Landlords recognize income based on their accounting method. Cash and accrual basis landlords will treat deferred rent, unpaid rent, and lease modifications differently.
The following scenarios all assume that a lease is not a Section 467 lease, which will be discussed at the end of this article.
Cash basis landlords recognize income when received. In the case of late rent, cash basis landlords will recognize income at the time they receive the cash in the future. Accrual basis landlords recognize income when the “all events” test is met. This means income recognition might not necessarily correlate to when cash is received. Under the “all events” test, a landlord recognizes rent when:
Since the lease will state these terms, accrual basis landlords will continue to recognize income according to those schedules even with deferred payments or a non-paying tenant.
If landlords have nonpaying tenants, cash basis landlords will not recognize any income since no cash is being received. There is no write-off for bad debts since they never recognized income in the first place.
Since accrual basis landlords accrue rental income, they can potentially claim a bad debt expense later on, but cannot simply claim a bad debt based on an estimate of unpaid rent. They can only claim a bad debt expense to the extent the rent receivable becomes fully worthless. Worthless rent receivable is a facts-and-circumstances determination and landlords can only claim wholly worthless bad debts, not partially worthless bad debts. Factors to support worthless rent receivable include, but are not limited to:
Fees associated with modifying an existing lease (for example, legal fees) must be capitalized and amortized over the remaining term of the lease. If there is a substantial lease modification, landlords and tenants could accidentally trigger the need to comply with IRC Section 467.
If the lease is modified under a formal agreement in writing then an accrual basis landlord would recognize income according to the new payment schedule.
Lease termination payments paid by the tenant to the landlord are considered a substitute for rent and should be included in the landlord’s taxable income in the year received.
Landlords cannot simply write off landlord-owned leasehold improvements if a tenant vacates the premises. Landlord-owned leasehold improvements can only be written off when the asset is actually demolished. Tenants can write off the remaining basis of their tenant-owned leasehold improvements at the time a lease is terminated.
Any unamortized fees initially capitalized with the original lease (such as leasing commissions or lease acquisition costs) can be written off by the landlord if a lease is terminated.