Tax Considerations for Amending Commercial Leases Under Section 467 of the Code
- The coronavirus (COVID-19) health crisis and associated economic downturn is expected to have a significant impact on commercial real estate lessees, as their ability to attract in-person customers and otherwise generate revenue suffers in the current climate.
- A lease amendment implicates significant U.S. federal income tax rules that may alter the timing and character of income and deduction to the lessor and the lessee in unexpected manners.
- Understanding the impact of Internal Revenue Code's Section 467 should allow taxpayers to manage and, in some cases, plan around the adverse aspects of these rules. In some circumstances, the deliberate application of Section 467 also may result in a lessor or lessee reducing its overall tax burden.
The coronavirus (COVID-19) health crisis and associated economic downturn is expected to have a significant impact on commercial real estate lessees, as their ability to attract in-person customers and otherwise generate revenue suffers in the current climate. Lessors and lessees will be incentivized to reexamine their current lease agreements, and are expected in many cases to negotiate changes to allow lessees to continue as a going concern and meet their payment obligations. Lease amendments to address the economic downturn are expected to take a variety of forms, including inter alia, deferral of rent, reduction of rent or changing from fixed rent to a net lease arrangement based on share of lessee revenue.
A lease amendment as described above implicates significant U.S. federal income tax rules that may alter the timing and character of income and deduction to the lessor and the lessee in unexpected manners. These rules are located at Section 467 of the Code1 and its accompanying regulations. Section 467 was enacted in 1984 along with other provisions of the Code directed at proscribing the ability of taxpayers to reduce their effective tax burden through accounting methods and structures that utilize time value of money concepts. Thorough and voluminous regulations were subsequently issued by the U.S. Department of the Treasury in 1999. The recent federal legislation enacted in response to the COVID-19 health crisis made no significant changes to these rules.
The primary import of Section 467 is to require lessors and lessees to report income and deductions arising from a "Section 467 lease agreement" on the accrual basis, regardless of their otherwise applicable methods of accounting. In addition, these rules may alter the amount of income or deduction recognized in a particular period, or recharacterize payments of stated rent as interest. Section 467 is thus both a potential exposure for taxpayers when entering into leases and lease amendments, and also a potential planning opportunity to a well-advised lessor or lessee. Understanding the impact of Section 467 should allow taxpayers to manage and, in some cases, plan around the adverse aspects of these rules. In some circumstances, the deliberate application of Section 467 also may result in a lessor or lessee reducing its overall tax burden.
What Types of Lease Agreements Are Subject to Section 467?
The special accounting rules under Section 467 apply only to "Section 467 lease agreements." There are two requirements for a lease of real property to be treated as a "Section 467 lease agreement." First, the sum of all rent due under the lease must be reasonably expected to exceed $250,000. For purposes of the $250,000 threshold, related agreements for the use of tangible real or personal property are treated as a single lease and payments are not discounted to present value. Second, the rent that accrues for a rental period must change over the term of the lease, or alternatively rental payments must be prepaid or deferred relative to when such rent is accrued, in each case as described by the regulations under Section 467.
The regulations contain exceptions for certain circumstances where rent accruals may change over time, and further do not treat certain prepayments or deferrals in form as captured prepayments or deferrals. For purposes of determining whether rent accruals change over time, many forms of contingent rent prevalent in commercial leases are disregarded, including rent that adjusts based on a price index tracking inflation, percentage of lessee revenue, common area maintenance charges or real estate taxes. In addition, any initial rent holiday not exceeding three months is ignored. With respect to deferred or prepaid rent, a deferral or prepayment of one year will generally be disregarded.
Generally the terms of a lease agreement should specify how rent accrues over the duration of the lease, and the regulations generally allow the allocation of rent under a lease agreement to control. If a lease agreement does not specify how rent accrues, the regulations allocate rent according to when payments are required to be made on the lease. Prudent taxpayers should be cognizant of the import of the terms of the lease agreement with respect to specific allocations of rent to specified time periods in the context of Section 467. In most cases taxpayers will be afforded increased flexibility by including such an explicit allocation in the lease agreement.
