Tenant Improvements: Different Ways to Skin the Cat

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Philip J. Holthouse, Esq. and Kevin A. Cordano, CPA  

Holthouse Carlin & Van Trigt LLP, Los Angeles, CA

In structuring their lease transactions, landlords and tenants continue to search for tax-favored ways to address the economics of the tenant improvements called for under the leases.  Below, several approaches for handling tenant improvements are summarized.

Landlord Pays  

A traditional approach is for the landlord to pay for the tenant improvements and factor the cost into the rents payable under the lease. This approach provides the landlord tax basis in the improvements, along with the related depreciation deductions.  However, under this approach, if the lease term is relatively short, the landlord may realize more taxable income during the lease term.  If the lease is long and bonus deprecation or faster write-offs are available, this approach could result in tax deferral for the landlord.

Landlord Loans/Tenant Pays  

An alternative structure has the landlord making a loan to the tenant to finance the improvements. In addition to rent (which presumably would be somewhat lower than in the "Landlord Pays" alternative), the tenant pays principal and interest to the landlord. In this scenario, the tenant is entitled to deduct the depreciation for the improvements and the interest expense on the loan. In contrast to the "Landlord Pays" scenario, the landlord here is not entitled to the depreciation deductions for the improvements, but presumably has less rental income (even when factoring in the interest income on the loan). The length of the lease and the tax recovery period of the improvements determine whether this alternative provides a better or worse tax result for the parties to the lease.

Tenant Pays  

The tenant may pay for the improvements and bear the out-of-pocket cost, possibly borrowing funds from an outside lender. In theory, this approach should result in the lowest rent payments for the tenant, and the tax treatment with respect to the tenant improvements should follow the treatment described in the "Landlord Loans/Tenant Pays" alternative.

Hybrid Deals  

Most substantial leases involve some combination of the "Landlord Pays" and "Tenant Pays" options.  In practice, the landlord will often agree to provide a tenant improvement allowance (e.g., $50 per square foot), with the tenant responsible for all improvement costs in excess of the allowance. Because tenant improvements typically involve assets with different tax recovery periods, the hybrid approach requires the parties to determine who paid for which improvements. Especially where significant tenant improvements are involved, a cost segregation study may support faster depreciation recoveries.

Non-Tax Considerations  

As with most things in life, practitioners and clients should be wary about letting tax considerations distort or overly complicate the core business transaction. A structure that may provide certain tax advantages, may impact the landlord's or tenant's legal or economic position in a case in which one of the following events occurs: credit or security issues arise with respect to a party, a default occurs, the property is destroyed or cannot be occupied, the landlord or tenant files for bankruptcy protection, or an insurance coverage disputes arises.

For more information, in the Tax Management Portfolios, see Holthouse, 593 T.M., Real Estate Leases, and in Tax Practice Series, see ¶1230, Rents and Royalties and ¶2210 Rents and Royalties.

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