Tenant Improvement Allowances Paid to Exempt Organizations

This article was published in the September/October 2018 issue of Taxation of Exempts.

Landlords do this in soft markets to fill buildings that might otherwise be empty. When landlords offer such inducements to exempt organizations, the exempt organization is confronted with the question of whether the amount of such allowance (a “tenant improvement allowance”) or the amount of such tenant improvement allowance that is in excess of the hard and soft costs incurred to build-out its space (an “excess allowance”) is unrelated trade or business income. There is no direct authority on this question. The tax treatment of payments by landlords to tenants of tenant improvement allowances has been the source of much uncertainty over the years. The receipt of cash by a tenant can look like an accession of wealth by the tenant and therefore constitute gross income to the tenant. To the extent, however, that the amount paid by the landlord does not exceed the cost of the improvements and the landlord is considered to own those improvements, the traditional position has been that there was no accession of wealth by the tenant and, therefore, the payment does not constitute gross income to the tenant.

Section 110

In the Taxpayer Relief Act of 1997,2 Congress attempted to bring some clarity to this issue with respect to one class of leases by enacting Section 110. Section 110 provides that gross income of a tenant of retail space does not include tenant improvement allowances received from its landlord under a lease of 15 years or less to the extent such tenant improvement allowance is used by the tenant to pay for the hard and soft costs incurred by it to construct retail space pursuant to a lease under which the build-out constitutes real property and reverts to the landlord at the end of the lease term. To that extent, any such amount paid by the landlord to the tenant is excluded from the tenant’s gross income under Section 110, but the excess allowance would constitute gross income. By implication,amounts not excluded under Section 110 might be treated as income to tenants, but if Section 110 is viewed as merely a safe harbor for certain tenants, it would not preclude other tenants from following the traditional position outlined above that treats all tenant improvement allowances used to pay for landlord-owned improvements as excluded from income.

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