The negotiation of the construction allowance is a major part of any lease transaction; however, those negotiations rarely, if ever, consider the resulting tax consequences. This article examines the tax consequences of certain forms of construction allowances and suggests how to negotiate tax-beneficial terms for these allowances.
In structuring construction allowances, tenants and landlords must consider two fundamental tax principles. First, income received is taxable in the year in which it is received. Second, the owner of a leasehold improvement must depreciate the improvement ratably over 39 years . The interplay of these two principles creates different and conflicting tax objectives for landlords and tenants. Tenants do not want construction allowances characterized as income, and landlords do not want to “write off” the construction allowances over 39 years. But a tenant can only avoid “income” if the landlord owns the leasehold improvements, while a landlord can only avoid a 39-year depreciation period and “write off” the construction allowance over the shorter lease term if the tenant owns the improvements. Put simply, to maximize tax benefits, each party must foist ownership of the improvements onto the other.
Tax Treatment of Construction Allowances
What are the tax consequences of tenants receiving cash and “free rent” allowances? What special tax treatment is afforded anchor department stores?
Construction Allowances Disbursed from the Landlord Directly to the Tenant
To finance leasehold improvements, a landlord can disburse a cash allowance directly to the tenant or give the tenant rent credits. The tax treatment of allowances and credits is generally determined by who owns the improvements constructed with the allowance or credit. Ownership dictates who depreciates the improvements, what the depreciation period is, and whether the allowance constitutes income.
Under current law, when cash is given to a tenant to construct leasehold improvements that the landlord will own, the tax treatment is straightforward. The landlord must depreciate the improvements over the statutory 39-year depreciation period for nonresidential real property, even if the lease is for a term of less than 39 years, except for those exceptions created by the Small Business Job Protection Act of 1996 . See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, Sec. 1120, 110 Stat. 1766 (1996) ; §168(i)(8) . Although the tenant receives cash from the landlord, this cash is not treated as income to the tenant. The tenant is treated as a conduit for the landlord’s cash. In re Elder-Beerman, 97-1 U.S.T.C. ¶50, 391, p. 87, 939, 207 B.R. 548 (Bankr. S. Dist. W. Div. OH).
When the landlord does not own the improvements, the landlord is not required to use the 39-year depreciation schedule and, therefore, can “write off” the allowance ratably over the lease term. Bonwit Teller & Co. v. Commissioner, 17 B.T.A. 1019, 1026 (1929), rev’d, 53 F.2d 381 (1931) . If the lease includes option periods, the allowance is “written off” over the initial term plus option periods if “reasonable certainty” exists at the time of lease execution that the option will be exercised. Joseph Neel Co. v. Commissioner, 22 T.C. 1083, 1091 (1954); Westinghouse Broadcasting Co. v. Commissioner, 36 T.C. 912 (1961). Determination of whether “reasonable certainty” exists is dependent upon a facts and circumstances analysis that examines whether the economic terms of the lease make the exercise of the option likely. Joseph Neel Co., 22 T.C. at 1091; Westinghouse Broadcasting Co., 36 T.C. at 918. Because most options are exercisable at market rates, option terms are rarely added to the period over which the allowance is written off.
When cash is given to a tenant to construct leasehold improvements and the tenant owns the improvements, the cash received by the tenant is income in the year received because it “enhances” a tenant’s wealth by enabling it to acquire or construct suitable facilities. John B. White v. Commissioner, 55 T.C. 729 (1971). Further, because the tenant owns the improvements it must depreciate the improvements constructed with the allowance over 39 years.
Recent legislative development; proposed changes affecting the recovery period of certain leasehold improvements
A bill was recently introduced in the Senate and House of Representatives that would allow building owners to depreciate specified building improvements using a 10-year depreciable life, rather than the 39 years required by current law. H.R. 1634, 108th Cong. (2003), S. 576, 108th Cong. (2003). A shorter depreciable life would more closely match the expenses incurred to construct the improvements with the income the improvements generate under the lease. The bill would amend subparagraph (D) of section 168(e)(3) of the Internal Revenue Code of 1986 by adding “any qualified leasehold improvement property” to be classified as 10-year property. The term “qualified leasehold improvement property” means any improvement to an interior portion of a building which is nonresidential real property if i) such improvement is made under or pursuant to a lease (I) by the lessee (or any sublessee) of such portion, or (II) by the lessor of such portion; ii) such portion is to be occupied exclusively by the lessee (or any sublessee) of such portion, and iii) such improvement is placed in service more than 3 years after the date the building was first placed in service. Qualified leasehold improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building. Section (D) requires that if an improvement is made by the person who was the lessor of the improvement when the improvement was placed in service, the improvement will be qualified leasehold improvement property (if at all) only so long as the improvement is held by such a person. Id.
Strategies Employed by Tenants and Landlords To Avoid Construction Allowance Income
Many tenants treat construction allowances in a manner that is inconsistent with case law. For example, even though they otherwise treat the improvements as tenant-owned, some tenants neither declare these allowances as income nor include the allowance in the basis of the improvements.
