Thoughts About Tenant Allowances – Part 2

Print Friendly, PDF & Email

Two weeks ago, Ruminations rolled out some thoughts about Tenant Allowances and that triggered a whole bunch of comments, some directly to the blog, and many more on various LinkedIn group discussion boards. Each contribution is sincerely appreciated.

A couple of readers brought up the category of “Trade Fixtures,” and how they, too, were improvements to real property. Those readers are correct – Trade Fixtures are improvements to real property, but of a special kind. They are ones that belong to the tenant and are intended to be removed at the end of the term of the lease. This doesn’t mean that a landlord should or shouldn’t allow the tenant allowance to be used to pay for a trade fixture. Instead, it has tax ramifications as well as raising questions as to whether they are part of a mortgagee’s collateral. We’re not “going” either place in this blog entry.

Part 1 of our thoughts about Tenant Allowances promised that this installment would cover two issues, the first of which was “how does the payment of a tenant allowance affect tax obligation.” This isn’t a tax treatise and this lone Ruminator disclaims any special expertise in tax matters. That, however, however doesn’t preclude our “taking a shot at it.” We’re going “broad brush,” however, just getting concepts, not even principles, on the table. That should help readers figure out the “map,” but not draw one. Here goes.

Part 1 already made it clear that a Tenant Allowance means money is going from the landlord to its tenant. So, two fair questions would be: “how does the tenant treat this for tax purposes – is it income or not, and “does the corresponding expense ‘offset’ the receipt of income”? The answer to those questions will lead to figuring out how the landlord-payer gets treated for tax purposes.

If the landlord just gave its tenant “key” money – “here it is – enjoy it,” that’s income to the tenant just like the tenant sold a widget. It’s an expense to the landlord, just like it bought the widget. In this case, the widget that the landlord bought is a lease with a given term. If it is a ten year lease, the landlord has to amortize that expense over 10 years even though the tenant has to report the income in the tax year it got the money. That shouldn’t be a surprise. If the landlord bought a machine with a usable life of 10 years, it would have to write the machine off over 10 years even though its seller would record the sale right away. That’s the same tax treatment when the tenant gets a check from its landlord for all but a tenant’s Leasehold Improvements.

So, is there anything special about a leasehold improvement? Yes there is when the leasehold improvement belongs to the landlord. For any given leasehold improvement, the landlord or the tenant could have arranged for the work to be done and could have supervised the work. At the end of the project, you’d see the walls, the sinks, the HVAC, etc., and you couldn’t tell “who” did the work. At the end of the day, the landlord’s building will have been improved. So, who cares if the landlord paid the general contractor directly or if the landlord paid the tenant who then paid the general contractor? Actually, no one. You see, if the landlord hired the general contractor, the improvement to real property would be depreciated over 39 years (ignoring any special “tax breaks” of the day), and even though all of the money would have been spent, the landlord can only “take the expense” little by little. If the lease comes to an end before the 39 years have run, the balance of the money paid to the tenant can generally be written off by the landlord. When a Tenant Allowance is paid, then as to the part that goes toward leasehold improvements, is that the tenant is going to be treated as the landlord’s agent whose job it is to hire people, such as a general contractor, to do the actual work. In effect, all that is happening is that the landlord is using its tenant as a middleperson to handle the money.

By this time, you head must be spinning with lots of questions that go beyond: “how does the payment of a tenant allowance affect tax obligation.” The more common questions are addressed in this very fine piece on the McGladrey accounting firm’s website:

To make this simpler or more complicated, depending on the reader’s level of understanding, there is a special Section of the Internal Revenue Code. It is called Section 110, and it provides a safe harbor that allows tenants to exclude, from gross income, any amount received in cash (or treated as a rent reduction) from a landlord under a short-term lease of retail space, for the purpose of the lessee’s constructing or improving qualified long-term real property for use in the lessee’s trade or business at the retail space. “Qualified long-term real property” is nonresidential real property which is part of, or otherwise present at, certain retail space and which reverts to the landlord at the termination of the lease that has a term of 15 years or less. There are some exceptions, but that’s the principle.

Section 110 is only a safe harbor. If one follows the principles set out in Section 110 and documents everything, a tenant with a longer lease will get the same treatment.

Lastly on this topic – what kinds of items constitute eligible leasehold improvements? Eligible leasehold improvements to which the Tenant Allowance may be applied can include the following costs or fees: architect, building permit, dumpsters and clean-up, barricades and staging areas, demolition, concrete work, masonry work, structural and miscellaneous steel, roof work, carpentry, doors and roll-up grilles, drywall and metal studs, lay-in ceiling work, floor coverings (carpet, VCT, vinyl base), ceramic tile, granite and marble, non-fixture package millwork and trims, painting and wall coverings, storefronts and glazing, plumbing, fire protection sprinklers, HVAC work (including curbs and units), electrical and lighting work and fixtures, fire alarms, connections to energy management systems, meters and connection fees, utility usage fees, and impact fees. They can not include point of sale equipment, security systems, counters, display cases, free standing display racks, unattached movable equipment and machinery, goods held for sale to the public, other personal property or trade fixtures.

Oh yes, there was a second question for today – “what conditions, if any, must be met before the check (for the Tenant Allowance) is written”? The answer depends on what interests a landlord wants to protect and what requirements a given tenant will accept. Here are some common conditions that a landlord might insist be met before it writes the “check.” Not all of these items will be applicable in all cases, and some might be adapted to an agreement wherein a landlord would be making “advances” as the leasehold improvements progress. Of course, if there are to be installment payments, no landlord will want to advance more money than the “job” has consumed, and certainly it would be wise to hold out a “retainage.”

