Lease termination payments: Considerations for the lessor

Editor: Jeffrey N. Bilsky, CPA

The taxation of payments made by a lessor to terminate a lease has been a long-standing point of contention between taxpayers and the IRS, with case law dating back to the 1920s. One basic question is whether the lessor may immediately expense the payment: Is it an ordinary and necessary business expense deductible in the year paid or incurred? Or is it an item that must be capitalized and recovered over time? IRS regulations effective in 2003 answered this question. Regs. Sec. 1.263(a)-4(d)(7)(i) (A) generally requires the capitalization of amounts paid by a lessor to a lessee to terminate a lease of real or tangible personal property.

Cost recovery

While the Sec. 263(a) regulations provide the basic requirement to capitalize termination payments made by lessors, the Code and regulations do not explicitly address how the capitalized costs should be recovered (unlike, for example, the mandatory 15-year recovery period provided by Sec. 197 for certain intangibles). Lacking such guidance, practitioners can consider applying different cost-recovery strategies.

Limited guidance under the regulations

The Sec. 263(a) regulations that require capitalization of various intangibles contain a general cross-reference to Regs. Sec. 1.167(a)-3 for “rules relating to amortization of certain intangibles” (Regs. Sec. 1.263(a)-4(m)). The regulations under Sec. 167 provide that an intangible asset may be depreciated if it is known to be of use in the business or production of income for a limited period and that period can be estimated with reasonable accuracy. When the intangible asset does not have a useful life that may be estimated with reasonable accuracy, the regulations provide for a safe-harbor amortization period of 15 years, with certain exceptions. Putting these pieces together, the practitioner can conclude that, while amortization is available for certain capitalized intangibles, a determination of the appropriate recovery period must be made based on all the facts and circumstances. 

When the lessor terminates a lease to take back the property for its own use, the amortization period assigned by Rev. Rul. 71-283 is the remaining unexpired term of the terminated lease. This ruling was issued prior to the release of the relevant Sec. 263(a) regulations, but its conclusion is consistent with them. The following example has been adapted from the regulations (Regs. Sec. 1.263(a)-4(f)(8), Example (7)):

Example 1: V Corporation owns real property that it has leased to A for a period of 15 years. When the lease has a remaining unexpired term of five years, V and A agree to terminate the lease, enabling V to use the property in its trade or business. V pays A $100,000 in exchange for A’s agreement to terminate the lease. 

The regulations conclude in this case that the payment creates a benefit for V with a duration of five years, requiring V to capitalize the payment rather than apply the “12-month rule” (see “Application of the 12-Month Rule,” below).While the regulations do not specifically address the useful life for purposes of amortization, it is reasonable to conclude that in this case, the useful life is also five years, and V should amortize the payment over this period. This conclusion is both logical and consistent with Rev. Rul. 71-283.

An approach based on case law: While a complete survey of relevant case law is beyond the scope of this item, one approach to cost recovery may be culled from the Ninth Circuit’s analysis in Handlery Hotels, Inc., 663 F.2d 892 (9th Cir. 1981). As one might expect, analysis of the treatment of a lease termination payment requires a clear understanding of the motivation behind the termination and the steps that are expected to follow. The Ninth Circuit analyzed prior case law and concluded that a lessor’s capitalized termination costs should generally be amortized over the remaining term of the lease, consistent with the example discussed above. The court also identified certain exceptions to this general principle.

In its analysis, the Ninth Circuit considered situations in which a lessor makes a termination payment to a lessee to demolish an existing structure and build a new one or make extensive improvements to the property. In these cases, according to the court, the capitalized cost should be amortized over the term of the new lease or treated as a cost of the newly constructed property. As the court noted, it may be appropriate to draw a distinction between improvements made to existing property for the sake of the lessee (Latter, T.C. Memo. 1961-67) and the demolition of an old building to erect an entirely new structure (Business Real Estate Trust of Boston, 25 B.T.A. 191 (1932)). The former is a cost of acquiring a new lease and is amortized over the new lease term, while the latter results in the creation of an asset with independent value that should be depreciated over its own tax life.

The court in Handlery also considered Wells Fargo Bank & Union Trust Co., 163 F.2d 521 (9th Cir. 1947), which involved a payment made for the lessor to enter into a new lease. In this case, the lessor made a termination payment to its original lessee to enter a lease with a new lessee. The new lessee paid larger lease payments to the lessor for the first 12 months of the new lease that were tied to the lessor’s cost of terminating the old lease. In essence, a portion of the income from the new lease was used to cover the lessor’s cost of making the termination payment to the original lessee. Although the new lease had a shorter period than the remaining period of the old lease, the court held that the amortization period for the lease termination payment was the term of the new lease.

The Handlery court did not, however, discuss a scenario where a lessor terminates a lease to sell the property. An earlier decision, Shirley Hill Coal Co., 6 B.T.A. 935 (1927), held that, in this situation, the lease termination payment must be capitalized as part of the basis of the property sold, which appears to be consistent with the rules above.

