Revenue Procedure 2006-10 for Construction Allowances
Understand the framework of IRS Rev. Proc. 2006-10 for structuring a retail lease so a construction allowance is not taxable income to the tenant.
When a landlord provides a tenant with funds to build out a leased space, it can create tax questions for both parties. Internal Revenue Code (IRC) Section 110 provides a safe harbor that, under specific circumstances, allows a retail tenant to exclude these construction allowances from gross income. By following these guidelines, the landlord treats the improved assets as their own for tax depreciation purposes, and the tenant avoids an unwelcome addition to their taxable income.
Conditions for the Safe Harbor
To benefit from the tax exclusion, the arrangement must be for a “short-term lease” of “retail space.” A short-term lease has a term of 15 years or less, including any options to renew. The lease must be for a property used in the business of selling tangible personal property or services to the general public.
The allowance must be for constructing or improving “qualified long-term real property” for use in the tenant’s business at that retail location. To qualify, the funds must be spent within 8 ½ months after the end of the tax year in which the allowance was received. Any portion of the allowance not spent within this timeframe may be considered taxable income.
The amount of the allowance must also be reasonable. The exclusion from the tenant’s gross income cannot exceed the actual amount expended on the qualified property. For example, if a landlord provides a $500,000 allowance but the tenant only spends $450,000 on qualified improvements, the remaining $50,000 would not be protected by Section 110.
Defining Qualified Long-Term Real Property
Qualified long-term real property is nonresidential real property that becomes a permanent part of the retail space and reverts to the landlord when the lease terminates. These improvements are integrated into the building itself.
Examples of qualifying property include:
- Interior walls and doors
- Permanent floor coverings
- Plumbing and electrical wiring
- HVAC systems
The definition excludes property under IRC Section 1245, which includes tangible personal property and other assets that are not structural components. Examples of non-qualifying items are trade fixtures, business equipment, and furniture that a tenant would take when they move. The construction allowance cannot be used for these items if the tenant wishes to exclude the funds from income.
This distinction separates the landlord’s real property from the tenant’s business assets. The landlord is responsible for depreciating the qualified long-term real property, while the tenant capitalizes and depreciates their own Section 1245 property over shorter recovery periods.
Required Lease Agreement Provisions
For the construction allowance to qualify under Section 110, the lease agreement must contain specific language. The contract must expressly state that the allowance is for constructing or improving qualified long-term real property for use in the lessee’s business at that retail space.
While the lease does not need to mandate that the entire allowance be spent on qualified property, Section 110 will only apply to the portion that is.
If this provision is not in the original lease, it can be added through an ancillary agreement signed by both parties. This agreement must be executed before the construction allowance is paid to the tenant.
Tax Reporting and Information Requirements
Both the landlord and the tenant have reporting duties to comply with Section 110. Each party must attach a detailed statement to their timely filed federal income tax return for the taxable year in which the allowance was paid and received.
Both statements must include the name, address, and employer identification number for the lessor and lessee. The statements must also specify the location of the retail space and the full amount of the construction allowance.
The lessor’s statement must declare that the allowance is for improving qualified long-term real property. It must also state that they are treating the property as nonresidential real property they own.
The lessee’s statement must confirm the amount of the allowance being excluded from income under Section 110. It must also state that the excluded amount does not exceed the amount spent on qualified long-term real property.