Small Business Taxes & Management

Special Report


Lease Terms Determine How Income Reportable

 

Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.

 

 

Introduction

Often you can change how you'll report income by making an election on your tax return, selecting the right wording in a contract, etc. On the other hand, making a mistake can be costly. Real estate leases can be three, five, ten or even more years. And they can be a major expense of the business. Unless you've used this form of lease before, best to get advice from both your attorney and tax advisor.

 

Facts

In Michael H. Stough et ux. (144 TC-- No. 16) the taxpayer was the sole shareholder of an S corporation we'll call SDC. SDC was in the business of developing real estate and entered into a development agreement with T to construct a building designed for a particular function. SDC acquired land acceptable to T and, upon completion would own the building and lease it to T. The taxpayer negotiated the terms of the development agreement and the proposed lease. The latter was to be for an initial term of 10 years.

SDC acquired the property and with the aid of a bank loan on which it (and the taxpayer) were liable. T was not liable or obligated to make payments under the loan. SDC subsequently transferred the property to an LLC, where the taxpayer was the only member (thus a disregarded entity for tax purposes). After completion of the building T began occupancy and paying rent on or about March 1, 2008. The LLC and T signed the lease agreement for the building on June 6, 2008. The parties agreed that the terms of the proposed and final lease were the same.

The lease required T to pay a monthly rent which would be determined by a mathematical formula based on "project costs" that SDC incurred in acquiring and developing the property. The lease defined project costs as the sum of the Acquisition Costs; the Hard Construction Costs; the Soft Construction Costs; and the Financing Costs. A provision in the lease allowed T, on or before the commencement date to provide written notice to the LLC to elect to pay or reimburse it in a lump sum for any portion of the project costs. The actual terms of the lease were:

(v) Notwithstanding any other provisions of this Lease to the contrary, Tenant may, by written notice given by Tenant to Landlord on or prior to the Commencement Date, elect to pay or reimburse Landlord in a lump sum for any portion of the Project Costs as Tenant may specify in such notice. If Tenant makes such an election, Tenant shall, on or prior to the Commencement Date, make a lump sum payment to Landlord in respect of Project Costs in the amount specified in Tenant's notice of election, and, for purposes of determining the Assumed Term Loan Principal Amount, the Assumed Term Loan Amortization Amount and the Base Rent, the Project Costs and the Maximum Project Costs shall be reduced by the amount of such payment.

Because rent was a function of project costs, a lump-sum payment under the lease would reduce project costs, and consequently, reduce the amount of rent that T owed. It was within the sole discretion of T to make an election under the lease and to determine the amount of such lump-sum payment. As of April 1, 2008, there was an outstanding balance of $2,365,400.72 owed by SDC on the commercial loan. On April 17, 2008, T made a $1 million lump-sum payment to the LLC. The taxpayers applied the $1 million lump-sum payment to the outstanding balance of the bank loan.

T issued to the LLC a Form 1099-MISC, Miscellaneous Income (original Form 1099-MISC), reporting rents of $1,151,493.18 for 2008. This amount represented $151,493.18 in monthly rent for the property along with the $1 million lump-sum payment. Subsequently, T issued a corrected 1099 reporting rents of $151,493.18 for 2008. Initially the taxpayers reported the $1,151,493 as rental income on their return. They subsequently argued only $151,493 was rental income and the $1 million was not intended as rent by the parties but rather to reimburse the taxpayers for leasehold improvements.

The IRS argued the $1 million payment the taxpayer received was additional rental income in the year received, 2008.

The regulations state that, as a general rule, if a lessee pays any of the expenses of his lessor such payments are additional rental income of the lessor. If a lessee places improvements on real estate which constitute, in whole or in part, a substitute for rent, such improvements constitute rental income to the lessor. Whether or not improvements made by a lessee result in rental income to the lessor in a particular case depends upon the intention of the parties, which may be indicated either by the terms of the lease or by the surrounding circumstances.

The Court noted that when a lessee pays an expense or obligation incurred by the lessor in bringing the leased property into existence, there is a direct economic benefit to the lessor to the extent that the lessor is relieved of his or her financial obligations. Under these circumstances there is no ambiguity regarding the financial benefit that the lessor receives. That being the case, there need be no inquiry into the intent of the lessor and lessee unless the lessee's payments were unrelated to the lease. In the instant case there is no question that the $1 million lump-sum payment was made pursuant to the terms of the lease; was optional at the election of the lessee; was to “reimburse” the lessor for “project costs” incurred and paid by the lessor in bringing the property into existence; and reduced the lessee's future rents otherwise due. Given these facts the $1 million lump-sum payment falls within the purview of Reg. Sec. 1.61-8(c), as the lessee's payment of the lessor's expenses and therefore constitutes rent without the need to inquire into the subjective intent of the parties.

