Early Lease Terminations Due to Transitions to a Remote Workplace: Tax Considerations

October 09, 2020

By Michael Torhan, CPA

The COVID-19 pandemic has created a fundamental shift in the operations of many companies. The rush hour traffic jams as well as packed trains and buses that many workers have for so long been accustomed to have become a distant memory for many. Due to the quarantines and lockdowns that started in March 2020, many companies were forced to have employees work remotely from home. Many companies were prepared for technological requirements for work from home (WFH) operations, whereas others had to quickly get up to speed. Ultimately, many companies have realized that most employees continued to be as, or even more, productive while working from home. Furthermore, social and psychological benefits have also been realized by employees.

In addition to the benefits for employees, companies have realized the potential that remote work has for economic incentives as well. Rent is commonly a significant expense for companies, especially those in high-cost cities such as New York City or San Francisco. As a result, companies have been exploring the option of leaving some of their traditional office footprints and moving toward a bigger degree of remote work. Some companies have even gone to the extreme of entirely eliminating their offices. 

In addition to the setup of all the various technological and logistical requirements for a remote workplace, pre-existing leases may need to be terminated early. Due to the nature of commercial leases which are often for 10+ years, various provisions exist in such leases that may require compensation to be paid by tenants to landlords for the future loss of rent. Furthermore, tenants and/or landlords may have expended significant amounts of money on building out office space which may or may not be usable for future leaseholds.

Several tax considerations need to be analyzed and understood when early lease terminations are contemplated: by landlords currently leasing space to tenants that may be terminating their leases as well as tenants themselves that are considering early lease terminations. The following table provides a summary of some of the key tax considerations for landlords and tenants in early lease terminations. Each of these considerations is discussed in more detail below as well as some potential tax planning opportunities.

Landlord and Tenant Tax Considerations for Early Lease Terminations

Landlord’s Tax Impact

Tenant’s Tax Impact

Lease Cancellation Payment from Tenant to Landlord

Generally ordinary income; exceptions do exist

Generally ordinary deduction; exceptions do exist

Tenant Leasehold Improvements Left Behind by Tenant

Value not included in income and no basis increase

Loss equal to adjusted basis of improvements

Landlord Leasehold Improvements Previously Made for Vacating Tenant

Loss equal to adjusted basis of improvements if disposed of by landlord

N/A

Unamortized Leasehold Acquisition Costs

Generally ordinary deduction; exceptions do exist

Generally ordinary deduction; exceptions do exist

Sale or Sublease of Lease by Tenant

N/A

Sale: gain or loss equal to amount realized by tenant less the tenant’s basis in the lease

Sublease: ordinary income due to new landlord-tenant relationship

Lease Cancellation Payment from Tenant to Landlord

Landlord’s Perspective

In order to terminate a lease early, a tenant may need to pay a cancellation payment to its landlord. The regulations clearly state that an amount received by a landlord from a tenant for cancelling a lease constitutes gross income in the year in which it is received, since it is essentially a substitute for rental payments. Such income would generally be treated as ordinary income.

Some limited exceptions do exist to this general rule. For example, if part, or all, of a payment by a tenant to a landlord is in lieu of the tenant making repairs to a damaged building required under a lease, such portion of a payment may be treated as a return of capital. To the extent such amount exceeds the basis of a landlord’s property, capital gain may result.

Furthermore, the Internal Revenue Code (“IRC”) provides that gain or loss attributable to the cancellation or termination of a right with respect to property which is a capital asset in the hands of a taxpayer is treated as a capital gain or loss. In order for a lease cancellation payment to fall under this provision, the real property would need to be a capital asset in the hands of the landlord and not an asset used in a trade or business (i.e., it could not be IRC Sec. 1231 property). In order to qualify as a capital asset and not as IRC Sec. 1231 property, a landlord’s activities in such property would need to be minimal. Therefore, only certain limited rental properties would qualify under this provision. For example, a ground lease or a triple-net lease property may each be a type of property that would not be considered IRC Sec. 1231 property, and therefore termination payments on leases thereto would need to be analyzed further under these provisions.

