 |
Tax Considerations for Commercial Real Estate Lease
Inducements
Date: November 1992
Due to the excess vacant office space
currently available in most U.S. real estate markets, building owners
are offering a variety of creative lease inducement packages. The
income tax ramifications of these inducements must be carefully
considered to maximize tax benefits and avoid adverse tax results to
either the landlord or the tenant.
Lease
inducements take many forms. Among the most common are: v
cash payments, v reduced
rent, or “rent holidays,” v allowances
for tenant improvements, and v
assumption of the tenant’s existing lease obligations. Many
lease agreements fail to adequately address the proper tax
characterization of these various inducements, which may result in
higher taxes. To complicate matters further, a landlord and tenant
will frequently benefit from inconsistent tax positions. Below is a
brief discussion of some of these issues.
From
the landlord’s perspective, a rent holiday is preferable to a cash
payment to the tenant. A cash payment must generally be amortized over
the term of the lease. A rent holiday, on the other hand, has the same
tax effect to the landlord as an immediate deduction since the
landlord reports less income. A rent holiday can also avoid
complications to the landlord from assuming the tenant’s existing
lease obligations. In structuring a rent holiday, consideration must
be given to Section 467 of the Internal Revenue Code, which may affect
the timing of income to the landlord and deductions to the tenant.
Another
area in which tax planning is a necessity arises with a tenant
improvement allowance. Many lease agreements do not clearly define
which party owns tenant improvements funded by the landlord. Since
1986, the owner of tenant improvements must amortize their cost over a
period of 31.5 years. Leasehold inducement payments, on the other
hand, are amortizable over the life of the lease, which is generally
significantly shorter than 31.5 years. For this reason, landlords
often attempt to minimize their cost of tenant improvements and
maximize their leasehold inducement payments. The landlord will prefer
to treat the tenant as the owner of the improvements. Improvement fund
disbursements to the tenant are then treated as leasehold inducement
payments, amortizable by the landlord over the life of the lease. Such
a characterization is, of course, undesirable from the tenant’s
perspective, since the payments will result in current income. The
tenant cannot immediately deduct these payments as they are used to
pay for the improvements, but must capitalize and depreciate these
improvement costs over 31.5 years. The tenant will thus recognize
“phantom income,” i.e., an increase in taxable income upon receipt
of the improvement disbursements with no corresponding cash since the
cash will be immediately invested in the tenant improvements.
This
result may be avoided with proper tax planning. One possibility is to
structure the disbursements from the tenant improvement fund as a loan
from the landlord to the tenant. The tenant will not be taxed on
receipt of the loan proceeds. The tenant will be treated as the owner
of the tenant improvements, and will depreciate them. The landlord and
tenant may agree to a rent reduction in light of the fact that the
tenant is receiving a loan and not an inducement payment.
Alternatively, the lease can specifically provide that the leasehold
improvements will remain the property of the landlord. The tenant will
then avoid the recognition of income. The landlord, however, will be
required to depreciate the improvements over 31.5 years, rather than
over the generally shorter term of the lease.
Tax
considerations are also important when the tenant is tied to an
existing lease. The tenant’s assignment of its existing lease to the
new landlord may have tax advantages over a sublease of the existing
lease. If properly structured, the tenant’s assignment of its
existing lease can avoid current income while permitting the tenant to
deduct its remaining adjusted cost
in the leasehold improvements in the existing leased premises.
A sublease by the tenant of the existing premises to the new landlord
is less advantageous, since the tenant must continue to amortize its
cost in the tenant improvements.
Additional
tax planning opportunities may be available to benefit your particular
situation. If you have questions or wish further information please
call our Tax Department at (310) 858-7700.
Our
Tax Department handles a wide range of federal, state and
international tax matters involving tax planning for high net worth
individuals, partnerships and corporations with particular emphasis on
the entertainment industry. We have extensive experience in
structuring real estate transactions, motion picture financings,
partnerships and syndications, structuring the purchase, sale and
reorganization of companies, and executive compensation arrangements.
Rosenfeld,
Meyer & Susman was founded in 1957. The firm's areas of expertise
include: Tax, Litigation, Corporate, Entertainment, Estate Planning,
Trusts and Probate, Labor and Employment Law, Real Estate, Family Law,
Insurance Coverage and Defense, Real Estate and Employee Benefits Law.
 Return to top
|
