Editor: Anthony S. Bakale, CPA
In 2020, most landlords found themselves in a constant state of renegotiating leases due to shutdowns related to COVID-19. Succeeding years may bring additional disruptions to the real estate industry as office tenants offer hybrid work schedules and hoteling and try to gain more efficient use of their space. This may result in lease termination payments or revisions to existing leases. In addition, in the retail sector, zero cash flow property structures have risen in popularity over the last few years. If applied properly, Sec. 467 can benefit landlords by providing a significant deferral.
With the changing circumstances in the real estate industry, commercial property holders need to be aware of their tax options when considering revisions to and negotiations of leases of their properties. Sec. 467 provides both unexpected pitfalls and opportunities to plan for the timing of income recognition and deductions. Careful tax planning and proper drafting with respect to provisions incorporated into property leases need to be considered as the commercial real estate industry enters a period of flux. Temporary measures put in place during the past year may have already affected the tax accounting for existing leases if such temporary measures constitute a significant modification. Now is the time to reexamine those temporary measures and consider whether more permanent provisions should be put into effect via additional negotiations with tenants. Landlords also need to be aware of potential changes, both temporary and permanent, in current tax law that may impact the tax effects of changes in lease terms with tenants.
This item explores commercial property holders' use of Sec. 467, which governs the timing of rental income and expense in certain circumstances.
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 (plus the aggregate value of any other consideration to be received) exceeds $250,000. In addition, the rental agreement must have 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.
- 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.
- 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).
Rental accruals under Sec. 467
There are two methods of allocating rent under Sec. 467: (1) constant rental accrual or (2) proportional rental accrual.
Constant-rental-accrual method: This 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 that, if met, the principal purpose will not be tax avoidance. These safe harbors are:
- If the rent allocated to each calendar year does not vary from the average rent allocated to all calendar years by more than 10% (known as the "uneven return test"); or
- 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.
Proportional-rental-accrual method: This 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. Interest would be subject to Sec. 163(j) limitations for the tenant, assuming one of the exceptions to Sec. 163(j) does not apply.
Since a Sec. 467 loan is considered true debt for tax purposes, it will be considered additional proceeds upon its sale. Sec. 467 recapture also applies to any rental agreement that is a leaseback or long-term agreement as defined in Regs. Secs. 1.467-3(b)(2) and 1.467-3(b)(3), respectively. Recapture is not required if the principal purpose for providing increasing or decreasing rent is tax avoidance and the IRS determines that the agreement should be treated as a disqualified leaseback or long-term agreement.
Changes in leases due to COVID-19
The most common changes to leases in 2020 were to offer a three-month rent payment holiday, to offer a rent payment holiday in exchange for extending the existing lease, or to offer a rent payment holiday that is payable at the end of the existing lease. Tax advisers need to review leases to determine the application of Sec. 467.
If the modification of the lease is considered substantial, then the modified lease is considered a new lease that begins on the date of the modification. Regs. Sec. 1.467-1(f)(6)(iii) provides a safe harbor in which a lease modification will not be considered substantial if the change in the amount of fixed rent allocated to a rental period, when combined with all previous changes in the amount of fixed rent allocated to the rental period, does not exceed 1% of the fixed rent allocated to that rental period prior to the modification. Due to this limited safe harbor, most modifications will be considered substantial, and as a result, the modified lease will need to be tested again under Sec. 467.
Three-month rent payment holiday: Regs. Sec. 1.467-1(c)(2)(i)(B) provides that rent holidays for a period of three months or less will be disregarded for purposes of Sec. 467.
Rent payment holiday payable at the end of the existing lease: Regs. Sec. 1.467-1(c)(3)(i) provides that rent is only considered deferred if the cumulative amount of rent allocated to the year exceeds the cumulated amount of rent payable as of the close of the succeeding year. If rent was deferred in 2020, it would need to be paid by Dec. 31, 2021, to not be considered deferred for Sec. 467 purposes. Alternatively, if the modified agreement included a revised payment schedule, the rent would not be considered deferred.
Structure into Sec. 467
Leases can be structured to fall into the constant or proportional rental accrual rules by including a rental accrual schedule that provides for a deferral of rent when compared to the rent payment schedule. The tenant would need to report its rent deduction in accordance with the rental accrual schedule. This strategy works well with tenants that have net operating losses where the timing of the deduction is not relevant or with publicly traded companies where the rent deduction is immaterial.
Zero cash flow property
In the last few years, zero cash flow property has become significantly more popular. A zero cash flow property is highly leveraged with long-term financing (15-20 years), supported by a long-termtriple-net lease (15-20 years) with an investment grade credit tenant. The structure is designed so that the net operating income matches the debt service.
As the loan amortizes, phantom income is created as depreciation and interest deductions decline over the life of the loan. Sec. 467 is utilized in this financing structure to defer income to the back end of the lease to provide the landlord with additional tax deferral.
Commercial property holders need to be aware of their tax options when considering revisions to and negotiations of leases of their properties. While some potential pitfalls exist, Sec. 467 offers opportunities to plan for the timing of income recognition and deductions.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.