In our previous article, we covered late or unpaid rents — one of the biggest issues lessors are facing as a result of the COVID-19 pandemic and the temporary shut-down of non-essential businesses. Click here to read about the tax rules applicable to late and unpaid rents.
But it’s not just rent issues that landlords are facing. The remainder of this article provides a general discussion of the tax rules applicable to the modification or termination of lease agreements and the write-off of previously capitalized improvements and intangibles.
Lease modifications generally include increasing or decreasing the remaining lease term or the amount of space leased or modifying the payment structure. A termination of an existing lease combined with a new lease involving the same premises will also be treated as a lease modification.
To the extent a landlord incurs costs to modify a lease (e.g., legal costs), those costs cannot be immediately expensed for income tax purposes. Instead, they must be capitalized and then amortized over the remaining term of that lease.
In addition, if the lease modifications are substantial, the post-modification agreement can be considered a new lease for purposes of applying Sec. 467. A modification is considered substantial if, based on the facts and circumstances, the legal rights or obligations that are altered are economically substantial.
Generally, leases are subject to Sec. 467 if the total payments to be received over the term of the lease exceed $250,000 and either 1) at least one amount allocable to the use of property in one calendar year is to be received after the close of the following calendar year or 2) there are increases in the amount to be received as rent under the agreement, such as graduated increases or stepped rents.
In that case, the lessor’s use of the cash or accrual method of accounting are ignored. The lessor will instead recognize rental income on a straight-line basis over the term of the lease, and a portion of the amount received will be characterized as interest income, as if the tenant had paid the landlord a level rent amount each year and then borrowed some or all of that amount back under an interest-bearing arrangement.
Income from lease termination fees
Generally, the amount received from a tenant for the early cancellation of a lease is considered the recovery of future lost rent and is therefore taxed as ordinary rental income in the year received, regardless of the lessor’s accounting method for income tax purposes.
If an amount received from a tenant is instead to release the tenant from a requirement in the lease that the premises be restored on termination of the lease, that payment may qualify as capital gain rather than ordinary income.
Write-off of lessor’s lease acquisition fees and leasehold improvements
Upon the termination of a lease, the lessor can write off any lease acquisition costs that remain unamortized for tax purposes. The write-off of leasehold improvements on the lessor’s books, however, is not so straightforward.
Generally, a lessor cannot write off the remaining tax basis in any leasehold improvements until they are irrevocably disposed of or abandoned. While a tenant vacating the premises is not sufficient to satisfy this test, the physical removal of the improvements so that new improvements can be constructed for a future tenant is clearly sufficient.
In between those two endpoints is the more ambiguous situation where the improvements have not yet been removed but can still be considered irrevocably disposed of or abandoned because they are so unique to the former tenant that they could not be used by any future tenant.
Because the write-off of improvements is not the result of a sale, disposition, exchange or involuntary conversion, the loss should be reported as an ordinary loss, not a loss from the sale of business property. This treatment is favorable for taxpayers that have net gains from the sale of business property in the same tax year as the write-off.
Tax treatment of forfeited security deposits
Forfeiture of a tenant's security deposit upon termination of their lease is treated much like a tenant's lease termination payment. If a lease provides that the tenant's security deposit is not to be applied to rent, it nevertheless becomes income to the landlord if and when the landlord's obligation to return it to the tenant, in whole or in part, ceases to be contingent.
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