Tax Treatment of Construction Allowances

When a business leases a new commercial space, it often needs to be customized. A construction allowance, also known as a tenant improvement allowance, is a common incentive offered by a landlord to help cover the costs of renovating the leased property. This financial arrangement helps tenants create a space suited to their specific operational needs without bearing the full upfront cost of the improvements.

This reduces the tenant’s initial cash outlay. For the landlord, it is a negotiating tool to secure a long-term tenant, enhancing the property’s value and ensuring steady rental income.

Landlord Tax and Accounting Implications

From a landlord’s perspective, a construction allowance is not an immediate, deductible business expense but an investment in their own property. The physical improvements made to the building, such as new walls and plumbing, become part of the landlord’s real estate asset, and the landlord is viewed as the owner of these improvements for tax purposes.

The landlord must capitalize the cost of the improvements, which means the total amount of the allowance is added to the property’s basis. This capitalized cost is then recovered over time through depreciation. For improvements made to nonresidential real property, the landlord will depreciate the capitalized cost over a 39-year period.

Tenant Tax Implications

For a tenant, the Internal Revenue Service (IRS) generally considers a cash allowance from a landlord to be a form of income. This means the full amount is included in the tenant’s gross income for the tax year in which it was received, which can create a significant tax liability.

This rule stems from the idea that the payment is a lease inducement, akin to a cash bonus for signing the lease. An exception exists that can prevent the allowance from being taxed if specific conditions are met. If the allowance does not meet these requirements and is taxable, the tenant is then considered the tax owner of the improvements and can claim depreciation deductions.

Requirements for Tax-Free Treatment

To avoid having a construction allowance treated as taxable income, the arrangement must satisfy strict requirements under Internal Revenue Code Section 110. This section provides a safe harbor for tenants, but failure to comply with even one rule can make the entire allowance taxable.

• The lease agreement must explicitly state the allowance is for constructing or improving qualified long-term real property.
• The allowance must be for a “short-term lease” of “retail space.” A short-term lease is 15 years or less, including all renewal options, and retail space is property used to sell goods or services to the public.
• The funds must be used for “qualified long-term real property,” which is part of the retail space and reverts to the landlord when the lease ends. This excludes the tenant’s trade fixtures, equipment, and furniture.
• The entire allowance must be spent on qualifying improvements within 8.5 months after the close of the taxable year in which it was received. Any unspent or improperly used funds become taxable income.
• Both the landlord and tenant must attach a statement to their tax returns disclosing information about the allowance.

Capitalizing and Depreciating Leasehold Improvements

Who capitalizes the improvements and claims depreciation deductions depends on how the construction allowance is treated for tax purposes.

If the allowance meets the safe harbor requirements and is excluded from the tenant’s income, the landlord is treated as the tax owner of the improvements. The landlord capitalizes the value of the improvements and depreciates them.

Conversely, if the allowance is taxable income to the tenant, the tenant is considered the tax owner. The tenant reports the allowance as income, capitalizes the cost of the assets they constructed, and can then claim depreciation deductions on those leasehold improvements.

In many cases, these improvements may be classified as Qualified Improvement Property (QIP), which is any interior improvement to a nonresidential building made after the building was first placed in service. QIP has a 15-year recovery period, which is much shorter than the standard 39 years.

QIP may also be eligible for bonus depreciation. For property placed in service in 2025, the bonus depreciation rate is 40%. This rate is set to decrease to 20% in 2026 and phase out entirely in 2027.