Rev Proc 2017-41: Tenant Construction Allowance Safe Harbor

When a landlord provides a tenant with funds to build out a commercial space, it creates a complex tax question: who owns the resulting improvements? Internal Revenue Code Section 110 offers a solution by providing a safe harbor test. This guidance from the Internal Revenue Service (IRS) clarifies the tax treatment for these payments, known as tenant construction allowances.

The purpose is to establish clear rules for determining whether the landlord (lessor) or the tenant (lessee) is the tax owner of the assets built with the allowance. By meeting the safe harbor’s criteria, both parties can achieve certainty in their tax reporting. The lessor treats the improvements as their property and depreciates them, while the lessee can exclude the allowance from its gross income.

Qualifying for the Safe Harbor

To use the safe harbor, the arrangement must involve a lessor and a lessee in a commercial lease context. The property subject to the lease must be classified as “nonresidential real property.” This category includes buildings and their structural components but excludes residential rental properties. The safe harbor is specifically aimed at tenants operating a trade or business of selling tangible personal property or services to the general public from that location.

A written lease agreement is required, and its term must be 15 years or less. For purposes of this rule, the lease term includes all renewal option periods, except for any options to renew at fair market value determined at the time of renewal. Leases extending beyond this timeframe are automatically ineligible for the safe harbor treatment.

The funds must be designated for constructing or improving “qualified long-term real property.” This term refers to improvements that are a permanent part of the nonresidential real property and are for use in the lessee’s trade or business at that specific retail space. It does not include tangible personal property, such as trade fixtures or equipment. A feature of these improvements is that they revert to the lessor at the termination of the lease, solidifying the lessor’s ownership claim for tax purposes.

There is an expenditure requirement. The allowance can only be excluded from the lessee’s income to the extent it is actually spent on the qualified improvements. The funds must be fully expended by the lessee within an 8.5-month period after the close of the taxable year in which the allowance was received.

Required Lease Provisions and Information Statement

For the safe harbor to apply, specific language must be included directly within the lease documentation. The written lease agreement must contain a provision that expressly states the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee’s business. An ancillary agreement executed at the same time as the lease can also satisfy this requirement.

A sample clause might read: “The Tenant Improvement Allowance is for the purpose of constructing qualified long-term real property for use in the Tenant’s trade or business at the Premises and will be treated as a qualified lessee construction allowance under the applicable tax code.”

Beyond the lease itself, both the lessor and lessee must prepare a detailed information statement which serves as the formal election to use the safe harbor. To make the election, both parties must attach the completed information statement to their respective, timely filed federal income tax returns, including any extensions. The statement must be attached to the tax return for the specific taxable year in which the construction allowance was paid. The statement must contain:

• The names, addresses, and employer identification numbers (EINs) for both the lessor and the lessee.
• The specific location of the real property.
• The exact dollar amount of the construction allowance.
• An explicit declaration that both the lessor and lessee agree to treat the construction allowance consistently as required by the tax code.

Tax Treatment for Lessor and Lessee

For the Lessor

When the safe harbor requirements are met, the lessor is treated as the tax owner of the improvements constructed with the allowance. The lessor must capitalize the value of the improvements as their own nonresidential real property. The lessor is responsible for depreciating the cost of these assets over the appropriate recovery period as determined by tax law, which is 39 years for nonresidential real property.

For the Lessee

For the lessee, the benefit is excluding the construction allowance from gross income. Because the lessee is not considered the tax owner of the improvements funded by the allowance, it cannot claim depreciation deductions for those specific assets. The lessee is only able to depreciate improvements it paid for with its own funds.