As we have discussed in a prior issues of iTaxblog, the Tangible Property Regulations (TPRs) have focused practitioners’ attention on the treatment of tenant improvements. This new focus has led practitioners to pay more attention to existing issues with the leasing of property, especially how §110 treats construction allowances. Before examining how §110 and the TPR interact, it is important to understand the tax treatment of tenant improvements under prior law.
Prior Law Overview
The chart below captures the tax treatment of the tenant improvements (TI’s) under prior law. (Please note that the chart makes certain assumptions about the drafting of the lease agreement and that §467 does not apply.)
|Situation||Payor||Tax Owner||Tax Effect on Landlord||Tax Effect on Tenant|
|Landlord constructs tenant improvements.||Landlord||Landlord||Depreciate TI’s basis over 15 or 39 years under section 168.||None|
|Landlord provides construction allowance to tenant for the construction of improvements.||Landlord||Tenant||Amortize the basis of the improvements as a lease acquisition cost over the lease term under §178.||Include construction allowance in gross income and depreciate the allowance over 15 or 39 years under §168.|
|Landlord provides rent reduction in lieu of construction allowance.||Tenant||Tenant||The landlord’s gross income is decreased by the amount of the foregone rent.||Lost rent deductions, but recovers the cost of the TI’s under §168.|
|Tenant constructs its own improvements.||Tenant||Tenant||None||Depreciate TI’s basis over 15 or 39 years under §168.|
|Tenant constructs improvements and then conveys them to landlord upon completion.||Tenant||Landlord||Include basis of TI’s in gross income as a substitute for rent under §1.61-8(c) and depreciate over 15 or 39 years under §168.||Amortize the basis of the TI’s as a lease acquisition cost over lease term under §178.|
As shown in the above chart, if a tenant receives a construction allowance, the tenant generally must include the amount of the allowance in income if it is the tax owner of the improvements. Given this harsh treatment, in 1997 Congress added §110 to the code. This code section provides limited relief to tenants who receive construction allowances for certain short-term, retail leases.
Though this section has been in place for almost 20 years, taxpayers rarely have qualifying leases. This is due to the many requirements for the section to apply.
- Under 1.110-1(b)(3), the lease agreement must expressly provide that the construction allowance is 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. If the original lease agreement does not include this provision, the taxpayer has until the payment of the construction allowance to enter into an ancillary agreement with the provision.
- The lease must be short-term, which is 15 years of less.
- The lease must be for retail space, which is qualified long-term real property used by the lessee in its trade or business of selling tangible personal property or services to the general public. Retail space includes back office and storage areas plus showroom or sales areas.
- The qualified long-term real property is nonresidential real property that reverts to the lessor at the end of the lease. It does not include 1245 property.
- The lessor must have consistent tax treatment.
- Both the lessor and lessee must include in their timely filed tax returns a statement that includes the other party’s name, EIN, and address; the location of the retail space, including any location and store names; the amount of the construction allowance and the amount treated as for nonresidential property owned by the lessor.
Section 110 has become more prominent in recent years, since the TPRs provide specific rules relating to it. Specifically, lessees must capitalize all related amounts it pays to improve leased property unless §110 applies to a construction allowance or the improvements were a substitute for rent. Similarly, lessors must capitalize the related amounts it pays for improvements to leased property, including via a §110 construction allowance.
If you need assistance applying these provisions, please contact one of our directors of business development.
 Treas. Reg. section 1.110-1(b)(iii)(2)(ii).
 Treas. Reg. section 1.110-1(b)(iii)(2)(iii).
 Treas. Reg. section 1.110-1(b)(iii)(2)(i).
 Treas. Reg. section 1.110-1(b)(5).
 Treas. Reg. section 1.110-1(c).
 Treas. Reg. section 1.263(a)-3(f)(2)(i).
 Treas. Reg. section 1.263(a)-3(f)(3)(i).