The negotiation of the construction allowance is an important part of a lease transaction; however, those negotiations rarely consider the tax consequences. The tax treatment of the construction allowance can greatly impact your negotiations.
When a landlord provides a cash allowance to a tenant to construct leasehold improvements that the landlord will own, the tax treatment is straightforward. The landlord must depreciate the improvements over an unfavorable 39-year period applicable to nonresidential real property, even if the lease term is less than 39 years. Since the tenant is merely a conduit for the landlord’s cash, the cash received is not treated as income, and the tenant is not allowed to capitalize and depreciate any of the improvements.
When the tenant owns the leasehold improvements, the landlord can amortize the allowance as a deduction ratably over the lease term. Since the tenant owns the improvements, the cash received is taxable income because it “enhances the tenant’s wealth” by enabling the tenant to construct suitable facilities. The tenant must then depreciate the leasehold improvements over their proper useful life.
In summary, the tax treatment of a construction allowance largely depends on who owns the improvements. To further complicate matters, the IRS has a benefits and burdens ownership test that helps taxpayers make this key determination. “Tax ownership” is not always the same as legal ownership. If you are negotiating a construction allowance as part of your lease and need help understanding the tax complexities, please contact your Schneider Downs representative for further assistance and information.
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