With contributions from Marcus Atherly
There’s an old saying about assumptions. Jaime Anderson recently fulfilled a lifelong dream to open his own business. He carefully researched a location and knew just the improvements he needed to make it work.
Then comes the assumption part.
Jaime assumed that he would be in a better financial position if he paid for the improvements himself and received a rent holiday from his landlord in exchange. And his landlord assumed that, since cash is king, it’s better to let the tenant pay for improvements.
Are they right?
A leased property isn’t always suitable for its tenant. Sometimes the tenant needs improvements to use the property most effectively. The decisions that determine who owns such leasehold improvements — landlord or tenant — and who ultimately pays for them can have important financial and tax consequences for both.
Tax consequences alone don’t typically drive the terms of a commercial lease, but identifying and understanding them is critical during the lease negotiations. Both parties need to consider them in structuring the lease. Then, after the landlord and tenant have settled on the terms, the lease document should clearly reflect the intent of both parties.
Who owns the leasehold improvements?
Before you can determine the financial and tax effects of a leasehold improvement, you must determine who ultimately owns the improvement.
To help determine tax ownership, the IRS published a position paper that established an ownership test. This test evaluates a range of factors to determine the party with the benefits and burdens of ownership. These factors include the following:
Who possesses legal title
How the parties treat the transaction (intention)
Whether an equity interest is acquired in the property
Whether the contract creates a present obligation on the seller to deliver a deed and a present obligation on the purchaser to make payments
Whether the right of possession and control transfers to the purchaser
Who bears the burden of property taxes
Who bears the risk of loss or damage
Who receives the profits from the operation and sale of property
Who pays for the improvements?
There are various alternative approaches to the funding of tenant improvements. Below are a few examples, along with the associated tax implications.
Landlord pays for and owns the improvements
If the landlord pays for the improvements and retains ownership, the improvements will either be expensed or capitalized and depreciated over the appropriate life of the asset. For more on the tangible property regulations, refer to our white paper Overview: Tangible Property Regulations and our blog post Ready for the Tangible Property Regulations? An Overview.
If an improvement is capitalized, the cost would be depreciated over a term up to 39 years, depending on the improvements. For more, refer to our blog post Improving Your Leased Business Property? Know the Beneficial Tax Rules for Qualified Leasehold Improvements and Qualified Improvement Property.
Planning tip for improvements that are less significant and therefore could be eligible for expensing as repairs under the recent tangible property regulations: Having the landlord pay for and own the improvements can provide a faster deduction than a construction allowance scenario, described below.
Tenant pays for and owns improvements
The tenant will determine whether the expenditures can be expensed or capitalized based on the tangible property regulations.
While the landlord compares the expenditure to the building as a whole, the tenant is restricted to comparing the expenditure to their specific leased space. As a result, the tenant is more likely to be required to capitalize the improvements than the landlord.
A key difference is that upon termination of the lease, if title to the improvements transfers to the landlord, the tenant can generally write off the remaining unrecovered improvement costs in the year of termination. For costs that must be capitalized, this can result in a faster recovery of costs for the tenant compared to the landlord.
The landlord will also experience no tax consequences under this scenario. Since initially the landlord will not make payments or own the improvements, there will be no effect. Should the title of the improvements shift to the landlord upon termination of the lease, a special tax provision in the tax code provides an exclusion from income for the landlord. As a result, the receipt of title is not a taxable event.
Landlord provides tenant with allowance
Landlords can provide tenants with an allowance for constructing improvements. The allowance may be in the form of reduced future rents, a lump sum payment, or a combination of the two.
Generally, the tenant is taxed on the entirety of the allowance as income for the year in which it is received. The tenant is then required to recover the cost of the improvement over the appropriate life. The landlord recovers the allowance as a lease acquisition cost over the lease term.
This arrangement can be unfavorable for the tenant due to the length of time between recognizing the income and obtaining the related depreciation deduction.
An alternative is to structure the arrangement under Internal Revenue Code (IRC) Section 110. This requires that the lease be no longer than 15 years. The lease must also be for retail space, defined as real property leased, occupied, or otherwise used by a lessee in its trade or business of selling tangible personal property or services to the general public. The definition is broad, and even includes services such as doctors, lawyers, accountants and financial advisors.
Under Section 110, the tenant can exclude the allowance from income, however the ownership of the leasehold improvement shifts to the landlord. The landlord must depreciate the allowance over the appropriate period.
Unfortunately, under the tangible property regulations, the allowance must be capitalized by the landlord and depreciated over the appropriate life. Due to these regulations, the allowance option is less favorable to landlords that may have been able to expense minor expenditures as repairs if paid directly.
Instead of an allowance, the landlord could provide the tenant with a loan to finance the improvements, payable throughout the lease term. In this scenario, the tenant depreciates the improvements over the appropriate life and deducts interest expense on the loan. The landlord recognizes interest income on the loan.
Landlord provides rent reduction
The landlord can offer the tenant a rent holiday in lieu of a construction allowance.* Due to the lower up-front rent payments, the tenant has additional cash flow to either directly fund or borrow to construct the leasehold improvements. The landlord’s gross income is decreased by the foregone rent, which equates to an immediate deduction.
Depending on the extent of the improvements, the tenant may be required to capitalize and depreciate the improvements over a 15 or 39 year life.** This defers the deduction over a longer term than if the tenant had paid higher rents up-front. As a result, this structure is more advantageous to the landlord than the tenant.
In assessing the rent holiday structure, tax regulations allow for an examination of the lease terms and surrounding circumstances to determine if the parties intended the improvements constructed by the tenant to constitute rent. If so, this would reclassify the improvements as immediate income to the landlord.
However, the IRS has followed case law and does not treat leasehold improvements as rent unless specified in the agreement.
In any case, to ensure the IRS respects the lower rent, landlords and tenants should not link the rent holiday or below-market rents to a construction allowance.
|Scenario||Payor||Tax Owner||Tax Effect on Landlord||Tax Effect on Tenant|
|Landlord pays for tenant improvements||Landlord||Landlord||Determine whether to capitalize or expense TIs. If capitalizing, depreciate over 15 or 39 years**||None|
|Tenant pays for its own improvements||Tenant||Tenant||None||Depreciate improvements over 15 or 39 years|
|Landlord provides construction allowance to tenant for the construction of improvements||Landlord||Tenant||Amortize the basis of the improvements as a lease acquisition cost over the lease term||Include construction allowance in gross income and depreciate the allowance over 15 or 39 years|
|Landlord provides construction allowance to tenant for the construction of improvements – structured under IRC Section 110||Landlord||Landlord||Depreciate the basis over 15 or 39 years||None|
|Landlord loans money to tenant to pay for improvements||Tenant||Tenant||Recognizes interest income||Tenant depreciates improvements over appropriate life and deducts interest expense on loan|
|Landlord provides rent reduction in lieu of construction allowance||Tenant||Tenant||The landlord’s gross income is decreased by the amount of the foregone rent||Lost rent deductions, but recovers the cost of the improvements by depreciating over 15 or 39 years|
* IRC Section 467 rental agreements govern increasing or decreasing rents and are beyond the scope of this article.
** Certain improvements may qualify for shorter depreciable lives, but those are beyond the scope of this article.
Need tax or financial advice with regard to leasehold improvements?