rr-01-20.pdf

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# Part I

Section 110 .-- Qualified Lessee Construction Allowances For Short-Term Leases
26 CFR 1.110-1: Qualified lessee construction allowances.
(Also § 61; 1.61-1.)

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 § 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 X's business at the retail space located at Y's
shopping center.

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During X's 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 § 110(a) and which reverts to the lessor at the termination of the lease.

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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 § 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 § 1.110-1(b)(3), an amount is excluded from
gross income under § 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 § 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 § 1.110-1(b)(3) does not require a lease agreement to provide that the

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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 § 110(a).

HOLDING

The purpose requirement under § 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 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 on (202) 622-3040 (not a toll-free
call).