Leases often provide that a landlord has agreed to give a tenant an improvement allowance (Allowance) for enhancements to be made to the leased premises. However, because leases often fail to describe who owns those improvements to be paid for by the landlord, such failure could result in unexpected and unwanted tax consequences.
Currently, if a landlord provides a tenant with an Allowance and the landlord owns the improvements for tax purposes, a landlord can depreciate only the cost of the improvements. Those enhancements are considered real property over a period of 39 years using the straight-line method of depreciation.
If the tenant owns the improvements for tax purposes, the landlord can depreciate the improvements over a shorter time period (i.e. over the lease term), but the tenant will be forced to treat the Allowance as income and depreciate the cost of the improvements over 39 years.
So both the landlord and tenant have an incentive to clearly state in the lease which party owns the improvements paid for by an Allowance.
When a lease does not clearly state which party owns the tenant improvements, the IRS has used a “benefits and burdens of ownership” test. The actual receipt of the Allowance is not the determining factor, but rather who owns the improvements and which party received the Allowance as income.
“Landlords and tenants have attempted to avoid the tax ownership issue by recharacterizing the Allowance as rent reductions or rental abatements rather than direct cash payments.”
Tenants have attempted to claim Allowance funds disbursed through a construction escrow, support an argument that the benefits and burdens of ownership of the improvements utilizing such escrow, rests with the landlord. But such structure will not necessarily relieve the tenant from reporting the Allowance as income.
The Allowance funds may be paid by a landlord, but a number of factors must be considered to determine the applicable party's relationship with the Allowance, including: (i) who is responsible to carry insurance on the improvements; (ii) who has the replacement responsibility therefore; and (iii) who owns the improvements at the end of the lease term.
A tenant may view these factors as skewed in favor of a landlord, because a tenant usually carries insurance on tenant improvements and is responsible to maintain and replace them.
However, some courts have determined these factors may be taken into account, but the real test is to look at the lease itself and determine whether the structure was created for tax avoidance purposes or a legitimate business purpose. If the latter is true, a tenant would not be required to claim the Allowance as income.
Congress has provided a safe harbor for retail tenants receiving an Allowance under Section 110 of the Internal Revenue Code. Under the safe harbor, the Allowance is not treated as income by the tenant. The safe harbor applies to retail leases entered into after August 5, 1997, with terms of 15 years or less (including options, unless the rent, during such extension periods, is based on fair market value) and which constitute “qualified long term real property.”
The safe harbor also requires the Allowance must be used to construct realty improvements for use in the tenant's business and cannot exceed the amount expended by the tenant for such improvements.
Landlords and tenants have attempted to avoid the tax ownership issue by recharacterizing the Allowance as rent reductions or rental abatements rather than direct cash payments. While this should control tax consequences, a tenant will have to advance the construction funds, which may be a financial hardship. In addition, the cost of the tenant improvements must be depreciated over 39 years.
The recharacterization is beneficial to a landlord because the rent reduction or abatement is treated as a reduction in income and may be taken over the rent reduction or abatement period rather than 39 years or the lease term.
James T. Mayer and Harold B. Pomerantz are partners with Piper Marbury Rudnick & Wolfe, a national law firm with offices in Chicago, Washington, Baltimore, New York, Tampa, Philadelphia, Dallas, Reston (VA) and Los Angeles.
