TYPES OF INCENTIVE S
Generally, there are three types of rent inducements.
Cash payments. A cash payment inducement is a payment from a landlord for a tenant's unrestricted use of the cash. The tenant must report those amounts as income when received.
Often, the tenant uses such payments for improvements to the property, depreciating them over 39 years (the current recovery period for nonresidential real property). Typically, the landlord capitalizes the cash payments as lease acquisition costs and amortizes them over the term of the lease.
Rent holiday. A rent holiday is either a rent-reduction or a rent-free period. Either situation immediately reduces the landlord's income. The tenant recognizes income as a result of the reduced rent to be paid and improves cash flow by paying a lower or no rent at the start of the lease period.
A variation of the rent holiday is a graduated rent payment schedule, under which a tenant pays less rent in the first year(s) of a lease; each year thereafter, the rent increases. (The tenant pays the same amount of rent in total over the lease's duration but pays less at the beginning and more at the end of the term.) This type of arrangement may benefit both the landlord and the tenant. It defers income for the landlord and improves cash flow at the beginning of the lease for the tenant.
Any of these arrangements (a rent-reduction or a rent-free period or a graduated rent payment), however, may be subject to the deferred rent agreement rules of IRC section 467. Generally, deferred rent agreements are tangible personal property agreements involving more than $250,000 in rent payments under which either of the following applies:
- At least one payment, allocable for property use during a calendar year, is to be paid after the close of the following calendar year.
- There are increases (or decreases) in the amount of rent to be paid under the agreement.
If a lease is subject to those rules, the IRS may ignore its express terms and redetermine the amounts of income allocable to the landlord and rent deductible by the tenant (based on the present value of future lease payments).
Build-out allowances. In a build-out-allowance inducement package, the landlord offers a prospective tenant an allowance to make improvements for the tenant's benefit. The tenant specifies the improvements subject to landlord approval. The landlord pays for the improvements made on the tenant's behalf, and the tenant gets to use the improvements for the term of the lease. From a tax perspective, this type of rent inducement favors the tenant. The tenant does not recognize any income from the construction of the improvements (as their cost is built implicitly into the amount of rent charged). On the other hand, the landlord, who pays for the costs of the improvements, must depreciate them over 39 years.
SHORT-TERM LEASES OF RETAIL SPACE
An exception to the general tax treatment of rent income and expense is available for short-term-lease retail tenants that receive cash or rent reductions from a landlord. If the proceeds are used for qualified construction of leasehold improvements to the space, the cash or rent reduction will not be included in the tenant's gross income. To qualify, the lease must be an agreement for occupancy or use of retail space with a duration of 15 years or less (including renewal options). For a discussion of this and other current developments, see the Tax Clinic, edited by Anthony Bakale, in the August 1999 issue of The Tax Adviser.
— Nicholas Fiore, editor The Tax Adviser