Landlords and tenants should know the tax treatment of items associated with the language built into a lease and all ancillary agreements, as well as items that are not included in any written agreement. Three areas that present tax opportunities are tenant improvement allowances, lease inducement payments, and lease termination payments. This item addresses the tax consequences for the lessor and lessee in these areas.
Tenant Allowances
A lessor pays a tenant allowance to provide a lessee with funds to prepare the space for its intended business use. Generally, the tenant treats a tenant allowance received from the landlord as ordinary income. The tenant would recognize income and depreciate assets over their useful life, resulting in a mismatch of income and expenses. However, if the parties structure a tenant allowance correctly, Sec. 110 provides a safe harbor so that the tenant is not required to recognize income for the allowance.
Sec. 110(a) allows a lessee to exclude from income the amount of a qualified construction allowance received from a landlord to the extent the allowance does not exceed the actual costs incurred to improve the leased space. For tenant allowance payments from a landlord to a lessee to be considered a qualified lessee construction allowance, the lease must be short-term and for retail space. Regs. Sec. 1.110-1(b)(2)(ii) defines a short-term lease as any agreement for the occupancy or use of a retail space for a term of 15 years or less. The lease term is determined by taking the initial lease term in the lease agreement and including any lease extension options unless the rent is to be renewed at fair market value determined at the time of the renewal (Sec. 168(i)(3)). Regs. Sec. 1.110-1(b)(2)(iii) defines retail space as space "that is leased, occupied, or otherwise used by the lessee in its trade or business of selling tangible personal property or services to the general public . . . [and includes] space where activities supporting the retail activity are performed." Regs. Sec. 1.110-1(b)(3) also contains a purpose requirement, which requires that the tenant allowance be expressly provided for in the lease agreement (or an ancillary agreement) and be for the purpose of constructing or improving qualified long-term real property for use in the lessee's trade or business at the retail space. Personal property, even if it is used in the retail space, will not qualify under the safe harbor.
Sec. 110 provides that improvements related to a qualified leasehold improvement allowance are determined to be owned by the landlord. For purposes of retail space, qualified property generally meets the following requirements: It has a recovery period of 20 years or less; is acquired prior to Jan. 1, 2020; and is deemed qualified improvement property (Sec. 168(k)(2)(A)(i)). Once these guidelines are met, the improvements are then eligible to be treated as 15-year recovery qualified leasehold improvement property eligible for special depreciation, which includes 50% bonus depreciation for tax year 2016.
When developing language within the lease agreement concerning the tenant allowance, the landlord should consider including a restriction on the use of funds to ensure the allowance is eligible to be treated as qualified leasehold improvement property and for special depreciation allowance treatment under Sec. 168(k). Qualified leasehold improvement property is carved out of the general definition for qualified property, as it applies specifically to improvements made to the interior of nonresidential real property. The property must be placed in service more than three years after the building was first placed in service, and the space must be occupied solely by the lessee (Sec. 168(e)(6)(A)).
When a qualified lessee construction allowance is paid pursuant to a lease agreement, both parties are required to make disclosures with their federal tax returns under Sec. 110. The lessor and lessee must attach a statement to their returns that includes the location of the retail space and the full amount of the tenant allowance provided. The lessor is also required to disclose what portion of the allowance is being treated as nonresidential real property owned by the lessor. The lessee should include the portion of the construction allowance that is deemed to be a qualified lessee construction allowance under Regs. Sec. 1.110-1(b) (Regs. Sec. 1.110-1(c)(3)). Parties that fail to make the required tax return disclosures associated with a construction allowance may be subject to penalties under Sec. 6721.
Lease Inducement Payments
Another common arrangement between landlords and tenants (which the parties may or may not provide for in the lease agreement) is a lease inducement payment. Lease inducement payments are those made by or on behalf of the landlord to entice a tenant to sign a lease agreement. Lease inducement payments may be in the form of cash but may also include a transfer of ownership of a building or land, payment of costs by the lessor on the lessee's behalf, a lessor's assumption of the lessee's prior lease obligation with a different landlord, moving expenses, or payment of termination fees to the lessee's previous landlord. When the landlord makes a lease inducement payment, the tenant recognizes income in the year in which the payment is received or earned, depending on the tenant's accounting method. If the tenant uses the amount received for real property improvements, the tenant can capitalize and depreciate the improvements under Sec. 168.
