In commercial real estate, the financial success of a lease often hinges on the fine print of tax planning. Whether you are funding a high-end retail build-out or navigating the complexities of a lease with a nonprofit, the way you structure fit-out contributions can be the difference between a significant cash flow boost and an unexpected tax burden. This month, we dive into the powerful “safe harbor” protections of Internal Revenue Code (IRC) Section 110 for retail tenants and the potential tax drawbacks that arise when leasing to tax-exempt entities.
Both scenarios have their nuances. Without a clear strategy, stakeholders risk losing 100% bonus depreciation or reverting to long-term depreciation schedules that eat away at the tax advantages of owning the property.
Landlord-Funded Fit-Outs – Understanding Section 110
In commercial leasing, landlords frequently provide payments or allowances to tenants to fund fit-out or improvement costs. Commonly used as strategic investments to attract high-quality tenants in competitive markets, enhance property value, and secure longer lease terms, these fit-out contributions can have significant tax implications. Proper structuring, particularly within the lease agreement, is essential to achieve favorable tax treatment for both parties.
Section 110 of the Internal Revenue Code (IRC) provides tenants with safe harbor protection by the IRS, allowing them to exclude certain landlord-provided construction allowances from their gross income. To qualify, several strict requirements must be met:
- The allowance must relate to improvements to real property (e.g., land and permanently attached structures such as buildings, fixtures, roads, driveways, utility lines) made under a short-term lease of retail space, generally 15 years or less. Retail space is defined as being used by a tenant in its trade or business of selling tangible personal property or services to the general public.
- The improvements must be owned by the landlord and used exclusively in the tenant’s retail trade or business.
- Payments must be in the form of either cash or treated as a rent reduction and cannot exceed the tenant’s construction expenses.
When these criteria are satisfied, the tenant qualifies for an income exclusion, and the landlord can capitalize and depreciate the improvement costs. However, the exclusion only applies to qualified “long-term real property.” If the improvements are removable trade fixtures, the IRS may treat the allowance as taxable income to the tenant.
Leasing Requirements
The lease itself also plays a critical role in allowing the tenant to take advantage of the tax relief provided by Section 110. To support exclusion from income, the lease must:
- Explicitly identify the payment as a “qualified construction allowance of real property”
- Clearly describe the nature and scope of the permitted improvements, confirm that the improvements constitute real property, and state that ownership of the improvements vests with the landlord upon installation
- Specify the lease term and confirm that the space qualifies as retail property
Additionally, the lease must require the tenant to use the allowance solely for qualifying improvements and to provide documentation substantiating the use of funds. Any unspent or misapplied amounts should be addressed to avoid recharacterization as taxable income for the tenant.
Investor Benefits
As mentioned, property owners also benefit from Section 110 by being able to capitalize and depreciate any tenant fit-out allowances given to tenants. If the allowances are provided to a tenant leasing a space in an existing building and these costs are all internal to the building, they most likely will qualify as Qualified Improvement Property (QIP) and be eligible for 100% bonus depreciation. Working with a trusted cost segregation firm will help investors identify which improvements qualify for both QIP and other personal property within their building that can be depreciated at accelerated rates.
Leasing to Tax-Exempt Organizations
Leasing all or a portion of a building to a tax-exempt entity can create significant depreciation implications for property owners. IRS rules that govern “tax-exempt use” property can limit depreciation benefits for both real and personal property associated with the leased space.
When a building, or a portion of it, is leased to a tax-exempt entity (such as a government agency, nonprofit organization, or educational institution) the leased portion is generally treated as tax-exempt use property. As a result, that portion of the building must be depreciated using a slower Alternative Depreciation System (ADS) rather than a faster General Depreciation System (GDS). For nonresidential real property, ADS requires a 40-year straight-line recovery period, and for residential rental property, a 30-year recovery period.
These limitations also extend to personal property and QIP associated with the tax-exempt use space. For example, landlords must depreciate personal property and land improvements over 125% of the lease term under something called the “125% rule” when the lease term exceeds the ADS recovery period. This is where a cost segregation professional can help determine what is the appropriate asset life for tax-exempt property.
Unfortunately, perhaps the biggest downside for investors is that property classified for tax-exempt use is also ineligible for bonus depreciation.
So How Can Investors Benefit from This Type of Lease?
While the tax rules for leasing to nonprofits or government agencies can seem restrictive at first glance, these tenants often offer unique, long-term stability that outweighs the depreciation trade-offs. Here is why many savvy investors actively pursue these tenants:
- The 35% Threshold: For many properties, the slower ADS depreciation rules are only triggered if the tax-exempt entity occupies more than 35% of the building. This allows owners to mix tenant types to maintain faster GDS benefits for much of the property.
- Proportional Benefits: Even when ADS applies, it only affects the specific portion of the building used by the tax-exempt tenant. A detailed cost segregation study ensures that an owner can still benefit from accelerated and bonus depreciation available to the remaining property.
- Stability: Tax-exempt tenants, such as government agencies, are often “recession-proof” and sign longer leases, providing the reliable cash flow needed to secure better financing terms or fund future projects that can be eligible for more tax benefits.
Because leasing to tax-exempt entities can materially reduce depreciation deductions, careful analysis of lease terms, renewal options, and asset classifications is essential. However, by working with both a trusted tax and cost segregation professional to gain an understanding of how to navigate the tax-exempt use rules, landlords can turn a potential drawback into a predictable, high-value investment.
