Important Tax Angles of Tenant Inducements

          Tenant inducements play an increasingly vital role in today’s real estate market — even in those locations where occupancy rates are high. In the scramble to constantly increase occu­pancy rates, property managers offer pro­spective and current tenants a vari­ety of perks. Rent holidays, stepped rent, lump-sum payments and leasehold improve­ments top the list of popular tenant incen­tives at the higher end of the cost scale.

When structured properly, these inducement packages do more than just attract and retain tenants — they yield the best possible tax results for both the lessor and the tenant. To develop the most advanta­geous inducement packages, property managers must under­stand the tax angles of various tenant incen­tives. Those who ignore these tax angles risk incurring hidden costs as well as unpleasant tax results.

Rent Holidays

A “rent holiday” or free-rent period is one of the most popular tenant inducements. While the tenant experiences a cash flow boost, the lessor’s cash flow is negatively impacted. The lessor does, however, receive a tax bene­fit for granting the rent holiday: a reduction in income during the time rent is not received.

Another tax advantage of rent holidays is that they trigger this reduction in income during rather than after the free rent period. In con­trast, tax benefits from most other forms of lease inducements are spread over a much longer period.

Stepped Rents

Stepped-rent agreements are characterized by deeply discounted rates, which generally con­tinue during the first year of the lease. After the initial low-rate period, the lease agree­ment calls for a rent increase for the remain­ing term. One advantage of stepped-rent agreements is the higher starting point in renewal negotiations, since the lease amount is at its peak by the end of the lease term. For example, if office space is leased for five years at an average of $18 per square foot but the final year of the lease agreement calls for $20 per square foot, the lessor can start nego­tiations at $20 per square foot or more.

In a stepped-rent agreement, a reduced-rent period is allowed. By receiving reduced rental payments, the lessor avoids the cash flow strain that accompanies rent holidays. The lessor also receives the tax benefit of reduced income during the initial phase of a stepped-rent agreement, except perhaps when Internal Revenue Code Section 467 applies. Stepped-rent agreements offer the same tax benefit as rent holidays — the tax benefit occurs during rather than after the free-rent period.

Lump-Sum Payments

Lump-sum payments are another common form of tenant inducement. Lessors fre­quently make lump-sum payments to:

	Cover the tenant’s moving expense
	Buy out an existing lease
	Pay furniture and equipment costs
	Provide a true cash bonus

The lessor must capitalize lump-sum pay­ments made to a tenant (to the extent not attributable to leasehold improvements) and amortize them over the term of the lease. For example, if a lessor makes a lump-sum cash payment of $50,000 to a tenant for signing a new 10-year lease, the lessor would capital­ize the payment and deduct $5,000 annually during each year of the lease.

When the lessor makes cash payments directly to the tenant, the tenant will have taxable income (except when the payment is characterized as a reimbursement for lease­hold improvements owned by the landlord) when the payments are received. If the tenant then uses the money to pay moving or other expenses, the tenant will also have an offset­ting deduction. If the allowance the tenant receives exceeds the amount actu­ally spent, the excess amount would be income.

A lump-sum payment to buy out an existing lease is not always a practical tenant induce­ment. Sometimes it makes more sense for the new lessor to sublease the tenant’s former space. Subletting, however, can create tax problems for some tenants if it results in undesirable passive income or a loss. In such cases, one option would be to quantify the value of the lease buyout and convert that value into another type of inducement, such as a rent holiday.

Lump-sum payments for furniture and equipment purchased by tenants must be depreciated over the life of the furniture or equipment. In many ways, the tax treatment of lump-sum payments for furniture and equipment would be the same as for lease-
hold improvements. For tax purposes, a rent holiday is generally more advantageous for the tenant and the lessor than a lump-sum payment.

