Lessee Construction Allowances

A landlord may induce a prospective tenant to lease space by arranging to reimburse the tenant for costs incurred to make leasehold improvements or build-outs (lessee construction allowances). The most critical tax issue that arises is whether the allowance payments should be included in the tenants income. A lesser issue is determining who (landlord and/or tenant) may depreciate such costs as commercial real property, or amortize them as lease acquisition costs.

Exclusion

In determining whether the allowances may be excluded from the tenants gross income, many tax advisers mistakenly rely solely on Sec. 110. In general, Sec. 110 precludes a tenant from including in gross income certain lessee construction allowances associated with certain short-term leases. These advisers erroneously believe that lessee construction allowances that fall outside of Sec. 110 are automatically includible in tenant gross income. However, this is incorrect. Sec. 110 is not the only road to exclusion. According to the IRSs Specialization Program Retail Industry Coordinated Issue Paper (CIP) titled, Tenant Allowances to Retail Store Operators, issued on Oct. 7, 1996, if a landlord is considered the owner (tax owner) of the improvements, the allowances will not be included in the tenants gross income. If the tenant is considered the tax owner, the opposite is true.

In short, a tenant is not required to include construction allowances in gross income if the (1) landlord is deemed the tax owner of the property in light of relevant factors identified in case law, which are summarized in the CIP non-safe-harbor rules discussed below or (2) tenant meets Sec. 110s safe-harbor rule.

Non-Safe-Harbor Rules

Before the enactment of Sec. 110 by the Taxpayer Relief Act of 1997 (TRA 97), the Service provided guidance on the taxability of construction allowances in the CIP mentioned above. This guidance still applies to leases that do not fall within Sec. 110. The Conference Agreement under the TRA 97 states, the conferees wish to emphasize that no inference is intended as to the treatment of amounts that are not subject to the provision [i.e., newly enacted Sec. 110], and that the provisions of the IRS issue paper and present law (including case law) will continue to apply; see H. Rept No. 105-220, 105th Cong., 1st Sess. (1997).

CIP: The CIP is a statement of the IRSs position and has no precedential value in court, although as a practical matter, it relies on Federal case law, the positions of which are very difficult to counter. The IRS position in the CIP is based on Grodt & McKay Realty, Inc., 77 TC 1221 (1981). This case (discussed below) appears to reflect the general conceptual view of most relevant cases on the matter of lessee construction allowances; if the landlord is considered the tax owner in the improvements, the allowances will not be included in the tenants income, and the landlord will depreciate the improvements. If the tenant is deemed the owner, the allowances must be included in the tenants income and the tenant will depreciate the improvements. The landlord would treat the allowances as lease acquisition costs and amortize them ratably over the lease term (see the exhibit below).

The situation analyzed in the CIP involved an anchor tenant that operated retail stores and entered into leases that generally reflected the fair market value of the unimproved retail space and ranged from five to 40 years. The developers were responsible for completing the buildings shell; the anchor tenant was responsible for the build-out of tenant improvements, subject to the developers approval. As an incentive to enter into the lease, the developers made lump-sum cash payments to the anchor, which generally coincided with the completion of some or all of the tenant improvements. It was determined that, for Federal tax purposes, the lessor would own some of the leasehold improvements and the an-chor tenant would own others.

The IRS concluded that the cash payments received by the anchor were accessions to wealth and had to be included in gross income to the extent that the tenant owned the leasehold improvements for tax purposes. However, to the extent that cash was expended on tenant improvements owned by the landlord for Federal tax purposes, no accession to wealth occurred and the tenant did not realize gross income.

