Tax treatment of tenant allowances

Tenant allowances are payments a lessor makes to a lessee to provide the tenant with funds to prepare the rented space for its intended business use. Generally, the tenant treats a tenant allowance received from the landlord as ordinary income. Normally, the tenant would recognize income when the allowance is received and depreciate the 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 from it.

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)).

For a detailed discussion of the issues in this area, see “Tax Clinic: Lease Payments Are Not Always Rent,” by Lisa M. Parente, CPA, and Kimberly Palmer, CPA, in the August 2016 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief,The Tax Adviser

The Tax Adviser is the AICPA’s monthly journal of tax planning, trends, and techniques.

Also in the August issue:

• A look at how new due dates should make next tax season better.
• A discussion of ethical issues involved in powers of attorney.
• An analysis of how to write a client tax letter.

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