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Tax consequences of tenant leasehold improvement allowances.

In this period of high vacancy rates, many landlords are providing significant landlords are providing significant incentives to gain new tenants and retain existing tenants whose leases are up for renewal. One method of encouraging tenants to move in--or to stay--is through tenant leasehold improvement allowances. This may allow a property owner to retain a potential benefit (the improvement) after a tenant moves out. The income tax consequences to a landlord will vary depending on how the lease (i.e., allowance) is structured.

The moral of this story is that the form of the transaction counts. The lease and/or other written agreements should be structured to follow the intended income tax consequences.

In this article we assume that the leasehold improvements are considered real property (walls, electrical, heating, etc.) versus personal property such as furniture or trade fixtures. We also assume that the rental arrangements are not subject to rent levelling provisions.

Build-out allowances

In some cases, a tenant will pay for leasehold improvements in lieu of rent payments. For example, a new tenant will be given the first year rent free in exchange for payment to contractors for leasehold improvements.

If the lease clearly states that the improvements are in lieu of rent, then the value assigned to the improvements will be treated as rental income to the landlord. In such a case, the landlord will include the value of the improvements in taxable income in the year the improvements are completed or paid.

If the costs of the improvements are a direct offset (i.e., dollar for dollar) against stated rent, then rental income is measured by the actual cost of the improvements. The tenant in turn will receive a rental deduction for the cost of the improvements.

In general, this structure is not favorable to landlords because it creates taxable income without any cash and a depreciable asset with a 31.5-year life.

An alternative structure would be to allow a rent holiday and require the tenant to pay for and own the leasehold improvements. In such a case, the landlord still has no cash but his or her taxable income has been reduced during the rent holiday period and the tenant owns the depreciable asset.

In other cases, landlords offer cash sums to tenants for purposes of tenant build-outs. If the tenant has great latitude in how the money can be used and is considered the owner of the property, then the tenant has taxable income in the amount of payments received and an asset depreciable over 31.5 years.

Conversely, the landlord has a deferred lease acquisition cost asset amortizable over the term of the lease, including renewal periods, which is usually substantially less than the 31.5 years for depreciation. This structure is more advantageous to the landlord from an income-tax standpoint.

If the lease does not specify who is responsible for tenant improvements, then the intention of the parties and all the facts and circumstances should be considered in making the determination. The improvements may not be rent if the lessee is allowed to remove the improvement at the end of the lease or if the useful life of the improvement is shorter than the lease term.

Improvements in lieu of rent will result in taxable income to the landlord without cash flow to pay any increased income tax liabilities. Tenant build-out allowances in which the tenant is considered the owner of the property will result in taxable income to the tenant. Therefore, the income tax consequences of tenant allowances should be considered in setting the timing and amount of rental payments. Passive-activity limitations should also be considered in any analysis.

Landlord improvements

If the landlord pays for improvements and is considered the owner, the landlord is required to capitalize and depreciate on the straight-line basis the cost of tenant leasehold improvements over 31.5 years. (Longer periods are used for Alternative Minimum Tax purposes.)

In most cases, the tenant will not stay in the space for 31.5 years. Usually, after five to ten years the tenant will move out and be replaced by a new tenant. Generally, the new tenant will remove the old leasehold improvements and install new improvements which meet its needs.

The issue raised is whether or not the landlord is entitled to write off the remaining unamortized basis of the leasehold improvements or must continue to depreciate the assets removed. The IRS has commented informally that the tenant leasehold improvement is a structural component and is not subject to write-off when destroyed.

This position is based on an interpretation of the legislative history of the Economic Recovery Act of 1981, which provided that a retirement of a structural component of the building is not a disposition requiring gain or loss. Therefore, based on the IRS' interpretation of the law, the landlord is required to continue to depreciate the asset even after it has been demolished.

Because it is questionable as to whether tenant leasehold improvements should be considered structural components, there is an argument that the landlord is entitled to write off the undepreciated basis of the destroyed improvements.

If this position is taken, it is extremely important that detailed records are maintained keeping track of the costs on a space-by-space basis to support a write-off of the remaining unamortized basis when a tenant leaves and improvements might be classified as personal property (rather than structural components) and depreciated over a shorter life.

The IRS has not issued formal guidance on this issue, and to date it has not been litigated. Therefore, if detailed records are maintained, a position exists to write off the abandoned assets. However, it should be noted that this issue will surely be an item of dispute between taxpayers and the IRS.

Because of the uncertainty in this area, you should consult your tax advisor prior to claiming a write-off of the abandoned assets. Your decision should include possible understatement penalties and possible disclosure requirements to avoid such penalties.

Dennis M. Byrnes is a partner, and Perry V. Plescia a senior manager, with KPMG Peat Marwick, Chicago.
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Title Annotation:Tax Issues
Author:Byrnes, Dennis M.; Plescia, Perry V.
Publication:Journal of Property Management
Date:Mar 1, 1993
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