Tax Planning for Building Owners Making Tenant Improvements (article)
Lessors (the landlords or building owners) are eligible for write-offs and other tax benefits related to the upkeep and improvement of leased properties. In some arrangements, the provisions of a lease agreement could limit the full extent of a building owner’s tax-saving opportunities from tenant improvement (build-out) payments or allowances. The lease agreement can be drafted to specify that build-out allowances belong to the building owner and may further specify that such allowances are intended to qualify for tax treatment under Code Section 110. The subtleties of these provisions can dramatically change the timing of tax benefits available to a building owner.
Navigating Section 110
Section 110 generally provides a framework by which certain payments made by building owners to lessees (tenants) may be excluded from the Tenant’s taxable income. Although the arrangement is beneficial to the tenant, the building owner is required to capitalize and depreciate such payments. In some circumstances, this requirement could limit opportunities that otherwise are available to the building owner under the tangible property regulations.
Build-out allowances commonly are provided by building owners to tenants so that leased space can accommodate the new tenant’s business needs. Section 110 provides that cash payments (or rent reductions) furnished by the building owner are excluded from the tenant’s taxable income under the following circumstances:
- The payments are received under a short-term lease of retail space (generally, a lease with a term of 15 years or less);
- The lease agreement stipulates expressly that the payments are to be used for build-out costs consisting of qualified long-term real property at the leased retail space in the tenant’s business;
- The tenant expends the payments for such purposes in the tax year such payments are received, or within 8 ½ months after the end of such tax year; and
- Disclosure information is included with the tax returns filed by the building owner and the tenant for the tax year in which the payment is received.
Retail space for these purposes means real property used in a trade or business of selling tangible personal property or services to the general public. Qualified long-term real property for these purposes consists of nonresidential real property situated at (or part of) the leased retail space that reverts to the building owner when the lease expires. Personal property will not qualify; therefore, building owners that identify portions of build-out costs as personal property (through cost segregation studies or otherwise) will cause those portions to fall outside of Section 110.
As previously stated, the building owner is required to capitalize and depreciate build-out payments subject to Section 110. These payments often will meet the definition of “qualified leasehold improvement property,” allowing the building owner to utilize a 15-year straight-line depreciation method of recovery (where a 39-year period otherwise applies). Because qualified leasehold improvement property generally fits within the broader definition of “qualified improvement property,” such property also will avail the building owner to first-year bonus depreciation on a portion of the build-out payment. Even so, the capitalization requirement under Section 110 results in depreciation over the appropriate number of years for some portion of the build-out payment.
The tax treatment for build-out payments not conforming to Section 110 focuses on the owner of the associated improvements. The lease agreement often is used to evidence this factor. If the tenant holds the benefits and burdens of ownership over build-out assets, the tenant will be taxed on the receipt of the build-out payments. In that case, the building owner generally treats the build-out payments as a cost of obtaining a lease, which is capitalized and amortized over the term of the lease. If the building owner retains the benefits and burdens of ownership over build-out assets, the tenant generally receives similar treatment to Section 110 (and is not taxed on the build-out payment). In this case, the tangible property regulations may provide a shorter depreciable life that benefits the building owner.
Build-out Payments under the Tangible Property Regulations
The standards of capitalization under the tangible property regulations reference a unit of property. For buildings, the unit of property is the entire building including its structural components and building systems. Subsequent capitalizable building improvements therefore become part of this single unit of property. If a building is leased, the portion of the building allocable to leased space becomes a separate unit of property (a building entirely leased obviates the need for this separate unit of property). With leasehold property, build-out payments are measured against this separate unit of property to ascertain a capitalization decision. The decision focuses on whether the build-out payment results in a “betterment,” “adaptation,” or “restoration” to the applicable unit of property.
The specific criteria of these three conditions are beyond the scope of this article. Generally, a larger unit of property is less likely to result in a capitalizable betterment, adaptation or restoration. For instance, an example contained in the tangible property regulations confirms that build-out payments are not capitalizable as an adaptation when they are associated with an entire building that is leased, and where the build-out payments relate to three leased retail spaces out of 20 total leased retail spaces.
Even with a situation similar to the above example, the criteria of the other two conditions (betterments and restorations) must still be considered to reach a capitalization decision. These conditions generally provide that a building’s initial build-out payments for its first tenants are capitalizable. Substantial build-out payments associated with successor tenants may sometimes meet these conditions (particularly, betterments).
Portions of build-out payments identified as personal property through cost segregation studies or otherwise (e.g., carpeting, cabinetry, and removable partitions) also are subject to capitalization. Personal property is separate from leasehold property and becomes its own separate unit of property. The tangible property regulations confirm through various examples of capitalizable betterments that personal property expenditures must be capitalized, even when other expenditures made concurrently are not capitalizable as betterments.
Lastly, and most notably, a peculiar nuance of the tangible property regulations could require capitalization of a building owner’s build-out payments in many cases. Initial build-out payments generally will be treated as improvements to a newly-constructed building, because a new building seldom will be fully occupied as soon as it is placed in service. Although these capitalizable improvements do not result in a separate unit of property for capitalization purposes, they are treated as separate units of property for disposition purposes. And since initial build-out payments are separate units of property for disposition purposes, the later disposal of such units of property necessarily involves the entire asset. In that case, the tangible property regulations mandate taxpayers to claim disposals of entire assets when the disposal occurs.
This mandate becomes relevant when considering one of the three conditions to capitalization. The tangible property regulations provide that a capitalizable restoration results when there is an expenditure to replace a component of a unit of property, and the taxpayer reports the disposed property as a disposition. Hence, the mandate for entire asset dispositions triggers a requirement to capitalize the build-out payments the building owner makes to successor tenants. This dilemma generally does not exist, however, with respect to acquired buildings that are fully occupied. In that case, the existing build-out costs will be part of the single unit of property acquired all at once, which eliminates the issue of determining separate units of property for disposition purposes.
Lease Agreement Recommendations
Building owners may circumvent the application of Section 110 by excluding its reference in a lease agreement, and by excluding a specification that some portion of the build-out payments be used to construct qualified long-term real property. So long as the building owner retains the benefits and burdens of ownership over the build-out improvements (which can be specified in the lease agreement), the tangible property regulations govern the tax treatment for the building owner’s build-out expenditures. In some circumstances, the tangible property regulations may provide for a faster means of cost recovery to the building owner.
For more information on how lease arrangements can be structured to be tax-efficient, please contact us.
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