The past eighteen months have brought unprecedented challenges for businesses, business owners and the economy.  The pandemic affected all sectors of the economy, some of which have still not fully recovered.  Even minimally impacted sectors are now contending with supply chain interruptions, labor shortages and an increasingly remote workforce.  These pressures and disruptions have prompted many commercial tenants to seek rent relief.  Landlords, suddenly concerned with occupancy rates, seem more willing than ever to accommodate tenants in distress.

The need to enter into lease modification agreements is undoubtedly understandable. However, landlords should consider that such arrangements may trigger unintended tax consequences.

Section 467 Background

Section 467 governs the tax treatment of leases for both tenants and landlords. In 1984, the Internal Revenue Service enacted the statute to address a perceived lack of symmetry in leasing arrangements and curtail manipulation of lease agreements to achieve desired tax outcomes.  Previously, it was relatively easy for landlords and tenants to take advantage of timing differences between accrual basis and cash basis taxpayers.

The statute’s goal is for landlords to recognize income in the same period that tenants deduct the associated lease payments.  Effectively, the rule pits lessors against lessees, requiring the creation of a rental schedule under which both parties must record lease activity, regardless of when they exchange cash.  Leases with total payments above $250,000 and which have deferred or accelerated rents fall within the purview of Section 467.

Section 467 & Lease Concessions

If lease modifications constitute a “significant modification” relative to the overall lease terms, retesting may be necessary to ensure compliance with Section 467. Both the landlord and tenant may be required to use the accrual method of accounting for the lease, regardless of their current overall tax accounting method.

Further, if the negotiated concessions result in significant deferred rent (within the meaning of Section 467), the lease could be re-characterized as a loan for tax purposes. In that case, Section 467 may require recognition of interest and rental income for the landlord and rental and interest deductions for the tenant, all while cash is potentially not changing hands.  These outcomes may produce tax and financial results markedly different from those contemplated when the parties negotiated the original lease.

The Section 467 rules are very complex and full of traps for the unwary.  We recommend landlords and tenants seek guidance from their legal counsel or CPA as they negotiate lease concessions. If you need additional information on how to manage lease concessions, we are available to help. Don’t hesitate to contact us so we can strategize on the best approach for you.

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mike-pompilio-moore-colson-tax-partner-real-estate-practice-leader Mike Pompilio, CPA, is a Partner in Moore Colson’s Tax Services Practice. Mike leads tax services for our Real Estate Practice. He brings over 20 years of technical expertise to the firm in the complex federal taxation areas of real estate, partnerships and corporation.

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