As the tenant of a retail space, you may receive funds from your landlord to make improvements, or construct the space you lease for your business. Fortunately, such funds, which are commonly referred to as a construction allowance, often are exempt from taxes under a safe harbor from the IRS. In short, this means that those taxpayers who follow the rules, and follow them precisely, can be assured of advantageous tax treatment. In fact, those who play by the rules and meet certain conditions will enjoy the benefit of not having any such funds treated as taxable income.
- Can be issued via an advance of funds or credit on rent payments
- Tax treatment can be uncertain, for tax purposes
○ Depends upon whether the tenant or the landlord owns the improvements made/built with the funds
○ Ownership of the tenant improvements for tax purposes may not be the same as ownership under state/local real estate laws, which can complicate the correct tax treatment
○ Compliance with IRS rules allows tenants to exclude from income amounts given by the landlord to spend on improvements
The Rules
- Lease must be for commercial real estate
- Term must not be for more than 15 years, including any renewal options
- Landlord and tenant must execute an agreement that clearly states that the construction allowance is given with the intent that it be used to improve or build the retail space
- Agreement can be part of the lease or a separate document
- Agreement must be signed by both parties before allowance is paid
- Allowance must be used to build or improve commercial property in a retail space, meaning this space must be used in the trade or business of selling goods and/or services to the general public
- The space can include an adjacent space where activities that support the retail activities, such as an administrative office, storage space or lounge, are carried out
- Records should be kept of amounts received and expenditures made to improve or construct the property
- Allowance must be spent within 8.5 months following the end of the calendar year during which the money was received
- Allowance can be paid as a reimbursement for personal expenditures made in an earlier year
As this is a complex, but beneficial situation, tenants and landlords may wish to have their construction allowance agreement reviewed to ensure that they are meeting the IRS reporting environments. If you’re in need of review, Convergence CPA can help. We’re a top-notch Denver CPA firm with deep knowledge of real estate taxes and business concerns.
Convergence CPA Group is a highly credible CPA firm in Denver, Colorado