Tax Implications of Lease Modifications

COVID-19 has caused a significant amount of disruption to almost every type of organization and has prompted state mandated closures of many businesses. This has resulted in a significant amount of companies transitioning to a work-from-home model. Furthermore, many commercial office buildings and retail locations have closed for several weeks, if not longer. Therefore, in addition to the health and social impacts of the pandemic, both landlords and tenants of commercial buildings have been economically affected. Many tenants have been unable to make their rent payments due to the economic downturn and have, therefore, requested modifications of their rental agreements.

Both landlords and tenants contemplating a potential modification to a lease agreement need to carefully analyze and understand the tax implications thereof. For example, whereas cash basis taxpayers generally recognize income/expense when cash is received/paid, respectively, accrual basis taxpayers follow the “all events test” and may recognize income or expense inconsistently with the underlying cash flow. For a cash basis taxpayer, a tenant’s late rental payment generally creates a deferral of the related taxable income until such time of receipt. On the other hand, a tenant’s late payment of rent may not delay an accrual basis taxpayer’s rent recognition, since the revenue accrual would still need to be made; however, a prepayment of rent would accelerate income recognition.

The rules for rental recognition, and corresponding rent expense by a tenant, are further complicated by the Internal Revenue Code (“IRC”) Section 467. As noted below, modifications to Section 467 lease agreements may create unexpected accounting requirements.

General Section 467 Rules

Agreements for the rental of tangible property are subject to the IRC Section 467 rules if (1) the total amount to be paid for the use of the tangible property exceeds $250,000; and (2) under the agreement there are increasing or decreasing rents, or deferred or prepaid rents.

For purposes of IRC Section 467, a lease has increasing or decreasing rents if the annualized fixed rent allocated to any rental period exceeds the annualized fixed rent allocated to any other rental period in the lease term. Certain variations from level rent are disregarded for purposes of determining whether or not a lease has increasing or decreasing rents.

A lease is considered to have 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 lease is considered to have prepaid rent if the cumulative amount of rent payable as of the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year.

While the terms increasing and decreasing rents are generally defined as expected, the concepts of deferred rent and prepaid rent require additional analysis. The term rent allocated under IRC Section 467 has a unique definition. The statute provides that a lease agreement may provide for a specific allocation of rent to a rental period. Alternatively, if there is no separate allocation schedule defining how the rent payments are to be allocated over the terms of a lease, the payment schedule determines how the payments are allocated. In this scenario, deferred and/or prepaid rent should not exist. Generally, for deferred and/or prepaid rent to arise, a lease agreement would need to provide for a schedule of specific allocations of rent in addition to rental payment due dates.

When a lease falls under the rules of IRC Section 467, the provisions require both the lessor and lessee to recognize rental income/expense under the lease on an accrual basis, regardless of the actual method of accounting used and regardless of when it is actually paid. In certain circumstances, the Section 467 rules result in a straight-lining of rental income based on a complex set of calculations as defined in the statute.

Modifications to Section 467 Leases

A modification of a lease agreement is defined as any change, including any deletion or addition in whole or in part, of a legal right or obligation of the lessor or lessee, whether the change is evidenced by an express oral or written agreement, conduct of the parties, or otherwise.

There generally will not be federal income tax consequences unless the changes to a lease constitute a “substantial modification.” Therefore, in the absence of a substantial modification, the rental income recognition for a Section 467 lease will continue as per the original rental agreement. As noted above, if there is no separate allocation schedule in a lease defining how the rent payments are to be allocated, the payment schedule determines how the payments are allocated and, therefore, recognized as taxable income. As a result, in the absence of a substantial modification, delays in payments by a tenant would not provide a landlord the ability to defer recognition of the taxable income for such payment periods.

Not all lease modifications trigger a substantial modification. The regulations contain several safe harbors so that certain common modifications will typically be excluded from the definition of a substantial modification. Generally, a modification is considered substantial if the legal rights and obligations that are altered and the degree to which they are altered are “economically substantial.”

If there is a substantial modification in a lease, the modified lease is treated as a new lease effective on the date of modification. Furthermore, the new lease must be reviewed to determine whether the new lease is classified as a Section 467 lease. Under certain circumstances, a lease that originally was not classified as a Section 467 lease agreement may be considered a Section 467 lease for purposes of the new lease.  

If a substantial modification creates a new lease under these provisions, the rental allocation schedule for the new lease is followed. Therefore, if a new Section 467 lease provides that a rent payment is delayed for several months and allocable in the same timeline, a landlord’s rental income recognition should also be delayed. Conversely, in scenarios where both the rental accrual and rental payment schedules are not simultaneously amended, or where they are amended but the accrual and payment timelines are incongruent, deferred and/or prepaid rent may occur. An unexpected tax result may then occur because the complex rental recognition rules under Section 467 may be invoked.

Planning Opportunities and Next Steps

The rules of Section 467 are rather complex, and it may not always be readily apparent whether a modification is substantial or whether the terms of a modified lease cause it to become subject to the Section 467 rules. Before entering into any lease modification that changes the accrual or payment terms of rents under the lease, tenants and landlords should consult with their tax advisors to help analyze the potential tax consequences.