In this case, William owns a building and it is leased to Lester’s Machine Shop. The lessee needs to rewire the building so that it can accommodate new equipment. The estimated total cost of wiring the building is $4,000. Also, it is anticipated that the value of the building will not go up because the wiring is only used in relation to the new equipment. Instead of losing the lessee, William allows Lester to rewire the building and he forgoes one month’s rent ($1,000) if Lester will incur the cost of wiring. The lessee agrees to the offer because they don’t intend to move out of the building.
In lease agreements, there are always concerns about which party records improvements on the building in the gross income for tax purposes (Ward and Smith, P.A. 2). In the case above involving William, the lessor and Lester Machine Shop the lessee, there is a need to determine who includes the suggested improvements within the gross income. According to Section 109, “gross income does not include income (other than rent) that is received by a lessor of real property on the termination of a lease, representing the value of such property attributed to building erected or other improvements made by the lessee” (Legal Information Institute 1a). Further, Regulation Section 1.109-1, states that the exclusion applies only with respect to income that is recognized by the owner of the building once the lease is terminated (Legal Information Institute 1b). The law does not have an application to income that is generated in form of rent that is earned by the owner of the building during the lease period and is ascribed to building put up or upgrading that is made by the lessee. These two sections indicate that the value of improvements to real property should be included in gross income if the lessee makes the improvements in lieu of rent (Frecknall-Hughes 201).
In the case CIR v. Grace H. Cunningham, 2AFTR 2nd 5511, 58-2 USTC Par 9771 (9th Cir., 1958), the lessee did not pay rent but he was accountable for the payment of taxes on the land (Vlex.Com. Case Law 1). The Commissioner argued that the erection of the building as an improvement constituted rent. However, the building was not constructed on the basis that it was to be in lieu of rent. Therefore, the intention was not determinative. The court ruled that there was no income to the lessor because the improvements made did not increase the value of the property. In this case, the rewiring will benefit the lessee. Further, the two parties agreed that the lessee will pay the total cost of $4,000 while the lessor will forgo one month’s rent amounting to $1,000. Considering the provisions presented in Section 109 and Regulations Section 1.109-1, and the ruling in the case, the agreement allows Lester to substitute payment of $1,000 for rent in order to rewire the building. Therefore, William should include $1,000 for gross income despite the fact that the rewiring costing $4,000 did not increase the value of the property (Chirelstein and Zelenak 105).
Works Cited
Chirelstein, Marvin, and Lawrence Zelenak. Federal Income Taxation, USA: Foundation Press, 2015. Print.
Frecknall-Hughes, Jane. The Theory, Principles and Management of Taxation: An Introduction, USA: Routledge, 2014. Print.
Legal Information Institute. 26 CFR 1.109-1 – Exclusion from Gross Income of Lessor of Real Property of Value of Improvements erected by Lessee. 2016. Web.
Legal Information Institute. 26 U.S. Code § 109 – Improvements by Lessee on Lessor’s Property. 2016. Web.
Vlex.Com. Case Law – Commissioner of Internal Revenue, Petitioner, v. Grace H. Cunningham, Eugene F. Cunningham and Grace H. Cunningham, Respondents., 258 F.2d 231 (9th Cir. 1958). 2016. Web.
Ward and Smith, P.A. Before Executing a Commercial Lease, Landlords and Tenants Need to Understand the Tax Consequences of the Lease Terms. 2015. Web.