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In writing: construction allowances must be detailed before any tax benefits are reaped.

Before signing a lease, a tenant should make sure the fine print addresses construction allowances for improving long-term property.

Too often, lessees and lessors ignore or are unaware of the tax laws governing such payments or credits.

If not properly addressed, the money could be considered taxable income for the lessee.

Even if the lessor isn't planning to fund any long-term improvements being made to the space by the lessee, the lease agreement should acknowledge the possibility and how such allowances would be treated.

In the last few years, the Internal Revenue Service (IRS) has provided specific guidelines for qualified tenant construction allowances not to be treated as taxable income.

These relatively recent changes occurred in part, because in the past some property owners ultimately worked the system to pay contractors for such improvements through tenant-created escrow accounts.

The landlord would then treat such payments as lease inducements instead of leasehold improvements, and write off the expenses over the lease term, instead of over the longer life of the building. The tenant on the other hand ignored the entire transaction.

As such, neither the landlord nor tenant capitalized nor depreciated the improvements over the prescribed 39 years. Known in some circles as the "New York" method because the practice was commonplace in the city, it effectively removed the tenant from the transaction.

Under Internal Revenue Code Section 110, the IRS now requires the landlord and the tenant to agree on the ownership of the leasehold improvements.

If the lease falls within the safe harbors provided under the code section, the tenant will avoid taxable income and the landlord will be deemed the owner of the improvements.

After considering these implications, you may realize that the fine print in your lease may need some citation before you sign it. Or perhaps may need to consider an amendment to an existing lease.

Safe Harbors

Qualified construction allowances for short-term retail leases, (see below for definition), for construction or improving leased space in the retail space occupied by the lessee's trade or business that meets the stipulated time requirements for expenditures, will be exempt from tax.

These allowances cannot be paid towards tangible personal property such as computers and fixtures. In lay terms, under Section 110, a property owner (lessor) can pay or give an allowance (work letter) to its tenant (lessee) to make long-term property improvements. The lessee has the taxable year in which the payment was made plus 8 1/2 months to spend the money on improvements to qualify for non-taxable treatment. For example: if a lessee received a construction allowance in January 2004, it has until mid-September 2005 to make the improvements to avoid taxable income.

A short-term lease of retail space is defined as, "a lease with a term of 15 years or less (taking into account certain options)." However, be careful, if for example, you sign a 10-year lease with two five-year options at less than fair market value.

That 20-year rental possibility could eliminate the lessee from short-term qualification, leaving the lessee with the burden of taxable income on the construction payments. Retail space is defined as any property used in a trade or business of selling tangible personal property or services to the public.

This would include space such as a retail store as well as any business outlet that supports retail activity such as administrative offices or storage space. It also includes property where any business services are available to the public, thus the office's of accountants, lawyers, insurance agents, etc. are included in this definition.

By meeting the definition of qualified lessee construction allowances, the tenant will avoid taxable income on such allowance.

Others who do not meet the exact definitions should explore alternative options with their tax advisor.

Tenants and landlords taking advantage of Section 110 must each attach a statement to their returns in the taxable year in which the construction allowance was paid or received.

These statements include information about the lessor and the lessee--name, address, employee identification number, location of "retail" space and the amount of the construction allowance.

Meeting the definitions outlined in Section 110 and attaching the appropriate paperwork are all that's needed to make sure that income is not taxable.

While the process to avoid taxable income may appear simple and straight-forward, it is important that both tenant and landlord make sure the treatment of construction allowances is specified in their agreement.

That way, the simple process doesn't turn into a complex and possibly costly one for any of the parties.
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Title Annotation:Insiders Outlook
Author:Wieder, Marc
Publication:Real Estate Weekly
Geographic Code:1USA
Date:Jun 30, 2004
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