As a result of the COVID-19 pandemic and the temporary shutdown of non-essential businesses, commercial lessors are coming up against several challenges. They’re finding that many of their distressed tenants are choosing to simply not make their current monthly lease payment timely or are seeking mutually agreed upon modifications to their lease agreements.
If current economic conditions continue, many commercial tenants will be at risk of closing their businesses permanently and be unable to pay the remaining payments due under the terms of their lease agreements. In those cases, the lessor may receive a lease termination fee under the terms of the lease agreement. The lessor may also have capitalized costs related to the lease that they will be able to write off for income-tax purposes.
Landlords will need to address not only the detrimental cash-flow impact resulting from these situations but also the income tax implications. The remainder of this article provides a general discussion of the tax rules applicable to late and unpaid rents.
The second article in this series will provide 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. Click here to read part two.
Late rental income
The tax treatment of late rental income depends on the method of accounting that the lessor used for income tax purposes. The two most common methods are the cash method and the accrual method.
The cash method: Under the cash method, the lessor generally recognizes taxable income as cash is received. Therefore, lessors that use the cash method of accounting are not taxed on rental income until they have actually or constructively received the cash.
As an example of constructive receipt, say a lessor received a lease payment from a tenant prior to the end of the year. For income tax purposes, the lessor must report the amount of the check as income for that year, even if the lessor did not actually deposit the check until after the end of the tax year. What matters is that the lessor had access to the income, even if they delayed that access until they deposited the check in the following tax year.
The accrual method: Under the accrual method, the lessor recognizes taxable income as it is earned, which is deemed to have happened when the “all events” tests have been satisfied, regardless of whether the lessor has actually received the rent yet or not.
Under the all events test, income is recognized when 1) the right to receive the payment is fixed and 2) the amount of the payment can be determined with reasonable accuracy. Since the terms of the lease agreement will clearly specify both the timing and the amounts of the required lease payments, the accrual basis lessor will generally recognize rental income according to that schedule.
An exception to the above recognition of rental income may apply if the lease is subject to the Sec. 467 income rules. 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.
Unpaid rental income
The tax implications of unpaid rental income that is never collected also depend on the method of accounting the lessor uses for income tax purposes.
Because lessors that utilize the cash method of accounting do not recognize rental income until the rent is actually received, they therefore cannot claim a bad debt deduction if that rent that is never received.
On the other hand, because lessors that utilize the accrual method of accounting are required to recognize rental income as it accrues, they can claim a bad debt deduction for income tax purposes if rental income that they previously recognized as income is ultimately not collectible.
However, lessors are not allowed to simply create a bad debt reserve for such uncollectible amounts and claim a corresponding tax deduction based upon the amount they estimate will be uncollectible, as they can for book purposes. Instead, they must use the specific charge-off method. This means the lessor can only claim the bad debt deduction for tax purposes when and to the extent that the rent receivable becomes worthless.
Determining when a receivable becomes worthless is a facts-and-circumstances test. Factors that should be considered include:
- Financial condition of the tenant, although this alone is insufficient
- Bankruptcy of the tenant and amount of assets available for satisfaction of unsecured debt
- Permanent cessation of the tenant’s business
- Whether the lessor is still continuing collection efforts
- Whether the lessor has sued and won a judgement and can show the judgement is uncollectible (note that the lessor is not required to file a judgment against the tenant if doing so would not improve the success of collection — i.e., no need to throw good money after bad)
- Documentation that the lessor has made every effort a reasonable person would take to collect the unpaid rent
In addition to the above rules that apply in determining when a receivable is worthless, if only part of the receivable is being written off for tax purposes, the income tax rules require that same amount to also be written off for book purposes. If the full amount of the receivable is being written off for tax purposes, there is no similar rule requiring that amount to also be written off for book purposes.
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