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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.