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Tax Consequences of Lease Modifications under COVID-19

The COVID-19 pandemic has had a domino effect on the real estate industry. Businesses who have taken a hit as a result of shutdowns may have paid rent late, not paid at all, or renegotiated lease terms with their landlords, including rent deferrals or abatements. These aspects can have unintended tax consequences on both the landlord and tenant.

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.

Deferred Rental Income

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:

  1. The right to income is fixed, and
  2. The amount can be determined with reasonable accuracy.

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.

Non-paying Tenants and Worthless Rents

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:

  • Tenant shut their doors permanently,
  • Tenant filed bankruptcy or is insolvent, or
  • Landlord made all reasonable efforts to collect unpaid rent.

Modifying Rental Agreements

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 Terminations

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.

IRC Section 467 Issues

Section 467 applies to leases that have total of $250,000 rent payments and prepaid rent, deferred rent, or increasing/decreasing rental payments. In a nutshell, the purpose of Section 467 is to stop landlords and tenants from taking advantage of income and deduction timing differences between accrual and cash basis taxpayers. In a manner of speaking, landlords generally try to delay recognizing rental income, while tenants try to accelerate rent expense. Section 467 puts both the landlord and tenant on the same terms for recognizing income and deductions regardless of their accounting methods. Substantial lease modifications need to be retested under Section 467. A lease modification is considered substantial if the legal rights and obligations that are altered under the lease are economically substantial based on facts and circumstances.

Author: Ashley Kettler, CPA, akettler@withum.com

Section 467 has many complexities and nuances not discussed here. If the above situation applies, please reach out to a Withum real estate team member for further assistance.

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