Negotiation of the construction allowance is an important part of most commercial lease transactions and usually centers around the size of the allowance and the type of improvements to be constructed. However, the tax consequences flowing from the construction allowance are frequently subject to far less negotiation. If the tenant owns the improvements after construction, the value of the construction allowance will be considered as current taxable income to the tenant and taxable in the year in which it is received.
There is, however, a safe harbor for commercial tenants who received a “qualified lessee construction allowance” under the Taxpayer Relief Act of 1997 (the “Act”) and the Treasury Regulation promulgated under Section 110 of the Act (Treas. Reg § 1.110.1) (the “Regulation”). Section 110 of the Act provides that a retail tenant with a “short-term lease” for “retail space” that receives cash or rent reductions from a landlord is not required to include the cash or credit in gross income if the funds are used to construct improvements of “qualified long-term real property.”
- A “qualified lessee construction allowance” is defined as any amount received in cash, or treated as a rent reduction, by landlord or tenant (i) under any short-term lease of retail space; (ii) for the purpose of constructing or improving qualified long-term real property for use in tenant’s trade or business; (iii) to the extent that the amount is expended by the tenant “in the taxable year received.”
- A “short-term lease” is defined as a lease with a term of 15 years or less including option periods (unless renewable at fair market value).
- “Retail space” is defined as real property leased, occupied or otherwise used by a tenant for the sale of tangible personal property or services to the general public, and includes not only the space where the retail sales are made, but also space where activities supporting the retail activity are performed (such as an administrative office, a storage area, and employee lounge). This broad definition of retail space extends to office and warehouse leases of retail tenants. In addition, the Regulation provides examples of “services [sold] to the general public” such as hair stylists, tailors, shoe repairmen, doctors, lawyers, accountants, insurance agents, stock brokers, securities dealers (including dealers who sell securities out of inventory), financial advisors and bankers, and goes on to state that a taxpayer will be considered as selling to the general public if the products or services for sale are made available to the general public, even if the product or service is targeted to certain customers or clients.
- “Qualified long-term real property” is defined as nonresidential property that is part of, or present at, the retail space and reverts to the landlord when the lease terminates.
The construction allowance will qualify for the safe harbor only if the lease agreement provides that the allowance is 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. However, an ancillary agreement between landlord and tenant providing for a construction allowance, executed contemporaneously with the lease or during the term of the lease, is considered a provision of the lease agreement so long as the agreement is executed before payment of the construction allowance.
Expenditures will be deemed first made from the tenant’s construction allowance and tracing of expenditures to the allowance is not required. An amount is deemed expended by the tenant “in the taxable year” in which it was received only if the amount is spent within 8 ½ months after the close of the taxable year, or if the amount received represents a reimbursement from the landlord for amounts spent by the tenant in previous years for which the tenant has not claimed any deductions.
Because most retail leases are for terms of less than 15 years and allowances rarely exceed construction costs, Section 110 provides a safe harbor for most retail tenants receiving construction allowances. However, Section 110 is not a cure-all. It applies only to realty improvements, and allowances for non-realty improvements may be subject to tax. Tenants should also be mindful of the time frame for spending the construction allowance. If the funds to be received cannot be spent within 8 ½ months after the taxable year in which they are received, it would be preferable to receive the allowance in installments.
Finally, both landlord and tenant should remain aware of another important tax principle that comes into play here: the owner of a leasehold improvement must depreciate the improvement ratably over 39 years. Therefore, if the tenant owns the improvements, the tenant must depreciate the improvements constructed with the construction allowance over 39 years even if the allowance qualifies for the safe harbor. For the landlord, this means the construction allowance can be “written off” over the lease term. If the lease includes options periods, the write-off period may include the option periods if there is reasonably certainty at the time of lease execution that the options will be exercised. However, this certainty does not exist for options exercisable at market rates, and these types of option terms are rarely added to the period over which the construction allowance may be written off.