Some tenants and landlords use a disbursement mechanism called a “New York Escrow” whereby the landlord places the construction allowance in an escrow account. Subject to landlord approval, disbursements are made from the escrow to pay the construction costs for the tenant improvements. Treating sums disbursed from the escrow as a lease inducement, landlords write off the construction allowance over the lease term and tenants do not report the construction allowance as income under the theory that the tenant neither receives the cash nor includes the amount of the allowance in the basis of the leasehold improvements. This treatment is flawed. The physical receipt of cash is not the touchstone for determining whether a taxpayer has income; rather, the tax laws look to whether the tenant has “enhanced” its wealth and who owns the improvements. Thus, if the tenant owns the improvements, the New York Escrow does not avoid the tenant’s tax liability for a construction allowance.
Another technique used by tenants and landlords to avoid having an allowance treated as income to the tenant is to convert the allowance to a loan repayable by the tenant over the lease term. A loan is not income to the tenant. Although preferable to receiving income, a loan has some negative tax consequences for tenants. A portion of the monthly loan payments to the landlord constitutes principal repayment and, therefore, unlike rent payments, is not deductible by the tenant. The reduced rent deduction is only partially offset by the tenant’s depreciation (on a 39-year schedule) of the improvements. A loan may be beneficial to the landlord because the landlord does not own the improvements and can effectively “write off” the loan/allowance over the lease term. Use of the loan structure may include an unexpected price; that is, loss of some lease remedies in some jurisdictions.
Ownership Tests for Leasehold Improvements.
As noted above, the determining factor in the tax treatment of allowances and improvements is the “tax ownership” of the leasehold improvements. “Tax Ownership” is distinct from legal ownership. It is not based on whether a person or entity holds title to a particular property but, rather, is based on a broad analysis of a person’s economic relationship to that property. Courts have applied this concept of ownership in a variety of contexts, such as the sale-leaseback. Only recently have the IRS, Congress, and the courts begun to develop tests and guidelines for determining who owns leasehold improvements constructed with tenant allowances. The following section sets forth the tests and guidelines that have been applied in determining ownership of leasehold improvements.
The IRS Ownership Test: A Modified Version of the Benefits and Burdens Test
The Internal Revenue Service (“IRS”) has published an “Issue Paper” on construction allowances as part of its Industry Specialization Program, a program designed to ensure the uniform application of the Federal tax laws. See IRS Position Paper, Industry Specialization Program, Retail Industry Coordinated Issue Paper on Tenant Allowances, Tenant Allowances to Retail Store Operators, October 8, 1996 [hereinafter Issue Paper]. In the Issue Paper, the IRS seized upon the “benefits and burdens” test as the means of determining ownership. This test was developed in the “sale-leaseback” context to determine whether a lease constitutes a sale. The benefits and burdens test establishes tax ownership by evaluating the following factors to determine which party has the benefits and burdens of ownership:
- Whether legal title passes;
- How the parties treat the transaction;
- Whether an equity interest is acquired in the property;
- Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;
- Whether the right of possession is vested in the purchaser;
- Which party pays the property taxes;
- Which party bears the risk of loss from damage to the property; and
- Which party receives the profit from the operation and sale of the property. Grodt & McKay Realty v. Commissioner, 77 T.C. 1221 (1981).
After identifying the benefits and burdens test as the appropriate analysis for determining tax ownership of leasehold improvements, the IRS supplemented the test by adding the following factors:
- Who maintains property and liability insurance on the leasehold improvements;
- Who is responsible for replacing the leasehold improvements if they wear out before term expiration; and
- Who has the remainder interest in the improvements. Issue Paper, supra. As to this factor, the IRS’ preliminary inquiry is whether the tenant improvements have any value at the end of the lease term. FSA 1997-27, August 4, 1997 reprinted in 2000 TNT 170-23. If the improvements have no value, the IRS takes the position that the tenant owns the improvements regardless of who owns the remainder interest. Id.
The IRS is sensitive to tenant allowance issues and, therefore, the IRS’ modified benefits and burdens test is being applied by IRS auditors reviewing construction allowances. See also Internal Revenue Manual, Chapter 126.96.36.199.20.2.3. This test may be problematic for tenants. Tenants generally pay taxes and maintain insurance on improvements and replace them if they wear out during the term. If the improvements have little value at the termination of the lease, the application of the modified benefits and burdens test will tend to find ownership vested with tenants, thereby causing the construction allowance to be income to the tenant.
Elder-Beerman: A Bankruptcy Court’s Analysis
The first court to address and analyze the guidelines for determining the ownership of leasehold improvements was a bankruptcy court in Ohio. In In re Elder-Beerman Stores Corp. (“Elder-Beerman”), 97-1 U.S.T.C. at 87, 939, an anchor department store, Elder-Beerman, received approximately $43 million in reimbursed construction costs from 13 developers during the period from 1992 to 1995. Before 1992, developers had constructed the building shell or “vanilla box” for each store and Elder-Beerman had built out the interior improvements. Unsatisfied with developers constructing the building shell, Elder-Beerman subsequently entered into agreements with developers in which Elder-Beerman constructed the building and interior improvements and received a reimbursement of its costs as a construction allowance.
The reimbursements covered the cost of the building shell but rarely covered the entire cost of constructing the interior build-out. Under the leases, the developer retained the improvements on lease termination and held title to and bore the risk of loss of the building. The leases were typical commercial “net” leases which provided that Elder-Beerman would pay both a fixed and percentage rent. Elder-Beerman did not treat the reimbursed construction allowances as income. The IRS took the position that the transactions were a sham because Elder-Beerman owned the stores and, thus, the allowances were taxable as income. Based upon this analysis, the IRS sought tax delinquencies in the bankruptcy proceeding.
