Get Piece of Tenant's Assignment Profit

Your leases may require your tenants to share their assignment profit with you. Unfortunately, tenants sometimes take steps to structure their assignments in a way that artificially lessens the assignment profit and deprives you of your fair share.

To get your fair share of an assignment profit, make sure that your lease protects you from a tenant who might try to mask its assignment profit, says New York City attorney Aaron C. Kinderlehrer. Even if the leasing market is weak and assignment profits are less likely, it's best to be prepared. To do that, Kinderlehrer suggests using the Model Lease Clause on p. 3.

Stop Tenant from Inflating Costs

If your lease lets you share in the tenant's assignment profit, you'll typically calculate this share by multiplying the assignee's assignment payment by a certain percentage. But the tenant will demand that you first let it subtract its costs, such as broker's and attorney's fees, from the assignment payment. The tenant will also want to subtract any portion of the assignment payment that was payment for its personal property, such as furniture. With a strong tenant, you may have to give in on that point. This is the type of arrangement assumed by our Model Lease Clause [Clause, pars. a & b].

But you can get burned with this arrangement: The tenant could cut the assignment profit by inflating the costs and payments it subtracts from the assignment payment. As a result, there's less assignment profit to share with you, says Kinderlehrer.

Here are three ways the tenant might try to inflate its costs and payments, and solutions you can use to stop it from doing so:

1) Hidden profit from fully or partially unamortized property. A tenant who assigns its lease might sell or rent its personal property—such as its used copy machine, furniture, or other equipment—to the assignee. The sale or rental price is often included in the assignment payment. Usually, you'll agree to let the tenant deduct the sale price or rental charge from the assignment payment, says Kinderlehrer. But suppose the sale or rental price is set much higher than the amount necessary to recover the tenant's “unamortized” or “undepreciated” costs for the equipment—that is, the amount of its costs that the tenant hasn't yet recovered through amortization or depreciation on its federal tax return. If the tenant deducts the inflated sale price or rental charge, you'll lose out on your share of assignment profit from the sale or rental of the equipment.

Example: An assignee pays a $5,000 assignment payment to the tenant. This payment includes $1,000 for the tenant's furniture. The tenant deducts the furniture sales price from the assignment payment, leaving $4,000 ($5,000 – $1,000) on which you figure your percentage of assignment profits. But the used furniture has an unamortized value of only $500. You lose out on your share of the $500 profit the tenant made from the unamortized furniture sale.

Solution. Say that the tenant can subtract only the amount necessary to recover the unamortized or undepreciated cost of its personal property that it sells or rents, says Kinderlehrer. And to prevent disputes about the amount, say that the unamortized or undepreciated cost of the property must be based on the tenant's federal income tax return [Clause, par. b(iv)–(v)].

Example: In the example above, the unamortized cost is $500. The assignment profit after deducting only the unamortized furniture cost would be $4,500 ($5,000 – $500). Now you can share on the $500 profit the tenant made from the unamortized furniture sale.

Practical Pointer: Why would the assignee agree to pay too much for the furniture? Most assignees are interested only in the size of their payment; they don't care how the tenant allocates the payment between the assignment and the tenant's property, Kinderlehrer explains. So to cut the assignment profit, the tenant could allocate too much money to the furniture costs and leave the assignee with the same payment, he says. For instance, instead of requiring the assignee to pay $35 per square foot for the assignment and $500 for the furniture, the tenant may require the assignee to pay $34 per square foot for the assignment and $1,000 for the furniture.

2) Hidden profit from sale or rental of improvements. A tenant will often demand that you let it deduct from the assignment payment the unamortized value of any improvements it made to the space, says Kinderlehrer. But suppose you paid for part or all of those improvements—say, by giving the tenant a tenant improvement allowance (TIA). If the tenant deducts the unamortized value of the total cost of the improvements, including the TIA, from the assignment payment, it will unfairly benefit from your money, he warns.

Example: The improvements to the space cost $5,000. You gave the tenant a TIA of $2,000. Halfway through the lease term, the tenant assigns its lease. The assignee pays a $10,000 assignment payment. Using a straight-line amortization method, the unamortized amount of the improvements is $2,500. The tenant deducts the unamortized amount of the improvements from the assignment payment, leaving $7,500 ($10,000 – $2,500) to share with you.