The consideration paid by the landlord to induce a tenant to enter into a lease is considered a cost of obtaining a lease, and therefore it must be amortized by the landlord over the term of the lease under Sec. 178. The lease inducement payment is considered an expense related to acquiring the lease. If the lessor constructs the improvements and owns the property pursuant to the lease agreement, the lessor treats the improvements as a trade or business asset and depreciates them over the appropriate recovery period. At the end of the lease, the landlord may be able to treat the improvements as abandoned property and write them off under Sec. 168(i)(8)(B). To qualify as an abandonment loss under Sec. 168, the improvement must have been paid for by the lessor and related to leased property and be disposed of or abandoned subsequent to a lease termination. To be considered abandoned, it should be more than just vacated by the tenant. For example, if the improvement is unique to the tenant and unable to be used by another tenant, this may qualify as abandonment. Another potential abandonment would be if the improvement is no longer functional or legally allowed to be used by a future tenant.
Lease Termination Payments
The third area of consideration relates to lease termination payments. The parties should draft an additional lease termination agreement at the time of termination if the original lease agreement does not outline any conditions surrounding the termination payment in order to specify the terms for payment. There are two types of lease termination payments: (1) payments made by the landlord to the tenant and (2) payments made by the tenant to the landlord.
Payments made by the landlord to the tenant: Generally, the tax treatment by the lessor depends on the reason the landlord makes the lease termination payment. If a landlord pays a tenant to vacate a space before the end of the lease term, the landlord cannot take a deduction in the year in which the lease termination payment is made. The landlord generally recovers a lease termination payment made to the lessee over the remaining term of the terminated lease (Miller,10 B.T.A. 383 (1928)). When a lessor terminates a lease to make the space available for a new tenant, the lessor should amortize the payment over the life of the new tenant's lease (Wells Fargo Bank & Union Trust Co., 163 F.2d 521 (9th Cir. 1947); Latter, T.C. Memo. 1961-67). If the landlord is terminating the lease early in anticipation of selling the building, the landlord should add the termination payment to the cost of the building (Shirley Hill Coal Co., 6 B.T.A. 935 (1927)). If the tenant is required to vacate the space due to construction or a buildout, the lessor should add the termination payment to the capitalized cost of the improvements (Keiler, 285 F. Supp. 520 (W.D. Ky. 1967)).
Sec. 1241 governs the tenant's treatment of a lease termination payment. Sec. 1241 states that amounts received by a lessee for the cancellation of a lease shall be considered as amounts received in exchange for such lease or agreement. Therefore, if the lease is a Sec. 1231 asset, the tenant can potentially recognize the income as capital gain. Sec. 1241 does not determine whether the lease is a capital asset (Regs. Sec. 1.1241-1(a)). The taxpayer should look to Sec. 1231 to determine whether it can treat the lease as a capital asset. Also, the entire lease termination payment could potentially be deferred under Sec. 1031; the payment must be made to a qualified intermediary and used to acquire a replacement lease (that qualifies under Sec. 1031) or even a fee simple interest in real estate. One should review the remaining lease term (including extension options) to determine whether this would qualify. A leasehold interest in real estate with 30 years or more left on the lease can be considered a fee simple interest in real estate under Sec. 1031.
Payments made by the tenant to the landlord: Lease termination payments received by the landlord are taxable income to the landlord as a substitute for rental payments under Regs. Sec. 1.61-8(b). If a tenant is required to pay a fee to terminate a lease early, the landlord should be careful to not require such a payment in excess of the actual and reasonable loss incurred as a result of the early lease termination. It is possible that the lessor could recognize capital gain treatment on the receipt of a lease termination payment if Sec. 1234A applies. Sec. 1234A states:
gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation . . . with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer . . . shall be treated as gain or loss from the sale of a capital asset.
For the payment to qualify under Sec. 1234A, the property must be a capital asset and not an asset used in a trade or business, which would be considered Sec. 1231 property and would not qualify as a capital asset under Sec. 1221. For the property to be qualified as a capital asset, the activities of the landlord should be minimal with respect to it, and the landlord should hold the property for investment purposes. This provision under Sec. 1234A would not apply to a real estate professional.
Whether the tenant's lease termination payment is deductible depends on the reason for early termination. If the lease was terminated because the lease agreement has become unprofitable, the payment is fully deductible under Sec. 162 (Cassatt,137 F.2d 745 (3d Cir. 1943)). However, if the tenant is terminating to acquire new property, the tenant capitalizes and amortizes the payment as outlined in Letter Ruling 9607016.
Several areas must be considered when entering into a lease agreement. The prospective landlord, tenant, and each party's tax representative and legal counsel should examine the language built into an agreement to occupy space. Frequently, the lease agreement does not list the areas of opportunity addressed in this item, so a separate agreement may be warranted. The scenarios that may have a tax effect for either party can be addressed through the appropriate analysis of the lease language. Such an analysis leads to tax planning and a smoother tenant-landlord relationship.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
