city held the right to audit all records and on occasion rejected items as noneligible improvements. The partnership held the right to decide which eligible improvements it would use for rent credit.

Each year, the partnership provided the city with a comprehensive spreadsheet of eligible improvements it designated to be used toward rent credits. Titles to the eligible improvements were transferred to the city at the end of each year they were credited against rent.

Eligible improvements were recorded on the books of the partnership as capital assets. When the partnership elected to use a current year improvement as a rent credit, it took a deduction for rent expense on its income tax return for that year. When eligible improvements were made but were not credited against rent in the year they were made, the partnership recorded the capital asset and depreciated it in accordance with Secs. 167 and 168. When the partnership selected an eligible improvement that was placed in service in a prior period to be used as a rent credit for a different year, the partnership recorded it like the sale of a capital asset. The sale price was determined to be the amount of rent credit being given; when applicable, depreciation recapture was recorded and gain recognized. The partnership then deducted the cost of the improvement as a rent expense in the appropriate year and recognized the income on the disposal of the eligible improvement.


The primary issue in the case was whether the transfer of leasehold improvements from a lessee to a lessor in return for rent credits was a rent substitute. The Tax Court also addressed whether the rent credit arrangement had economic substance, whether the use of the rent credits was a clear reflection of income, and whether the use of credits was a change of accounting method.


Rent substitution: The Tax Court found that “whether the value of the improvements constitutes rent turns upon the intent of the parties to the lease.” It first considered the lease itself. The amended lease agreement between the partnership and the city stated that the partnership “shall be entitled to receive a credit towards the payment of the annual Percentage Rent, in an amount equal to the cost of eligible improvements . . . which have been made and paid prior to the completion of the lease year.” Referring to the lease agreement that pertained to the parking lot, the agreement stated that the partnership “may deduct the cost of eligible improvements made and paid for in a lease year from any percentage rent due for that lease year.” The Tax Court noted that in Brown, 22 T.C. 147 (1954), it had “held that a similar provision requiring that the cost of improvements ‘be credited to the lessee from the rental due and owing by it under this lease’ resulted in income to the lessor.”

The court next looked at the actions of the parties with respect to the improvements and the credits. The court found that the partnership consistently treated the eligible improvements on its books and records as a deductible rent expense in the same year it received rent credits, consistent with the language of the lease agreements. The court also rejected the IRS’s argument that the city’s status as a tax-indifferent party had any bearing on the determination of intent, finding that the record showed that the city’s status did not have a significant impact on the city’s intent regarding the rent credit arrangement.

Economic substance: The Tax Court stated that when determining economic substance, “courts look at both the objective economic effect (i.e. whether, absent tax benefits, the taxpayer benefited from the transaction) and the subjective business motivation (i.e. whether the taxpayer was motivated by considerations beyond tax benefits) of the transaction.” Looking at the issue, the Tax Court found that the rent credit structure was not chosen for its tax benefits to the partnership but for the subjective business purposes of helping the partnership renovate the hotel so it could make a profit and stay in business. The partnership needed a way to fund capital improvements because it could not borrow funds due the terms of its lease with the city, and the city needed an uncomplicated way other than a straight rent reduction (which was not viable politically) to help the partnership make the needed improvements. The rent credit structure met both parties’ aims. The court found that the partnership was thinking beyond tax benefits; it was thinking about survival.

Clear reflection of income: The Tax Court stated that a method of accounting clearly reflects income when it results in accurately reporting taxable income under a recognized method of accounting. It further noted that the IRS has broad discretion but cannot require a taxpayer to change from an accounting method that clearly reflects income merely because the Service considers an alternate method to more clearly reflect income; if a taxpayer’s method of accounting is authorized by the Code or regulations and has been applied consistently, the IRS cannot arbitrarily require a change or reject the taxpayer’s method. Finding that both the courts and the regulations approved of the method of accounting for improvements made in lieu of rent and that the partnership had consistently applied the method, the Tax Court held that this method clearly reflected the partnership’s income.

Change in accounting method: The Tax Court stated that Sec. 446(e) “provides that a taxpayer must secure the consent of the Secretary before changing his method of accounting.” It quoted the following passage from Woodward Iron Co., 396 F.2d 552, 554 (5th Cir. 1968):

The reason for this rule is that a change in an accounting method will frequently cause a distortion of taxable income in the year of change; therefore, the Commissioner is empowered to prevent such distortion and consequent windfall to the taxpayer by conditioning his consent on the taxpayer’s acceptance of adjustments that would eliminate any distortion.
Appropriately, the Tax Court determined that there was no change in accounting method because the partnership received a rent credit for the cost of eligible improvements. When eligible property was transferred, the partnership recaptured all depreciation and recognized gain. The partnership consistently treated all transactions in this manner. The partnership never doubled up on depreciation expenses and rent expenses without recapturing depreciation that was taken on eligible improvements when transferred for rent credits. Therefore, the Tax Court held that a change in accounting method never occurred, and the partnership treated all transactions as stated in the lease agreement.


If the lease agreement did not clearly stipulate how the leasehold improvements would be used as rent credits, and if the partnership did not continually record and handle each transaction as it did, the outcome of the court case may have been different. The intent of both parties, as evidenced by the lease agreement and the parties’ actions, was the driving force of the decision. The evidence showed that the rent credit arrangement had economic substance because it had the nontax business purpose of continuing an ongoing business relationship.


Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or

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