With the changing work environment in recent years, many businesses are reconsidering their office spaces and current leases. This could include renegotiating leases, reducing or increasing space, or leasing a new space. While there are many things to consider before signing or modifying a lease for office space, one of the areas that should not be overlooked is tax implications. Some tax items to consider are how is rent deducted, if the lease is subject to IRS Section 467 (which applies additional rules), how improvements are treated and what happens if you cancel the lease early.

Background

Rent is defined as any amount paid for use of property that the taxpayer does not own. Depending on the taxpayer’s method of accounting and subject to a few exceptions, the taxpayer lessee can deduct rent expense if it is paid or incurred by them during the year in connection with their trade or business, is ordinary and necessary and the taxpayer has no equity and is not taking title of the property being leased.¹ However, any portion related to personal use is not deductible. Leases should be scrutinized to make sure they are not a disguised purchase, sale-leaseback or any type of arrangement that lacks economic substance as a rent deduction will not be allowed for those.

Section 467 Rental Agreements

Section 467 rental agreements provide additional rules. Section 467 kicks in for rental agreements for use of tangible property if:

• Payments aggregate more than $250,000²; and
• The agreement includes either deferred, prepaid or increasing or decreasing rent.³

One exception to the above is if there is rent holiday which is under three months or less at the beginning of the lease.⁴

When Section 467 applies, the lessee and lessor must treat rents consistently and use both the accrual method of accounting and time value of money principles regardless of if their overall method of accounting is not accrual.⁵ Both the lessor and lessee must accrue rent and consider interest on amounts that were taken into account for prior years and either accrued and unpaid or prepaid. This can create either interest income or expense for the lessee or lessor. The interest is calculated at 110% of the applicable federal rate at the time the agreement is entered into and is compounded semiannually.⁶

Improvements

Improvements made on leased property by the lessee should be capitalized if they are above de minimis thresholds. It is important to note that the improvement will be depreciated under the applicable IRS allowed recovery period based on the type of improvement made regardless of if the remaining period of the lease is shorter than the recovery period.⁷ Considerations should be made on the depreciable life of improvements, if they can be considered as qualified improvement property and, if eligible, should bonus depreciation or Section 179 expensing be elected.

Tenant Improvement Allowances

Often leases will include an allowance for tenant improvements, which is an agreed upon amount the lessor will pay to the lessee for qualified improvements the lessee makes to the rented space. For the lessee, subject to exceptions, the cash payment received for this tenant improvement allowance would often be ordinary taxable income in the year of receipt and the amount the lessee expends toward capital improvements they will own and use would be capitalized on their books. One common exception however, which would result in the tenant lessee not picking up income for the improvement allowance and not being able capitalize any improvements made with the allowance, would be if the lessee is under a short-term lease (15 years or less) of retail space and the allowance is used for constructing or improving nonresidential real property at the retail space.⁸ Retail space is defined 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.⁹

Cancellation of Leases

Leases get cancelled for many reasons. The landlord could offer the lessee money to cancel the lease or the lessee could offer the landlord money to leave the lease early. Amounts received by the lessee from the lessor to cancel a lease will be includable in the lessee’s income. Payments made by the lessee to cancel the lease early may be deductible as an ordinary business expense either in the year paid or incurred depending on the lessee taxpayer’s method of accounting.^[0 However, depending on the facts and circumstances, there are cases where the lessee would have to capitalize the termination payment. One instance is when the lessee taxpayer pays to either modify or cancel the lease and then initiates a new lease with the same lessor. In that case the lessee may have to capitalize the payment over the term of the new lease as opposed to deducting it as rent when paid.¹¹

Conclusion

The tax implications and planning surrounding leases are a very complex topic. There are many things to consider before signing a new lease or modifying an existing lease which makes consulting professional advisors imperative.

For more information, contact Joshua Goldschmidt at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Law Firm Group.

1 IRC §162(a)(3)
2 IRC §467(d)(2)
3 Regs. §467-1(c)(1)
4 Regs. §467-1(c)(2)(i)(B)
5 Regs. §467-1(a)(1)
6 IRC §467(e)(4)
7 IRC §168(i)(8)(A)
8 IRC §110(a)(1-2)
9 IRC §110(c)(3)
10 Rev. Rul. 69-511
11 Rev. Rul. 73-176