Solution. If you permit a deduction for improvements, require the tenant first to subtract the full amount of the TIA from the unamortized amount of the improvements, says Kinderlehrer. Again, say the unamortized amount must be based on the tenant's federal tax returns [Clause, par. b(iii)].

Example: Assume the same facts as above, but the tenant must now subtract the $2,000 TIA from the unamortized amount of the improvements, leaving $500 ($2,500 – $2,000). The tenant can subtract only $500 from the assignment payment of $10,000, leaving $9,500 ($10,000 – $500) to share with you.

Practical Pointer: If the tenant already paid back some of the TIA through its rent during the lease, expect it to demand that only the as-yet unpaid amount—not the full amount—of the TIA be subtracted from the unamortized amount of the improvements, says Kinderlehrer. This is a point you'll have to negotiate, he says.

3) Hidden profit from transaction costs. The tenant will likely demand the right to deduct its transaction costs associated with the assignment—such as broker's commissions, attorney's fees, alteration costs (to make the space ready for the assignee), and advertising fees it paid in connection with the assignment payment, says Kinderlehrer. But the tenant could end up subtracting unreasonably high costs or costs that the tenant claimed to have paid, but didn't, he warns. Either way, there's less assignment profit to share with you.

Solution. If you agree to let the tenant deduct any of its transaction costs, to protect yourself, make sure that:

• The tenant's transaction costs are “reasonable,” so the tenant can't deduct unusually high costs, says Kinderlehrer [Clause, par. b(i)];

• The tenant's transaction costs have been paid to parties that aren't related to the tenant, says Kinderlehrer [Clause, par. b(i)]. A related party could be in cahoots with the tenant and bump up its cost to help the tenant reduce the assignment profit;

• The tenant actually has paid the transaction costs before it deducts them, says Kinderlehrer [Clause, par. b(i)]. To find that out, give yourself the right to make the tenant give you any information necessary to verify its transaction costs—such as bills and invoices, he advises [Clause, par. c]; and

• For alteration cost deductions (that is, the money the tenant spent altering the space for the assignee), the tenant has used the alteration cost figure it listed in its federal income tax returns, says Kinderlehrer. That will stop the tenant from inflating its alteration cost, he explains [Clause, par. b(ii)].

Practical Pointer: The tenant may also request that it be allowed to deduct any real property transfer tax (if your state requires it) and/or transfer fee (if the lease requires it), warns Kinderlehrer. You'll have to negotiate those points, he adds.

Make Tenant Amortize Costs over Installment Payment Period

There's another possible block to your assignment profit. Suppose the tenant can deduct certain costs from the assignment payment, but the assignee is paying the tenant the assignment payment in installments. Because the tenant doesn't have to pay you your share of the profits until it gets the assignment payment, you won't get any share of the assignment profit in the early stages of the assignment unless the deductible costs are amortized on a straight-line basis over the installment payment period, says Kinderlehrer.

Example: The tenant assigns its lease. The assignment payment is $36,000, including $2,000 to cover the unamortized cost of the tenant's furniture sold to the assignee. The tenant also spent $10,000 in transaction costs. The assignee will pay the tenant monthly installments of $1,000 over three years. Without deducting the tenant's costs, if you and the tenant are splitting the assignment profit, you would get $500 of each monthly installment ($1,000 × 50%). If you agree to deduct the tenant's costs, but they aren't amortized, the tenant will claim that there's no assignment profit for the first year, since it would take 12 months to recover its costs of $12,000 ($10,000 transaction costs + $2,000 unamortized furniture cost).

Solution. Require the tenant to amortize its costs over the entire installment payment period [Clause, par. d]. While the total amount of profit, and your share of it, is the same with or without the amortization, this solution lets you start collecting your share right away.

Example: Assume the same facts as above, but now the tenant's costs are amortized on a straight-line basis over the payment period. The tenant may only deduct $333 per month ($12,000 costs ÷ 36 months) of its costs from each installment of the assignment payment. The monthly assignment profit is $667 ($1,000 – $333). You get your share—$333 ($667 x50%)—starting with the first month after the assignment.

CLLI Source

Aaron C. Kinderlehrer, Esq.: Partner, Siller Wilk LLP, 675 Third Ave., New York, NY 10017-5704; (212) 421-2233; akinderlehrer@sillerwilk.com.