Lease payments are not always rent.

• Author: Parente, Lisa M.

Landlords and tenants should know the tax treatment of items associated with the language built into a lease and all ancillary agreements, as well as items that are not included in any written agreement. Three areas that present tax opportunities are tenant improvement allowances, lease inducement payments, and lease termination payments. This item addresses the tax consequences for the lessor and lessee in these areas.

Tenant Allowances

A lessor pays a tenant allowance to provide a lessee with funds to prepare the space for its intended business use. Generally, the tenant treats a tenant allowance received from the landlord as ordinary income. The tenant would recognize income and depreciate assets over their useful life, resulting in a mismatch of income and expenses. However, if the parties structure a tenant allowance correctly, Sec. 110 provides a safe harbor so that the tenant is not required to recognize income for the allowance.

Sec. 110(a) allows a lessee to exclude from income the amount of a qualified construction allowance received from a landlord to the extent the allowance does not exceed the actual costs incurred to improve the leased space. For tenant allowance payments from a landlord to a lessee to be considered a qualified lessee construction allowance, the lease must be short-term and for retail space. Regs. Sec. 1.110-1(b)(2)(ii) defines a short-term lease as any agreement for the occupancy or use of a retail space for a term of 15 years or less. The lease term is determined by taking the initial lease term in the lease agreement and including any lease extension options unless the rent is to be renewed at fair market value determined at the time of the renewal (Sec. 168(i)(3)). Regs. Sec. 1.110-l(b)(2)(iii) defines retail space as space "that is leased, occupied, or otherwise used by the lessee in its trade or business of selling tangible personal property or services to the general public ... [and includes] space where activities supporting the retail activity are performed." Regs. Sec. 1.110-1(b) (3) also contains a purpose requirement, which requires that the tenant allowance be expressly provided for in the lease agreement (or an ancillary agreement) and be for the purpose of constructing or improving qualified long-term real property for use in the lessee's trade or business at the retail space. Personal property, even if it is used in the retail space, will not qualify under the safe harbor.

Sec. 110 provides that improvements related to a...