If you plan on getting into the real estate investment game, you need to understand what goes into and is allowed under a tenant improvement allowance. Commercial spaces are great for renting out to tenants, but knowing what those tenants require from the space ― and enabling them to ensure the space works for them ― is the difference between short- and long-term tenant relationships.
Similarly, as a tenant. You also want to know what you can and cannot do in your space to make sure your landlord is happy with you and willing to rent to you for a longer stretch of time. Here’s everything landlords or tenants should know about tenant improvement allowances to ensure they negotiate favorable terms and can build the best partnership situations to thrive in an ever-more competitive market.
What is a Tenant Improvement Allowance?
Also called a TI, TA, or TIA, a tenant improvement allowance is a pre-negotiated sum of money that a landlord will provide to a tenant to cover construction costs related to leasehold improvements. These include any structural, layout, or decorative changes a tenant needs to successfully carry out their business efforts during their lease.
Here are a few things to keep in mind:
- These TIAs are typically paid directly to the vendors on behalf of the lessee.
- They are explicitly stated in the lease agreement as either a lump sum or a per square foot amount.
- In some instances, the landlord can also award a tenant with “free rent,” an arrangement that allows the tenant to use the extra money to pay for updates on the space.
In general, landlords are likely to prefer that the tenant improvement allowance amount cover necessary construction costs, while tenants typically try to expand these TIAs to cover additional expenses like legal, architectural, and permit fees.
These improvement allowances are often designed to cover costs related to:
Construction Costs
Your landlord will allow a TIA to be spent on both hard costs (materials and labor) as well as soft costs involved in the construction process. These costs typically include:
- Plumbing
- Electric
- Paint and carpet
- HVAC
- Windows and doors
- Space plans
- Construction plans and drawings
- Permit fees
- Fixtures
- And more
These construction efforts are intended to improve the structure of the space to ensure the tenant is able to properly carry out their business efforts in the office space or commercial space. As a tenant, you may need to negotiate the dollar amount you are allocated as part of your improvement allowance to ensure the space will be able to work for you. As a landlord, you may want to be flexible about the total TI allowance to keep your tenant happy and help allow its team to build the solutions it needs to operate at its best.
Built-Out Costs
In general, a landlord is only willing to reimburse for a tenant improvement that increases the building’s value or maximizes its square footage. As a result, decorations and furniture are often not covered. If the renovations can benefit the building, however ― even if they are specifically designed to help the tenant’s brand ― then the expenses will most likely be recovered.
These can include:
- New flooring
- Upgraded doors
- New walls
- Updated lighting
Such costs may be included in the tenant improvement allowance because landlords want their spaces to keep tenants happy throughout the lease, but they also want to keep their commercial space or office space looking its best to attract a subsequent commercial lease once the tenant vacates. As such, the landlord may approve an amount of money to be given to the tenant for build-out costs if he or she feels the improvement will up the rental rate in the future or keep the space relevant in the real estate market.
Miscellaneous Expenses
Landlords do not usually cover miscellaneous costs that benefit the tenant more than them, but they may be more willing to contribute a small portion of a TIA to some of them in select situations. One such situation might be if they are trying to get the tenant to lease the space, for example, and miscellaneous expenses may include:
- IT cabling and data services
- Moving costs
- Architect and attorney fees
Due to the considerable cost involved with real estate improvements, the landlord will typically place restrictions on the TIA and what it can and cannot be used for. Some of these stipulations can be negotiated, but both parties would have to be relatively flexible to find an agreement that allows each to receive benefits from the arrangement.
Do Commercial Real Estate Owners Have a Say in How Tenants Use TIAs?
Usually, a commercial real estate owner will provide the tenant a TIA and give them free reign to choose the contractors and control the construction process. This does not work for all landlords, though, and there are options available for a more hands-on approach. Real estate owners who are looking for ways to ensure their tenants stay within specific commercial space requirements may consider the “turnkey build-out” option, for example, which allows landlords to manage the construction process and remain responsible for all construction project elements.
If the tenant insists on using its own contractor, a commercial real estate owner can remain in control by taking the following steps:
- Requiring the tenant to get approval from them on all contractors, plans, suppliers, construction contracts, and specifications.
- Monitoring the work that is performed to make sure it conforms to the plans and specifications.
- Requiring the tenant to indemnify them against construction liens for the work to be done.
These actions can give the owner peace of mind that they will have a say in how a tenant uses its tenant improvement allowance and ensure the construction fits their specific requirements.
How Tenants Adhere to TIA Rules
As a tenant, if you want to be sure you adhere to any rules regarding TIAs. You need to consider the following:
- DO NOT enter into a lease providing an allowance until you have final space plans and estimates for the work. This can assure that the desired changes can be completed with the available funds.
- DO confirm whether the landlord will provide necessary cash flow on a pre-determined basis or if they will pay the improvement allowance after the project is complete, essentially reimbursing for the work.
- DO discuss your plans and ideas with the landlord before construction begins to ensure your total dollar amount of projected work and TI allowance coincide.
It is also important to speak with a TIA expert no matter how your TI allowance is being managed. These professionals can help you make sure you are making the most out of your arrangement, receive tenant improvement allowance that will fit your needs, can negotiate as required, and that the terms of the agreement you get are fair.
Are TIAs Taxable?
Tax considerations for leasehold improvements typically focus on which party ends up paying for the changes and which ends up retaining ownership of them. Consequently, the party that pays and owns the improvements may take the depreciation deductions, but sometimes determining ownership is not as obvious and depends on several factors.
As a result, the parties in the lease need to consider including specific provisions in their agreement to ensure they document the intent as to who retains ownership of any changes made during the lease. Consider some of the following options:
- The landlord pays, owns, and depreciates the improvements. There are no tax consequences to the tenant.
- If the improvement is tenant-specific and will be abandoned when the lease terminates, then the landlord is entitled to deduct the remaining tax basis in capitalized leasehold improvements if the changes will not be used again.
- If a landlord constructs and owns the improvements and the tenant reimburses him or her as a substitute for rent under the lease, then the landlord must then recognize rental income for the amount of the reimbursement and depreciate the improvements as its own assets.
- If the tenant makes, uses, and owns the improvements, and the landlord does not reimburse them, then the landlord has no taxable income. Instead, the tenant is treated as the owner of these improvements, and may claim abandonment loss for the remaining tax basis if they are left behind when the tenant vacates the space.
These lease transactions can produce significant tax savings, which is why landlords and tenants must carefully consider all their options and ensure their tax positions align with them before beginning any improvement projects.
Tenant Improvement Allowance Done Right: Leave It to the Experts
TIAs do not need to be complicated as long as all relevant contingencies are adequately addressed before tenant improvement construction begins. They can be a huge perk for both parties in a lease, helping a tenant maximize the square footage of their rented commercial or office space and giving the landlord a leg up in renovations that keep its building relevant in the real estate market.
Contact The Genau Group today to speak with an expert about any tenant improvement allowance questions you might have.
