In a Chief Counsel Advice, a Taxpayer owned an office building that was leased to an agency of the United States Government (the “Agency”). The primary issue was whether the payments for the cost of certain tenant improvements was rental income to the Taxpayer pursuant to Internal Revenue Code (“IRC”) Section 61(a)(5).
The Taxpayer paid for renovations and a building expansion as requested by the Agency and as permitted under the terms of the lease. The Taxpayer received lump sum reimbursements for the cost of the tenant improvements, payable by lump sum under the lease as supplemented.
These amounts were not included in the stated rent. Additionally, the Taxpayer did not include the amount of the lump sum reimbursements in income in the year received, and reduced the basis of the tenant improvements by these lump sum amounts for purposes of depreciation.
The revenue agent’s position was that these lump sum reimbursements were rental income in the year received, and that the cost of the tenant improvements should be increased by the amount of these reimbursements. The Taxpayer’s position was that the lump sum reimbursements were not a substitute for rent; rather, the payments were reimbursements of costs that the Lessor incurred on behalf of the Lessee.
Section 61(a)(5) says that gross income includes all income from whatever source derived, including rents. Furthermore, Regulation Section 1.61-8(c) provides:
- As a general rule, if a lessee pays any of the expenses of his lessor such payments are additional rental income of the lessor.
- If a lessee places improvements on real estate which constitute, in whole or in part, a substitute for rent, such improvements constitute rental income to the lessor.
- Whether or not improvements made by a lessee result in rental income to the lessor in a particular case depends upon the intention of the parties, which may be indicated either by the terms of the lease or by the surrounding circumstances.
The Chief Counsel noted that “even when improvements are required by the terms of a lease, the intent of the parties to treat improvements on real estate as a substitute for rent must be plainly disclosed … In deciding the intent of the parties, first consider the express terms of the lease and then consider the surrounding circumstances.”
Here, the Chief Counsel concluded that the terms of the original lease, as supplemented by numerous supplemental lease agreements, together with the surrounding circumstances, did not indicate that the parties intended the lump sum reimbursements to be rent.
