Rev. Proc. 2004-34: Safe Harbor for Construction Allowances

Revenue Procedure 2004-34 provides a “safe harbor” for the tax treatment of cash allowances that landlords, also known as lessors, provide to tenants, or lessees. These funds are for constructing improvements in commercial retail properties. The guidance clarifies the tax ownership of the resulting improvements and determines whether the allowance constitutes income to the tenant. For an allowance to meet the definition of a “qualified lessee construction allowance,” it must be for constructing or improving long-term real property for the lessee’s retail business. The procedure sets forth specific conditions that, if met, ensure a predictable tax outcome.

Conditions for the Safe Harbor

For a construction allowance to fall within the safe harbor, the lease agreement is the foundational document. The agreement must be for a “short-term lease,” which is a lease with a term of 15 years or less, including all renewal option periods unless they are at fair market value at the time of renewal. The contract must explicitly state that the allowance is for constructing or improving “qualified long-term real property” for use in the lessee’s trade or business at that retail space. This requirement ensures that the funds are tied directly to the physical structure of the building.

Definition of Retail Space

The safe harbor is specifically limited to leases for “retail space.” The IRS defines this as real property leased, occupied, or otherwise used by a lessee in its trade or business of selling tangible personal property or services to the general public. This includes a wide range of businesses, such as clothing stores, restaurants, and personal service providers. An office space used for internal administrative functions, even if located in a retail shopping center, would not qualify. The distinction is the nature of the business conducted within the leased premises.

Use of the Allowance

A condition of the safe harbor is how the lessee uses the construction allowance. The funds must be expended on the construction or improvement of “qualified long-term real property.” This term refers to nonresidential real property that is part of, or permanently affixed to, the building and will revert to the lessor at the termination of the lease. It includes items like walls, flooring, wiring, and HVAC systems. The allowance cannot be used for assets that constitute personal property or trade fixtures, such as freestanding shelving units or specialized manufacturing equipment.

Expenditure Timeline

To qualify for the safe harbor, the lessee must meet a specific expenditure deadline. The construction allowance must be fully spent on qualified improvements within 8.5 months after the close of the taxable year in which the allowance was received. For instance, a calendar-year lessee who receives an allowance has until September 15 of the following year to spend the entire amount. Failure to expend the full amount within this timeframe can disqualify the entire allowance from the safe harbor provisions.

Tax Treatment for Lessor and Lessee

When all the conditions of the safe harbor are met, the tax treatment for both the landlord and the tenant is clearly defined. The rules are designed to align the tax ownership of the improvements with the party who ultimately bears the economic benefit and burden of the assets. The treatment is bifurcated, with specific and distinct consequences for the lessor and the lessee.

Tax Treatment for the Lessor (Landlord)

Under the safe harbor, the lessor must treat the constructed or improved property as their own asset. The improvements are considered nonresidential real property owned by the lessor for tax purposes. This means the lessor is responsible for capitalizing the cost of the improvements and depreciating them over the appropriate recovery period, typically 39 years. The construction allowance provided to the tenant is considered an investment by the lessor in their own property.

Tax Treatment for the Lessee (Tenant)

The benefit for the lessee under the safe harbor is that the qualified lessee construction allowance is excluded from their gross income. The payment from the landlord is not considered a taxable event for the tenant. The trade-off for this income exclusion is that the lessee cannot claim any tax benefits associated with the improvements. Since the improvements are treated as owned by the lessor, the lessee is not permitted to depreciate them.

Required Information and Disclosure Statements

To take advantage of the safe harbor, both the lessor and the lessee must attach a specific disclosure statement to their respective federal income tax returns. These statements must be included with a timely filed return for the taxable year in which the construction allowance was paid by the lessor and received by the lessee. The purpose of this requirement is to ensure that both parties are treating the transaction consistently for tax purposes. Failure to provide this information can result in the arrangement falling outside the protection of the safe harbor.

Lessor’s Disclosure Requirements

The lessor’s disclosure statement must state that it is a disclosure under Revenue Procedure 2004-34. The statement needs to include the lessor’s name, address, and employer identification number (EIN), as well as the same information for the lessee. Furthermore, the statement must specify the location of the retail space and state the full amount of the construction allowance provided.

Lessee’s Disclosure Requirements

The lessee’s disclosure statement mirrors the lessor’s but includes additional detail. The lessee must include their name, address, and EIN, along with the corresponding information for the lessor and the location of the retail space. The lessee must report the full amount of the construction allowance received. They must also state the amount of the allowance that was expended on qualified long-term real property.

Tax Consequences Outside the Safe Harbor

If a construction allowance arrangement fails to meet the specific conditions of the safe harbor, its tax treatment is determined by general tax principles. This typically brings the arrangement under the purview of Internal Revenue Code Section 110. Without the certainty of the safe harbor, the tax outcome becomes less predictable and may be subject to challenge by the IRS.

The primary consequence of failing to qualify is that the construction allowance is generally presumed to be includible in the lessee’s gross income. This shifts the burden of proof to the tenant to demonstrate that the payment should be treated as a non-taxable event.