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Tax Treatment of Leasehold Improvements When Paid by Lessee vs Lessor

When entering into a new lease agreement, both tenants and landlords need to be careful when determining who will be paying for the leasehold improvements. There are multiple options available and the decision could have tax impacts on both parties.

Option #1

One option would be for the landlord to pay for the improvements, in which case they would own the improvements and would depreciate the cost of the improvements over the statutorily prescribed life. There would be no tax consequences for the tenant in this scenario unless the tenant also contributes to the cost of improvements.

Option #2

Another option would be for the landlord to provide the tenant with an improvement allowance, which is an amount the landlord is willing to spend so that the tenant can renovate the space. The allowance amount and intent should be clearly stated in the lease agreement. In this scenario, the tenant would be the owner of the improvements and would depreciate the amount of the allowance over the statutorily prescribed life. If the tenant vacates the property before the end of the depreciable life, the balance can be written off at that time. The allowance would be taxable income to the tenant. The landlord can then amortize the amount of the allowance over the lease term as a leasehold acquisition cost. The lease term is typically shorter than the depreciable life, and therefore this scenario would be advantageous to the landlord who is able to recover the costs over the shorter period.

The landlord could also provide the tenant with free rent, in lieu of an improvement allowance, at the beginning of the lease (typically for the same amount that the allowance would have been). The tenant would have to use its own funds for the cost of the improvements and would depreciate the cost over the statutorily prescribed life. The lease agreement must stipulate that the rent is being reduced in consideration for the lessee’s expenditures for improvements in order for it to be considered taxable income and a depreciable asset to the landlord. Unless there is significant evidence that the parties intended for the improvements to substitute for rent, the courts generally have not found taxable income.

If the tenant opts to pay for the improvements, they would own the improvements and would depreciate the cost of the improvements over the statutorily prescribed life. There would be no tax consequence to the landlord unless the tenant conveys the improvements to the landlord. If the improvements revert to the landlord, whether upon completion of the work or upon termination of the lease, the landlord would have taxable income and become the owner of the improvements. If the tenant transfers ownership to the landlord at the beginning of the lease term, the tenant can then amortize the cost of improvements over the lease term as a leasehold acquisition cost.

The Exception

There is an exception to some of the scenarios above, related to retail leases under Section 110 of the Internal Revenue Code. Specifically, Section 110 provides that cash or an amount treated as a rent reduction, received by a retail tenant is not gross income if the amount is used for qualifying construction of leasehold improvements. In order to meet these requirements, the lease must be a short-term lease of retail space and the amounts excluded must be expended in the taxable year received on constructing or improving qualified long-term real property for use in the lessee’s retail business.

The differing tax consequences in the above scenarios should be carefully considered by both tenants and landlords when negotiating lease terms.

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

How Can We Help?

For questions or to speak with a member of Withum’s Real Estate Services Group, please contact us by filling out the form below.

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