Tenant construction allowances are a common detail in commercial real estate leases. Because landlords need tenants to fill their commercial spaces, and tenants need to customize these spaces for their business, a tenant allowance is a vital lease term which significantly pushes forward and finalizes a commercial real estate leasing transaction. An allowance must be structured accordingly to avoid undesired tax consequences.
I.R.C. § 110 provides landlords and tenants with a safe harbor which ensures that a tenant is not required to recognize income for a tenant allowance in leases which are for 15 years or less of a retail space. Otherwise, the tenant treats a tenant allowance received from the landlord as ordinary income, while depreciating assets over their useful life, typically resulting in much more income than expenses.
The Tax Code permits lessees to exclude the amount of a qualified construction allowance received from a landlord, but only to the extent the allowance does not exceed the actual costs incurred to improve the leased space.
Under the Tax Regs, as mentioned previously, a short-term lease is any agreement for the occupancy or use of a retail space for a term of 15 years or less. Purusant to I.R.C. § 168(i)(3), this lease term is measured by the initial lease term with any lease extension options, unless a renewal of the rent at fair market value is determined at the time of the lease’s renewal.
A retail space is defined as space “that is leased, occupied, or otherwise used by the lessee in its trade or business of selling tangible personal property or services to the general public.” This includes space where activities are performed in support of the retail activity.
There is also a purpose requirement under the Tax Regulations which requires that the the lease agreement, or an ancillary agreement thereto, expressly provides for the allowance. The allowance’s purpose must be to construct or improve qualified long-term real property for use in the tenant’s trade or business at the retail space. The property must be real property as personal property does not qualify for safe harbor prtoection.
Under I.R.C. § 110, improvements related to a qualified allowance are owned by a landlord. For retail spaces, property to qualify must generally meet the following requirements:
- the recovery period must be 20 years or less;
- the property is acquired prior to Jan. 1, 2020; and
- the property is deemed qualified improvement property under I.R.C. § 168(k)(2)(A)(i)).
If the above guidelines are met, the improvements are eligible to be treated as 15-year recovery qualified leasehold improvement property, thus qualifying for special depreciation, including 50% bonus depreciation for 2016. Qualified leasehold improvement property must be placed in service more than three years after the building was first placed in service, and the space must be occupied solely by the lessee under I.R.C. § 168(e)(6)(A)).
When a qualified lessee construction allowance is paid pursuant to a lease agreement, both parties are required to make disclosures with their federal tax returns under I.R.C. § 110. An experienced tax professional may offer valuable assistance to landlords and tenants alike in this situation. If you have any questions about commercial tenant allowances, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704. 