When Must a Lease Amendment Be Tested Under Section 467?
Not every amendment of a lease requires testing under Section 467. Prior to amendment, whether a lease is subject to Section 467 should be determined as of the outset of the lease. If an amendment triggers retesting under Section 467, the as-amended agreement is treated as a new lease for purposes of these rules.
An amendment triggers retesting if it changes the parties' rights and obligations with respect to the lease agreement, and such change is "economically substantial," taking into account all of the facts and circumstances.
Certain amendments are explicitly excluded from triggering retesting, including certain amendments in connection with refinancing of acquisition indebtedness of the lessor with respect to the leased property, changes in lessee obligations to pay certain costs in connection with the lease (e.g., common area maintenance), and any change in the amount of rent accrued in a period that does not exceed 1 percent of the preamendment rent accrued in such period, taking into account prior modifications that were not treated as economically substantial.
While the regulations provide that falling out of the enumerated safe harbors should not automatically result in an amendment being treated as economically substantial, the 1 percent safe harbor for rent payments is instructive as to what changes in rent payment obligations may raise the specter of Section 467 retesting. From this perspective, most amendments that eliminate payment obligations for a period or make significant alteration to the rent accrual schedule would likely implicate retesting under Section 467.
What Are the U.S. Federal Income Tax Consequences of a Lease Being Subject to Section 467?
As stated above, the principal impact of a lease being subject to Section 467 is that the lessor and lessee must report income and deductions from the lease on the accrual method of accounting. Large taxpayers that are organized and classified as C corporations under the Code generally should already be required to adopt the accrual method of accounting for most purposes. For a lessor that is on the cash method of accounting, however, income generally will be accelerated as a result of a lease being subject to Section 467. By contrast, for a lessee that is on the cash method of accounting, deductions arising from accrual of lease payment obligations generally will be accelerated as a result of a lease being subject to Section 467.
In addition, Section 467 may further alter the amount of income or deduction recognized in a particular period beyond the ordinary operation of the accrual method, and may further recharacterize or impute interest by treating any deferral or prepayment of accrued rent as a loan between the lessor and the lessee. These aspects of the rules can have a significantly greater impact on the tax profile of the lessor and the lessee as compared to being required to be on the accrual method of accounting with respect to the lease, which the taxpayer may have already otherwise adopted as its general method of accounting.
There are two circumstances that may implicate such additional accounting requirements. First, additional accounting rules apply if there is a tax avoidance motive for the amendment, rent that accrues for a rental period changes over the term of the lease, and the lease is either sufficiently long-term or is a leaseback to an owner of a former interest in the real property. The regulations provide that this first category of transactions may only be classified as such by the Internal Revenue Service (IRS) (e.g., on an audit). Thus, under the approach of the regulations, a taxpayer should not unilaterally apply the additional accounting rules associated with this category of transactions. However, it should also be noted that if the determination is only made by the IRS upon a later audit, penalties and interest may be due on any assessment arising out of the change. Thus, a taxpayer may be better off affirmatively adopting the accounting treatment notwithstanding the regulatory language if the facts are applicable. More saliently, it is not expected that lease amendments that arise from an economic downturn and associated financial distress of a lessee would be treated as having the avoidance of taxes as a principal purpose.
If this first category of transactions is implicated, total rent is generally accounted for on a constant basis over the term of the loan, notwithstanding the terms of the lease, and a loan will be imputed to take into account the differences in timing of payments. In addition, if there is no tax avoidance motive but the other requirements are met, and if the lessor subsequently disposes of the leased property, the lessor will be required to recharacterize its gain as ordinary income to the extent additional rent would have resulted in prior periods if a tax avoidance motive had been found.
Second, additional accounting rules apply if rental payments are prepaid or deferred relative to when such rent is accrued, and the lease agreement does not provide for "adequate interest" on such prepaid or deferred amounts. It should be recalled that a one-year deferral or prepayment generally should not be treated as a deferral or prepayment under Section 467. It also should be noted that if the rent accrual schedule matches the payment schedule, or alternatively if there is solely a payment schedule and no rent accrual schedule, there also should be no prepaid or deferred rent.
