Transitioning Tenants – a Tax Planning Opportunity for Real Estate Owners
“Transitioning Tenants – a Tax Planning Opportunity for Real Estate Owners ” by Toby Kaye, CPA | Senior Associate – Tax
Unexpected tenant turnover can create challenges for a commercial real estate owner. The owner may have adjusted the leasing area specifically for the old tenant. The owner may now need to spend time and resources to find a new tenant. Owners can reduce the impact of these changes with proper tax planning at the exit of the old tenant and entry of the new tenant.
Leasehold Improvements of Old Tenants
The real estate owner may have made leasehold improvements to the commercial space specifically for the purposes of the old tenant. Leasehold improvements have a depreciable life of 15 years (other than certain exceptions). Real estate owners are permitted to immediately deduct the leasehold improvements that will not be used in the future and are abandoned by the owner. Owners should review their leasehold assets in a timely fashion upon tenant departure to classify assets as abandoned.
The tenant may have paid for the leasehold improvements. The owner is not required to recognize income if the improvements transfer to the owner upon cessation of the lease. Owners should review which of the tenant paid leasehold improvements can be maintained and used for the new tenant.
Cash payments by the real estate owner to persuade new tenants to lease the property are capitalized and amortized over the lease term. Tenants include these payments as current income creating an unsatisfactory tax result for each party. Other benefits paid by the owner to the tenant, such as moving expenses, are treated similar to cash payments. The owner should consider reducing the monthly rent over the term of the lease instead of these lump sum inducements. Another option for the real estate owner is to structure the payment as a loan to the tenant with arms-length interest and repayment terms.
If the tenant requires money from the real estate owner to adjust the retail space to its specifications, the owner should consider paying construction allowances to the tenant under specific safe harbor rules. These payments are not included into income by the tenant and capitalized as real estate property by the real estate owner. The cash must be paid in connection with a short term lease (i.e. less than 15 years) of retail space and must be for the purpose of the tenant constructing or improving qualified real property for their business in the retail space. These allowances need to be disclosed by both the real estate owner and tenant in a statement on their respective tax returns.
Rent holidays are a common enticement for new tenants. The owner should be careful to structure the rent holiday to meet safe harbor rules. Otherwise the rent over the term of the lease will be recognized evenly despite the fact that cash has not been received.
To learn additional tax planning ideas for commercial real estate owners, contact Toby Kaye at mailto:firstname.lastname@example.org 330.315.7805, or your trusted advisor at 330.867.7350.