The tax treatment of deferred rental agreements.by Wolitzer, Robert M.
Rent holidays, or graduated rent payment structures, are easy under GAAP. For tax purposes, the IRC may require one of two different computation methods, both requiring the use of present-value computations.
Recent economic hard times have led agents and realtors to become very creative when offering bargains in lease agreements. A common lease agreement may include a rent holiday: a period, usually at the beginning of the lease, when the lessee is free from paying rent to the lessor. Also typically included in these agreements is a graduated rent payment structure in which the rent is increased every few years over the life of the lease.
Rules Under GAAP
For financial reporting purposes, GAAP require the use of a straight- line method. Annual rent expense is determined by totalling the annual rent payments under the terms of the lease and dividing the total by the number of years of the lease (provided, of course, the use of the rent space remains constant over the life of the lease). This may be illustrated as follows:
In the above example, the financial statements of the lessee would report rent expense as $110,000 for each year of the lease.
Rules Under Tax Law
For tax purposes, the treatment is quite different. Original issue discount treatment is imposed on parties with deferred rental agreements under IRC Sec. 467. These rules are generally effective for rental agreements entered into after June 8, 1984, with some exceptions.
Agreements for the rental of tangible property are subject to the IRC Sec. 467 income rule if the amount to be paid for the use of the rental property exceeds $250,000, and under the agreement either--
1. at least one amount, allocable to the use of property in one calendar year, is to be paid after the close of the following calendar year (deferred payments); or
2. there are increases in the amount to be paid as rent under the agreement such as graduated increases or stepped rents |See IRC Sec. 467(d)(1).
The lessor or lessee of a deferred rental agreement must take into account for any tax year, regardless of the accounting method used, the sum of--
1. the accrued rental payments; and
2. any interest for the year (calculated at the rate of 110% of the applicable Federal rate |AFR compounded semi-annually) on unpaid rents (amounts that were taken into account in a prior tax year but are still unpaid as of the current tax year).
Thus, if the agreement calls for rent of $X per month (or other lease period) payable at the beginning (or close) of each month (or other lease period) throughout the agreement's life, it is presumably not an IRC Sec. 467 rental agreement provided payment for the use of property in one calendar year is not deferred until after the close of the following calendar year. A lease covering more than two calendar years which provides for a single payment at the termination of the lease term is, therefore, an IRC Sec. 467 agreement. If the parties specify no rent is allocable to the first year (a reasonable rent holiday), the agreement would be a stepped rent agreement subject to IRC Sec. 467.
IRC Sec. 467 will not apply to any amount paid for the use of property if the sum of the following amounts does not exceed $250,000:
1. the aggregate amount of payments received as consideration for the use of the property; and
2. the amount of other consideration for such use |IRC Sec. 467 (d) (2).
The Rationale of IRC Sec. 467
IRC Sec. 467 purports to correct certain IRS perceived abuses, where rental payments are either forgiven or deferred. The classic example of perceived abuse is the deduction for unpaid rent by an accrual-basis lessee without income being currently recognized by a cash-basis lessor.
IRC Sec. 467 operates to change the timing and character of deductions and income. Present-value discounting results in recharacterizing a portion of lease payments as interest expense. In certain instances, IRC Sec. 467 "rewrites" the lease so the tax consequences are as if the tenant had paid the landlord a level rent amount each year and then borrowed the amount (or a portion of it) back in the first years of the lease in an interest-bearing arrangement. The rental and interest amounts allocable to a given year, rather than the money paid, is taken into account for tax purposes. If IRC Sec. 467 applies, it will function in a manner similar to the original issue discount rules and will force both cash and accrual basis taxpayers onto an economic accrual method. In certain cases, the application of IRC Sec. 467 may be advantageous as a planning tool. A cash-basks lessee may accelerate its rental expense deductions without an increase in cash outlays. A lessor possessing otherwise unusable passive activity losses under IRC Sec. 469, could use IRC Sec. 467 to create passive income to offset these losses without any adverse tax effects. Computation Where Rental Agreement Allocates Rent
Under IRC Sec. 467(b), if the parties to an IRC Sec. 467 rental agreement allocate rents to be paid to periods covered by the agreement, this allocation will be given effect in accruing rental income and expenses for the taxable year. This is illustrated by the following example.
