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Expenditure Structuring in Connection with Tenant Leases

Unemployment and underemployment rates have increased (although now relatively stable), certain tenants are downsizing and need less space, vacancies have increased, rents have decreased and more sublease space is on the market.

All of these factors, when combined with increasing cap rates and general uncertainty, have contributed to a precipitous drop in real estate values.

With the downturn in the metropolitan NYC real estate market, owners of office buildings (“lessors”) are dealing with tenants that have (or feel they have) the upper hand in lease negotiations.

In this environment it is particularly important for lessors to structure lease costs or incentives in a tax advantageous manner. There are potential alternatives to consider in structuring amounts incurred by a lessor in connection with new or renewal leases.

The overall goal is to structure the expenditures in such a manner to either accelerate deductions, or at the very least, match the timing of the deduction and resulting tax benefit to the period over which rental income is recognized.

Amounts paid to or on behalf of a tenant for improvements to the leased premises and for tangible property (collectively, “TI’s”) are capitalizable and the costs are either depreciable or amortizable depending on the structure and facts and circumstances. Alternatives the lessor may consider include the following:

The cost of TI’s may be effectively funded through a “reasonable rent holiday” (rent abatement) during the lease term. Care must be exercised so that there is no inference in the documents that the abatement is for TI’s.

An “allowance” or inducement may be given to the tenant that in turn funds the tenant’s cost of the TI’s. A properly structured “lease inducement” is amortizable over the lease term.

The lessor may make a loan to the tenant payable over the lease term to fund the improvements.

In the less advantageous event that the lessor “builds out” the TI or the “allowance” is required to be used to fund the TI, the lessor will capitalize the cost and depreciate such cost over 5-39 years depending on the character of resulting assets. In this event, a “cost segregation study” may maximize the classification to shorter tax depreciation “lives.”

From a property owner’s perspective, it is always important to structure lease related costs in a tax advantageous manner.