Security deposits which are held by landlords are also a consideration for lease terminations. If a security deposit is not returned to a tenant, such amount also results in ordinary income to the landlord.

Tenant’s Perspective

Amounts paid by a tenant to a landlord to terminate a lease early are generally immediately deductible in full by the tenant in the year paid.

However, some exceptions to this general rule apply and tenants may not always deduct such expenses relating to terminating a lease.

In one such significant example, the IRS ruled that a cancellation payment made by a tenant in order to acquire a new property was not immediately deductible, but rather required to be capitalized. In that fact pattern, the IRS determined that a termination of the tenant’s location #1 lease and the agreement to purchase location #2 were not separate events, but rather one overall plan. The tenant's right to terminate was conditioned on the purchase of location #2 as well as the start of construction at location #2.  Furthermore, the taxpayer would not terminate its location #1 lease if it did not plan to acquire an alternative site for its headquarters. The IRS stated that the interrelation between the lease termination at location #1 and the acquisition of location #2 justified the conclusion that the lease termination payment was a cost of acquiring location #2. The lease termination payment was not merely an amount paid to reduce or eliminate expenses, nor was it in the nature of damages to relieve the tenant from an uneconomic contract.

Furthermore, it should also be noted that a payment made by a tenant to a landlord to purchase leased real property, effectively cancelling such lease, would not be immediately deductible but rather capitalized as part of the cost of the newly acquired property.

Tenant Leasehold Improvements Left Behind by Tenant

Landlord’s Perspective

Whenever a lease is terminated, whether early or at the end of a lease, a landlord generally becomes the owner of improvements which were made to such leased space during the lease. The IRC provides relief for a landlord from recognizing any income from such property acquisition. The specific provision states that gross income for a landlord does not include income derived by a landlord of real property on the termination of a lease, representing the value of such property attributable to buildings constructed or other improvements made by a tenant. Simultaneously, a separate provision prevents a landlord from increasing the basis of its property for such acquired improvements.

Tenant’s Perspective

At the time a lease terminates, whether early or at the end of the lease term, a tenant generally walks away from improvements made during such lease. At lease termination, a tenant who does not retain the improvements is eligible to recognize a loss by reference to the adjusted basis of the improvements at that time.

Landlord Leasehold Improvements Previously Made for Vacating Tenant

Landlord’s Perspective

If a landlord had incurred and capitalized costs relating to a tenant that is now vacating space, such leasehold improvements made by the landlord may be treated as disposed of by the landlord at the time of the lease termination if the landlord actually disposes of them. For example, a landlord may have prepared space for the vacating tenant such as installing wall partitions. In order to get the property ready for a new tenant, the landlord may need to dispose of those prior improvements. In this scenario, the landlord should generally be able to recognize a loss for any unrecovered basis in those prior improvements.

Tenant’s Perspective

At the time of lease termination, a tenant generally has no tax impact from a landlord’s leasehold improvements.

Unamortized Leasehold Acquisition Costs

Landlord’s Perspective

It is common industry practice for landlords to utilize the services of a broker to arrange leases with new tenants. The commissions that a landlord pays for the successful acquisition of a new tenant are generally not immediately deductible for tax purposes. Furthermore, legal costs are common as well due to the document drafting and negotiations that take place. These costs are also not immediately deductible. Rather, a landlord must capitalize all such costs and amortize them over the life of the lease.

If a lease is cancelled or terminated early, any remaining unamortized leasehold acquisition costs are deductible in the year such lease is cancelled or terminated. It should be noted that this treatment is in contrast to the treatment where a landlord sells a property subject to a lease with unamortized leasehold acquisition costs. In a sale scenario, such unamortized costs would be added to the basis of the property sold and therefore reduce the net income from the sale. Although both scenarios provide for a reduction of taxable income, the character of such reduction may differ. The former scenario results in an ordinary loss whereas the income or loss from a sale may be capital gain or loss.

