IRC 110 Exclusion: Lease Term, Retail Space, and IRS Filings

The IRC Section 110 construction allowance lets a commercial tenant leave a landlord-funded build-out payment off the tax return, but only when three conditions line up: the lease runs 15 years or less, the space is retail, and the lease itself designates the money for permanent improvements the tenant actually spends it on during the year it’s received.¹ Miss any one of them and the whole allowance becomes ordinary taxable income to the tenant.

The trade-off for the exclusion is real. The improvements are treated as the landlord’s property, so the tenant gets no depreciable basis in the portion funded by excluded dollars.¹ Cash now, no cost recovery later.

The 15-Year Lease Term

Section 110 defines a short-term lease as one running 15 years or less, and it uses the lease-term rules of Section 168(i)(3) to do the counting. Those rules generally require adding tenant renewal options to the base term.² A 10-year lease with two five-year renewal options totals 20 years and is out.

There is one carve-out that matters. Renewal options that reset to fair market rent, determined at the time of renewal, do not count toward the 15-year limit for nonresidential real property.² So a 12-year lease with a fair-market-rent renewal option stays a 12-year lease for Section 110 purposes. A renewal option locked to a predetermined rent does count. This distinction is where a lot of otherwise qualifying deals die at drafting.

What Counts as Retail Space

The space must be used in a trade or business of selling tangible goods or services to the general public.¹ “Retail” reads narrower than the statute actually is. The IRS final regulations count services sold to the public and specifically list doctors, lawyers, accountants, hair stylists, insurance agents, stock brokers, financial advisors, and bankers as qualifying.³ Targeting a specific clientele is fine as long as the offering is available to the public.

Supporting areas inside the same leased premises count too: back offices, storage rooms, and employee lounges.³ What doesn’t qualify: a corporate headquarters not open to the public, a manufacturing plant, a distribution warehouse. What controls is the activity at that leased location, not the tenant’s broader corporate identity.

The Purpose Clause and How the Money Is Spent

The lease itself must state that the allowance is for constructing or improving “qualified long-term real property” for use in the tenant’s business at the retail space. A generic “tenant improvement allowance” clause is not enough. The IRS treats this lease language as the mutual acknowledgment between landlord and tenant that the improvements will be owned by the landlord.⁴ Track the statutory language closely when drafting.

Qualified long-term real property means nonresidential real property located at the retail space that reverts to the landlord at lease end.¹ Think permanent, structural interior work. Movable trade fixtures, furniture, and equipment the tenant will take on the way out do not qualify.

Timing matters as much as category. The exclusion only covers amounts the tenant actually spends on qualifying improvements during the tax year the allowance was received.⁵ Receive $200,000, spend $150,000 on qualifying work by year-end, and the remaining $50,000 is taxable. Same result for any dollars that went to moving expenses, equipment, or other non-qualifying items.

What the Tenant Gains and Gives Up

The gain is straightforward. The qualifying portion of the allowance stays off the return, freeing up cash during a build-out phase when expenses are heaviest and revenue often hasn’t started.

The cost is on the back end. Because Section 110(b) treats the improvements as the landlord’s property, the tenant has zero depreciable basis in the portion of the construction funded by the excluded allowance.¹ No depreciation, no cost recovery. Claiming depreciation on that portion anyway is a familiar audit trigger.

When the tenant puts their own money in on top of the allowance, the basis splits. On a $100,000 build-out with $60,000 from the landlord and $40,000 from the tenant, the tenant’s depreciable basis is $40,000. That $40,000 portion will typically be 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 structural framework.⁶ QIP carries a 15-year recovery period.

Because the split determines what is depreciable and what isn’t, tenants need to trace every construction dollar to either the allowance or their own funds. Sloppy records here are where the depreciation deduction gets challenged.

What the Landlord Has to Do

Section 110(b) requires the landlord to treat the improvements as their own nonresidential real property.¹ The allowance is a capital expenditure added to the landlord’s basis in the property, not a current expense. The landlord is treated as having constructed the improvements at a cost equal to the allowance paid, and the interior improvements will generally be QIP for the landlord as well.⁶

This matters to the tenant because if the landlord tries to expense the allowance instead of capitalizing it, the symmetry Section 110 requires breaks and the IRS may reclassify the allowance as taxable rental income to the tenant. Before signing, confirm the landlord intends to follow the capitalization requirement, and consider a lease clause committing both parties to the tax treatment.

What Both Parties File With the IRS

Section 110(d) requires each side to furnish information to the IRS about the allowance.¹ The Treasury Regulations require each party to attach a statement to their timely filed federal income tax return, including extensions, for the year the allowance is paid or received.³

Each statement identifies the filing party (name, EIN, taxable year), the counterparty (name, address, EIN), the location of the retail space (including mall or strip center and store name where applicable), the total construction allowance, and the amount being treated as nonresidential real property by the landlord or excluded under Section 110 by the tenant. A party with more than one qualifying allowance in the same year can combine them into a single statement.³

Keep the lease, payment records, construction invoices, and filed statements for as long as the depreciation schedule stays open. For the tenant, records tracing the source-of-funds split matter most if the depreciable basis is ever questioned.

Where These Deals Fall Apart

Renewal options are the most mechanical failure. Business teams negotiate them for flexibility and push the total term past 15 years without realizing that only fair-market-rent options are excluded from the count.² Fixed-rate options add directly.

A weak purpose clause is the next common failure. Language that doesn’t specifically tie the funds to qualified long-term real property gives the IRS room to reclassify the entire allowance as taxable rent.

Spending the money on the wrong things breaks the exclusion even when the lease is drafted well. Movable furniture, equipment, and tenant-removable trade fixtures are not qualified long-term real property, so those dollars become taxable. Any portion of the allowance still unspent when the tax year closes doesn’t qualify either.⁵

And the landlord’s tax treatment can pull the tenant down. If the landlord expenses the allowance instead of capitalizing it, the tenant’s exclusion is at risk regardless of how carefully the tenant handled everything on their side.

1
Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases
2
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
3
Internal Revenue Service. TD 8901 – Qualified Lessee Construction Allowances for Short-Term Leases
4
Internal Revenue Service. Revenue Ruling 2001-20 – Section 110 Qualified Lessee Construction Allowances
5
eCFR. 26 CFR 1.110-1 – Qualified Lessee Construction Allowances
6
Legal Information Institute (LII) / Cornell Law School. 26 USC 168(e)(6) – Definition of Qualified Improvement Property