The ripple effect caused by COVID-19 and changes in style of work are being felt by landlords across the real estate industry. Many companies are analyzing the impact of new remote work arrangements for their employees and the resulting reduced or altered space needs. The retail sector continues to deal with the economic uncertainties created by the pandemic, amplifying an already uncertain future. In both cases, it is common for a tenant to approach their landlord to discuss a modification of the existing lease. Landlords are working through creative lease modification strategies to help tenants in the short-term without sacrificing the properties long-term return on investment. Unfortunately, these lease modifications can have unintended consequences on the recognition of revenue for tax purposes.
There are two primary sections of the Internal Revenue Code that address the timing of revenue recognition from rental activities – Section 451 and Section 467. Most leases fall under the straightforward rules of Section 451, which follows the normal method of accounting, cash or accrual. However, a lease modification can be a trap for the unwary, triggering the more complex rules of Section 467.
Section 467 was enacted with the Deficit Reduction Act of 1984 to eliminate leases structured with a tax avoidance motive. Congress was concerned about the potential mismatches that could occur between the recognition of revenue and expenses. Thus, if a lease is determined to be a “Section 467 lease,” the landlord and tenant are required to treat rents consistently, using the accrual method of accounting, regardless of their overall method of accounting. The question now that needs to be answered: How do we know if we have a Section 467 lease?
When a landlord enters a new lease with a tenant, the lease is required to be tested to determine if the rules of Section 467 must be followed. Section 467 leases have the following characteristics: one, increasing or decreasing rents, or two, deferred or prepaid rents. Lease agreements that have equal amounts of rent each month throughout the lease term and all payments of rent are due in the year in which the rent relates are not considered Section 467 leases. In addition, leases that have total rents of $250,000 or less throughout the entire lease term are not considered Section 467 leases and thus not required to follow the special accounting rules under this section.
Fortunately, most leases do not fall under the requirements of Section 467. However, in our current environment, landlords are finding themselves negotiating new payment terms with their existing tenants and providing rate abatements or deferrals. Because the modified lease is often backloaded and does not provide for equal rents throughout the lease term, it could be considered a Section 467 lease if the modification is substantial and the total rent to be paid is greater than $250,000.
If a lease modification occurs, the terms need to be reviewed to determine if the changes to the lease are “substantial.” Under the Section 467 rules, a modification is any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the lessor or lessee thereunder, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. Such a modification may rise to the level of substantial if, based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically substantial.
If a landlord modifies a lease and the Section 467 rules are triggered, the landlord and tenant will be required to use the accrual method of accounting. Use of the accrual method of accounting could accelerate the recognition of income leaving landlords with tax due on revenue they may not collect for years.
The mechanics of Section 467 are complex, so you should consider consulting your tax advisor if you are contemplating a lease modification for one of your tenants. They will be able to assist you in determining if the rules of Section 467 will apply to your modification and if there are opportunities to structure the lease in a way to avoid application of the provision.
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