Rent inducements and the TRA '97.

In today's business environment, prospective tenants of commercial property have many alternatives when choosing commercial space and structuring lease agreements. In an effort to attract tenants to available commercial space, landlords often provide extraordinary benefits or favorable lease terms. Called rent inducements, these are clauses in a lease agreement that landlords provide in an effort to attract future tenants to lease available property. Prior to the Taxpayer Relief Act of 1997 (TRA '97), there was much ambiguity as to the tax treatment of rent inducements by both tenants and landlords. The TRA '97 more clearly defined treatment in some specific cases, but many gray areas still exist.

Generally, there are three types of rent inducements:

1. Cash payments;

2. Rent holidays; and

3. Build-out allowances.

Cash payments represent a payment by a landlord for the tenant's use. Because the tenant has an unrestricted use of the cash, it must be treated as income in the period received. More than likely, the tenant will use the cash payments to construct leasehold improvements, which will then be depreciated over 39 years (the current recovery period for nonresidential real property). Typically, the landlord will capitalize the cash payments as a lease acquisition cost and amortize them over the lease term. This type of rent inducement is typically more favorable to landlords, because the cost is amortized over the life of the lease (rather than being classified as a leasehold improvement owned by the landlord and depreciated over 39 years).

Another type of lease inducement is a rent holiday. A "rent holiday" is a rent reduction or rent-free period. The landlord will realize an immediate reduction in income (because of the reduced rents). The tenant recognizes income as a result of reduced rental expense but, more importantly, receives benefits from improved cashflow, because no rent (or less rent) is paid in the beginning of the lease period. Most often, the tenant will use the increased cashflow to construct leasehold improvements. A landlord will generally prefer this structure over a cash payment, because the rent-holiday period is typically significantly shorter than the lease term.

One variation of the rent holiday is a graduated rent payment schedule. In the first years of a lease, the tenant pays less rent; each year thereafter, the rent increases. Typically, a tenant pays the same rent over the lease's full duration, but less at the beginning of the term and more toward the end of the term.

A graduated rent payment schedule still achieves the desired benefits for both the landlord and tenant. It defers income for the landlord and provides improved cashflow in the beginning of the lease term for the tenant.

A rent reduction, rent-free period or a graduated rent payment schedule may be subject to Sec. 467. Normally, rent income and expense are taken into account by the parties under the lease agreement. However, in certain circumstances (e.g., when the rent is stepped up), a present value concept may apply. Sec. 467 applies to long-term leases or tax avoidance leases (sale-leaseback). If the cumulative rent under the lease agreement exceeds $250,000 and the rents are increasing, the lease agreement may be ignored and the income to the landlord and the deductions to the tenant determined by the present value of future lease payments.

A "build-out" allowance is an inducement package in which the landlord offers an allowance to prospective tenants to construct improvements for the tenant's benefit. The improvements are constructed according to tenant specifications, but the specifications are subject to landlord approval. With a build-out allowance arrangement, the landlord pays for the improvements made on the tenant's behalf. The tenant will use the improvements for the term of the lease. The landlord capitalizes the cost of the improvements and depreciates them over 39 years. Typically, this type of rent inducement is more beneficial to the tenant from a Federal income tax standpoint. The tenant does not recognize income from the construction of the improvements. (The cost of the improvements is implicitly built into the tenant's rent.) The landlord, who pays for the cost of the improvements, must depreciate those costs over 39 years.

One recent clarification for a landlord that uses the build-out type of rent inducement allows the landlord an abandonment loss when a lease terminates. The Small Business Job Protection Act of 1996 provided a legislative resolution to a much-debated issue for commercial real estate owners, adding Sec. 168(i)(8)(b), which allows a landlord to deduct, on the termination of a lease, its unrecovered basis in leasehold improvements it made for a tenant, provided the landlord irrevocably disposes of or abandons the improvements. Previously, a landlord was required to depreciate improvements over a 39-year life, as long as it still owned the building, regardless of the fact that the tenant for whom the improvements were placed in service was no longer renting the space.

The TRA '97 enacted Sec. 110, which provides guidance for tenants of retail space with short-term leases who receive cash or a rent reduction from a landlord. Sec. 110 specifies that any cash or rent reductions received will not be included in the tenant's gross income if the proceeds are used for qualified construction of leasehold improvements to the space. Sec. 110 defines a short-term lease as an agreement for occupancy or use of retail space with a duration of 15 years or less (including renewal options). This treatment differs from that described under a traditional cash-payment rent inducement; previously, these types of arrangements most often were treated as income to the tenant and a lease acquisition cost to the landlord.

The TRA '97 more clearly defined the tax treatment of certain leasing arrangements, but, in general, much ambiguity remains. For tenants whose lease agreements fall outside the parameters previously mentioned, no clear statutory guidance exists to relieve these taxpayers from the burden of uncertainty.

FROM KEVIN J. NOSS, CPA, COHEN & COMPANY, CPAs, CLEVELAND, OH