Guest Column: “Taxonomics” of Tenant Allowances

Negotiated tenant allowances are a key consideration for most commercial leases. Unfortunately, negotiations often overlook tax consequences during the structuring of the lease, creating an unanticipated tax burden for an unsuspecting property owner.

Negotiated tenant allowances are a key consideration for most commercial leases. Unfortunately, negotiations often overlook tax consequences during the structuring of the lease, creating an unanticipated tax burden for an unsuspecting property owner.

While recent tax law changes included in the Tax Relief/Job Creation Act of 2010 provide some temporary relief to owners making tenant improvements, the term of most current commercial leases will extend beyond the act’s expiration. Thus, it is imperative that leases consider how each party may be affected by allowances currently under negotiation.

Tenant allowances can take the form of direct cash payments made by the property owner or an agreement to accept lower rent payments in future years. When an allowance is granted, there are two primary tax issues facing the property owner: 1) if the allowance will be reportable as taxable income in the year it is granted; and 2) whether or not the concession will result in a tax deduction.

In most cases, cash payments made by the property owner will be considered either a capital improvement to the property or a lease acquisition cost. The key difference between the two is the period over which the payment will be deducted for tax purposes.

When a property owner makes an improvement to the property, it is common for them to retain ownership of those improvements. When ownership of the improvements is retained, the costs are capitalized and subject to recovery through depreciation over the life of the asset. For structural improvements, the depreciable life for tax purposes is 39 years, regardless of the term of the lease.

Not all improvements will be subject to depreciation over 39 years, however. For “Qualified Leasehold Improvement Property,” the costs can be recovered ratably over 15 years; however, a temporary provision in the Tax Code allows for a first-year depreciation deduction of 100 percent of the cost of QLIP acquired after Sept. 8, 2010, but before Jan. 1, 2012.

To be eligible, the improvements must be:

  • made pursuant to a lease;
  • made to a portion of the building occupied exclusively by the tenant; and
  • made more than three years after the building was originally placed in service.

If an improvement does not qualify as QLIP, a property owner may want to consider having a cost segregation study performed on the property. A cost segregation study will identify those improvements that can be depreciated over a shorter life. Any new improvements made after Sept. 8, 2010, but before Jan. 1, 2012, that are identified as having a class life, for tax depreciation purposes, of 20 years or less are also eligible for a 100 percent first-year depreciation deduction, regardless of the QLIP requirements.

When payments are made directly to or on behalf of a tenant, or ownership of improvements made by the property owner is transferred to the tenant, the payment will generally be categorized as a lease acquisition cost and be subject to amortization over the life of the lease. If the lease is terminated early, any unamortized amounts can be written off, unlike depreciable improvements, which will generally continue to be subject to depreciation after a tenant vacates the property. From a tenant’s perspective, direct payments are often less desirable because the payment may require recognition of income when received.

During the past several years, many property owners have been burned by tenants that defaulted on leases; thus, they have understandably been reluctant to offer cash payments or large build-outs as inducements to sign new leases. Instead, property owners have attempted to lessen their risk by agreeing to accept reduced rent over a period of time or grant a rent holiday. Unlike with methods discussed above that involve initial cash outlays, property owners granting rent concessions or holidays recognize the allowance through reduced rents at a future time.

When properly structured, a rent concession or holiday is a tax-efficient allowance method that does not result in negative cash flow up front. When problems arise, it is often because the reductions are explicitly tied to improvements made by the tenant, which can result in taxable income to the property owner and an asset subject to depreciation.

Because of the uniqueness of commercial leases and the individual situations of the parties negotiating them, there is no one strategy that applies in every circumstance. Before structuring your next lease, consider consulting your tax advisor to make sure the allowance being offered is best for your tax situation.

William F. Becker Jr., CPA, is a tax partner in the Tampa office of Cherry Bekaert & Holland L.L.P.  He can be reached at 813-251-1010 or bbecker@cbh.com.