Often used as an incentive by real estate lessors, tenant improvement allowances are an important factor and negotiation tool for many companies, especially restaurants, looking to refresh or build a new location that is or would be leased. Even though the concept is relatively straightforward, the structure of the lease, who pays for the improvements, and who has ultimate ownership of the improvements can have significant income tax impacts on the landlord and the tenant.
There are numerous structures to the terms of the tenant improvement and the associated allowance with various consequences as follows:
Landlord constructs, owns, and pays for the improvement:
- Tax consequences to the landlord: Landlord has no income recognition and depreciates the leasehold improvement. To the extent the leasehold improvement is tenant-specific, the landlord can typically deduct the remaining basis upon lease termination
- Tax consequences to the tenant: None (i.e., no income recognition nor depreciation deduction)
Landlord constructs and owns the improvement but is reimbursed by the tenant as a substitute for rent:
- Tax consequences to the landlord: Landlord will recognize rental income for the amount of the reimbursement and depreciate the improvement over the lease term
- Tax consequences to the tenant: The substitute for rent is expensed by the tenant but is amortized over the lease term versus immediately expensed
- Note: This is generally the least desired option as the landlord has immediate income recognition while the tenant amortizes the payment over the lease term.
Tenant pays for and owns the improvement:
- Tax consequences to the landlord: None
- Tax consequences to the tenant: The tenant owns the improvement and may depreciate the asset. Upon lease termination, the tenant would typically be allowed to claim a deduction for any remaining basis in the improvement
Landlord provides a cash allowance to the tenant and the tenant constructs the improvement:
- Tax consequences to the landlord: The payment is treated as a lease acquisition cost and amortizes the cost over the lease term.
- Tax consequence to the tenant: The tenant has immediate income recognition upon cash receipt. The tenant may then depreciate the improvement.
- Section 110 Exclusion: A statutory exclusion applies within the Internal Revenue Code which states that if a lease is “short term” (15 years or less, including options to renew) and is for a “retail space” (for which a restaurant is defined as a “retail space”), no income is recognized by the tenant if the cash allowance is used to pay for improvements. However, under this exclusion, the tenant must reduce its basis in the asset, reducing or eliminating depreciation deductions for the leasehold improvement. The landlord would then treat this as a depreciable asset.
Both the landlord and tenant should be diligent in negotiating the terms of leasehold improvements due to the tax impacts. Additionally, both parties’ tax advisors should also review the terms prior to the execution of the lease to avoid any unintended consequences of a tenant improvement allowance.
For questions regarding tenant improvement allowances or to discuss this information in more detail, contact Ryan Kilpatrick or your GBQ advisor.
Landlord Impacts |
Tenant Impacts |
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| Who Pays | Who Pays | |||||
| Landlord | Tenant | Landlord | Tenant | |||
| Landlord Owns | Improvement is owned by and depreciated by the landlord | Immediate income recognition upon payment from the tenant depreciates improvement over lease term |
Landlord Owns | None | Payment is deducted by amortizing the payment over the lease term. | |
| Tenant Owns | Payment is a lease acquisition cost and amortized over the lease term |
None | Tenant Owns | Immediate income recognition to the tenant. Tennant will depreciate the asset. *See §110 Exclusion Below* |
Improvement is owned by and depreciated by the tenant | |
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* §110 Exclusion: If the lease term is properly structured (i.e., 15 or fewer years and used for retail space), the tenant would have no income recognition if the allowance is used for the construction of the asset. However, the tenant must reduce their basis in the asset which would limit depreciation deductions. The landlord would treat the asset as a depreciable asset. |
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Article written by:
Ryan Kilpatrick, CPA
Director, Tax & Business Advisory Services
