Rental property lease terms can cost tax dollars
Folks renting new office space or commercial stores need to understand the tax implications of the terms of the contract or lease. In many cases the landlord will pay a broker to aid in finding a new tenant. Also, some landlords will provide the tenant with incentives to sign leases such as, free rent for a period, improvements (called leasehold improvements), lower rent in early years and increasing over time, or actually give tenants cash to do their own improvements. All of these wonderful incentives have serious tax implications, from both the landlord and the tenant perspective, that should be understood or at tax time, someone will not be a happy camper.
When a landlord pays a broker to help acquire a tenant, they typically will deduct the cost in the year that it is paid but that is not allowed by the tax code. Since the landlord is benefiting from this cost for more than one year, they are required to spread (amortize) that cost over the lease term. This is the same principle as when one purchases property for investment, they cannot deduct the cost in the year purchased but must spread (depreciate) the cost over the life of the building (asset). So, the landlord spends the money now but cannot get all of the tax benefit immediately.
Another situation that occurs regularly is an allowance for making the tenant space usable. If the landlord provides an allowance, cash or otherwise, so the tenant can improve the space, it is important to determine who owns the improvements. Ownership determines how fast the costs can be recaptured and whether the allowance constitutes income to the tenant. This should be documented in the lease. Normally, income received is taxable in the year in which it is received and the owner of the leasehold improvements must depreciate the improvements over 39 years, the life of the building.
If the landlord owns the improvements, then the allowance is not taxable income to the tenant but the landlord must spread the cost over 39 years. If the tenant owns the improvements, the landlord can recapture its cost over a shorter period of time, spread over the lease period instead of 39 years, and therefore recapture its cash faster but the tenant must report the allowance as income in the year received. Who owns the improvements is critical. So, the dilemma exists since the tenants do not want the allowance to be reported as taxable income and the landlord wants to write off the cost over a shorter period of time.
There are many more difficult issues that both the landlord and tenant need to negotiate, understand and document. The proper tax advice is critical during the lease contract period.