Tenant Improvement Allowances – Do You Qualify for Beneficial Tax Treatment?

Tenant improvement allowances are routinely used in lease negotiations, but certain criteria must be met in order to receive beneficial tax treatment. Tenant improvement allowances help cover the cost of construction, so it can be extremely frustrating for taxpayers to have to include the improvement allowance in taxable income. If the requirements issued by the Internal Revenue Service and Treasury Department are met, the improvement allowance is allowed to be an offset to certain capitalized fixed assets instead of being considered taxable income.

In order to qualify for this beneficial tax treatment under the safe harbor rules, the tenant improvement allowance must:
  1. Be under a short-term lease of retail space. Short-term lease is defined as a term of 15 years or less, and retail space is defined as space being used in a trade or business of selling tangible goods or services to the general public. The lease term includes options to renew, unless the options renew at fair market value.
  2. Be for the purpose of constructing or improving qualified long-term real property. The monies received may not be used for short-life personal property (i.e., furniture and equipment). If personal property is purchased with tenant improvement allowance monies, the assets would be capitalized and the allowance (for that portion) would be picked up in taxable income.
The Treasury regulations under Internal Revenue Code Section 110 require that the lease agreement for the retail space expressly provide that the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee’s trade or business at the retail space. Many professionals who draft leases are not aware of this requirement and often leave out wording that specifically identifies the tenant improvement allowance as meeting the requirements of the regulations. Since the regulations require consistent treatment by the lessor and the lessee, it is important to include this wording to make sure that these requirements are met.

The safe harbor was enacted to minimize controversies between the IRS and taxpayers. If you are not able to meet the safe harbor requirements, then you will have to look at a more burdensome analysis to determine ownership of the leased property including which party has the benefits and burdens.

Should you have any questions on tenant improvement allowances, please contact us.