Tenant improvement allowances (TIAs) are funds that landlords provide to tenants to customize their leased space. TIAs can be a powerful incentive for tenants to sign or renew a lease, but they also have tax implications for both parties. How can you structure tax-efficient TIAs that benefit both landlords and tenants? Here are some tips to consider.
The amount of TIA that a landlord offers depends on several factors, such as the market conditions, the lease term, the tenant's creditworthiness, and the scope of work. Generally, the longer the lease term and the higher the rent, the more TIA a landlord can afford to give. However, the TIA amount also affects the landlord's taxable income and depreciation deductions. Therefore, landlords should negotiate the TIA amount carefully and compare it with other leasing costs, such as vacancy, commissions, and operating expenses.
Negotiate the TIA items or components that will apply to the allowance to ensure you (landlord) can apply tax efficient bonus depreciation or 179 expense items to your books, not the tenants.
There are two common methods of providing TIA to tenants: direct reimbursement and turnkey build-out. In direct reimbursement, the landlord pays the tenant a fixed amount per square foot or a lump sum after the tenant completes the improvements. In turnkey build-out, the landlord hires a contractor and oversees the improvements according to the tenant's specifications. The TIA method affects how the improvements are classified for tax purposes. Generally, direct reimbursement allows the tenant to own and depreciate the improvements, while turnkey build-out allows the landlord to do so.
Landlord pays and owns: Simple, but higher lease rates for tenant. Tenant pays and owns: Lower lease rates, but more risk and responsibility for tenant. Landlord provides cash allowance: Beneficial for both, but only for short-term leases of retail spaces. Landlord and tenant share: Suitable for long-term leases, but requires agreement on cost, ownership, and depreciation.
If doing the reimbursement method, be your the lease states you (the landlord) will pay for the specialty and non-removeable TI's, not the FF&E should the buildout exceed the allowance. Get receipts to apply appropriate depreciation deductions on your books. If turnkey, landlord controls the buildout and hence the tax efficient components.
The tax consequences of TIA depend on whether the improvements are considered leasehold improvements or building improvements. Leasehold improvements are made by or for a specific tenant and have a useful life of 15 years or less. Building improvements are made to the structure or common areas of the building and have a useful life of 39 years. Leasehold improvements are usually deductible by the tenant as rent expenses over the lease term, while building improvements are usually capitalized and depreciated by the landlord over their useful life. However, there are exceptions and nuances to these rules, so it is advisable to consult a tax professional before finalizing a TIA agreement.
Any leasehold or building improvements will have tax and bonus depreciation benefits to whoever pays for them. Be sure that negotiated allowances specify the tax efficient components that are paid via the TIA to ensure tax benefits to the landlord.
There may be tax incentives and credits available for certain types of improvements, such as energy efficiency, accessibility, or historic preservation. These incentives and credits can reduce the tax liability of either the landlord or the tenant, depending on who owns and pays for the improvements. For example, the federal Section 179D deduction allows a tax deduction of up to $1.80 per square foot for energy-efficient commercial building improvements, which can be allocated to the landlord, the tenant, or both. Similarly, the federal Rehabilitation Tax Credit allows a tax credit of 20% or 10% for qualified rehabilitation expenditures on historic or older buildings, which can be claimed by the owner or the lessee.
There are new rules starting January 1, 2023 in regard to 179D, the deduction is still beneficial for anyone remodeling or building new investment. 179D would be for any commercial building or housing at four stories are above. You could look at 45L for anything three stories and below.
The lease terms and clauses should clearly define the TIA amount, method, ownership, allocation, and timing, as well as the responsibilities and obligations of both parties regarding the improvements. The lease should also address any contingencies or disputes that may arise during or after the improvement process, such as delays, defects, changes, or damages. Additionally, the lease should specify how the improvements will be treated at the end of the lease term, such as whether the tenant has to remove them, restore them, or leave them in place.
I agree with this. This highlights the importance of clear lease agreements, particularly regarding Tenant Improvement Allowances (TIAs). By specifying TIA details like amount, method, ownership, allocation, and timing, the lease establishes transparent expectations. Provisions on responsibilities, contingencies, and dispute resolution create a comprehensive framework. Addressing improvements' treatment at the lease end adds prudence. In summary, this approach promotes clear understanding between landlords and tenants, enhancing the leasing experience…. overly detailed clauses might lead to a more complex lease document, potentially creating confusion or room for misinterpretation.
In crafting a lease agreement, it's crucial to include these key elements for tax advantages: 1. Explicit Ownership of Improvements: The agreement should state that the tenant owns any improvements they finance, making them eligible for depreciation deductions. 2. Detailed Description of Improvement Costs: Include a detailed breakdown of improvement costs for accurate depreciation calculations. 3. Clear Terms for Improvement Allowances: If the landlord provides an improvement allowance, the terms should be clear, including how the allowance is treated for tax purposes. This clarity helps in leveraging potential tax benefits under Sect. 110 of the IRC. As always the devil is on the details, so make sure all is outlined clearly in the lease
Structuring tax-efficient TIAs can be a complex and challenging task that requires careful planning and execution. Therefore, it is important to collaborate with professionals who have the expertise and experience in commercial real estate, such as brokers, attorneys, accountants, contractors, and engineers. These professionals can help you evaluate your options, negotiate the best deal, comply with the tax laws and regulations, and optimize the value and performance of your leased space.
While the suggestion to collaborate with professionals for tax-efficient TIAs is generally well-accepted, some may argue for a more self-reliant approach. Those holding this perspective might emphasize the importance of educating oneself about tax implications and real estate regulations to make informed decisions independently, potentially avoiding additional costs associated with professional services. However, the counterargument acknowledges the complexity of tax laws and the intricate nature of commercial real estate, emphasising the value of expert guidance to navigate these complexities effectively.
When negotiating allowances for improvements, the company needs to plan for potential shifts in business operations. For instance, for a technology company to have flexibility and infrastructure support in their lease could make it easier to adapt the space for different uses without extensive renovations (i.e., making sure from the beginning that the space can support high-tech infrastructure), thus optimizing their tax benefits. This was invaluable when they shifted to remote work during the pandemic.