That having been said, here they are: (a) the tenant must deliver lien waivers from the tenant’s general contractor and from each subcontractor and from each material supplier, where failure to provide such a lien waiver could result in a valid lien against the landlord’s interest in all or any part of the property; (b) the tenant must deliver an estoppel letter confirming the commencement date of the lease; (c) the tenant must deliver a complete set of ‘as-built’ plans or a marked-up set of construction drawings; (d) the tenant must deliver evidence of payment of the construction costs; (e) the tenant must deliver a cost certification (which will be described below); (f) the tenant must have opened for business (and, if a retail store, then it must be fully fixtured, staffed, and stocked; (g) the tenant must deliver copies of the applicable certificate of occupancy for the leased premises (unless it relates to landlord’s work); and (h) the tenant must deliver an architect’s certification, reasonably satisfactory to the landlord, certifying that all of the tenant’s work was completed in accordance with the plans as delivered and approved (if applicable) by the landlord.

That’s not all. No landlord will want to pay the Tenant Allowance “on demand,” so payment will usually be required 30 days (or whatever number is agreed-upon) after all of the conditions have been satisfied. But, if the tenant is in default of any provision of the lease, the landlord will want to wait until 30 days (or whatever number is agreed-upon) after there no longer is a default.

Now, a tenant might have a few “adjustments to suggest.” For example, a tenant might not want to chase down every little subcontractor and might negotiate for a dollar threshold for lien waivers, like only getting them from contractors or material suppliers whose goods or service amounted to more than, say, $25,000. Or, in jurisdictions with a way to protect a landlord (fee owner) against such liens, to only be required to obtain such protection for its landlord. Another ”gloss” might be that if there are any liens, the landlord might be convinced to pay the Tenant Allowance less a holdback to “cover” the lien and then some.

What was that “cost certification” referred to above? It is only the tenant’s certification of its actual, out-of-pocket cost to make the qualifying leasehold improvements, outlining the leasehold improvements actually constructed, in reasonable itemized detail, including the associated costs, for which Tenant is seeking payment.

Well, this Ruminator is exhausted, barely looking forward to the next installment intended to answer these remaining questions: “(5) should the landlord get any part of the money back if the lease is prematurely terminated; (6) what happens if the landlord doesn’t pay the allowance; and (7) should the lender pay the allowance if it takes the property over before the money is paid?”



  1. Ira, sorry for joining this part of the allowance discussion so late. When crafting construction allowances, I have used the following provision with respect to the income tax issue:

    The Allowance is for the purpose of constructing or improving qualified long-term real property for use in Tenant’s trade or business at the demised premises, in accordance with Section 110(a) of the Internal Revenue Code and the Internal Revenue Service Regulations promulgated pursuant thereto.

    Regarding conditions for payment, I have always suggested to my client to get a large percentage of the allowance up-front as a delivery of possession requirement. When I was in-house for a large retailer, 75% -90% was usually required. As a back-stop, the rule was that enough of the allowance was paid on delivery of possession such that the balance could be recovered within 6 months as a rent offset if the landlord didn’t pay. Often a letter of credit was required for the full amount – to be given as a delivery of possession requirement – when the landlord didn’t want to lay out the cash. His credit line would be impaired for that amount. For subsequent clients, 50% at delivery of possession was often agreed upon. For the remainder and because tenant always had the obligation to remove liens by whatever method available, (i) a lien waiver was required from the general contractor (“GC”) only, not the subs, and only upon completion of the work – never in advance thereof which is often attempted in Pennsylvania, (ii) notices of completion were unnecessary, (iii) proof of payment was not required because of the GC’s lien waiver. Many tenants have ongoing relationships with the GC and the latter will often give a lien waiver without having been actually paid. Instead of specifically listing the improvements (they are incorporated into the approved plans), a list of the trades involved with the amounts expected to be paid listed (no proof of actual payment was required because of potential disputes). Estoppels, opening for business or payment of first month’s rent were also discarded. Completion of the work and the GC’s and architects certification as to conformance with the approved plans, the GC lien waiver and a certificate of occupancy were all that was required. If landlord didn’t pay when due (usually 30 days later), then rent offset kicked in with interest. I hate and often resist the method by which payment of a percentage allowance is paid (with a list of paperwork submissions) when that percentage of work was completed. Too difficult to administer and by the time one completed documentation, the work was finished and the entire allowance was due.

  2. Here is a link to AIA draw form for TIA tracking.

    The forms can be used for draw amounts, project completion tracking and keeping all contractor’s on schedule.

  3. I know this topic has been up for a while now and I wanted to ask a situational question strictly regarding tax.

    From the landlord stand point, in business real property, if the lessee does not make necessary improvements as it is stated in the lease agreement at the end of the lease term, does lessor still takes on the benefit of lessee improvements? Assuming that lessor makes the necessary improvements on behalf of the lessee after the lease term and files a law suit and wins the case with lessee having to write a check to the lessor for the amount incurred for the improvements?

    It’s a situation where the lessor makes the improvements and wanting to not recognize the check written out to the lessor. Because either way, the improvements will be depreciated but the check written to the lessor makes the difference in booking the income or account it as a reimbursement.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.