Though the bankruptcy court recognized that the benefits and burdens test provided a “useful guidepost,” the court determined that the proper focus was whether the transactions between Elder-Beerman and the developers should be respected under the “substance over form” doctrine. Under this doctrine, the form of the transaction governs for tax purposes if it is genuine, has economic substance which is compelled or encouraged by business realities, and is not solely shaped by tax avoidance features. Id. at 87, 943, citing Frank Lyon v. U.S., 435 U.S. 561, 583-84 (1979). Applying this doctrine, the court found that Elder-Beerman leased the stores because it chose to use its limited capital to purchase and merchandise its goods rather than own its stores. Moreover, the court found that by constructing its leasehold improvements, Elder-Beerman could both control its construction costs and prevent delays in opening a new store. Thus, the court held that Elder-Beerman had significant business purposes, independent of tax considerations, for choosing to lease the stores, for assuming the responsibility for construction, for accepting reimbursements for construction costs as allowances, and for investing its capital in the developer’s stores. In re Elder-Beerman, 97-1 U.S.T.C. at 87, 944. As a result, the court respected the transactions as structured by the parties and held there were no tax delinquencies. Id. at 87, 945.
The court dismissed the benefits and burdens test as unsupported by case law. Nonetheless the court applied the factors from the benefits and burdens of ownership test and held that even under this test, Elder-Beerman did not own the leasehold improvements constructed with the allowances. In applying the test, the court faulted the IRS for misconstruing the economic realities of net leases. Even though the developers had shifted certain responsibilities (i.e., the payment of property taxes and insurance) to Elder-Beerman, only the shopping center owners had a proprietary interest in the leasehold improvements, the ultimate risk of loss on these improvements, and ultimate responsibility for the tax obligations that attached to the stores.
Aftermath of the Elder-Beerman Decision
Elder-Beerman provides some authority for applying the substance over form doctrine in determining the ownership of leasehold improvements. This, together with the outright rejection of the IRS’ added factors, may inhibit the IRS’ efforts to apply the mechanical analysis of its modified benefits and burdens test.
The authors believe the bankruptcy court in Elder-Beerman reached the correct result. However, neither tenants nor landlords should rely too heavily on the Elder-Beerman holding because it is difficult to predict the deference a court with tax jurisdiction (a Tax Court, a Court of Claims, or a Federal district or circuit court) might give the bankruptcy court’s decision. An additional factor is that the Bankruptcy court, which focuses on debtors’ rights and creditors’ remedies, may not be a receptive forum for the IRS to advance its position on the ownership of leasehold improvements.
The Taxpayer Relief Act of 1997; Treatment of Construction Allowances under Short-Term Retail Leases.
Section 110, Treatment of Construction Allowances under Short-Term Retail Leases
In 1997, Congress passed the Taxpayer Relief Act of 1997 which included a safe harbor for retail tenants that receive “qualified lessee construction allowances.” According to the Committee Report, the safe harbor provision was enacted because Congress was concerned that in determining the tax ownership of lease improvements landlords and tenants might interpret the benefits and burdens factors differently, thus causing controversies between the IRS and taxpayers. H.R. Conf. Rep. No. 105-220, 105 Cong., 1st Sess. 678 (1997), reprinted in RIA’s Complete Analysis of the Taxpayer Relief Act of 1997, 5208, at 2152.
The safe harbor provision, section 110, provides that a retail tenant with a “short-term lease” that receives cash or rent reductions from a landlord of “retail space” 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.” Taxpayer Relief Act of 1997, §110(a). A “short-term lease” is a lease that has a term of 15 years or less including option periods unless they are renewable at fair market value. Id. at §110(c)(2). “Retail space” is real property leased, occupied, or otherwise used by a tenant for the sale of tangible personal property or services to the general public. Id. at §110(c)(3). “Qualified long-term real property” means nonresidential property that is part of or present at the retail space and reverts to the landlord when the lease terminates. Id. at §110(c)(1). To fit within the safe harbor, the allowance must be used to construct improvements for use in the tenant’s trade or business and cannot exceed the amount expended by the tenant for the improvements. Id. at §110(a).
Treasury Regulations Promulgated Under Section 110
Though section 110 is applicable to “qualified lessee construction allowances,” this term is not defined in the statute. However, final Treasury Regulations issued in September of 2000 define it and further refine the mechanics of section 110. Treas. Reg §1.110-1, 65 FR 53584 (September 5, 2000). A “qualified lessee construction allowance” is any amount received in cash or treated as a rent reduction by a lessor or a lessee (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 the lessee’s trade or business; (iii) to the extent that the amount is expended by the lessee “in the taxable year received.” Id. at §1.110-1(b).
Under the first prong, retail space is nonresidential real property that is used to sell tangible personal property or services to the “general public” and includes not only the space where retail activities are performed but also space where supporting activities are performed like administrative offices and storage areas. Id. at §1.110-1(b)(2)(iii). The definition of retail space includes property where services are provided by “hair stylists, tailors, shoe repairmen, doctors, lawyers, accountants, insurance agents, stock brokers, (including dealers who sell securities out of inventory), financial advisors, and bankers.” Id. at §1.110-1(b)(2)(iii). The surprisingly broad definition of retail space is helpful because many practitioners were unsure as to whether section 110 only applied to traditional retail stores, such as clothiers. See Carolyn Joy Lee, Certain Recent Developments Affecting The Federal Tax Treatment of Leasing Transactions.  Given the breadth of the definition, the safe harbor will generally extend to office and warehouse leases of retail tenants. Finally, services are deemed made available to the general public even if the product or service is targeted to certain customers and clients. Treas. Reg §1.110-1(b)(2)(iii).
As to the second prong, “qualified long term real property” is property that for depreciation purposes has a class life of greater than 27.5 years and is not nonresidential property with an accelerated cost recovery schedule (e.g. tangible personal property, in tax nomenclature this property is section 1245 property). Id. at §1.110-1(b)(2)(i).
As to the third prong, the Regulations state that expenditures for qualifying tenant improvements will be deemed first made from the lessee’s construction allowance and that tracing of expenditures to the allowance is not required. Id. at §1.110-1(b)(4). Further an amount is deemed to have been expended by a lessee “in the taxable year the construction allowance was received” if the amount is expended within 8 ½ months after the close of the taxable year or the amount received represents a reimbursement from the lessor for amounts expended by the lessee in earlier years for which the lessee has not claimed any deductions. Id. at §1.110-1(b)(4)(ii).
The Treasury Regulations impose a “purpose requirement”; that is, a construction allowance can only be a qualified lessee construction allowance if the lease expressly provides that the construction allowance is for the purpose of constructing or improving the space for use in the tenant’s trade or business. Id. at §1.110-1(b)(3). An ancillary agreement between a lessee and a lessor providing for a construction allowance if executed contemporaneously with the lease or during the lease term also satisfies the purpose requirement. Id.
If the tenant excludes the subject allowance from gross income under section 110, the regulations require that the landlord treat the property in a consistent manner (i.e., as nonresidential real property owned by the landlord) and to treat the allowance as fully expended unless notified to the contrary in writing by the tenant. Id. at §1.110-1(b)(5). But the lessee’s exclusion of the allowance from gross income is not dependent on consistent treatment of the property by the landlord. Id.
Finally, the Regulations require that the landlord and tenant provide detailed statements to the IRS containing specific information about the construction allowance. Id. at §1.110-1(c). A landlord or tenant who fails to furnish the requisite information or files incorrect information may be subject to penalties unless it can show “reasonable cause.” Id. at §1.110-1(c)(4); see §§6721, 6724. If, for example, the lessor received information in good faith from the lessee and reported it and this information is incorrect, the reasonable cause exception is satisfied. Treas. Reg. §1.110-1(c)(4); see IRC §§6721, 6724.
Some practitioners have argued that the purpose requirement, which calls for express language that an allowance is for improving qualified nonresidential real property, requires de facto tracing to the express amount set forth in the lease agreement for qualifying construction allowances and that consequently this requirement may be inconsistent with the provisions of these Regulations which does not require the tracing of construction allowances. Perhaps in response to this perceived inconsistency, the IRS has clarified the purpose requirement. See Rev. Rul. 2001-20, 2001-18 IRB 1 (April 10, 2001). In Rev. Rul. 2001-20, X, the tenant, and Y, the landlord, sign a 10-year lease agreement, beginning in 2001, for retail space. Under the lease agreement Y provides X with a construction allowance in the amount of $1 million. The lease states that to the extent the $1 million is spent on qualified long-term real property, it is for the purpose of constructing or improving qualified long-term real property. During X’s 2001 taxable year, X spends $800,000 on qualified long-term nonresidential real property, $100,000 on nonqualifying property, and retains the $100,000 excess-purpose requirement. The IRS advises that requiring express language in a lease regarding the construction allowance does not mean that the amount designated as a construction allowance must be spent on qualifying long-term property; rather, this express language serves as an acknowledgement by the lessor and lessee that to the extent the construction allowance is spent on qualified long term real property, the improved or constructed property will be treated as owned by the lessor. Only when this acknowledgement is expressly provided in a lease will amounts spent on qualified long-term real property be excluded from gross income. Under the above facts, the IRS determined that the language in the lease satisfied the purpose requirement and the $800,000 was a qualified lessee construction allowance under section 110.
General Comments Regarding Section 110 and the Regulations
Because most retail leases are for terms of less than 15 years and allowances rarely exceed the tenant’s cost of construction, section 110 provides a safe harbor from tax for most retail tenants that receive construction allowances. Tenants should be aware that section 110 is somewhat restrictive because it only applies to realty improvements. Allowances for non-realty improvements may be subject to tax. Tenants should also be aware of the time frame within which construction allowances, once received, must be spent. If these amounts cannot be spent within 8 ½ months after the taxable year in which they are received, then the tenant should seek to have the amounts received in installments and execute contemporaneous agreements when these installments are received.
Landlords should be aware that section 110 treats improvements constructed with the allowance as the landlord’s nonresidential real property, which must be depreciated over 39 years. As noted below, once the landlord abandons or irrevocably disposes of the improvements after term expiration, it can accelerate the depreciation of the balance.
Section 110 applies to leases entered into after August 5, 1997; therefore, allowances under some existing retail leases remain vulnerable to IRS assertions that they are income. See FSA 1997-27, supra. The legislative history emphasizes that no inferences are to be drawn regarding the treatment of construction allowances under prior law and that the case law and IRS Issue Paper will continue to apply to leases entered into before the effective date. H.R. Conf. Rep. No. 105-220, supra n.17 reprinted in RIA’s Complete Analysis of The Taxpayer Relief Act of 1997 at 2152.
The authors wish to note that the final Regulations are a significant improvement over the Proposed Regulations and reflect the responsiveness of Treasury to problems identified by practitioners. SeeProp. Treas. Reg. §1.110-1(c), 64 Fed. Reg. 50,783 (September 20, 1999); Treas. Reg. § 1.110-1, supra.
Indirect Construction Allowances: Reduced Rent or Rent Holiday Periods
Rather than make direct cash disbursements, some landlords and tenants have employed lower rental payments or rent holidays-“free rent”-that have the economic effect of granting a construction allowance. By providing “free rent,” the landlord allows the tenant to use sums that would otherwise be paid as rent for the payment of construction costs. Tenants may balk at the use of “free rent” in lieu of cash allowances because they may find it difficult or undesirable to borrow money to fund the construction of leasehold improvements.
Generally, the form of “free rent” should control the tax consequences. The tax consequences of a “free rent” structure are more beneficial for landlords than tenants. With either a rent reduction or rent holiday, the landlord reduces income by forgoing a rental payment. This reduction has the same economic effect as a deduction; unlike a construction allowance, which must be depreciated over a 39-year period (if the landlord owns the improvements) or the lease term (if the tenant owns the improvements), this “deduction” is taken over the rent reduction or rent holiday period-a marked improvement in the landlord’s tax position. Although the tenant will benefit because the “free rent” construction allowance will not be treated as income, the other tax consequences of “free rent” are not favorable. The tenant loses the full rental deduction it would have had if the tenant had paid full rent and received a cash allowance. Further, the tenant must depreciate the cost of the leasehold improvements it constructs over 39 years. Recognizing that the “free rent” structure may be worse for the tenant on an after-tax basis than a construction allowance, some tenants seek rent adjustments to compensate for the adverse tax effect. Landlords should be aware that a tenant may not respect the “lower rent” form and may assert that the free rent period was really an agreement between the parties that the landlord would forego rent and the tenant would use the foregone payments as a construction allowance. Under such a theory, on its tax return a tenant would deduct the full amount of rent. Thus, the landlord is in some respects relying on the tenant’s cooperation to maintain the form of this transaction. It may be unwise for retail tenants to engage in such a gambit because the Treasury Regulations under section 110 require express language in a lease for a rent reduction to qualify as a qualified lessee construction allowance excludible from income under section 110. See Treas. Reg. § 1.110(b)(3).
The IRS could contend that the “free rent” structure merely hides the payment of rent to the landlord coupled with the simultaneous funding of a construction allowance in the amount of the “free rent.” Treasury Regulations permit an examination of the terms of the lease and the surrounding circumstances to determine if the parties intended the improvements constructed by the tenant to constitute rent. Treas. Reg. §1.61-8(c).
Generally, courts have treated leasehold improvements as rent only when the parties have specified in an agreement that the arrangement was, in fact, an indirect construction allowance. In both Your Health Club, Inc. and Brown, the lease agreement expressly provided that the landlord reduced the tenant’s rental payment in lieu of a construction allowance. Your Health Club, Inc. v. Commissioner, 4 T.C. 385 (1944); Brown v. Commissioner, 22 T.C. 147 (1954). In both cases, the Tax Court held the arrangement constituted an “indirect payment” of income to the landlord. Conversely, in Cunningham v. Commissioner, the landlord leased real property to a corporation (of which it was the principal stockholder) that constructed a building on the property. Cunningham, 28 T.C. 670, 682 (1957), aff’d 258 F.2d 231 (9th Cir. 1958), acq. 1958-2 C.B. 40. The tenant-corporation was only to pay taxes on the property and transfer title to the building to the landlord at lease expiration. The lease agreement did not specify that the improvements constituted rent. Consistent with this treatment, the tenant-corporation did not treat the cost of the leasehold improvements as rent but rather as a capital expenditure. The Tax Court held the improvements did not constitute rent either at the time of the building’s construction or at the termination of the lease. Id.
The IRS has followed the case law and does not treat leasehold improvements as rent unless specified in an agreement. In Technical Advice Memorandum 79-25-008, two tenants paid below-market rents and made substantial improvements to a landlord’s building. Another tenant made no improvements and paid rent in excess of market rates. After a review of the case law, the IRS concluded that no authority permitted treating the leasehold improvements as rent merely because the rents charged were both lower than fair market rent and lower than those charged to the other tenant who did not make any improvements. Tech. Adv. Mem. 79-25-008 (March 9, 1979).  To ensure that courts and the IRS respect lower rents, landlords and tenants should not link the rent holiday or below-market rents to a construction allowance.
One complicating consequence of having a rent reduction or free rent period is that the parties could trigger section 467. Generally, section 467 has no tax effect on most normal business leases. But if triggered, section 467 changes how landlords and tenants account for rental income and deductions by requiring these parties to use the accrual method for recognizing rent regardless of their actual accounting method and could change the character of a portion of those payments into an interest payment. A discussion of section 467 is beyond the scope of this article.
Special Treatment for Inducements to Anchor Stores
Anchor stores often command significant inducements as a condition to locating in a shopping center. These inducements involve many of the same tax issues as construction allowances. The IRS has attacked these inducements and characterized them as income to the anchor store. Federated Dept. Stores v. Commissioner, 51 T.C. 500 (1968), aff’d. 426 F.2d 417 (6th Cir. 1970), nonacq. 1971-2 C.B. 4. Anchor stores which receive inducements such as cash, land and buildings have an extra weapon in their arsenal not available to retail tenants-one that has been quite successful-to defend against the IRS’ attacks. Under section 118, gross income does not include capital contributions made by a nonshareholder. The recipient of the contribution will qualify for tax-free treatment if the contributing party only receives an “indirect” and “intangible” benefit as a result of its contribution. Treas. Reg. §1.118-1. Case law has established what constitutes an indirect and intangible benefit.
In Federated Dept. Stores, the shopping center owner conveyed ten acres of undeveloped land in a shopping center to Federated and paid Federated $200,000 a year for 10 years. Federated treated the payments as contributions to capital under section 118. Federated Dept. Stores, 51 T.C. at 500. The IRS contended that section 118 was inapplicable because the shopping center owner transferred the property with the expectation that the presence of a Federated store would permit it to receive higher rents from the other stores in the shopping center and that this benefit was direct and tangible. Further, relying on the Treasury Regulations, the IRS contended that section 118 was only available for government units or civic groups. The Tax Court found for Federated, and the Sixth Circuit upheld the decision. Focusing on the Senate Committee Report which was drafted when section 118 was originally enacted, the Sixth Circuit found that Congress intended section 118 to apply to nonshareholders who transfer property and expect only an indirect or intangible future benefit and that “nonshareholders” included associations of individuals as well as community groups. Because it found that the shopping center owner’s expectation of benefit was indirect and speculative, the Sixth Circuit held that the transfer of land and money constituted a nonshareholder contribution of property and was excludable from Federated’s gross income. Federated Dept. Stores, 51 T.C. at 519-20.
One year later, in John B. White, the Tax Court again addressed the application of section 118 and held against the taxpayer. John B. White, Inc. v. Commissioner, 55 T.C. 729 (1971). In John B. White, the Ford Corporation offered the taxpayer, the owner of a Ford dealership, $52,290 as an inducement to move its dealership to a more desirable neighborhood in a more attractive and better-equipped building. The taxpayer leased the new store site and used the $52,290 to construct improvements in the building. The parties stipulated that Ford sought the relocation to increase the sale of Ford products and enhance the Ford image. The Tax Court found that the benefits that Ford anticipated were neither indirect nor intangible. Thus, the court held that Ford’s cash contribution was not a capital contribution and was income to the taxpayer. John B. White, 55 T.C. at 737.
Three years later, the Tax Court heard a case similar to Federated Dept. Stores. In May Dept. Stores Co. v. Commissioner, T.C. Memo. 1974-253, 1,128, a shopping center conveyed 16.4 acres of undeveloped land to May. May agreed to build a store on the land and covenanted to operate for twenty-five years. The Tax Court found that the shopping center owner would have neither title nor use of the building constructed by May and would not receive proceeds from May in the form of rents based on gross receipts or net income. Relying on Federated Dept. Stores, the Tax Court held the transfer of land was a capital contribution excludable from May’s gross income. May Dept. Stores Co., T.C. Memo. 1974-253 at 1,130. Shortly after the Federated Dept. Stores decision, the IRS announced its opposition to the case in 1971 2 C.B. 4. In the recent Issue Paper, the IRS continues to question the holdings in the Federated Dept. Stores and May Dept. Stores cases. In the Issue Paper, the IRS seems still to be surprised that the Court in May Dept. Stores found for the taxpayer. “The court refused to limit the meaning of ‘indirect benefits’ to those enjoyed by a contributor solely as a result of its being a member of the community at large. Although the overriding and dominant motive of the contributor was to secure a financial benefit for itself, the transfer was accorded capital contribution status.” Issue Paper, supra.
In an attempt to limit these cases, the IRS has opined that construction allowances for property that will be owned by the developer and on which the developer will receive rent, whether or not based on the tenant’s gross income, cannot qualify for the section 118 exclusion. Under the IRS’ analysis, the developer’s benefit, rent, is too direct and tangible to qualify under this provision. Some tax practitioners and the authors of this article agree with this view. Raby and Raby, Reimbursed Construction Costs: Income or Not? Tax Notes, September 22, 1997, at 1603.
In structuring inducements for anchor tenants, the parties should consider that if the anchor tenant receives the land and owns the building in the development, the contribution of land and any cash contribution should be excludable from income under §118. However, if the anchor tenant leases the land, the construction allowance must be analyzed under the safe harbor provision of section 110 or under Elder-Beerman and the benefits and burdens test.
The Limited and T.J.X. Companies
Two Tax Court cases involved nearly all of the issues discussed in this article. In 1995 the IRS challenged The Limited’s tax treatment of improvement allowances and inducements paid to it. The Limited Inc., et al. v. Commissioner, Dkt. No. 26618-95, filed December 22, 1995. The Limited, over the course of two years, allegedly received approximately $348 million in cash payments, rent abatements and combinations thereof from shopping center owners to construct improvements in its stores. The IRS asserted that the payments, abatements, and inducements constituted income to The Limited.
In 1996, the IRS also challenged the receipt of construction allowances by T.J.X. Companies for two of its retail operations, T.J. Maxx and Hit or Miss. T.J.X. Companies v. Commissioner, Dkt. No. 25343-96. The IRS asserted that $6.5 million that T.J.X. Companies received from shopping center owners to construct the T.J. Maxx and Hit or Miss stores was includable in income. T.J.X Company filed a Tax Court petition and rebutted the IRS’ determination by demonstrating that under the terms of the lease the landlord should be deemed the owner of the leasehold improvements. Id.
These cases were settled, so there is no decision to provide additional guidance. The IRS’s enforcement efforts in these cases, however, demonstrate its renewed scrutiny of construction allowances and nonshareholder contributions of capital. The IRS’s scrutiny of the construction allowances for T.J. Maxx and the Hit or Miss stores (“Stores”) is particularly puzzling. See Jacobson and Zebulon, Section 110(a): The Fall and Rise of the “Exclusion” from Gross Income of “Tenant Allowance,” BNA, Tax Management Memorandum, February 2, 1998, Vol. 39, No. 3, p. 3. Under the terms of the leases for the Stores, T.J. Maxx surrendered the improvements made with the allowances upon lease expiration. The Stores could only remove certain fixtures, equipment, and signs not purchased with the construction allowance. The lease designated the landlord as the owner of the improvements, and the landlord had the ultimate risk of loss in the event of fire, casualty, or eminent domain. Finally, all of the leases were net leases with ten-year terms. If the section 110 safe harbor provision had applied, most of the allowances would be excludable from income. Further, Elder-Beerman suggests that the improvements were the landlord’s and, thus, that the construction allowance should not constitute income.
Deduction of Leasehold Improvement Costs Uplon Lease Termination
What are the tax consequences of the disposition of leasehold improvements at the end of the lease term?
The Tax Treatment of Leasehold Improvements Owned by the Landlord.
Before enactment of the Small Business Job Protection Act of 1996 (“SBJPA”), the IRS’s position was that a landlord could not deduct the remaining depreciable balance of leasehold improvements even after a landlord demolished the improvements and constructed new ones for a new tenant. The IRS required the landlord to continue to depreciate its improvements over the 39-year statutory period. With the enactment of section 168(i)(8) of the SBJPA, Congress changed this requirement. After June 12, 1996, a landlord may accelerate its leasehold improvement depreciation if the improvements are “irrevocably disposed of” or “abandoned.” H.R. Conf. Rep. on H.R. 3448, Small Business Job Protection Act of 1996, 142 Cong. Rec. H9568-03. The landlord must be able to separately account for the adjusted basis of these leasehold improvements. Taxpayer Refund and Relief Act of 1999, H.R. Conf. Rep. No. 106-120, (1999).
Unfortunately, neither the SBJPA nor section 168(i)(8) discusses what constitutes “irrevocable disposition” or “abandonment.” As the IRS issues regulations or case law develops, these terms will be defined. Even without these definitions, the principles of section 168(i)(8) can be applied in certain situations. For instance, if a landlord demolishes all existing improvements immediately upon lease termination and builds all new improvements for a new tenant, “irrevocable disposition” or “abandonment” has occurred and the landlord can accelerate its leasehold improvement deductions. If a successor tenant demolishes one-third of the existing improvements and incorporates two-thirds of the existing improvements into the new improvements, a landlord should deduct only one-third of the remaining depreciable basis of the existing improvements because only one-third would be irrevocably disposed. The landlord would continue to depreciate the remaining two-thirds of the improvements over their 39-year depreciable life.
As a planning matter, landlords should document in the lease or construction agreement which leasehold improvements are constructed with their allowances. By so doing, landlords can establish how much depreciation can be accelerated upon disposing of or abandoning the improvements. In addition, purchasers should require that sellers provide this information because successor landlords should be able to take this accelerated depreciation deduction when the improvements are subsequently disposed of or abandoned.
The Tax Treatment of Leasehold Improvements Owned by the Tenant
New section 168(i)(8) does not affect the treatment of improvements owned by a tenant. As before, tenants must depreciate their leasehold improvements over 39 years. At lease-end, tenants can deduct the remaining depreciable balance of these improvements. Cassatt v. Commissioner, 137 F.2d 745 (1943).
For landlords, the transfer of tenant-owned leasehold improvements upon lease-end generally causes few tax consequences. Even though the landlord receives the improvements with no countervailing obligation, section 109 provides that the receipt of this property is not income. Landlords and tenants will fall out of this exclusion if the facts disclose that the transfer of these improvements represents a rent payment. Treas. Reg. §109. This transfer will then be characterized as income to the landlord. Id. at §1.109-1.
As a corollary to this exclusion, landlords are not permitted to increase the basis of their property by the value of the improvements. §109. As a result, landlords may eventually be taxed on these improvements, but at capital gains rates. For instance, if a landlord receives valuable leasehold improvements upon a lease termination and subsequently sells the property, the transfer of the leasehold improvements likely increased the fair market value of the property, resulting in the landlord being taxed on the value the improvements added to the property.
To control the tax consequences of construction allowances, tenants and landlords should focus on who owns the leasehold improvements. The lease should designate the owner of the improvements and specify that at lease-end all the improvements-whether they are improvements, fixtures, or equipment-made with the construction allowance are the property of the owner. Finally, at lease-end, the parties should respect the designated owner’s interest in the improvements.
