The economic downturn brought on by the COVID-19 pandemic has hampered the ability of many residential and commercial tenants alike to meet their rent obligations. Late or partial rent is better than no rent, however, and many landlords have entered into agreements with tenants to defer collection of rent payments and renegotiate the terms of the leases as they wait for the economy and tenants’ revenue streams to improve. What landlords and tenants may not be aware of when restructuring their rental agreements are the tax implications laid out under Internal Revenue Code (IRC) Section 467.
To properly assess the nature of any tax implications that may result from modifications to lease agreements, it is beneficial for commercial landlords and tenants to have at least some basic knowledge of the Section 467 rules. In certain cases, lease modifications under Section 467 rules could require the landlord and tenant to change how they account for rental income and deductions and subject both parties to complicated computations using present value principles rather than their regular methods of accounting.
IRC Section 467 Rules
Generally, IRC Section 467 rules apply to agreements for the use of tangible property if the total payments for the use of rental property are greater than $250,000 over the term of the lease and the lease has either: (1) at least one amount allocable to the use of property during a calendar year which is to be paid after the close of the following calendar year following the calendar year in which such use occurs (deferred rent), or (2) there are increases in the amount to be paid as rent under the agreement (stepped rent).
A rental agreement has Section 467 deferred rent if the cumulative amount of rent allocated as of the close of the calendar year exceeds the cumulative amount of rent payable as of the close of the following year. Lessors and lessees with Section 467 rental agreements that have “deferred” rent may be required to treat certain accrued unpaid rent as a loan and reclassify a portion of rental payments as interest using the proportional rental accrual method described in Regulations (Regs.) Section 1.467-1(d)(2). A rental agreement has increasing or decreasing rent (stepped rent) if the annualized fixed rent allocated to a rental period exceeds the annualized fixed rent allocated to any other rental period.
The following examples will help to illustrate the application of the Section 467 rules.
Here is an example from the Regulations where the rent accrual schedule does not match the payment schedule, but the lease is not subject to Section 467:
A and B enter into a four-year rental agreement that provides for the lease of property to begin on January 1, 2000, and end on December 31, 2003. The rental agreement provides that rent of $100,000 accrues during each year of the lease term. Under the rental agreement, no rent is payable during calendar year 2000, a payment of $100,000 is to be made on December 31, 2001, and December 31, 2002, and a payment of $200,000 is to be made on December 31, 2003. The amount of rent allocated to each rental period is $100,000, thus there is no increasing rent. There is no deferred rent because the accrued rent obligations were not deferred by more than one year.
The rent allocated to 2000 ($100,000) does not exceed the cumulative rent payable as of December 31, 2001 ($100,000); the rent allocated to 2001 and preceding years ($200,000) does not exceed the cumulative rent payable as of December 31, 2002 ($200,000); the rent allocated to 2002 and preceding ($300,000) does not exceed the cumulative rent payable as of December 31, 2003 ($400,000); and the rent allocated to 2003 and preceding ($400,000) does not exceed the cumulative rent payable as of December 31, 2004 ($400,000). Therefore, because the agreement does not provide for increasing rent or deferred rent, the agreement is not subject to Section 467. The lessor and lessee can retain their regular methods of accounting.
This is another example found in the Regulations of a lease agreement with increasing and deferred rent where the proportional accrual method will need to be applied:
A leases property to B for a three-year period beginning on January 1, 2020, and ending on December 31, 2022. The rental agreement has the following rent allocation schedule and payment schedule:
The rental agreement requires a $1.8 million payment to be made on December 31, 2022, but does not provide for interest on deferred rent. Assume A and B choose the calendar year as the rental period length. Because the rental agreement does not provide adequate interest under Regs. Section 1.467-2(b), the fixed rent that accrues during each rental period is the proportional rental amount as described in Regs. Section 1.467-2(c). The accrued rent obligations are deferred in excess of one year, thus the lease agreement is subject to Section 467. The lessor and lessee will need to use the accrual method of accounting and a portion of the accrued rent will be recharacterized as interest income to the lessor and interest deductions to the lessee over the term of the lease in accordance with the proportional rent accrual rules.
Assume an existing lease goes through 2025 with annual rent set at $1 million per year. In 2020, the tenant encounters financial difficulties and agrees with the landlord that the $1 million of rent for 2020 will be added ratably to each month’s rent payment in 2021. Here, the one-year deferral exception applies, and both the landlord and tenant would continue accruing the $1 million of rent each year, including for 2020.
Lease modifications can be significant and complicated and this article only touches upon some of the nuances of Section 467. Upfront planning is critical prior to finalizing any amendment or modification. Be sure to consult with your tax advisor whether you are the landlord or the tenant.
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