The terms of a commercial real estate lease can raise complicated tax issues for the owner of the leased premises (the "Landlord") and the party entitled to occupy and use the premises (the "Tenant"). However, Landlords and Tenants often overlook the tax implications of lease terms during lease negotiations. This article presents a brief overview of some of the tax issues that may arise in the commercial lease context and create a material and adverse effect on the tax liability of the Landlord, the Tenant, or both.
Related Party Leases
If the Landlord and Tenant are related parties either by common ownership or familial relations, the Internal Revenue Service ("IRS") may scrutinize the lease terms to determine if the lease is an attempt by the parties to improperly shift income. In general, the payment of rent made in connection with a taxpayer's trade or business is deductible. However, if the rent is paid to a related party, the IRS may challenge the reasonableness of the rent and disallow a portion of the deduction as excessive. Alternatively, the IRS may scrutinize the business purpose for the lease and reallocate income and deductions between the related parties as it deems appropriate. Therefore, the parties should be prepared to demonstrate that the rent is a valid cost and the amount is comparable to what an unrelated party would pay. In addition, the arrangement should be properly documented in a well-drafted and formal written lease. The Landlord and Tenant should never be lax about lease terms just because the Landlord and Tenant are related.
Lease Acquisition Costs
The Landlord and Tenant may incur certain costs in connection with the lease such as professional fees and commissions. These costs are generally tax deductible. However, the parties may be surprised to learn that they are not totally deductible in the year in which the costs are paid. Instead, the costs must be recovered over the term of the lease.
Frequently, improvements must be made before the Tenant can use the leased premises. As discussed below, the tax consequences related to an improvement generally depend on who pays for the improvement and who owns the improvement (who may not be the owner of the premises). The Landlord and Tenant often take conflicting positions on these issues because a particular arrangement can result in a tax benefit for one party and a tax detriment for the other. Therefore, it is crucial for a lease to specifically identify the payer and the owner of the improvement.
Additionally, the parties need to make it clear in the lease that the Tenant's obligation to pay for an improvement is not a substitute for the payment of rent. Otherwise, there may be ambiguity as to whether the payment is deemed to be rental income to the Landlord. This ambiguity could also cause the parties to take inconsistent positions on their tax returns which could trigger IRS scrutiny.
Below is a discussion of four alternative approaches to the funding and ownership of improvements for tax purposes, and the tax implications of each.
Landlord Funds and Owns Improvements
If the Landlord pays for and owns the improvement, the Landlord will be entitled to recover the cost of the improvement by taking tax deductions over the appropriate recovery period for the improvement (which could be as long as 39 years). This approach does not produce tax consequences for the Tenant.
Landlord Funds and Tenant Owns Improvements
A Landlord sometimes gives the Tenant an "upfitting" allowance and the Tenant becomes responsible for constructing and owning the improvements. Allowances can be a great way to attract Tenants. However, under general tax rules, the Tenant will be taxed on the full allowance as income for the year in which it is received and required to recover the cost of the improvement over the appropriate depreciation period for the improvement. Conversely, the Landlord will recover the allowance by taking tax deductions over the lease term (which is generally shorter than the depreciation period for the improvement).
If the parties want to structure the arrangement so that the Tenant does not have to report the allowance as income in the year received, the parties can comply with the safe harbor requirements of Section 110 of the Internal Revenue Code ("Section 110"). To fall within the Section 110 safe harbor, the lease term must be no longer than 15 years, and the parties must disclose certain information with their tax returns. The lease must include language requiring the Tenant to use the allowance solely to improve real property used in the Tenant's trade or business. Although the Tenant gets to exclude the allowance from income in the year received, the trade-off is that the Landlord is deemed to be the owner of the improvement and must recover the allowance over the appropriate depreciation period for the improvement instead of the lease term.
Tenant Funds and Owns Improvements
Similar to the Landlord, if the Tenant incurs the cost of constructing and installing the improvement and owns the improvement during the lease term, the Tenant will recover the cost of the improvement by depreciation deductions taken over the appropriate depreciation period for the improvement. However, upon termination of the lease, if title to the improvement transfers to the Landlord pursuant to the Lease terms, the Tenant generally can write off the remaining unrecovered improvement costs in the year in which the lease is terminated. A special tax provision, Section 109 of the Internal Revenue Code ("Section 109"), provides an exclusion from income for the Landlord. Under Section 109, the Landlord's receipt of title to the improvement upon termination of the lease is not a taxable event to the Landlord.
Tenant Funds and Landlord Owns Improvements
If the Tenant pays for the improvement but ownership of the improvement automatically belongs to the Landlord, the Tenant can recover the cost of the improvement over the lease term. Because Section 109 only applies to a transfer of ownership upon lease termination, the IRS often takes the position that the value of the improvements is fully taxable as income to the Landlord in the year received and deductible to the Landlord over the depreciation period of the improvement. Therefore, if the parties want to take advantage of Section 109, it is important for the lease to be clear on the timing of the transfer of ownership of the improvement. The improvements must belong to the Tenant during the term of the lease with the transfer of ownership taking effect only at the time the lease is terminated.
Below is a simple example to help demonstrate the contrasting tax interests between the parties:
Landlord wants to lease a building to Tenant for a term of 10 years. However, the building needs $500,000 in improvements in order for Tenant to be able to use it. Assume the improvements would be depreciable over 39 years.
If Landlord pays for and owns the improvements, the Landlord has to make an immediate cash outlay of $500,000 for the improvements but can only recover the cost over 39 years (approximately $12,820/year). The Tenant suffers no tax consequences so this approach is more beneficial to the Tenant.
However, if the Landlord gives the Tenant $500,000 in cash so that the Tenant can make and own the improvements, the tax consequences depend on whether Section 110 is applicable.
If Section 110 does not apply, the tax consequences are more favorable for the Landlord because the Landlord will recover the $500,000 over the shorter lease term ($50,000 per year) and will receive the improvements tax free at the end of the lease. However, the Tenant will have to recognize $500,000 in income for the year in which the upfit allowance is received and may be unwilling or unable to pay the tax. As a result, the Tenant may want the parties to satisfy the requirements of Section 110. If Section 110 applies, the Tenant can exclude the $500,000 from income, but the Landlord would be required to recover the $500,000 over the longer recovery period of 39 years.
Obviously, under either scenario, both the Landlord and the Tenant need to be aware of the tax implications of the options, and negotiate accordingly.
Although tax consequences alone may not drive the terms of a commercial lease, identifying and understanding tax issues is critical during the negotiation process. In structuring a commercial lease, each party needs to consider the potential tax costs and benefits. Once the parties have agreed to the terms, the lease should contain the appropriate language clearly reflecting the intent of the parties.
© 2021 Ward and Smith, P.A.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.