In a recently released internal legal memorandum (ILM201436048), the IRS National Office advised the field that certain payments made by a lessee to reimburse the lessor for tenant improvement costs above an agreed-upon allowance were not rental income to the lessor.  

The ILM also addressed whether the taxpayer (lessor) could depreciate tenant improvements owned by the taxpayer, but used by a tax-exempt lessee under the Modified Accelerated Cost Recovery System General Depreciation System (GDS), or whether they were required to use the Alternative Depreciation System (ADS). The IRS concluded that ADS must be used to depreciate those assets.

The taxpayer in the ILM owned a building that it leased to a tax-exempt government agency. The taxpayer paid for certain tenant improvements to the building up to an agreed-upon dollar amount. If the lessee anticipated it would spend more than the agreed-upon allowance on the improvements, the agreement allowed the lessee to either reduce the scope of the work, pay a lump sum for the overage upon completion or increase the rental payments according to the negotiated amortization rate over the term of the lease. The lessee did spend more than the allowance and paid the taxpayer in a lump sum to cover the overage.

Case law in this area looks to the express terms of the lease and the surrounding circumstances that demonstrate the parties' intent to determine whether such payments are considered additional rent. To determine the parties' intent, the IRS first considered the terms of the lease and then additional information provided on the lessee's website related to its leasing practice and procedures. Specific language in the lease included the tenant allowance in the stated rent, but expressly excluded the extra buildout in excess of the tenant allowance from the consideration for the stated rent.   

While the ILM didn't address whether the taxpayer or the lessee owned either tranche of improvements, language from the lessee's website states that the lessor would incur the cost of assets covered by the tenant improvement allowance and amortize that amount and that the lessee would incur the costs for any overage and amortize that amount. Therefore, it is implied that the taxpayer in the ILM had the tax ownership of the assets covered by only the tenant improvement allowance and not the overage.

Based on the lease terms, the IRS distinguished the facts in the ILM from case law in which the parties' intent was to treat the amount at issue as rent, and concluded that the lease terms and the surrounding circumstances don't indicate that the parties intended the overage to be rent.  

The second issue in the ILM addresses the proper recovery period and method for the assets owned by the taxpayer and paid for by the tenant improvement allowance. Tax-exempt use property is required to be depreciated using ADS under Section 168(g)(1)(B). Section 168(h)(1)(A) provides that the term "tax-exempt use property" for purposes of Section 168 means that portion of any taxable property (other than  nonresidential real property) leased to a tax-exempt entity.

In this case, nonresidential real property means the portion of the property leased to a tax-exempt entity in a disqualified lease under Section 168(h)(1)(B)(ii). The lease in the ILM wasn't a disqualified lease. Thus, the taxpayer wasn't required to use ADS for the nonresidential real property, such as the qualified leasehold improvements, but was required to use ADS methods and recovery periods to depreciate the personal property leased to the tax-exempt government agency.

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