Tenant construction allowances are a common element of commercial real estate leasing transactions. The concept is simple: Landlords need to attract tenants, and tenants need to customize space for their business. The construction allowance is an important negotiated term of the lease that helps the parties get the deal done. But if the allowance is not structured properly, the tax consequences could be unpleasant. One way to plan for the tax treatment of tenant allowances is to use the qualified-lessee-construction-allowance safe harbor provided by Sec. 110. However, proceed with caution: A misstep under Sec. 110 could mean immediate taxable income for the tenant and depreciation deductions spread over 39 years. The landlord could have lease acquisition costs that would be amortized over the term of the lease.
So what is Sec. 110 (other than an often overlooked section of the Code)? And what happens when a tenant construction allowance does not fall under these rules? While Sec. 110 is not a new provision, it is important to understand how it functions to properly account for improvements to leased property. This item provides an overview of the operation of Sec. 110, notes several planning considerations, and discusses the tax treatment of tenant allowances that are outside the scope of this Code section.
Sec. 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 broad meaning in this context and includes everything from auto dealers, electronics and clothing retailers, and restaurants to professional service providers such as doctors, lawyers, accountants, insurance agents, stockbrokers, and financial advisers.
Qualified long-term real property is nonresidential real property that is part of, or otherwise present at, the retail space and that reverts to the lessor at the termination of the lease. Qualified long-term real property does not include Sec. 1245 property. In addition, the lease must state specifically that the allowance is for the construction of (or improvement to) qualified long-term real property used in the tenant's trade or business (Regs. Sec. 1.110-1(b)(3)). While 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).
A separate agreement between the lessor and the lessee providing for a construction allowance, executed contemporaneously with the lease or during the term of the lease, is considered a provision of the lease agreement, provided the agreement is executed before payment of the construction allowance.
The allowance must be expended in the tax year received. The regulations provide some flexibility; an allowance amount is deemed expended in the tax year received if (1) the tenant expends the amount within 8½ months after the close of the tax year received or (2) the allowance amount is a reimbursement for amounts previously expended by the tenant (provided that the tenant did not claim any depreciation on the improvements).
From the lessor owner's perspective, qualified long-term real property constructed or improved by a tenant and excluded from the tenant's income under Sec. 110 is treated as nonresidential real property of the landlord (in other words, the landlord owns the improvements). 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.
First and foremost, the parties have to agree on the nature, extent, and ownership of the improvements, and document their intent in the lease. Tenant allowances are an important part of lease negotiations, and it is simply bad advice to tell clients to leave this on the table. If a construction allowance is part of the deal and the parties want to rely on the safe harbor, Sec. 110 can be used as a tool to achieve the desired results. Navigating Sec. 110 does not need to be daunting if advisers keep the following planning considerations in mind:
- Review all new leases with clients. If the owner is providing a construction allowance, make sure the lease contains the appropriate language regarding construction of qualified long-term real property and ownership of the improvements (i.e., the landlord owns the improvements). This language may be in a separate agreement, as long as that agreement is executed before payment of the allowance.
- To avoid any excess allowance/income recognition, the allowance can be paid in installments as costs are incurred, with a final "true-up" payment at the end of the project. Alternatively, the agreement can provide that the lessee will return any unused allowance to the lessor.
- Of course, a
build-out of tenant space may include both real and
personal property. The lessor may initially account
for all the improvements as 39-year property
(building) and later perform a cost-segregation study
to reclassify the personal property to shorter
recovery periods. Taxpayers need to be wary of a
potential trap in this situation. For example, assume
a tenant receives a $1 million allowance, constructs
and places in service $1 million of building
improvements, and excludes the full amount of the
allowance from income under Sec. 110. In the following
year, the lessor conducts a cost-segregation study and
reclassifies $250,000 to personal property. The IRS
could assert 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. (See the discussion of payments outside the Sec. 110 safe harbor, below.) Additionally, while tracing construction allowance expenditures is not required, tenants should maintain documentation of the amount of the allowance received and the expenditures made for qualified long-term real property.
- 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 the failure-to-file penalty under Sec. 6721; the penalty applies separately to each lease.
Construction Allowance Payments Outside the Safe Harbor
Leases to government agencies or tax-exempt entities (such as charitable organizations) generally are not considered retail leases under Sec. 110. However, the regulations do not address nonretail leases. So what if the allowance does not meet the safe-harbor requirements under Sec. 110? Or what if the parties to a retail lease want to avoid dealing with Sec. 110 altogether? Is the construction allowance automatically taxable income to the tenant?
Not necessarily. The tax treatment of the construction allowance and resulting improvements depends on who owns the improvements. In the preamble to proposed regulations (REG-106010-98), the IRS stated:
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 Sec. 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 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 Sec. 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 Sec. 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.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP