The tenant allowance amount that a landlord agrees to spend in renovations plays an important role in attracting new tenants to commercial spaces. From a tax perspective, a tenant allowance is normally treated as income on the tenant’s tax return and the improvements are depreciated by the tenant over a number of years. Qualified lessee construction allowances are a more attractive, alternative option that doesn’t require a tenant to include the allowance as taxable income.
Qualified Lessee Construction Allowance Criteria
Making a safe harbor disclosure under Internal Revenue Code Section 110 to treat the allowance as a “qualified lessee construction allowance” can be a big benefit for tenants. When properly advertised, this arrangement may pique the interest of prospective tenants. Given the aggressive environment of commercial real estate, it could be useful to offer this option to prospective tenants in order to gain a competitive edge over other commercial property owners. Qualified lessee construction allowances are allowed for lease agreements that meet the following criteria:
- Lease term must be 15 years or less of retail space
- Space must be occupied by the lessee
- “Retail space” indicates real property used in a trade or business of selling tangible personal property or services to the general public
- Allowance must be used for constructing or improving qualified long-term real property
- Allowance must not be used for personal property
- Allowance does not exceed the amount the lessee spent for the improvement
- The tenant spends the allowance in the tax year the allowance was received or within 8 ½ months after the end of the tax year
- Both the landlord and the tenant must disclose certain information with their tax returns for the year in which the allowance is received.
When setting up this type of agreement, it is key to include certain provisions in the lease documents. If the required verbiage is not included, the safe harbor may be deemed invalid by the IRS. It is also essential to include stipulations that help minimize tax impact to the landlord, such as requiring all improvements to be qualified for bonus depreciation. Changes to lease agreements should be consulted with a tax professional. If you’d like to offer this option to tenants, contact Anders for more information.
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