For retail tenants, section 110 excludes from income qualifying construction allowances. Tenants should note that this safe harbor provision only applies to realty improvements. Treasury Regulations under section 110 provide rules as to the type of language that should be incorporated in a lease for a taxpayer to qualify for the safe harbor in section 110. The Regulations also set forth reporting requirements and the time frame within which construction allowances, once received, must be expended.
Tenants and landlords can use other forms of transactions to effect a construction allowance such as a rent holiday or free rent period. These arrangements are beneficial to tenants because they avoid having the construction allowance treated as income. But they also require tenants to make a larger investment at the beginning of the lease and reduce tenants’ rental deductions. Tenants should only use these structures after evaluating their economic effect.
Finally, section 118 provides opportunities for anchor tenants to receive tax-free contributions of land and cash from developers and shopping center owners. Under the Federated Dept. Stores and May Dept. Stores cases, inducements of unimproved land and cash are excludable from income under section 118. Both these cases and the legislative history of section 118 indicates that the guiding principle is whether the developer/owner’s benefit is intangible and indirect. The IRS, in its Issue Paper, has stated that any rent, whether based on a tenant’s gross income or not, is a direct benefit to the developer/owner and, consequently, takes any inducement received by the tenant out of section 118. Further, the IRS still chafes at the May Dept. Stores and Federated Dept. Storesdecisions and continues to look for an opportunity to limit or overturn these cases. Thus, anchor tenants should structure inducements carefully.
Practice Checklist For Tax Considerations Affecting Construction Allowances and Disposition of Leasehold Improvements
The taxation of construction allowances is guided by two principles: income received is taxable in the year when it is received and the owner of a leasehold improvement must depreciate the improvement ratably over 39 years. A tenant can only avoid “income” if the landlord owns the leasehold improvements. A landlord can only avoid a 39-year depreciation period and “write off” the construction allowance over the shorter lease term if the tenant owns the improvements. To maximize tax benefits, each party must foist ownership of the improvements onto the other.
- To control the tax consequences of construction allowances, tenants and landlords should concentrate on who owns the leasehold improvements.
- The lease should designate the owner of the improvements and specify that at lease-end all the improvements made with the construction allowance are the property of the owner;
- At lease-end, the parties should respect the designated owner’s interest in the improvements.
- For retail tenants, section 110 excludes qualifying construction allowances from income. This safe harbor provision only applies to realty improvements.
- Tenants and landlords can use other forms of transactions to effect a construction allowance such as a rent holiday or free rent period. Retail tenants desiring to exclude a rent reduction from gross income should comply with the requirements for exclusion set forth in Section 110 and the related regulations.
- Tenants should consider using these because they avoid having the construction allowance treated as income.
- Because they require tenants to make a larger investment at the beginning of the lease and reduce tenants’ rental deductions, tenants should only use these devices after evaluating their economic effect.
- Section 118 provides opportunities for anchor tenants to receive tax-free contributions of land and cash from developers and shopping center owners. Under case law, inducements of unimproved land and cash are excludable from income under section 118: the guiding principle is whether the developer/owner’s benefit is intangible and indirect. The IRS has stated that any rent, whether based on a tenant’s gross income or not, is a direct benefit to the developer/owner and, consequently, takes any inducement received by the tenant out of section 118.
- Anchor tenants should be especially careful when structuring inducements.
- As this article will further discuss, a bill was recently introduced in the Senate and House of Representatives that would provide a shorter recovery period for the depreciation of certain leasehold improvements. S. 576, 108th Cong. (2003); H.R. 1634, 108th Cong. (2003). The bill would allow building owners to depreciate specified building improvements using a 10-year depreciable life rather than the 39 years required by current law.
- The Small Business Job Protection Act of 1996 amended Internal Revenue Code section 168(I)(8), stating that a landlord may accelerate its leasehold improvement depreciation if the improvements are “irrevocably disposed of” or “abandoned.”
- All section references are to the Internal Revenue Code (“IRC”), unless otherwise indicated.
- On Appeal, the court clarified that a landlord may not “write off” an allowance for improvements beyond the end of the lease term which was valued. 53 F.2d at 383-84. In Bonwit Teller & Co., the property in question was a leasehold having nineteen years to run, and containing an option to renew for twenty-one years at a rental to be determined by the appraisal of the property to be made at the time of the renewal. The appellate court stated that the existence or exercise of such an option does not change the period during which the lease will become exhausted. Id. But see Joseph Neel Co., 22 T.C. at 1091.
- Practicing Law Institute First Annual Review Real Estate Tax Forum p. 1080 (1999).
- Although this Technical Advice Memorandum may not be authority for tax purposes because it was issued more than 10 years ago, it has a very comprehensive discussion of this issue.
About the Authors
Mark S. Hennigh is the Managing Partner of the San Francisco law firm of Greene Radovsky Maloney & Share LLP. He has been a lecturer and writer for the American Bar Association, the Building Owners and Managers Association, and the International Council of Shopping Centers.
Stephen A. Bonovich is Tax Counsel for Intel. In this capacity, he analyzes and structures corporate acquisitions and mergers, investments, real estate transactions and other transactions in which Intel engages. Before working at Sun he was a tax attorney with Greene Radovsky Maloney and Share where much of his practice focused on real estate transactions. He is an adjunct professor at Golden Gate University where he teaches a course on real estate taxation.
Special thanks to Debra Maho, Boalt Law School.
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