The IRC Section 110 exclusion lets a commercial tenant leave a landlord’s construction allowance out of gross income, but only when the lease runs 15 years or less, the space is used to sell goods or services to the public, and the lease specifically designates the money for permanent improvements that the tenant actually builds during the same tax year.1Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases Miss any one of those conditions and the full allowance becomes ordinary taxable income to the tenant.
What the Lease and the Space Have to Look Like
Three conditions have to be satisfied together. They are mechanical, and the IRS treats them as all-or-nothing.
A Short-Term Lease of 15 Years or Less
Section 110 defines a short-term lease as 15 years or less, measured using the lease-term rules of Section 168(i)(3). Those rules generally require counting renewal options held by the tenant.2Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System A 10-year lease with two five-year renewal options totals 20 years and is disqualified.
One carve-out matters a great deal. For nonresidential real property, a renewal option that resets rent to fair market value at the time of renewal is not counted toward the 15 years.2Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System A 12-year lease with a fair-market renewal option is still a 12-year lease for Section 110 purposes. An option that locks in a predetermined rent, by contrast, adds directly to the term. If you are negotiating renewals, this distinction is where leases get saved or lost.
Retail Space
The leased premises must be used in a business of selling tangible goods or services to the general public.1Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases “Retail” is broader than storefront commerce. The IRS final regulations treat services sold to the public as qualifying and expressly list doctors, lawyers, accountants, hair stylists, insurance agents, stock brokers, financial advisors, and bankers as examples.3Internal Revenue Service. TD 8901 – Qualified Lessee Construction Allowances for Short-Term Leases A business can target particular clients and still qualify, as long as its products or services are available to the public.
Supporting areas inside the same leased premises — back offices, storage, employee lounges — count as part of the retail space.3Internal Revenue Service. TD 8901 – Qualified Lessee Construction Allowances for Short-Term Leases A corporate headquarters that does not serve the public, a manufacturing plant, and a distribution warehouse do not. What controls is the business activity at that leased location, not the tenant’s overall character.
Designated Purpose and Spent in the Same Year
The lease has to state expressly that the construction allowance is for building or improving “qualified long-term real property” for use in the tenant’s business at the retail space. A generic tenant improvement clause does not satisfy the statute. The IRS has described this lease provision as the formal acknowledgment between landlord and tenant that the improvements will be treated as owned by the landlord.4Internal Revenue Service. Revenue Ruling 2001-20 – Section 110 Qualified Lessee Construction Allowances
Qualified long-term real property means nonresidential real property located at the retail space that reverts to the landlord at the end of the lease.1Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases The improvements must be permanent and structural. Movable trade fixtures and equipment that the tenant takes when the lease ends do not count.
The exclusion only reaches amounts the tenant actually spends on qualifying improvements during the taxable year the allowance was received.5eCFR. 26 CFR 1.110-1 – Qualified Lessee Construction Allowances A tenant who receives $200,000 but spends only $150,000 on qualifying construction by year-end has $50,000 of taxable income. The same result follows for any portion spent on non-qualifying items like moving costs or equipment.
What the Tenant Gives Up in Return
The benefit is cash flow. The qualifying portion of the allowance never hits the tenant’s return, which helps during the build-out phase when expenses are highest and revenue often has not started.
The cost is depreciation. Because the improvements belong to the landlord under Section 110(b), the tenant gets zero depreciable basis in the portion of the construction funded by the excluded allowance.1Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases You cannot exclude the money on the front end and then write off the asset later. Claiming depreciation on that zero-basis portion is a common audit trigger.
When the tenant kicks in money of its own on top of the allowance, the basis splits. If a build-out costs $100,000, with $60,000 from the landlord and $40,000 from the tenant, the tenant’s depreciable basis is $40,000. That portion typically qualifies as Qualified Improvement Property under Section 168(e)(6), which covers interior improvements to nonresidential real property but excludes enlargements, elevators, escalators, and changes to the building’s structural framework.6Legal Information Institute (LII) / Cornell Law School. 26 USC 168(e)(6) – Definition of Qualified Improvement Property QIP carries a 15-year recovery period under MACRS. Careful recordkeeping is what makes the split defensible. Every construction dollar needs to be traced to either the allowance or the tenant’s own funds.
What the Landlord Has to Do
The landlord’s treatment is the mirror image. Section 110(b) requires the landlord to treat the improvements as its own nonresidential real property, which means the allowance payment is a capital expenditure added to the landlord’s basis, not a current deductible expense.1Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases The landlord is treated as having built the improvements at a cost equal to the allowance paid. The interior improvements generally qualify as QIP in the landlord’s hands as well.6Legal Information Institute (LII) / Cornell Law School. 26 USC 168(e)(6) – Definition of Qualified Improvement Property
This is the piece a tenant cannot ignore. If the landlord deducts the allowance as a current expense instead of capitalizing it, the symmetry Section 110 requires breaks, and the IRS can reclassify the allowance as taxable rental income to the tenant. Both parties then have audit exposure. Before signing a lease built around this provision, confirm the landlord understands and intends to follow the capitalization treatment, and put a clause in the lease committing both sides to it.
Reporting the Allowance to the IRS
Section 110(d) requires both parties to furnish information to the IRS about the allowance.1Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases The Treasury Regulations handle this through a statement each party attaches to its timely filed federal income tax return (including extensions) for the year the allowance was paid or received.3Internal Revenue Service. TD 8901 – Qualified Lessee Construction Allowances for Short-Term Leases
Each statement identifies both parties by name, address, and EIN, identifies the retail location (including mall or strip-center name and store name where applicable), reports the total construction allowance, and reports the amount the filer is treating as nonresidential real property (landlord) or as excluded under Section 110 (tenant). A party with multiple qualifying allowances in the same year can combine them in a single statement.3Internal Revenue Service. TD 8901 – Qualified Lessee Construction Allowances for Short-Term Leases
The lease agreement itself still has to carry the express purpose designation tying the allowance to qualified long-term real property; the IRS statement does not substitute for it.4Internal Revenue Service. Revenue Ruling 2001-20 – Section 110 Qualified Lessee Construction Allowances Keep the lease, payment records, construction invoices, and copies of the filed statements for as long as the depreciation schedule remains open. For the tenant, records that document the source-of-funds split between allowance and own money are what will carry an audit of the depreciable basis.
Mistakes That Disqualify the Exclusion
The lease term is the most mechanical failure point. Parties negotiate renewal options for flexibility without noticing they have pushed the total past 15 years. Only fair-market-value renewal options are excluded from the count for nonresidential real property; fixed-rate options add straight to the term.2Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
The purpose clause is the next weak spot. A general “tenant improvement allowance” line with no language specifically tying the funds to qualified long-term real property will not satisfy the statute. Tracking the statutory language in the lease is the safe approach.
Spending the money on the wrong things disqualifies those dollars even when the lease is drafted correctly. The exclusion is for permanent interior improvements that revert to the landlord. Money spent on movable furniture, equipment, or tenant-removable trade fixtures was never spent on qualified long-term real property. Any portion of the allowance unspent by the end of the tax year it was received is also taxable.5eCFR. 26 CFR 1.110-1 – Qualified Lessee Construction Allowances
And landlord noncompliance will undo the tenant’s exclusion. If the landlord expenses the allowance rather than capitalizing it, the structure Section 110 depends on no longer holds, and the tenant’s exclusion is at risk even if everything on the tenant’s side was done right.