It’s imperative that landlords and tenants know the tax ramifications — for better or worse — of the language that’s built into their lease and ancillary agreements. And it’s just as important to be aware of tax-impacting items not found in any written agreement. Specifically, there are three areas of a lease that can greatly impact the tax outcome: tenant improvement allowances, lease inducement payments and lease termination payments.
#1 - Tenant Improvement Allowances
A tenant improvement allowance is when a landlord pays an allowance to the tenant so that he or she can prepare the space for business use. Generally, a tenant allowance is treated as ordinary income to the tenant. The tenant recognizes income and depreciates assets over its useful life, resulting in a mismatch of income and expenses between the tenant and the landlord.
However, if structured correctly, Sec. 110(a) of the tax code provides a safe harbor so the tenant is not required to recognize income for the tenant allowance. Specifically, the code allows a tenant to exclude from its income the amount of qualified construction allowance received from a landlord, if the allowance does not exceed the actual costs incurred to improve the leased space.
For a tenant allowance to be considered a qualified lessee construction allowance, the lease must be:
Short-term (occupancy or use of a retail space for a term of 15 years or less), and
Used for retail space (used by the lessee in its trade or business of selling tangible personal property or services to the public).
There is also a purpose requirement to note under Reg. Sec. 1.110-1(b)(3) that requires the tenant allowance to be:
Expressly provided for in the lease agreement (or an ancillary agreement), and
Used for the purpose of constructing or improving qualified long-term real property for use in the tenant’s trade or business at the retail space.
Personal property, even if 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 owned by the landlord. For purposes of retail space, qualified property generally meets the following requirements:
Has a recovery period of 20 years or less,
Is acquired prior to January 1, 2020, and
Is deemed qualified improvement property.
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 the 2016 tax year.
When developing language within the lease agreement concerning the tenant allowance, the landlord should consider including a restriction as to the use of funds to ensure the allowance is eligible to be treated as qualified leasehold improvement property and for special depreciation allowance. 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, to a building that has been in service for three years, and to space that is occupied solely by the tenant.
So what happens when a qualified lessee construction allowance is paid, pursuant to the lease agreement? For starters, both parties are required to make disclosures with their federal tax returns. The landlord and the tenant must attach a statement to their returns that includes the location of the retail space and the full amount of the tenant allowance provided. The landlord is also required to disclose what portion of the allowance is being treated as nonresidential real property owned by the landlord. The tenant should include what portion of the construction allowance is deemed to be a qualified lessee construction allowance. Failing to make these disclosures may subject the landlord and tenant to penalties.
#2 - Lease Inducement Payments
Another payment common between landlords and tenants, which may or may not be provided for in the lease agreement, are lease inducement payments. Lease inducement payments are made by, or on behalf of, the landlord to entice a tenant to sign a lease agreement. Lease inducement payments can be in cash but also may come in other forms, including:
Paying costs on the tenant’s behalf,
Assuming the tenant’s prior lease obligation with a different landlord,
Paying moving expenses, or
Paying termination fees to the lessor’s previous landlord.
When lease inducement payments are made, the tenant recognizes income in the year in which the payment is received or earned, depending on the tenant’s accounting method. If the amount received is used for real property improvements, the tenant can capitalize and depreciate the improvements under Sec. 168.
For the landlord, regardless of the form the payment takes, the act of inducing a tenant to sign is considered a “cost of obtaining a lease.” The landlord must amortize the inducement over the term of the lease under Sec. 178. The lease inducement payment is considered an expense related to acquiring the lease. However, if the landlord constructs the improvements and owns the property pursuant to the lease agreement, the improvements are treated as a trade or business asset and depreciated over the appropriate recovery period. At the end of the lease, if certain qualifications are met, the landlord also may be able to treat the improvements as abandoned property and write them off under Sec. 168(i)(8)(B).
#3 - Lease Termination Payments
Lease termination payments are another key area to scrutinize when negotiating a lease. To make certain the terms for termination payments are clear, it’s often a good idea to have a separate lease termination agreement drafted at the time of termination, especially if any conditions surrounding the termination payment are not outlined in the original lease agreement.
There are two types of lease termination payments:
Payments made by the landlord to the tenant, and
Payments made by the tenant to the landlord.
Payments made by the landlord to the tenant
Generally, the tax treatment the landlord receives will depend on the reason for the termination payment:
If a landlord pays a tenant to vacate a space prior to the end of the lease term, the landlord is not allowed a deduction in the year the termination payment is made. Lease termination payments made by the landlord to the tenant are generally recovered over the remaining term of the terminated lease.
When a lease is terminated by the landlord to make the space available for a new tenant, the payment is amortized over the life of the new tenant’s lease.
If the landlord is terminating the lease early in anticipation of selling the building, the termination payment is added to the cost of the building.
If the space is required to be vacated due to construction or a build-out, the termination payment is added to the capitalized cost of the improvements.
For the tenant, a lease termination payment is considered an exchange for the lease or agreement:
There is potential that this income could be taxed favorably as capital gain income if the lease is considered a capital asset under Section 1231. It is also possible that the income could be deferred under Section 1031. The tenant would have to meet the requirements for either of these favorable treatments.
The entire lease termination payment could potentially be deferred under Sec. 1031. The payment must be made to a qualified intermediary and used to acquire a replacement lease (that qualifies under Sec. 1031) or even a fee simple interest in real estate. It’s important to review the remaining lease term (including extension options) to determine if this would qualify. A leasehold interest in real estate with 30 years or more left on the lease can be considered a fee simple interest in real estate under Sec. 1031.
Payments made by the tenant to the landlord
When a landlord receives a lease termination payment, it is taxable income to the landlord as substitute payment for rental payments. If a tenant is required to pay a fee to terminate a lease early, the landlord should be careful not to require a payment in excess of the actual and reasonable loss incurred as a result of the early lease termination. There is a possibility that the landlord could recognize capital gain treatment on the receipt of a lease termination payment, if Sec. 1234A applies.
For the payment to qualify under 1234A, the property must be a capital asset and not an asset used in a trade or business, which would be considered Sec. 1231 property and would not qualify as a capital asset under Sec. 1221. For the property to be qualified as a capital asset, the activities of the landlord should be minimal with respect to the property and the property should be held for investment purposes. This provision under Sec. 1234A would not apply to the real estate professional.
Whether or not the tenant’s lease termination payment is deductible relies upon the reason for early termination:
If the lease was terminated because the lease agreement has become unprofitable, the payment is fully deductible.
If the termination is made to acquire new property, the payment is capitalized and amortized.
Both landlords and tenants have numerous areas to consider carefully when entering into a lease agreement. The language built into an agreement to occupy space should be examined by the prospective landlord, tenant, and each party’s tax representative and legal counsel. More often than not, the areas of opportunity addressed in this article are not listed in the lease agreement, so a separate agreement may be warranted. Understanding the scenarios that may have a tax impact, for either party, is critical so they can be addressed in the resulting lease language. Landlords and tenants will benefit not only by maximizing property tax planning opportunities but by creating a clear tenant-landlord relationship.
This piece was originally published in full in the August 2016 issue of The Tax Adviser, an AIPCA publication.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.