There are two manners to satisfy the "adequate interest" requirement and avoid the application of additional accounting rules on a prepayment or deferral. There is adequate interest if the lease agreement provides for an explicit interest rate on the prepayment or deferral that is either fixed or variable in a manner that measures contemporaneous variations in the cost of newly borrowed funds, such rate is at least 110 percent of the applicable federal rate as of the outset of the lease, and such interest is compounded and paid or accrued at least annually. Alternatively, there is adequate interest if on a present value basis the payments that are actually provided for in the lease agreement equal or exceed the payments that would be required if accrued rent bore interest at 110 percent of the applicable federal rate. However, in such latter case, the timing of the interest inclusions may still be altered by the operation of Section 467.
If a lease agreement subject to Section 467 has prepaid or deferred rent without adequate interest, the rent that must be accounted for by the lessee and the lessor for each period is the "proportional rent amount." The proportional rent amount is the product of the rent payment for the period and a fraction, the numerator of which is the present value of all payments under the lease, and the denominator of which is the present value of all rent accruals under the lease. A loan is further imputed to take into account implied interest on prepaid or deferred amounts, applying a rate equivalent to 110 percent of the applicable federal rate. As a result of the imputed loan, stated rent may be recharacterized in part as interest or the timing of inclusion of stated interest may be altered. Accounting conventions enumerated in the regulations apply to the deemed loan to allow for the calculation of associated interest allocable to each period.
Summarized below are certain examples contained in the regulations promulgated under Section 467 of the Code, which are helpful to understanding how these rules operate.
Consider a four-year lease agreement that provides for accrual of $100,000 of rent per year. The rent that accrues does not change across rental periods, thus rent must be prepaid or deferred relative to when such rent is accrued for the agreement to be subject to Section 467. In this circumstance, no rent is payable in Year 1 (Y1), $100,000 is payable in Y2 and Y3, and $200,000 is payable in Y4. This agreement is not subject to Section 467, because the accrued rent obligations are in each case only deferred by one year, which is excepted from being treated as a deferral under Section 467.
Alternatively, consider a five-year lease that provides for no accrual of rent in the first year, but accrual of rent of $87,500 in each of the following four years. In addition, payments are only required to be made by the lessee in Y3 and Y4, each in the amount of $175,000. Again there is no deferral or prepayment of rent obligations under Section 467, because the accrued rent obligations are in each case either deferred or prepaid for no longer than one year. However, because the rent that accrues for a rental period changes over the duration of the lease, the lease agreement is subject to Section 467. The lessee and lessor will be required to report income and deduction from the lease on the accrual method, but there should be no application of the proportional rent amount rules implicated by deferred or prepaid rent.
Now consider a five-year lease that provides for accrual of $100,000 of rent per year, but provides that all payment will be made in Y5, in the amount of $500,000 of rent plus $120,000 of interest. This agreement is subject to Section 467, because the accrued rent obligations are deferred beyond one year. In addition, while there is interest provided for at the conclusion of the lease, the agreement does not specify the interest rate or associated accounting conventions. Applying 110 percent of the applicable federal rate, here assumed to be equivalent to 10 percent, the present value of the accrued rent obligations is $379,078.68 and the present value of the rent payment obligations is $384,971.22. Thus, while there is no interest rate, there is nonetheless adequate interest under Section 467. The proportional rent amount rules will not apply, but the timing of inclusion of the $120,000 of interest over the duration of the lease will be determined by Section 467.