A rental agreement entered into on January 1, 1993, having a term of three calendar years, provides for rent payable at the close of each year in the respective amounts of $500,000, $750,000, and $1,000,000, totaling $2,250,000. This is clearly an IRC Sec. 467 rental agreement. The parties to the agreement (the lessor and the lessee) allocate $750,000 in rent to each of the three years. In effect, this means that $250,000 of the rent allocable to Year 1 is not payable until the close of Year 3.
The $250,000 allocated to Year 1 and payable at the close for the Year 3 is accounted for at its present value. Assuming 110% of the AFR is 12%, the $250,000 allocable to Year 1 ks taken into account to the extent of $198,023, the present value of $250,000 discounted at 12%, semi- annually.
The rent taken into account for Year 1 is, therefore, $698,023 ($500,000 + $198,023). No adjustments are made to the Year 2 rent. However, the interest on the rent taken into account for Year 1 but remains unpaid, i.e., $198,023.42, is taken into account by the lessor and lessee for Year 2. Such interest is $24,475.69 calculated at 12% compounded semi- annually on the $198,023. In the third year, the rent taken into account is $750,000. In addition, $27,500.89 in interest on the deferred rental for Year 1 also must be taken into account.
The following amounts must be reported by the lessor and the lessee in their respective returns for each of the three years covered by the lease:
The rules generally apply to all IRC Sec. 467 rental agreements where the parties have allocated the rents payable to the periods covered. When no such allocation has been made or when the agreement is a "disqualified leaseback or long-term agreement," another rule applies. Under this rule a "constant rental amount" allocable to each period is accrued for each taxable year.
This rule, stated under IRC Sec. 467 (b)(2), applies rent leveling to--
1. IRC Sec. 467 agreements where the parties have failed to allocate the rent payments to the lease period(s), irrespective of any tax avoidance purpose, and 2. "disqualified" leasebacks and long-term agreements, i.e., leasebacks and long-term agreements found by the IRS to have tax avoidance as a principal purpose.
A leaseback transaction is an IRC Sec. 467 rental agreement that involves a leaseback to any person who had an interest in the property (other than a de minimis ownership interest) at any time within two years before the leaseback to that person (or related person). "Related person" is defined by IRC Sec. 465(b)(3)(C). Examples are family members, grantor and fiduciary of the same trust, 50% owners, and common control if involving more than one trade or business.
A long-term agreement is an IRC Sec. 467 rental agreement for a term in excess of 75% of the property's statutory (ACRS) recovery period. If the property is not property to which ACRS applies, it is treated as such for purposes of determining whether the lease is long-term. In general, the statutory recovery period is 19 years for residential rental property and nonresidential real property.
Options to extend the lease that are exercisable solely by the lessee are not taken into account in determining the lease term. Theoretically, if the agreement is a leaseback transaction or a long-term agreement, it is disqualified only if the IRS determines that a principal purpose for providing increasing rentals is the avoidance of tax. For this purpose, IRC Sec. 467(b)(5) mandates the promulgation of regulations providing specific exceptions to disqualification, i.e., circumstances under which an agreement will not be treated as having a principal tax avoidance purpose. Among such safe harbor circumstances will be included--
1. changes in amounts paid that are determined by reference to price indices;
2. rents based on a fixed percentage of lessee receipts or similar amounts:
3. reasonable rent holidays; and
4. changes in amounts paid to unrelated third parties.