Leasehold Improvement Allowances

Lessors frequently offer allowances for leasehold improvements as another form of tenant inducement. Tax treatment of lease­hold improvements hinges on which party retains ownership of the leasehold improve­ment. In most cases, the lessor receives tax benefits of the cost of leasehold improve­ments more quickly by making a lump-sum payment to the tenant for the improvement costs rather than paying for and retaining ownership of the improvements and receiving tax benefits through depreciation.

When the tenant retains ownership of the improvements, the cash payment from the lessor is recognized as income to the tenant. The tenant then depreciates the leasehold improvement over its statutory life, which is currently 39 years. The lessor capitalizes the cash amount paid to the tenant, amortizing it over the life of the lease — generally exclud­ing any option-to-renew periods.

When the lessor retains ownership of lease­hold improvements, the tenant is not entitled to depreciation even if the expenditures pass through the tenant’s books. In other words, the tenant’s taxes are not affected. The les­sor, on the other hand, capitalizes the amount paid for leasehold improvements and, rather than amortizing them over the life of the lease, depreciates the amount over the statu­tory life. If the lessor abandons the improvements by tearing them out on termi­nation of the lease, any undepreciated balance is written off.

If the tenant owns the improvements, but turns them over to the lessor on vacating the property, the lessor is generally not required to recognize income. Nor does the lessor receive a depreciable basis in the improvements. But if the lessor receives the improvements in lieu of rent, the lessor may have to recognize income and have a depre­ciable basis in the improvements.

Rent-Leveling Provisions

In the past, postponement of rental income and expense through stepped rent and rent holidays offered an ideal opportunity for deferring taxes. A cash-basis lessor could defer recognizing income until rent was actu­ally received, while an accrual-basis tenant could take a current tax deduction for accrued rent, even though that rent would not be paid until a later year.

To do away with the perceived abuse of this provision, Internal Revenue Code Section 467 attempts to smooth out the recognition of rental income that otherwise would have been deferred through rent holidays or stepped rent. Through its “rent-leveling” provisions, Section 467 requires rent charged in certain deferred arrangements to be leveled over the length of the agreement.

Section 467 applies to lease agreements for tangible property (real or personal) when:

 

	Total payments over the lease term (cash plus fair market value) exceed $250,000
	Rent is postponed for more than one year, and the lease agreement allocates the rent to a specific calendar year
	Rent is increasing or decreasing
	The lease term exceeds 75% of the leased property’s recovery period
	The principal purpose of the agreement is tax avoidance

The tax courts determine tax avoidance on a case-by-case basis. They consider the size of the gap between tax brackets of the lessor and tenant or whether an option exists for the tenant to renew at rents significantly less than the amounts in the original lease’s later years. Tax courts also look at whether the lease involves a tax-exempt organization placed between two taxable parties.

Tax courts won’t consider rent holidays or stepped-rent agreements tax avoidance in the following situations or safe harbors:

 

	Rent increases are linked to a price index, such as the consumer price index
	Rents are based on a fixed percentage of tenant’s gross receipts
	Reasonable rent holidays were given at the beginning of the lease term based on the current rental real estate market
	The lease term exceeds 75% of the leased property’s recovery period
	Rent increased because of escalations in amounts paid to unrelated third parties, such as insurance, taxes or maintenance costs. If a lease agreement does qualify for rent leveling under Section 467, both the lessor and the tenant must allocate an equal amount of rent to each period under the lease

The rent amount is determined by taking the present value of all payments that are to be made under the lease terms. This rent accrual is treated as any other debt owed by an accrual-basis taxpayer. Thus, both lessors and tenants are subject to the rules gov­erning bad debt deductions, discharge of indebted­ness and tax benefits. Interest must be imputed on any of the leveled rent amount that is not paid currently, and the total amount of rent and interest recognized for the entire lease term should equal the total amount of payments under the lease.

Sidestepping Section 467

When possible, structure your lease agree­ments to sidestep the provisions of Section 467. Review all proposed lease agreements with tax advantages and disadvantages in mind before granting any significant rent holidays or stepped-rent concessions. For more information on real estate tax strategies, please contact us.