IRS Revenue Ruling
2001-20

Code Secs. 110, 61

<<FULL TEXT>>

26 CFR 1.110-1: Qualified lessee construction allowances.
(Also section 61; 1.61-1)

Qualified lessee construction allowances for short-term leases. The
purpose requirement under section 1.110-1(b)(3) of the Income Tax
Regulations does not require a lease agreement to provide that the entire
construction allowance is for the purpose of constructing or improving
qualified long-term real property. However, only the portion of the
construction allowance actually expended on qualified long-term real
property for use in the lessee's trade or business at the retail space may
qualify as a qualified lessee construction allowance.


REV. RUL. 2001-20

ISSUE

Must a lease agreement provide that an entire construction allowance is
for the purpose of constructing or improving qualified long-term real
property to satisfy the purpose requirement under section 1.110-1(b)(3) of
the Income Tax Regulations?


FACTS

X is in the business of selling tangible personal property to the
general public. On February 5, 2001, X and Y sign a 10-year agreement for
the lease by X of retail space located in Y's newly constructed shopping
center. The 10-year lease term starts March 1, 2001. A provision of the
lease agreement provides that Y will provide X with a construction
allowance in the amount of $1 million for the retail space. The lease
agreement provides that, to the extent the $1 million construction
allowance is spent on qualified long-term real property, it is for the
purpose of constructing or improving qualified long-term real property for
use in Xs business at the retail space located at Y's shopping center.
During Xs 2001 taxable year, X receives the $1 million construction
allowance and spends $800,000 on qualified long-term real property and
$100,000 on section 1245 property for the leased retail space located in
Y's shopping center. X is permitted to retain any excess over the amount
it actually spends improving the retail space.


LAW AND ANALYSIS

Section 61(a) of the Internal Revenue Code provides that gross income
means "all income from whatever source derived" except as otherwise
provided in subtitle A of the Code.

Section 110(a) provides a safe harbor excluding from gross income any
amount received in cash (or treated as a rent reduction) by a lessee from
a lessor under a short-term lease of retail space, for the purpose of the
lessee's constructing or improving qualified long-term real property for
use in the lessee's trade or business at the retail space, but only to the
extent that the amount does not exceed the amount expended by the lessee
for the construction or improvement (a qualified lessee construction
allowance).

Section 110(c)(1) defines the term "qualified long-term real property"
as nonresidential real property which is part of, or otherwise present at,
the retail space referred to in section 110(a) and which reverts to the
lessor at the termination of the lease. Section 1.110-1(b)(2)(i) further
defines qualified long-term real property as not including property
qualifying as section 1245 property under section 1245(a)(3). Section
110(c)(2) defines the term "short-term lease" as a lease (or other
agreement for occupancy or use) of retail space for 15 years or less (as
determined under the rules of section 168(i)(3)). Section 110(c)(3)
defines the term "retail space" as real property leased, occupied, or
otherwise used by a lessee in its trade or business of selling tangible
personal property or services to the general public.

Under the purpose requirement in section 1.110-1(b)(3), an amount is
excluded from gross income under section 110(a) only to the extent that
the lease agreement for the retail space expressly provides that the
construction allowance is for the purpose of constructing or improving
qualified long-term real property for use in the lessee's trade or
business at the retail space.

The intent of the purpose requirement in section 1.110-1(b)(3), which
requires the lease agreement expressly provide that the construction
allowance is for the purpose of constructing or improving qualified
long-term real property, is to ensure that the lessor and the lessee take
consistent tax positions. The requisite provision in the lease agreement
serves as an acknowledgment by the lessor and the lessee that, to the
extent the construction allowance is spent on qualified long-term real
property, the improved or constructed property will be treated as owned by
the lessor. The purpose requirement in section 1.110-1(b)(3) does not
require a lease agreement to provide that the entire construction
allowance is for the purpose of constructing or improving qualified
long-term real property. However, only the portion of the construction
allowance actually spent on qualified long-term real property may qualify
as a qualified lessee construction allowance. Accordingly, of the $1
million construction allowance provided by Y to X, $800,000 qualifies as a
qualified lessee construction allowance that may be excluded from income
under section 110(a).


HOLDING

The purpose requirement under section 1.110-1(b)(3) does not require a
lease agreement to provide that the entire construction allowance is for
the purpose of constructing or improving qualified longterm real property.
However, only the portion of the construction allowance actually expended
on qualified long-term real property for use in the lessee's trade or
business at the retail space may qualify as a qualified lessee
construction allowance.


DRAFTING INFORMATION

The principal author of this revenue ruling is Paul Handleman of the
Office of Associate Chief Counsel (Passthroughs and Special Industries).
For further information regarding this revenue ruling, contact Mr.
Handleman at (202) 622-3040 (not a toll-free call).

<<END RULING>>

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