David M. Corbett is a certified public accountant with Canby, Maloney & Co. (www.canbymaloney.com) in Framingham.

The soft economy may have a negative impact on business owners, but they can at least take consolation in knowing that they may no longer have to pay top dollar for commercial space. In fact, for the first time in many years, landlords are making concessions to attract and keep commercial tenants.

While this is of course, good news for financially challenged business owners, it is important for both tenants and landlords to be aware of the tax implications of rent holidays, build-out allowances and other sweeteners.

By complying with new Internal Revenue Service regulations, commercial tenants can receive a construction allowance and the funds will not be considered to be taxable income. The landlord cannot deduct the cost of the allowance as a business expense, but must depreciate it as real property.

To qualify for this favorable tax treatment, the tenant must meet the following criteria:

The landlord may provide the allowance by advancing funds or providing a credit by reducing rent for a certain period. If the allowance exceeds the amount spent by the tenant, the difference will be treated as taxable income. If the tenant spends more than the landlord provides, the additional cost can be depreciated as a leasehold improvement.

The construction allowance can be used as reimbursement for improvements that have previously been made by the tenant, regardless of when the improvements were made, as long as the tenant has not already claimed depreciation deductions for the improvements.

Tenants should keep records verifying that the construction allowance was used for improvements, and should have the construction allowance agreement reviewed by an attorney to ensure that it complies with the regulations. A statement must be attached to both the tenant’s and landlord’s tax return explaining what was done for the year in which the construction allowance was paid.

Valid Allowance

Tenants who receive an allowance to pay for build out typically must follow construction specifications that are consistent for the entire building. In addition, they usually must hire contractors from a list of pre-approved vendors.

Unamortized leasehold improvements that are paid for by the tenant and left behind when the lease terminates can be deducted as a loss. However, the landlord does not have to pay taxes on the value of such improvements.

If lease rates are falling, it may be beneficial for the tenant to pay a cancellation fee to break a lease and to negotiate a new lease. In general, the tenant can deduct a lump-sum payment for canceling the lease, but the payment must be capitalized and amortized if the tenant enters into a new lease for the same space or purchases the space. For tax purposes, the landlord must treat the cancellation fee as income.

In some cases, the landlord may find it necessary to pay the tenant a lease termination fee, either to consolidate space for a larger tenant or to renovate the building. In such cases, if the lease is considered to be an asset of the business, the tenant may have to pay capital gains taxes on the termination fee.

In general, the landlord must amortize the termination fee over the remaining term of the canceled lease. In cases where the termination fee is paid solely to make room for a larger, more lucrative tenant, courts have held that the fee must be amortized over the term of the new lease. Unamortized improvements and lease acquisition costs remaining when the landlord disposes of the property are not tax deductible, but are considered to be part of the basis in determining the landlord’s gain or loss on the sale of the property.

Service Fees

Fees paid to attorneys, brokers and other professionals in conjunction with canceling a lease are generally deductible as part of the cost of canceling the lease. However, fees paid to professionals in connection with a new lease must be amortized over the term of the lease. Fees paid to professionals by the landlord in connection with the lease cancellation are deductible as a business expense, but fees paid in connection with enforcing a lease must be amortized over the term of the lease.

The tenant can deduct any unrecoverable portion of advance rent or a security deposit when leaving before the lease expires. The landlord must pay taxes on advance rent when it is received and on security deposits when the landlord has an unrestricted right to them.

Tenant concessions are limited only by the imagination of the landlord and tenant. The following are some of the other concessions that are often used to attract and retain tenants.

Rent holidays. Landlords often allow new tenants to lease space without paying rent, or to pay rent at a reduced rate, for a mutually agreeable period of time. This rent holiday can help a new business become established and develop cash flow before having to pay rent.

Section 467 requires both the landlord and tenant to treat rents consistently and to use the accrual method of accounting, even when they are using cash accounting for their business. The landlord cannot, for example, arrange to receive rent in a lump sum at the end of a lease and offset the rent with a loss. Tax returns must reflect the accrual of rent over the life of the lease, and both parties must consistently show how they are treating rent.

The rent holiday generally cannot exceed three months from the beginning of the lease term. If the rent holiday exceeds three months, it must be in line with local practice at the time it is provided and there must be a substantial business purpose for the rent holiday. For example, the tax court ruled that a Denver landlord could allow a rent holiday of 11-1/2 months in one case, because there was a high office vacancy rate in Denver at the time and the court determined that the lengthy rent holiday was needed to induce the tenant to lease space.

Interest must be included on amounts taken into account for previous tax years when taxes are not yet paid on those amounts.

Relocation allowances. Sometimes a landlord will induce a tenant to move by buying out an existing lease or sharing in the cost of moving. The cost of the buyout or relocation allowance is treated as income for the tenant. The landlord must amortize the allowance over the life of the lease, regardless of whether the cash method or accrual method of accounting is used.

While the tax treatment can sometimes be complicated, concessions provided for tenants are generally a good deal for the tenants and a good way for landlords to keep their space leased.