Tenants who meet certain conditions can get a tax break for TI allowances.
NEW LEASE AGREEMENTS are typically viewed as routine business decisions rather than tax-saving opportunities. Ignorance of rules can prove costly to a tenant who is unaware of the potential tax implications. As an enticement to a new tenant, landlords commonly offer a tenant improvement (TI) allowance to help offset the tenant’s cost of moving into the new space and fitting it to their unique needs. For leases with a term of 15 years or less, there are special tax treatments for these allowances.
Financial Reporting Versus Tax Treatment
For financial reporting purposes, generally accepted accounting principles (GAAP) typically require that an allowance used for property improvements be amortized over the life of the lease. The allowance is also recorded by the tenant as a deferred rent liability and prorated over the life of the lease. For book purposes, then, the tenant is deemed the bona fide owner of the improvements.
If tax rules followed GAAP, the tenant would be required to use a 39-year proper tax life for nonresidential real property (or 15 years, if the improvements meet the definition of qualified leasehold improvement property). Moreover, the tenant would also have to recognize the full allowance in gross income when received. Therefore, from a tax perspective, it is far more advantageous for the tenant to have the landlord own the improvements.
Section 110 of the Taxpayer Relief Act of 1997 essentially created a safe harbor for tenants. A tenant no longer needs to include in its gross income any cash amount or rent reduction used for constructing or improving qualified long-term real property.
Although disclosure is required in the taxpayer’s timely filed return (including extensions), if the criteria of the section are met, the exclusion of income is automatic. Unless notified by the tenant in writing to the contrary, the landlord must capitalize the improvements for tax purposes and depreciate them over 39 years (or 15 years, if applicable).
Example 1. Imagine that ABC Corp., a landscape design firm, leases space from XYZ LLC beginning in January 2016. The lease expires in December 2025. As an incentive to ABC (the tenant), XYZ (the landlord) includes in the lease an agreement to cover $1 million of improvements that ABC will make to the space within the first year of the lease. The lease specifies that at least some portion of the allowance will be used to improve long-term real property, and notes that any portion not used can be applied by ABC against rent payments within the year. ABC uses $800,000 of the allowance, $750,000 of which is spent on Section 1250 property (depreciable real property) and $50,000 on Section 1245 property (tangible personal property). ABC applies the remainder against its December 2016 rent.
On its 2016 federal income tax return, ABC would capitalize and depreciate the $50,000 of the allowance used to purchase tangible personal property. The company would also recognize $250,000 of gross income on its return for the $200,000 applied against the December rent payment and the $50,000 capitalized. However, the $750,000 would not be treated as income or as a capital investment on ABC’s return. According to Section 110, XYZ would treat the $750,000 as a fixed asset and depreciate it on its return, unless ABC agrees in writing to a different treatment. Both ABC and XYZ would attach a statement to their timely filed returns pursuant to the regulations.
When negotiating and executing a lease, tenants should be aware of Section 110 and should specify that at least some portion of their TI allowance will be used to construct or improve qualified long-term real property, in order to meet the purpose requirement. If this provision was missed in the master agreement, an ancillary agreement executed either with the lease or during the term of the lease is also acceptable. Although the lease agreement does not need to require the entire allowance to be used for this purpose, only the amount actually expended on qualified long-term real property will qualify under Section 110.
Example 2. Imagine that the facts are the same as in example 1, except that the lease did not specify that any portion of the TI allowance would need to be spent improving real property. In this instance, the treatment by ABC and XYZ should still be the same, but because there could be an issue under examination as to whether the purpose requirement was met, an ancillary agreement should be drawn up to cover this point.
Any portion of the allowance that the tenant does not use within eight and a half months after the close of the tax year in which it was received, or that the tenant does not apply as a rent reduction — including amounts used to acquire Section 1245 property — will not be included under Section 110 and will be recognized as gross income.
Example 3. Again, using the same scenario as in examples 1 and 2, suppose that ABC uses the entirety of its allowance on qualifying properties by the end of the 2016 tax year, but only spends $650,000 by September 15, 2016 — eight and a half months after the year in which the proceeds were received. In this case, ABC would recognize $350,000 of gross income on its 2016 federal income tax return, as this remainder of the allowance no longer qualifies under Section 110. Tenants should be aware of this clause and should ensure that intended improvements are made within the proper timeframe.
Section 110 requires both tenant and landlord to attach a statement to their timely filed federal income tax returns, including extensions, generally providing details of the parties to the lease agreement and the allowance. Given the detailed information required in the statement, tenants should request this from the landlord at the time the agreement is signed.
What Are Qualified Improvements?
A landlord may be entitled to use the shorter life of 15 years (rather than 39 years) for some leasehold improvements they are required to depreciate under Section 110. Improvements to building interiors are considered qualified leasehold improvements if all three of the following conditions are met:
1) The landlord and tenant are not related parties.
2) The leased space is occupied exclusively by the tenant.
3) The building has been in service for more than three years.
In this case, the TI allowance could not be used to:
- Enlarge the building.
- Install an elevator or escalator.
- Construct a structural component in a common area.
- Alter the internal structural framework.