Tax issues

Retail Tenants Get Tax Break for Construction Allowances

For years, federal income tax law was unclear about how to treat payments that owners or landlords make to tenants for construction allowances to improve leased retail space.

Last September, the Internal Revenue Service adopted final regulations on previously created construction allowance safe-harbor regulations to help eliminate controversy over related taxation. Landlords and tenants that adhere to the safe-harbor rules are afforded tax-free treatment on certain construction allowances.

Retail Construction Allowances Generally, a landlord provides a potential tenant with a construction allowance to induce the tenant to lease a property. This especially is true in the retail market, where an attractive tenant may improve the chance for a project's success as well as attract other key tenants. 

However, the broad definition of gross income in Internal Revenue Code Section 61 — “all income from whatever source derived” — has led to debate about the tax treatment of landlords' cash payment of construction allowances to tenants.

Because of the ambiguity, Congress enacted IRC Section 110 in the Taxpayer Relief Act of 1997 to provide a safe harbor under which certain tenants would not be taxed on construction allowances received to improve their leased space.

IRC Section 110 provides that a tenant's gross income does not include payments or rent reductions received from a landlord under a lease for 15 years or less for the purpose of constructing or improving qualified long-term real property. Retail space is defined as real property leased, occupied, and used by a tenant in its trade or business of selling tangible personal property or services to the general public. 

On Sept. 20, 1999, the Treasury Department issued proposed regulations to clarify IRC Section 110's safe-harbor rules. The proposed regulations clarify two requirements. To satisfy the “purpose” requirement, a lease agreement must state that the construction allowance is for the purpose of constructing or improving the property for use in the tenant's trade or business at that particular site. To satisfy the “expenditure” requirement, a tenant must use the construction allowance within 8½ months after the close of the taxable year in which the allowance was received.

On Sept. 1, 2000, the IRS adopted final regulations that were effective Oct. 5. These final regulations expand the definition of allowances to include space for office or storage supporting the retail activity and give examples of qualifying retail services, which include doctors, lawyers, accountants, bankers, insurance agents, stockbrokers, security dealers, tailors, hair stylists, and shoe repairers. They also state that a landlord can reimburse a tenant for amounts spent in a prior year, provided that the tenant did not depreciate the costs. 

Since the landlord retains the benefits and burdens of ownership with the safe harbor, the landlord depreciates the cost of a construction allowance. Under the final regulations, if a tenant takes depreciation on a construction allowance, the safe harbor would not be met.

Information Requirements To comply with the construction allowance safe harbor, the regulations require that property owners and tenants attach relevant information to their respective income tax returns. The owner's statement should include the tenant's name, address, employer identification number, location of the retail space, and the construction allowance amount. The tenant's statement should include the property owner's name, address, employer identification number, and the construction allowance amount. Failure to furnish the required information may result in a penalty. 

The safe-harbor provision and the related regulations were put in place to eliminate controversies between the IRS and taxpayers. This safe harbor provides that certain retail tenants are not taxed on receipt of construction allowances that are used to improve leased space.

Steven M. Friedman and Steven J. Szymanski

Steven M. Friedman is a tax partner and Steven J. Szymanski is a tax manager in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or steve.friedman@ey.com and steven.szymanski@ey.com.

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