Consider instead an example not from the regulations promulgated under Section 467 of the Code, but which includes certain circumstances lessors and lessees may encounter in today's environment. In this example, there is initially a five-year lease that provides both for accrual and payment of $100,000 of rent per year. In Y2, there is an economic downturn, and to accommodate the financial straits of the lessee, the lessor and lessee amend the lease to defer the rent originally due in Y2 and Y3 to be amortized over Y4 and Y5. Assuming that such amendment should be treated as economically substantial, taking into account all of the surrounding facts and circumstances, the lessee and lessor will be treated as entering into a new four-year lease for purposes of Section 467 as of such amendment. This lease is subject to Section 467, because the accrued rent obligations are deferred beyond one year. If there is no adequate interest provided with respect to the deferral, the proportional rent amount rules will apply, recharacterizing a portion of the stated rent as interest that will be taken into account over the term of the lease as proscribed by Section 467.
If the parties had taken the further step to also amend the lease accrual schedule, a different result would occur under Section 467. Consider if, in addition, the accrual schedule was amended to provide that no rent accrued in Y2 and Y3, and $200,000 accrued in each of Y4 and Y5. The rent accrual schedule would then match the payment schedule, and there would be no deferral or prepayment of rent. The amended lease would still be subject to Section 467, because the rent that accrues for a rental period changes over the duration of the lease. However, because this lease does not involve a deferral or prepayment, is not a long-term lease and is not being amended with a tax avoidance purpose, the principal impact of being subject to Section 467 is being required to adopt the accrual method of accounting with respect to the lease payments. The proportional rent amount rules should not apply, and no portion of the stated rent should be recharacterized as interest.
There are several circumstances where a lessor or lessee would be well advised to consider the potential application of Section 467 in the context of a lease amendment. To the extent that the tax implications are salient and material, care may be taken to implement amendments in a manner that either prevents the lease agreement from being subject to Section 467 or ensures that the rules will be applied in accordance with the parties' expectations. As described above, there are certain types of amendments that are excepted from triggering retesting under Section 467, including amendments in connection with lessor refinancing and changing allocations of third-party costs. In addition, even if retesting occurs, certain changes in rent amounts will not result in a lease agreement being subject to Section 467, including shifting to rent based on percentage of lessee revenue or providing for a three-month rent holiday.
For example, if there is a lump-sum payment made by a lessee to a lessor in connection with an amendment, the lessor should consider carefully how it is treating such lump-sum payment in the lease agreement. In Stough, a 2015 U.S. Tax Court case, a permissive prepayment was made by a lessee, and the lessor unsuccessfully attempted to assert that the agreement should have been subject to Section 467. The Tax Court suggested that if the parties had adopted a rent accrual schedule, they could have caused the agreement to fall under Section 467, which would have delayed income recognition to the lessor in part beyond the year of the prepayment. Although not before the court in Stough, commentators have also noted that any such prepayment should likely be required to be returned to the lessee if there is an early termination of the lease, to further bolster the argument that the prepayment in the nature of a loan that is repaid over time by offset of rental obligations of the lessee (i.e., in line with the potential Section 467 characterization of such amounts).
Another circumstance where the potential application of Section 467 is salient is where the lease agreement was already subject to Section 467. In such circumstance, the deemed principal amount of the loan that arises under Section 467 from the amended lease may differ from the principal amount of the loan that arose under Section 467 prior to such amendment, resulting in additional taxable consequences to the lessor and lessee. This could occur if the duration of a lease that is already subject to Section 467 is altered in connection with an amendment. In such circumstance, the parties may be incentivized to avoid retesting under Section 467 to the extent feasible.
Any recharacterization of rent as interest pursuant to Section 467 also affects taxpayers that are subject to the limitations on interest deductions under Section 163(j) of the Code. Conversion of rent into interest may accordingly result in such amounts not being deductible to the lessor or lessee, as applicable. Thus, the parties may be incentivized to avoid the application of Section 467 to avoid such associated adverse consequences to the lessor or lessee.
Finally, the complexity and compliance burdens associated with Section 467 should not be ignored. Maintaining control over the accounting and avoiding the need to engage advisors to parse through the voluminous Section 467 regulations (and any later amendments thereof) on an ongoing basis itself may be a sufficient reason to avoid the application of Section 467 to a lease agreement.
1 The Code refers to the U.S. Internal Revenue Code of 1986, as amended.
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