Offering tenant leasehold improvement allowances is one strategy used
by landlords to attract new tenants or to retain existing ones. This
arrangement gives the property owner a right to whatever improvements
have been made on a property after the departure of a tenant. The
structure of the leasehold improvement allowance will determine the
income tax treatment of the arrangement. If leasehold improvements are
made in exchange of rent payments, then they will be considered part of
the landlord's rental income. On the other hand, if the tenant
receives build-out allowances from the landlord, then this amount will
be treated as taxable income to the tenant. These tax consequences apply
in instances when the improvements are considered real property and not
personal property, and when the lease contract is not covered by any
rent levelling provisions.
In this period of high vacancy rates, many landlords are providing
significant landlords are providing significant incentives to gain new
tenants and retain existing tenants whose leases are up for renewal. One
method of encouraging tenants to move in--or to stay--is through tenant
leasehold improvement allowances. This may allow a property owner to
retain a potential benefit (the improvement) after a tenant moves out.
The income tax consequences to a landlord will vary depending on how the
lease (i.e., allowance) is structured.
The moral of this story is that the form of the transaction counts.
The lease and/or other written agreements should be structured to follow
the intended income tax consequences.
In this article we assume that the leasehold improvements are
considered real property (walls, electrical, heating, etc.) versus
personal property such as furniture or trade fixtures. We also assume
that the rental arrangements are not subject to rent levelling
In some cases, a tenant will pay for leasehold improvements in lieu
of rent payments. For example, a new tenant will be given the first year
rent free in exchange for payment to contractors for leasehold
If the lease clearly states that the improvements are in lieu of
rent, then the value assigned to the improvements will be treated as
rental income to the landlord. In such a case, the landlord will include
the value of the improvements in taxable income in the year the
improvements are completed or paid.
If the costs of the improvements are a direct offset (i.e., dollar
for dollar) against stated rent, then rental income is measured by the
actual cost of the improvements. The tenant in turn will receive a
rental deduction for the cost of the improvements.
In general, this structure is not favorable to landlords because it
creates taxable income without any cash and a depreciable asset with a
An alternative structure would be to allow a rent holiday and require
the tenant to pay for and own the leasehold improvements. In such a
case, the landlord still has no cash but his or her taxable income has
been reduced during the rent holiday period and the tenant owns the
In other cases, landlords offer cash sums to tenants for purposes of
tenant build-outs. If the tenant has great latitude in how the money can
be used and is considered the owner of the property, then the tenant has
taxable income in the amount of payments received and an asset
depreciable over 31.5 years.
Conversely, the landlord has a deferred lease acquisition cost asset
amortizable over the term of the lease, including renewal periods, which
is usually substantially less than the 31.5 years for depreciation. This
structure is more advantageous to the landlord from an income-tax
If the lease does not specify who is responsible for tenant
improvements, then the intention of the parties and all the facts and
circumstances should be considered in making the determination. The
improvements may not be rent if the lessee is allowed to remove the
improvement at the end of the lease or if the useful life of the
improvement is shorter than the lease term.
Improvements in lieu of rent will result in taxable income to the
landlord without cash flow to pay any increased income tax liabilities.
Tenant build-out allowances in which the tenant is considered the owner
of the property will result in taxable income to the tenant. Therefore,
the income tax consequences of tenant allowances should be considered in
setting the timing and amount of rental payments. Passive-activity
limitations should also be considered in any analysis.
If the landlord pays for improvements and is considered the owner,
the landlord is required to capitalize and depreciate on the
straight-line basis the cost of tenant leasehold improvements over 31.5
years. (Longer periods are used for Alternative Minimum Tax purposes.)
In most cases, the tenant will not stay in the space for 31.5 years.
Usually, after five to ten years the tenant will move out and be
replaced by a new tenant. Generally, the new tenant will remove the old
leasehold improvements and install new improvements which meet its
The issue raised is whether or not the landlord is entitled to write
off the remaining unamortized basis of the leasehold improvements or
must continue to depreciate the assets removed. The IRS has commented
informally that the tenant leasehold improvement is a structural
component and is not subject to write-off when destroyed.
This position is based on an interpretation of the legislative
history of the Economic Recovery Act of 1981, which provided that a
retirement of a structural component of the building is not a
disposition requiring gain or loss. Therefore, based on the IRS'
interpretation of the law, the landlord is required to continue to
depreciate the asset even after it has been demolished.
Because it is questionable as to whether tenant leasehold
improvements should be considered structural components, there is an
argument that the landlord is entitled to write off the undepreciated
basis of the destroyed improvements.
If this position is taken, it is extremely important that detailed
records are maintained keeping track of the costs on a space-by-space
basis to support a write-off of the remaining unamortized basis when a
tenant leaves and improvements might be classified as personal property
(rather than structural components) and depreciated over a shorter life.
The IRS has not issued formal guidance on this issue, and to date it
has not been litigated. Therefore, if detailed records are maintained, a
position exists to write off the abandoned assets. However, it should be
noted that this issue will surely be an item of dispute between
taxpayers and the IRS.
Because of the uncertainty in this area, you should consult your tax
advisor prior to claiming a write-off of the abandoned assets. Your
decision should include possible understatement penalties and possible
disclosure requirements to avoid such penalties.
Dennis M. Byrnes is a partner, and Perry V. Plescia a senior manager,
with KPMG Peat Marwick, Chicago.