Application of the 12- month rule

Tax practitioners are likely familiar with the 12-month rule in the context of prepaid expenses. Applying this rule to lease termination payments can provide some clarity in otherwise gray areas and potentially allow for planning opportunities.

The basic rule: The Sec. 263(a) regulations provide a simplifying convention: A payment does not need to be capitalized if the right or benefit it creates does not extend beyond the earlier of:

• Twelve months after the first date on which the taxpayer realizes the right or benefit; or
• The end of the tax year following the tax year in which the payment is made.

The 12-month rule applies by default. However, a taxpayer may elect not to apply this treatment to all similar transactions during a tax year. The election is made by capitalizing the expenses on a timely filed return (including extensions) and is revocable for that tax year only with the IRS’s consent (see Regs. Sec. 1.263(a)-4(f)).

Measuring the benefit: Although determining the useful life of a capitalizable termination payment is highly dependent on facts and circumstances, the Sec. 263(a) regulations provide a bright-line measurement for purposes of applying the 12-month rule. Specifically, Regs. Sec. 1.263(a)- 4(f)(2) provides that amounts paid to terminate a contract prior to its expiration date create a benefit for the taxpayer that lasts for the unexpired term of the agreement immediately before the date of the termination. This rule applies to all contract terminations described under Regs. Sec. 1.263(a)-4(d) (7)(i), regardless of their reason. 

This can be illustrated using an example from the regulations (Regs. Sec. 1.263(a)-4(f)(8), Example (8), modified slightly for clarity):

Example 2: V owns real property that it has leased to A for a period of 15 years. When the lease has a remaining unexpired term of 10 months, V and A agree to terminate the lease, enabling V to use the property in its trade or business. V pays A $100,000 in exchange for A’s agreement to terminate the lease. V’s payment creates a benefit for V with a duration of 10 months. The 12-month rule applies to the payment because the benefit attributable to the payment does not extend more than 12 months beyond the date of termination (the first date the benefit is realized by V) or beyond the end of the tax year following the tax year in which the payment is made. Accordingly, V is not required to capitalize the $100,000 payment.

Benefits of applying the rule: Although the example concerns a lessor taking back the property for use in its own business, the 12-month rule should apply to any lease termination payment that is covered by the Sec. 263(a) regulations. The 12-month rule is applied based on the remaining unexpired term of the original lease, which may not be the same as the period over which the lessor would otherwise be able to recover the termination payment.

This can produce an interesting result: If the taxpayer terminates the lease to enter into a new long-term lease or make significant property modifications, the IRS may argue that the payment must be recovered over the term of the new, longer lease or as part of cost recovery for the modified property (likely leading to a 39-year life). However, if the remaining term of the old lease at termination is 12 months or less and does not last beyond the end of the following tax year, the payment can be deducted immediately. This provides a potential opportunity for lessors contemplating the termination of a lease that is near the end of its term to attempt to time the payment to fit within the 12-month rule.

Another fact pattern where the 12-month rule could provide significant benefit can arise in the residential rental context. While leases are generally one year or less, jurisdictions often grant various tenant rights that can make tenant removal a time-consuming process that may span a period of years. If a payment is made to induce such a tenant to vacate immediately, what is the appropriate period over which to spread the expense? The IRS could argue that the leases have an indefinite duration and the payment may not be amortized at all.

A more reasonable approach may be to try to use experience to determine the average duration of the eviction process and amortize the payment over this period. However, where the 12-month rule applies, taxpayers may have a reasonable position to expense the termination payments immediately, as the benefit period for purposes of the 12-month rule is considered to be the unexpired term of the lease.

Additional considerations

In certain situations, it may not be immediately apparent whether a payment constitutes a lease termination payment under the regulations. For example, the relevant legal documents may refer to a payment made by the lessor as repurchasing the lease from the lessee rather than as terminating the existing lease. In other instances, the lessor may make a payment to the tenant for amounts designated for ancillary costs, such as moving costs of the lessee or reimbursement for tenant improvements being forfeited.

It may be reasonable to use the general principle of “substance over form” and treat these as costs included in the general framework of lease termination payments. This conclusion is supported by the Latter case mentioned above. In Latter, the documents stated that the lessees were “willing to assign and transfer all their right, title and interest in their said existing lease.” The package from the lessor also included payments to reimburse the lessees for their improvements. The court applied its lease termination analysis to the payments without regard to the contract language or the specific purpose for which the payments were designated.

Practitioners will need to look closely at each fact pattern to determine the proper treatment of a lessor’s termination payment, as the result will depend on the motivation behind the overall transaction and the steps undertaken to achieve it. Additional consideration should be given to the application of the 12-month rule. Where available, this rule can provide accelerated cost recovery and remove some of the uncertainty that often surrounds the treatment of these payments.

Editor notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta. Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Bilsky at jbilsky@bdo.com.