Lease Termination Payments

By Bernard Leibtag, CPA, MBA, Gorfine, Schiller & Gardyn, P.A., Owings Mills, MD

Editor: Kevin F. Reilly, J.D., CPA

A client owns a commercial building and leases it to various tenants. For business purposes, the client decides that he needs space currently occupied by tenants. To induce the current tenants to cancel their leases, the client will have to pay them a lease termination fee. What are the tax consequences to clients paying this fee?

As a general proposition, Sec. 263 disallows a current deduction for amounts chargeable to capital account. Regs. Sec. 1.263(a)-4(d)(7)(i)(A) provides that a taxpayer must capitalize amounts paid to another party to terminate a lease of real property between the taxpayer (as lessor) and that party (as lessee).

What the regulations do not discuss is whether the payment is a nondeductible capital expenditure or whether it is amortizable and, if so, over what period it may be amortized (i.e., is it capitalized into the cost of the building?). The courts first dealt with this situation in 1928 in Miller, 10 BTA 383. The court held that a lease termination payment was amortizable over the old lease’s unexpired term. More recently, in Handlery Hotels, Inc., 663 F2d 892 (9th Cir. 1981), the Ninth Circuit came to the same conclusion. The IRS position, which had been upheld in district court, was that while the payment was amortizable, it should be amortized over the (longer) term of the new lease that the landlord obtained in place of the old lease. Following Miller, the Ninth Circuit held that the lease termination payment was amortizable over the (shorter) unexpired term of the old lease.

In Rev. Rul. 71-283, the IRS also held that the lease termination payment was amortizable over the remaining term of the unexpired lease. However, in that ruling, the landlord wanted the space for his own use (i.e., not to re-lease to another tenant). It is possible that the Service will continue to argue that if the lease is terminated in order to lease for more money to a new tenant, especially if significant improvements are made, the amortizable period should be the new lease term. (See, e.g., Cosmopolitan Corp., TC Memo 1959-122, and Latter, TC Memo 1961-67.)

In Handlery Hotels, the lease was terminated in order to allow the landlord to re-lease to a new tenant. Considering that Handlery Hotels is a circuit court decision of relatively recent vintage (1981), while the other cases and the IRS ruling are older, there appears to be substantial support for the position that lease termination payments are amortizable over the unexpired term of the canceled lease.

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