Tenant’s Perspective

Similar to landlords, tenants may also incur costs such as brokerage commissions and legal fees while entering into leases. Such costs are also not immediately deductible but rather must be amortized over the life of a lease.  Analogous to the treatment for landlords, any unamortized costs remaining upon an early cancellation or termination of a lease are immediately deductible in such year of termination.

Note that this treatment contrasts to the scenario where a tenant purchases leased property from the landlord, thereby eliminating a lease. Under such a scenario, any remaining unamortized costs are not immediately deductible but rather added to the basis of the property acquired.

Other Options to Exit a Lease: Sale or Sublease of Lease by Tenant

Rather than making a significant payment to a landlord to cancel a lease, tenants may be inclined to sell or sublease their lease to another lessee. This would first be predicated by a lease agreement permitting such sale/sublease or a landlord otherwise agreeing to it.

In a sale of a lease, a tenant would be deemed to realize gain or loss equal to the difference between a) the amount realized by the tenant in the sale and b) the tenant’s basis in the lease. If the leasehold interest sold by the tenant is determined to be a capital asset or an IRC Sec. 1231 asset for the tenant, such gain or loss will generally be capital gain or loss. Ordinary income can result though if there is depreciation recapture or through the IRC Sec. 1231 loss recapture provisions. Ordinary loss can result through the IRC Sec. 1231 loss provisions.

Generally where a tenant completely disposes of its interest in a lease, the tenant will be deemed to have sold its interest in the lease. In other cases, a tenant may be deemed to only sublease to another tenant. The courts have held that the distinction between a sale of a lease and a sublease is whether the entire leasehold passes from a tenant to a transferee so as to put the new tenant and the landlord in a landlord-tenant relationship, or whether less than the entire leasehold interest passes so as to leave the new tenant in a landlord-tenant relationship with the original tenant. Example of situations where a sublease resulted were when the original tenant continued to be liable to the landlord and also retained a right of reentry for breach.

A sublease generally results in ordinary income treatment for a tenant. Furthermore, if a transaction contemplated to be a sale is actually recharacterized as a sublease, any sales price would be taxable as ordinary income to the tenant in the year of receipt as advance rent.

Planning Opportunities and Next Steps

As with most complex business transactions, careful analysis of all facts and circumstances as well as sufficient tax planning is required for lease terminations in order to ensure the most tax efficient results. Some examples of the tax analysis requirements and planning opportunities available are:

  • If a payment by a tenant to a landlord is in lieu of the tenant making repairs to a damaged building required under a lease, such payment should be treated as a return of capital for the landlord. To the extent such amount exceeds the basis of a landlord’s property, capital gain may result (i.e., rather than ordinary income). Therefore, it is essential that a lease agreement is carefully analyzed for requirements for a tenant to repair/replace property at lease termination. Furthermore, the economics of a lease termination payment need to be understood to identify the components of such payment.
  • Landlords commonly incur significant costs to prepare space for a tenant. If such a tenant subsequently vacates the space, early or timely, the landlord may be eligible to recognize a loss for such earlier leasehold costs if they are actually disposed of by the landlord. Therefore, a detailed analysis of the landlord’s fixed asset records is needed.
  • IRC Sec. 1031 Exchange Opportunity: Where a tenant sells a long-term leasehold interest (i.e., ground lease) and recognizes gain, an IRC Sec. 1031 exchange may be available as a tax deferral mechanism. The regulations provide that real estate leasehold interests with remaining terms of 30 years or more are like-kind with real estate fee interests. Note that optional renewal periods should be added to the initial term of a lease for the purpose of determining whether a leasehold interest qualifies as “like-kind” property.
  • IRC Sec. 467 Leases: Where a tenant subleases to a new tenant and receives a significant upfront payment as “sales proceeds,” the implications and planning opportunities from IRC Sec. 467 need to be considered. Although outside the scope of this article, IRC Sec. 467 dictates how rental income and expense are recognized for certain leases with deferred and/or prepaid rent.
About Michael Torhan

Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.