The Application of Rent Leveling
The constant rental amount is determined by calculating the amount of rent which, if paid in equal amounts at the close of each period, would have an aggregate present value equal to the aggregate present values of the rents called for in the agreement |IRC Sec. 467 (e) (1). Although IRC Sec. 467 (e)(4) provides for an interest rate of 110% of the AFR to be used in "determining present value and interest under IRC Sec. 467(a)(2)," this rate is not specified as the rate to be used in determining the constant rental amount. Regulations should clear up this point. It should be noted that in a stepped rental agreement, the higher the rate used to determine the constant rental amount, the lower the constant rental amount. Since interest on unpaid leveled rents is accruable under IRC Sec. 467(a)(2), it would be surprising if some rate other than 110% of the AFR were used to determine the constant rental amount. The constant rent amount is the amount accruable as rent for each period regardless of when paid. In addition, interest on unpaid rents also must be accrued. The application of IRC Sec. 467 may be illustrated in the following example in which there is a long-term agreement.
Facts. In October 1992, XYZ partnership signed a 15-year lease beginning on January 1, 1993. The monthly rent schedule is as follows:
On an annual basis, the rent payments would be as shown in column 2 of the accompanying table.
In October 1992, when the rental agreement was signed, the Applicable Federal Rate, long term on a semi-annual basis at 110%, was 7.60%. This rate may be found under Rev. Rul. 92-87 Table I, Applicable Federal Rates (AFR) for October 1992. It is defined under IRC Sec. 1274.
The next step is the computation of a level rent payment. It is determined by deriving a level payment annuity which has a present value equal to the present value of the actual cash payments required under the lease using 7.6% as the monthly discount rate.
This amount is calculated by using a two-step approach. It is again suggested that amortization software make the calculations. For this example, a program called T Value, Version 3.11, from Time Value Software was used.
First, the present value of the actual rent payments is determined at a rate of 7.6%. The present value of a deferred annuity of the actual cash payments (the "loan" amount) is $4,427,488.
The next step is to calculate the "deemed" level payment. This is done by computing the monthly payment derived from $4,427,488 at a rate of 7.6%. This calculates to an amount of $41,035.47 per month or $492,426 per year for the 180 months of the lease.
The operation of IRC Sec. 467 can be viewed as creating a series of deemed payments between the lessor and the lessee. During the year 1993, or the free-rent period, the lessee is treated as making deemed rental and interest payments. The lessor is then deemed to have loaned these amounts back to the lessee (as the lessee did not make a payment to the lessor). Thus, on January 1, 1994, the lessee is "indebted" to the lessor in the amount of the accrued level rent payments for the year 1993 totalling $492,426 (12 months x $41,035.47 per month) plus imputed interest of $17,520.
Based upon the calculations, the actual payments of $7,930,000 are separated into their rental and interest expense components, or $7,386,390 and $543,610, respectively, as shown in columns 4 and 5 of the table. The timing of the recognition of rental and interest expense reflect the economic reality of the lease, rather than the timing of cash payments.
To provide the IRS with sufficient information to ascertain whether a taxpayer has properly reported all income, the IRC requires the filing of information returns by persons making payments to others in the course of a trade or business. This rule applies to payments of rent under IRC Sec. 467.
Under IRC Sec. 6041, payments of a fixed and determinable nature (such as rent and interest) made by a taxpayer in the course of trade or business must be reported if they total $600 or more in any year. In the case of rent and interest paid under terms of a rental agreement designed to conform to IRC Sec. 467, the lessee would file Form 1099- MISC, and Form 1099-INT, respectively to reflect amounts to be picked up as income by the lessor.
Although the law is unclear on this point, for interest deemed paid, it is assumed that the lessee should file Form 1099-OID. Thus, the payor or lessee must be prepared to make the calculations amortizing payments between interest and rent and report those amounts on the applicable Forms 1099.
In the case of an IRC Sec. 467 rental agreement with decreasing payments, presumably Form 1099-OID would be filed by the lessor for the deemed interest payments back to the lessee, while the lessee would report the actual payments of rents on Form 1099-MISC. The lessee is in effect deemed to be lending to the lessor the amount by which the deemed level rent payment exceeds the actual cash payments. The lessee would then be required to report this interest income as an offset to the lessee's rent expense.
Robert M. Wolitzer, MBA, CPA, is a senior tax associate of Lopez, Edwards, Frank & Co. He is a member of the AICPA and the NYSSCPA and serves on the latter's Taxation of Individuals Committee.
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