Ownership of Tenant Improvements May Lead to Unintended Tax Consequences

The scenario is familiar. A tenant prevails upon his landlord to grant him an allowance for improvements. The TI allowance is often added in a rider to the landlord's basic lease form and may not on its face relate to other portions of the lease. The landlord or tenant who doesn't pay attention to what the lease says about ownership of the improvements built with the TI allowance may be in for an unpleasant surprise come tax time.

Where a landlord grants a tenant a TI allowance and the landlord owns the improvements for tax purposes, the landlord can depreciate the cost of the improvements (up to the amount of the TI allowance) that are part of the nonresidential real property (i.e. fixtures) over a period of 39 years. Although landlords often desire to own everything they can on the leased premises, the landlord may be better off financially if the tenant owns the improvements. If the tenant owns the improvements, the landlord can amortize the TI allowance over the term of the lease (which is almost always shorter than 39 years). In such case, because of the landlord's "generosity," the tenant will usually have to treat the TI allowance as income and depreciate the cost of the improvements over 39 years.

The IRS enacted Section 110 of the Internal Revenue Code to protect retail tenants from landlords who would thrust ownership of tenant improvements upon them. If the TI allowance is deemed a "qualified lessee construction allowance for short term leases," the landlord is deemed the owner of the improvements for tax purposes, triggering the 39 year depreciation period. Recent IRS regulations flesh out when a TI allowance in a retail context will be considered a "qualified lessee construction allowance for short term leases." The IRS definition of "retail" is fairly broad and may encompass more than what most typically consider retail uses.

Landlords may want to draft leases with the IRS depreciation rules and the new regulations in mind, to avoid being considered the owner of the tenant improvements. Tenants will want to consult the rules and regulations in an attempt to achieve the opposite result. Both sides should be mindful that the hasty inclusion of a TI allowance in a lease without careful drafting and analysis could lead to adverse tax consequences.

If you would like more information, please contact Beth Tiggelaar at beth.tiggelaar@strasburger.com, or consult your tax advisor.

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