What to Watch For in a Long-Term Lease

A long-term lease is one of the largest commitments a landlord or tenant makes, and the tax terms are often settled by default while everyone negotiates rent. These are the provisions worth reading twice, from either side of the table.

Who owns the improvements

Whoever owns the improvements for tax purposes generally depreciates them. That sounds simple until a lease is silent, or says one thing while the tenant pays for everything. Interior improvements to commercial buildings placed in service after the building itself is generally qualified improvement property, with a 15-year life that can qualify for bonus depreciation. Getting ownership right decides who gets those deductions.

Tenant improvement allowances

An allowance can be income to the tenant, a loan, or a landlord-owned improvement, depending on how it’s structured and spent. Retail tenants on leases of 15 years or less can often exclude a construction allowance from income under Section 110, if it’s spent on improvements the landlord owns. The lease language and the spending should match.

Uneven rent and Section 467

Section 467 can apply when total rent and other consideration exceed $250,000 and the rent schedule is uneven: it steps up, steps down, or is paid well before or after the period it covers. When it applies, both landlord and tenant may have to account for rent as it’s allocated or accrued rather than as it’s paid, and imputed interest can come into play.

Stepped rent. Fixed annual increases are common, and many cause no issue. Larger or irregular steps are what draw attention.

Free and deferred rent. A short rent holiday at the start of a lease, three months or less, is generally disregarded. Longer free-rent periods, or rent that isn’t payable until well after the period it covers, can create income and deductions on a schedule nobody planned for.

Long-term agreements. A lease longer than 75% of the property’s recovery period (19 years for buildings, so more than 14¼ years) with increasing or decreasing rent, where a principal purpose is avoiding tax, may have to spread rent on a level basis, whatever the lease says. Safe harbors exist, such as rent that stays within 10% of the annual average.

Amendments. A later change to fixed rent beyond a small amount can bring a lease back under review.

Ground leases and long terms

A leasehold of 30 years or more, including renewal options, can be treated as like-kind to owning the property outright for a 1031 exchange. Long terms also matter for property tax: in California, a lease of 35 years or more, counting options, is generally treated as a change in ownership that can trigger reassessment.

Sale-leasebacks: lease or financing?

A sale-leaseback, or a lease with a bargain purchase option or rent that looks like debt service, can be treated as a sale or a loan for tax purposes. That changes who depreciates the property and who deducts what. When the tenant, or someone related to it, held an interest in the property in the two years before the lease, uneven rent gets closer scrutiny under Section 467 as well.

Ending or changing a lease

Termination payments are taxed differently depending on who pays and why. A landlord who pays a tenant to leave generally amortizes the payment over the remaining term of the old lease. A tenant who receives one generally treats it as proceeds from selling the lease. A tenant who pays to get out usually creates ordinary income for the landlord.

When to get a second look

If a lease is large, long, uneven, or tied to a sale, review it while the terms are still open. Changing a rent schedule or an allowance clause in negotiation is easy. Recomputing years of income after the fact is not.