Question

Our Understanding of the Facts:

Samantha owns a nonresidential commercial building. Prior to 2008, the building had been used as office space. In 2008, she leased the entire building to HRV Corporation under a ten-year lease. HRV intended to use the building as an audio and video production studio. The lease specified that at the end of the lease term (2018), HRV had to restore the building to its original condition if any modification were made. During the lease term HRV had made substantial modifications to the interior of the building so that HRV could use the building as an audio and video production studio. Those modification cost HRV approximately $975,000.

At the end of the lease, HRV approached Samantha in an attempt to have the restoration clause nullified. HRV argued that the improvements made to the building enhanced the building’s value by at least $300,000. Samantha disagreed as the modification were specific to HRV’s usage of the building and potential tenants might not find them useful. After some negotiations, Samantha agreed that HRV could pay her $200,000 to be released from the restoration requirement. Samantha has come to you as her tax advisor to determine the Federal Income Tax treatment of accepting HRV’s $200,000 payment.

ACCORDING TO THIS, is the 200,000 payment included in Samantha’s GI?

Answer 1

As per the 26 CFR 1.109-1 - Exclusion from gross income of lessor of real property of value of improvements erected by lessee. of IRS, Income derived by a lessor of real property upon the termination, through forfeiture or otherwise, of the lease of such property and attributable to buildings erected or other improvements made by the lessee upon the leased property is excluded from gross income. However, where the facts disclose that such buildings orimprovements represent in whole or in part a liquidation in kind of lease rentals, the exclusion from gross income shall not apply to the extent that such buildings or improvements represent such liquidation. The exclusion applies only with respect to the income realized by the lessor upon the termination of the lease and has no application to income, if any, in the form of rent, which may be derived by a lessor during the period of the lease and attributable to buildings erected or other improvements made by the lessee. It has no application to income which may be realized by the lessor upon the termination of the lease but not attributable to the value of such buildings or improvements. Neither does it apply to income derived by the lessor subsequent to the termination of the lease incident to the ownership of such buildings or improvements.

Also as per law, If the lessee makes, in good faith, useful improvements which are suitable to the use for which the lease is intended, without altering the form or substance of the property leased, the lessor upon the termination of the lease shall pay the lessee one-half of the value of the improvements at that time. Should the lessor refuse to reimburse said amount, the lessee may remove the improvements, even though the principal thing may suffer damage thereby. He shall not, however, cause any more impairment upon the property leased than is necessary.

In the case of Boston Fish Market Corporation, Fulham and Maloney, Inc., Petitioners v. Commissioner of Internal Revenue, Respondent, 57 T.C. 884, the court found that the money was taxable to the extent that it exceeded the undepreciated basis of the leasehold improvements destroyed, removed, or disconnected by the tenant. The court found that I.R.C. § 109 provided only for the exclusion of income in the form of buildings and other improvements built by a tenant that inured to a landlord at the termination of a lease.

So, the payment of $200,000 was includable in Samantha's GI to the extent that it exceeded the undepreciated basis of the leasehold improvements destroyed, removed, or disconnected by the tenant.