The taxpayers advanced a second argument. That the $1 million lump-sum payment, should it be deemed rental income, may be reported ratably over the 10-year live of the lease pursuant to Sec. 467. While the Court found that the lease qualified as a Sec. 467 rental agreement, it did not meet the criteria for allocation because it failed other tests. The bottom line was the Court held the $1 million was taxable in the year received.

 

Other Situations

Rental agreements are often structured to meet the needs of the lessor and/or lessee. For example, leases can often have free rent periods to induce tenants to sign. Or a tenant must pay for improvements that become part of the property at the end of the lease. Here's how some situations are dealt with for taxes.

Prepaid Rent. Whether the lessor is on the cash or accrual method, advance rents are includable in the lessor's when received. In some cases a lessor will argue the amount received was a loan from the lessee. Whether the payment is a loan or rent will be determined by the intent of the parties, the existence of a loan document, how the transaction was recorded on the books, etc.

Signing Bonus. Not infrequently a tenant must pay an upfront amount to obtain a lease. That could occur in a tight market or certain other circumstances. The bonus is income to the lessor in the year received, but must be deducted ratably by the lessee over the life of the lease.

Security Deposits. Generally, a security deposit is not taxable income to the lessor, nor is it deductible by the lessee. That's true even if the lessor has control over the funds during the time they're in his hands. The lessor does not have to put the funds in an escrow or similar account. The IRS hasn't always agreed with this approach. The wording in the lease may can affect the status. Putting the funds in an escrow or separate bank account makes sense. Of course, the forfeiture of the deposit at the end of the lease for failure to pay the rent makes the deposit taxable.

If the security deposit is used to replace property destroyed by the tenant, a lessor can have a gain or loss similar to the tax consequences in a casualty loss. The gain or loss is measured by the difference between the lessor's basis in the property and the amount of the deposit forfeited. For example, Sue withholds $1,000 of Fred's deposit to replace an entry door his buddy broke. Sue's basis in the door was $600. Sue has a gain of $400. If Sue replaced the door within the two-year period (similar to a casualty loss), she could defer the gain.

Expenses Paid by Lessee. If the lessee pays some of the building expenses, either because the requirement is included in the lease or because the lessor didn't pay a required expense that normally the obligation of the lessor, they're rental income to the lessor and rent expense to the lessee. The lessor can then deduct the actual expense such as building repairs, taxes, etc.

Cancellation of Lease. Payments received by the lessor for the cancellation or modification of a lease are rent. On the other hand, an amount received by a lessee to cancel a lease are generally capital gains or losses.

Contingent Rent. Many leases provide for contingent rent such as increases based on the consumer price index, a share of the increase in the building's real estate taxes or operating expenses, or a percentage of the lessee's sales. All of these items art deductible as rent by the lessee and income to the lessor.

Improvements to Leased Property by Lessee. Whether or not improvements made by the lessee are rental income to the lessor depends on the facts and circumstances, including any wording in the lease. Clearly, if the lessor and lessee intend the improvements to be rent, they will be. If the lease states that improvements made by the lessee are intended to be rent, they will be. For example, Madison rents space in the Hudson Mall. In lieu of the first three months' rent Madison is required to retile the space's floor, sheetrock walls, and paint. The cost of the work would be rent to the lessor and deductible by Madison.

If there's no mention in the lease, things can get trickier. Then a facts and circumstances test can be applied, and the results may not be what one or both of the parties wanted.

If the lessor makes the improvements but charges the lessee for the work, the payment is usually rental income to the lessor and rent expense to the lessee.

Section 467 Rental Agreements. If the rental agreement calls for increasing or decreasing rents over the rental period, you might have to adjust the rent based on the rules of Sec. 467. A discussion is beyond the scope of this article. Fortunately, this isn't an issue if the increases are based on factors such as a consumer price index, the lessee's sales (as in percentage rent) or items based on an outside factor such as increases in taxes, utilities, or operating expenses of an unrelated party.

Related Party Transactions. Business owners frequently own a building in their own name which they rent to their business. While this generally makes sense from both a business and tax standpoint, there are issues to consider including a fair market rent, year-end payments, the character of the income for tax purposes, etc. Talk to your tax advisor before setting writing the lease.

 


Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536


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--Last Update 10/29/15