Before the Build-Out
Assess tax consequences prior to leasehold improvements.
In today’s competitive leasing market, build-outs or other capital
improvements are good ways for property owners to retain current tenants or
attract new ones. Creating more open floor plans or providing additional
capacity for new technologies can adapt older office buildings to fit the
changing needs of the occupants. The same is true for retail and industrial
properties where new build-outs can attract new types of tenants to the
After deciding to make improvements, property owners must figure
how to fund the construction costs. Three common methods provide funding for
tenant improvements: a direct investment in the improvements by the property
owner, a cash payment to the tenant to then make improvements, or a rent
holiday for the tenant.
For landlords and tenants, the tax consequences vary based on the
method, or combination of methods, used to fund improvements. Additionally, the
intent of the parties and the specific language used in their agreements will
directly affect the tax treatment of leasehold improvements. In all cases, both
parties should consider the potential tax consequences when agreeing on how to
provide for improvements to leased property.
In a direct investment in the leasehold improvements, the property
owner pays all of the construction costs, using its own money or borrowed
funds. Retaining ownership of the improvements, the owner records them as
assets on its books and receives a deduction for depreciation of the assets
over their useful lives. There is no tax effect on the tenant as a result of a
direct investment by the property owner.
When a property owner makes a payment directly to the tenant, the
nature of the payment, as determined by the parties’ intent and the lease
agreement, will influence the tax consequences. If the payment is considered a
cash incentive for signing the lease, it will be treated as taxable income to
the tenant and will be deducted by the landlord over the lease term. For
example, if a $50,000 incentive is provided for a five-year lease, the tenant
will have $50,000 of income in year one and the owner will deduct $10,000 of
expense in each of years one through five. Once the tenant uses the money to
make improvements, it will be able to depreciate them for tax purposes.
Contrast this with a payment that is considered to be a
construction allowance. In this case, whether or not the tenant has income is
based in large part on the lease agreement. If the lease is for retail space,
is for 15 years or less, and the lease agreement expressly provides that the
allowance is for the purpose of constructing or improving qualified long-term
real property (not personal property), then the payment is not considered
income to the tenant. The property owner would treat it as a direct investment,
to be depreciated over 39 years. If the tenant does not use the allowance to
pay for qualified real property, or the property does not revert to the owner
at the termination of the lease, the tenant must consider construction
allowance payments as taxable income. Therefore it is important to clearly
establish what the allowance is to be used for and who retains the property at
lease-end. Additionally if the lease is for nonretail space or the lease term
exceeds 15 years, then the allowance is considered taxable income to the
Free rent is often the most tax-effective way for a property owner
to adjust to market conditions and entice tenants to rent a property. The
tenant is given a rent holiday for an agreed-upon number of months, with or
without the holiday being explicitly tied to the tenant’s actual expenditures
on improvements. The tenant then uses the money saved on rent to make any
It is important for the lease agreement to state the terms of the
rent holiday. The tax treatment of the transaction will be determined based on
whether or not the improvements made by the tenant are considered to be in lieu
If the rent holiday explicitly is tied to tenant improvements or
the improvements are considered a substitute for rent, the landlord will have
both taxable income and depreciable assets (the improvements). For example, the
agreement stipulates the tenant is to make $50,000 worth of improvements for
the owner instead of paying rent. Then the owner would report $50,000 of
taxable income despite not having received the rent. The owner would have
$50,000 of assets to depreciate over their useful lives and the tenant would
have a rent expense of $50,000.
On the other hand, if the rent holiday is not explicitly tied to
improvements or the improvements are not made in lieu of rent, the owner should
not have to recognize taxable income to the extent of the improvements made.
The downside of this situation is that the owner has no tax basis in the
assets. The tenant will have the tax basis and depreciation expense until the
termination of the lease, at which time the tenant can write off any remaining
Necessary building updates should not lead to unnecessary tax burdens.
To fully examine the tax treatment of a specific situation, it is important
establish who owns the improvements during the term of the lease and what
happens to the property upon termination of the lease. The specific language of
the lease agreement and examination of the facts and circumstances are also
critical to establishing tax consequences. Owners and tenants should work with
their tax advisers to ensure the intended results are achieved.
Daniel Rowe, CPA, is tax
manager and John Vandaveer, CPA, CVA, is tax partner at the accounting firm
Deemer Dana & Froehle LLP in Savannah, Ga. Contact them at firstname.lastname@example.org and email@example.com.