One of the main elements of negotiating a leased space is the cost associated with the build out of the space. Tenants generally require some level of customization of the space for their business purpose. The construction allowance seems to be a straightforward mechanism that allows a landlord to improve their property by simply reimbursing the new lessee with a pre-negotiated amount. In exchange the lessee generally has significant control in matching the finishes to their needs while also limiting the size of their investment in their temporary home.
Under the most basic read of the Internal Revenue Code the payment from the landlord is taxable income to the lessee. This creates an obvious dilemma for the lessee. Internal Revenue Code Section 110 was created to address this inequity. The provision establishes the parameters of a tax-free construction allowance.
- The lease is limited to 15 years or less.
- The improvements are for nonresidential real property.
- The improvements must be part of a retail space (includes services to the public).
- The landlord owns the improvements.
- The provision will not apply to Section 1245 property (tangible personal property).
If the construction allowance violates any of these provisions then the payment will likely be taxable income at least in some portion. There are some planning steps that can help solidify favorable treatment under this provision and it all starts with adding the correct language in the lease agreement and following proper procedures for payment. From there proper documentation of the expenditures should be maintained and the tax return should have the proper disclosures. If some portion of the construction allowance will still be used for personal property then the terms of the lease should be adjusted to ensure that the tax consequences match the intended results.