Tax Court addresses leasehold improvements as a substitute for rent.

• Author: Pitt, Andrew J.
• Position: Memorandum decision in Hopkins Partners, Cleveland Airport Hotel L.P., Tax Matters Partner

In a U.S. Tax Court case published on May 19, 2009, Hopkins Partners, Cleveland Airport Hotel Limited Partnership, Tax Matters Partner, T.C. Memo. 2009-107, the court held that:

* A lease agreement under which a lessor accepted predetermined and explicitly stated eligible leasehold improvements as substitutes for rent credits from a lessee was the intention of both parties;

* The lease had economic substance and was not drafted to evade taxes;

* The partnership's treatment of the eligible improvements as a substitute for rent did in fact clearly represent income;

* Deducting the cost of the eligible improvements in lieu of rent credits as an alternative to depreciating the improvements was not a change of accounting method; and

* The partnership properly deducted the cost of the eligible improvements as a rent expense in the year the eligible improvement was credited against rent.

Facts

Hopkins Partners, an Ohio general partnership, operates the Sheraton Cleveland Airport Hotel, which is owned by the city of Cleveland, Ohio. The partnership has the leasehold right to operate the hotel and the attendant parking facilities through November 13, 2048.

During the mid-1980s, the hotel was in poor condition and needed to be renovated. The partnership believed that the rent under its lease agreement from the immediate predecessor in interest was unjust and significantly above the prevailing market rate. The partnership had projected it would lose $500,000 a year through 1997 but was looking for a way to make a profit. The city was concerned about the appearance of the hotel and wanted it renovated. The city went as far as intimidating the partnership by saying it would allow the construction of a second hotel on the airport premises if renovations were not completed.

The partnership did not have the money to make the improvements the city wanted and could not get a mortgage to pay for the cost of the improvements. The lender, American Real Estate Group, said the land rent was significantly above the market rate and stipulated that it would not provide funds for the cost of the improvements unless there was a large reduction in the land rent.

In 1987, the partnership made it known to the city that it could not get a mortgage to pay for the improvements. As an alternative, the partnership proposed a modification to the terms of the lease, requesting that the minimum annual rent increase to $300,000 and the annual percentage rent decrease. The...