Benefits-and-burdens test: In determining whether the leasehold improvements were owned by the tenant or the landlord for Federal tax purposes, the IRS applied the benefits-and-burdens-of-ownership test outlined in Grodt & McKay Realty, Inc. In that case, the Tax Court set forth the following ownership factors:

• Who has legal title;

• How the parties treat the transaction;

• Whether an equity interest is acquired in the property;

• Whether the contract creates present obligations on the seller to execute and deliver a deed, and on the buyer to make payments;

• Who has the right of possession of the asset;

• Which party pays the property tax;

• Which party bears the risk of loss or damage to the property;

• Who carries insurance with respect to the property;

• Who is responsible for replacing the property; and

• Which party receives the profits from the propertys operation and sale.

As ownership is the key determinant, logic would dictate that the relative weight of each factor should also be considered. Factors more closely related to rights of legal ownership and control should receive greater weight than those commonly attributable to both lessors and lessees. Factors that relate to rights of legal ownership and control include: legal title; right to receive profits from sale of property; possession of an equity interest in the property; and broad rights to enter property space to inspect tenant compliance with the lease. Factors that are commonly attributable to both lessors and lessees include: right of use and occupancy; which party bears the risk of loss or damage to the property; who carries the insurance with respect to the property; and who is responsible for replacing the property.

Safe-Harbor Rules

Concerns that the ownership factors outlined in the CIP may lead to controversies between the IRS and taxpayers (particularly when (1) construction allowances are provided to improve long-lived lessor property and (2) the lease is short-term), led to the enactment of Sec. 110. In conjunction with the enactment of Sec. 110 and its regulations, the House Committee (H Rept No. 105-220, 105th Cong., 1st Sess. (1997)) addressed the CIP, the treatment of lessee construction allowances and its rationale for creating Sec. 110.

The Committee said it:

[U]nderstands that it is common practice for a lessor to custom improve retail space for the use by a lessee pursuant to a lease. Such leasehold improvements generally may be provided by the lessor constructing the improvements to the lessees specifications. Alternatively, the lessee may receive a construction allowance from the lessor pursuant to the lease in order to build or improve the property. The Committee believes that the tax treatment of either case should be the same. The Committee understands that the IRS issue paper on this issue reaches a similar conclusion in cases where the lessor is treated as the tax owner of the constructed or improved property. However, the Committee is concerned that the traditional factors cited by the IRS in making the determination of who is the tax owner of the property may be applied differently by the lessor and the lessee and may lead to controversies between the IRS and taxpayers. Thus, the bill provides a safe harbor such that it will be assumed that a construction allowance is used to construct or improve lessor property (and is properly excludible by the lessee) when long-lived property is constructed and used pursuant to a short-term lease.

Apparently, the conferees concluded that a lease term of 15 years or less is short-term, as evidenced by the condition under Sec. 110(c)(2), which indicates that the safe harbor can apply only to a lease with a term of 15 years or less; see the sidebar below.

The Committee and Conference reports effectively confirm that (1) Sec. 110 is intended to be a safe-harbor provision for short-term leases involving long-lived lessor-owned property, and (2) transactions that do not fall within the safe harbor are still subject to the CIP and relevant case law (described above).

If a tenant meets Sec. 110s conditions, lessee construction allowances are not included in income and, as such, are treated as qualified lessee construction allowances. When Sec. 110 applies, the landlord is considered the tax owner of the improvement and, thus, must depreciate it. The tenant does not depreciate these costs.

Requirements

To meet the Sec. 110 requirements, the lease must be a short-term lease of retail space, and the amounts excluded from income generally must be expended in the tax year received (or within 8 months following the close of the tax year of receipt (subject to additional requirements and exceptions; see Regs. Sec. 1.110-1(b)(4)(ii)). The allowances must be expended in connection with constructing or improving qualified long-term real property for use in the tenants retail business. The lease must expressly provide that the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessees trade or business at that retail space (however, an ancillary agreement may be acceptable). Also, Regs. Sec. 1.110-1(c) imposes certain information reporting requirements on the lessor and lessee (which are beyond this items scope).

From Steven C. Barranca, CPA, CVA, Friedman LLP, New York, NY