Under Sec. 110, certain businesses that are tenants of a retail space may exclude from gross income amounts received from the lessor of the space to construct or improve real property used in the taxpayer’s trade or business. This safe harbor applies where the lease is for 15 years or less (including options to renew) and the property improved or constructed is nonresidential real property that is not Sec. 1245 property. The property must be part of, or present at, the retail space and revert to the lessor at the end of the lease.
“Retail” means selling tangible personal property or services, including professional services, to the general public.
Navigating Sec. 110 does not need to be daunting if advisers keep the following planning considerations in mind:
- Make sure the lease contains the appropriate language regarding construction of qualified long-term real property and its ownership (i.e., the landlord owns the improvements). To avoid any 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.
- If the construction or improvement includes personal property, the parties may wish to specifically allocate a portion of the allowance to it and agree that the tenant is acting as the landlord’s agent with respect to the personal property.
- Tenants should maintain documentation of the amount of the allowance received and the expenditures made for qualified real property. Both parties must provide with their tax returns the information described in Sec. 110(d) and Regs. Sec. 1.110-1(c), and are subject to a penalty if they fail to do so.
ALLOWANCE PAYMENTS OUTSIDE OF SEC. 110
Government agencies or tax-exempt entities are generally not considered retail lessees under Sec. 110. If that is the case, or an allowance otherwise does not meet the Sec. 110 requirements, the tax treatment depends on which party holds the benefits and burdens of ownership of the improvements. 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, the tenant is acting as the owner’s agent, and the allowance is not income to the tenant.
For a detailed discussion of the issues in this area, see “Qualified Lessee Construction Allowances for Retail Tenant Improvements to Real Property,” by Michael C. Schiavo, CPA, in the October 2014 issue of The Tax Adviser.
Alistair M. Nevius, editor-in-chief,
The Tax Adviser
Also look for articles on the following topics in the October 2014 issue of The Tax Adviser:
- A discussion of recent estate planning developments.
- A look at tax advantages for U.S. traders of securities and commodities who relocate to Puerto Rico.
- An analysis of the interplay of the orphan drug credit and the research tax credit.