The commercial real estate market boom continues to provide opportunities for tax planning, specifically in the area of lease structuring. Careful planning and documentation in the lease agreement is the key to income deferral, but practitioners need to be aware that the IRS's interpretation of Sec. 467 is stricter than once thought.
Income Recognition Under Secs. 451, 61, and 467
Regs. Sec. 1.451-1(a) requires income to be accrued when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. Regs. Sec. 1.61-8(b) provides that gross income includes advance rentals and cancellation payments, which must be included in income in the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer. This rule essentially puts income recognition for advance rentals and lease termination payments on a cash basis; however, both Secs. 451 and 61 provide an exception to the general rule when a Sec. 467 rental agreement is present.
Sec. 467 Rental Agreements
A Sec. 467 rental agreement is an agreement for the use of tangible property where the aggregate amount of payments received as consideration for use of the property and the aggregate value of any other consideration to be received for the use of the property exceeds $250,000, and that has increasing, decreasing, prepaid, or deferred rents.
A rental agreement has increasing or decreasing rent if the annualized fixed rent allocated to a rental period exceeds the annualized fixed rent allocated to any other rental period. A rental agreement has deferred rent if the cumulative amount of rent allocated as of the close of a calendar year exceeds the cumulative amount of rent payable as of the close of the succeeding calendar year. A rental agreement has prepaid rent if the cumulative amount of rent payable during the year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year.
Allocating Fixed Rent
Regs. Sec. 1.467-1(c)(2)(ii) provides two methods for allocating fixed rent to a rental period. This is important in determining whether a rental agreement has increasing, decreasing, prepaid, or deferred rents. If a rental agreement clearly specifies for periods no longer than a year a fixed amount of rent for which the lessee becomes liable, then the amount of fixed rent allocated to the rental period is the amount of rent indicated in the agreement. If there is no specific allocation in the rental agreement, then the amount of fixed rent allocated to a rental period is the amount of rent payable during that rental period.
The Importance of Rental Payment and Rent Allocation Schedules
The rent payment and allocation schedules will determine whether a rental agreement has increasing, decreasing, prepaid, or deferred rents. As long as the rental payments are made in accordance with the rent payment schedule, acceleration of expense/deferral of income generally will not be available. This issue was highlighted in Stough, 144 T.C. 306 (2015).
Michael Stough was the sole owner of Stough Development Corp. (SDC), a real estate development company, and Wintermans LLC, a rental real estate company. Talecris, a wholly owned subsidiary of Talecris Biotherapeutics, operates plasma collection centers.
SDC entered into a development agreement with Talecris to build a plasma collection center. Once the building was developed, title was transferred to Wintermans, and Wintermans entered into a 10-year lease agreement with Talecris. The lease required Talecris to pay monthly rent to Wintermans, and the rent would be determined by a mathematical formula based upon project costs that SDC incurred in acquiring and developing the property. The lease also provided Talecris an option to make a lump-sum payment that would reduce project costs and ultimately reduce the calculation of monthly rent.
Stough argued that the lump-sum payment should be spread ratably over the 10-year life of the lease under Sec. 467. The Tax Court found that since the rental agreement did not provide a specific amount of rent payable during a rental period under Regs. Sec. 1.467-1(c)(2)(ii)(B), the amount of fixed rent allocated to a rental period was the amount of fixed rent payable during that rental period. Thus, the whole lump-sum payment was includible in income in the year the payment was received.
This case highlights the importance of including a rent allocation schedule in a rental agreement when trying to allocate rent in a manner different from the rent payment schedule.
Rental Accruals Under Sec. 467
There are two methods of allocating rent under Sec. 467: (1) constant rental accrual or (2) proportional rental accrual.
The constant-rental-accrual method is required if the Sec. 467 rental agreement is a disqualified leaseback or a long-term agreement. A rental agreement will be considered a disqualified leaseback or a long-term agreement if the principal purpose for providing increasing or decreasing rent is tax avoidance. Whether the principal purpose is tax avoidance is determined by examining all of the facts and circumstances, although the regulations provide two safe harbors where, if met, the principal purpose would not be tax avoidance.
1. Uneven return test: If the rent allocated to each calendar year does not vary from the average rent allocated to all calendar years by more than 10%.
2. If the increase or decrease in rent is wholly attributable to a contingent rent provision, or a single rent holiday for a period of three months or less at the beginning of the lease term, or the duration of the rent holiday is reasonable and does not exceed the lesser of 24 months or 10% of the lease term.
A Sec. 467 rental agreement is a leaseback if the lessee or a related person had any interest in the property during the two-year period ending on the agreement date. A Sec. 467 rental agreement is a long-term agreement if the lease term exceeds 75% of the property's statutory recovery period. A list of statutory recovery periods is included in Regs. Sec. 1.467-3(b)(3)(ii) and Sec. 467(e)(3). The statutory period for nonresidential real estate is 19 years.
If the constant rental accrual is required to be calculated, the constant rental amount is equal to the net present value of amounts payable under the disqualified leaseback or long-term agreement divided by the present value of $1 to be received at the end of each rental period during the lease term.
The proportional-rental-accrual method is required if a Sec. 467 rental agreement is not a disqualified leaseback or long-term agreement and the rental agreement does not provide adequate interest on fixed rent. A Sec. 467 rental agreement provides adequate interest on fixed rent if the rental agreement has no deferred or prepaid rent; has deferred or prepaid rent and charges interest on the deferred or prepaid rent (the amount of which must be adjusted at least annually) at a stated rate paid or compounded at least annually that is no lower than 110% of the applicable federal rate; or the rental agreement provides either deferred or prepaid rent and the sum of the present values of all amounts payable as fixed rent is equal to or greater than the sum of the present values of the fixed rent allocated to each rental period.
If the proportional rental accrual is required to be calculated, the amount of fixed rent allocated to the rental period is the sum of the present values of the amounts payable under the terms of the Sec. 467 rental agreement as fixed rent and interest, divided by the sum of the present values of the fixed rent allocated to each rental period under the rental agreement.
Sec. 467 Loan
Taxpayers with Sec. 467 rental agreements that have deferred or prepaid rent are required to reclassify a portion of rental payments as interest based upon the Sec. 467 loan balance. The interest rate on a Sec. 467 loan is 110% of the applicable federal rate or the stated yield on deferred payments, whichever is higher.
Falling under the constant or proportional rental accrual rules may be somewhat difficult, depending on how many leases are written. Taxpayers wishing to fall under these rules do have a few options:
1. Include a rental accrual schedule in the lease agreement that is different from the rent payment schedule and make sure there are increasing or decreasing rents.
2. Look for opportunities to fall under the tax avoidance rules. An ideal fact pattern would be when, as of the agreement date, a significant difference between the marginal tax rates (more than 10%) of the lessor and lessee can be reasonably expected and none of the safe harbors under Regs. Sec. 1.467-3(c)(3) apply. Sale leasebacks followed by large prepayments of rent would be an example if the marginal tax rates of the lessor and lessee differed.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.