In the U.S. commercial real estate market, unique lease incentive packages are often structured to lure prospective tenants. Frequently included in these incentive packages is a leasehold improvement build-out allowance agreement. When entering into a new lease, the income tax consequences of these build-out allowance arrangements should be taken into consideration to maximize the benefits to both landlord and tenant. The tax issues in play include depreciation of the improvements and whether income recognition would be required.
One scenario for lease build-out arrangements is where the landlord retains the ownership, and the tenant receives a build-out allowance that the landlord funds. The build-out allowance can be used to the tenant’s specifications. This allowance may be negotiated as a function of square footage. For example, a landlord may grant a $25 per square foot build-out allowance, with the tenant responsible for the expenditures in excess of this landlord commitment. In this case, specific asset identification may be difficult. The tenant should allocate its depreciable cost (the excess over the $25 allowance) first to moveable tangible personal property (e.g. furniture), since the tenant has a clearer title to those items. Under this scenario, it should follow that neither the landlord nor the tenant has income on account of the build-out arrangement, and both would depreciate their respective costs.
A second scenario involves a tenant who enters into a lease agreement and pays for the improvements through a substitute or reduction in rent (i.e. “rent holiday”). The landlord must include in gross income the fair market value of the improvements, because the improvements will revert to the landlord at the termination of the lease.
Under both scenarios it is also important to consider what can be capitalized and who can capitalize the costs. The current depreciation rules are favorable for leasehold improvements whether they are owned by the landlord or the tenant. Specifically, for improvements that are “qualified leasehold improvement property” placed in service after October 22, 2004 and before January 1, 2012, depreciation deductions are allowed over a 15-year period. This treatment provides considerable relief from the general rule that depreciation deductions for leasehold improvements in non-residential buildings are allowed over a 39-year period. If the leasehold improvements meet the definition of “qualified leasehold property”, then they also could be eligible for bonus depreciation. Bonus depreciation continues to be revived with recent tax laws trying to stimulate the economy. If the asset qualifies, bonus depreciation accelerates future depreciation deductions into the current tax year.
Many, but not all, improvements made under a lease may meet the definition of “qualified leasehold property”. To qualify, the improvements may not enlarge the building, be attributable to internal structural framework nor be placed in service three years or sooner after the building was first placed in service.
With proper tax planning, a leasehold improvement arrangement can be structured to enhance tax benefits for both the landlord and tenant. This requires coordination of the tenant allowances (i.e. possible income recognition), documenting the expenditures to substantiate the maximum amounts that can be treated as depreciable personal property instead of real estate and understanding the tax consequences of the build-out arrangement. The tax savings and the present value of current year deductions can be significant.
For more information, contact us at Anna Coldwell at 312.670.7444.