The Impacts of COVID-19 on Rental Revenue and the Resulting Tax Implications
March 27, 2020
By Michael Torhan
COVID-19 has had an impact on virtually every area of life for most people. Major cities have gone into lockdown, businesses have closed, and the economy is currently being stressed in unprecedented ways. The rental real estate industry will certainly face challenges and obstacles as well. One of the potential impacts on the real estate industry will be to its lifeline: rental income. Whether in the form of late rents, unpaid rents, or rent deemed uncollectible/forgiven, the main source of revenue for rental real estate businesses may be at a risk of being affected by the impacts of COVID-19. A brief overview of the tax implications of the various situations may be helpful for property owners looking to analyze their future cash flows and any relevant tax implications.
Generally, rents from the rental of real estate are included in a landlord’s taxable income. The timing of inclusion in taxable income depends on whether the landlord is on a cash or accrual basis. For cash basis taxpayers, rents are includible as income when cash is received. For accrual basis taxpayers, rents are includible as they are accrued (i.e., subject to certain “all events” tests which fix the right for a landlord to receive income). Therefore, an accrual basis taxpayer may record income without the receipt of cash as compared to a cash basis taxpayer. It should be noted, though, that prepaid rents received by an accrual taxpayer are includible in taxable income even though the rental period to which they relate has not occurred yet. As a result, accrual basis taxpayers are effectively on a cash basis in regard to prepaid rents. It should also be noted that certain rental agreements fall under IRC Sec. 467, which provides for its own rules for income recognition. Such rules are complex and are outside the scope of this article.
In times of economic uncertainty, late or unpaid rents will impact taxable income. For a cash basis taxpayer, no cash received translates to no gross receipts for taxable income purposes. However, for an accrual basis taxpayer, an accrual for rental income is still required even if the cash payment is late or ultimately unpaid. An accrual basis taxpayer may not be able to determine that a rent payment will ultimately be uncollectible until a later date -- which could be well into the future. Furthermore, an accrual basis taxpayer would not be eligible to reverse such income until a bad debt expense was allowed for tax purposes. While GAAP allows for provisions for doubtful accounts based on certain estimation rules, the tax rules only allow a bad debt expense when a debt is deemed worthless.
An additional perspective that should be considered under the economic circumstances that COVID-19 has created is future leasing. Once the pandemic starts to ease, the real estate industry will look for opportunities to stimulate economic activity. Incentives to restart leasing activities may include rent holidays, or rent-free periods, in lease agreements. For tax purposes, such rent holidays generally result in a related reduction in taxable income since no cash is received (cash basis taxpayers) and no rent would be accruable (accrual basis taxpayers) since no rent was payable for such period. However, it should be noted that IRC Sec. 467, previously mentioned, includes provisions that create a straight-lining of rent if certain factors are present in a lease agreement. This could occur where a lease includes periods of deferred or prepaid rent and certain specific allocations of rent are also included.
Economic uncertainty and downturn are extremely difficult for industries such as real estate because of the wide ranging impacts. The loss of revenue for any business is detrimental. For landlords, the loss of revenue results in difficulties in meeting the ability to fully fund all operating expenditures and planned capital expenditures. As discussed above, tax implications of rent payment delays and uncollectibility in certain circumstances generally result in reductions in taxable income. However, the timing of such reductions are dependent on various taxpayer factors. While businesses are looking to review budgets and project cash flows in these uncertain times, consultations with tax advisors are also recommended to help determine whether tax impacts may provide any ancillary cash flow benefits.