Tenant Inducements for Real Estate
Landlords often offer inducements, most commonly to commercial tenants, in order to incentivize them into signing new long-term leases or to encourage lease renewals. Some of the common types of inducements include the following:
- Free rent period;
- Landlord-paid renovations;
- Allowances for renovations, improvement to the space, moving costs, and furnishings.
The accounting and tax treatments for tenant inducements can differ and the treatments may not follow the actual cash flows. Also, the treatment of an inducement by the tenant does not always match that of the landlord. The following covers the accounting and tax treatments for the different types of tenant inducements, from both the perspective of the landlord as well as the tenant.
FREE RENT PERIOD
Accounting treatment: If the lease includes a free rent period, the total expected rent by the landlord for entire lease is recognized on a straight-line basis over its term (including the rent-free period). A receivable would be set up during the free rent period, which is then reduced as rent is collected from the tenant. The tenant also recognizes the rent, but as an expense, on a straight-line basis over the term of the lease (including the free rent period).
As an example, if the term of the lease is 23 months and includes one month of free rent for a total of 24 months, with monthly rent set at $12,000 per month, the landlord would recognize rent of $11,500 per month (23 months x $12,000 / 24 months).
Tax treatment: This type of inducement is generally ignored since there is no actual cash outlay for the free rent period. Rental revenue (for the landlord) and expense (for the tenant) are reported based on the actual cash received and paid, respectively.
Accounting treatment: For the landlord, any immediate cash outlay for renovations is generally recorded as an asset and expensed over the term of the lease. For the tenant, there is no impact if the renovations are made on an asset owned by the landlord.
As an example, if the landlord paid for renovations costing $30,000 and the lease with the tenant lasts for 5 years, the landlord would initially capitalize the $30,000 inducement and then expense $6,000 of the capitalized cost annually for 5 years.
Tax treatment: In limited circumstances, the renovation may be considered a capital improvement if the landlord directly incurs the renovation costs. However, tax treatment may differ depending on the landlord’s overall rental operations. If a landlord is in the commercial rental business with multiple tenants, the renovation costs may be deductible in the year incurred if the landlord incur such costs in the ordinary course of operations. For the tenant, there is no tax impact if the renovations are made on an asset owned by the landlord.
ALLOWANCES FOR RENOVATIONS, IMPROVEMENT TO THE SPACE, MOVING COSTS, AND FURNISHINGS
Accounting treatment: For the landlord, allowances paid to the tenant for various expenses such as moving costs or décor require an immediate cash outlay. As such, they have the same accounting treatment as landlord-paid renovations. This means that the landlord would record an asset and amortize the expense over the term of the lease. For the tenant, the allowance received would be recorded as deferred revenue and then amortized over the term of the lease. However, in situations where the purpose of the allowance is for capital improvement, the amount can be treated as reduction of the related improvement.
Tax treatment: For the landlord, an allowance paid to the tenant for purpose that is not capital in nature (moving costs, for example) is generally deductible when paid or deductible over the term of the lease. For the tenant, the general rule is that allowance paid by the landlord is taxable in the year it was received. However, if the allowance is for purpose that is capital in nature (making leasehold improvement, for example), the tenant can elect to treat the amount as reduction of the cost of the property improvement.
In summary, there could be significant differences between the accounting and tax treatments for landlords, while for tenants the accounting and tax treatments are generally similar.
The proper treatment of tenant inducements requires careful analysis of the specific facts of the situation. The information presented above is not meant to be a comprehensive discussion of the accounting and tax reporting requirements for tenant inducements. If you have any questions regarding tenant inducements, please visit the Smythe Real Estate & Construction webpage at https://www.smythecpa.com/industries/real-estate-construction/ for contact information for our Smythe advisors.