Tax Implications of ASC Topic 842 on Lease Accounting
Originally published on July 25, 2022
Updated on November 1st, 2023
Operating lease information will soon be moving from the footnotes of your financial statements right onto your balance sheets. The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842, Leases, requires that companies and organizations that lease assets such as real estate, airplanes and equipment include these operating leases on their balance sheet. (Previously, they were only listed under operating expenses and in the notes to the financial statements.)
The standard was introduced in response to requests from investors and other users of financial statements for more transparent, comparable information about lease obligations and a more accurate representation of an organization’s leasing activities and future commitments.
ACS Topic 842 takes effect for private companies and nonprofit organizations with annual reporting periods beginning after Dec. 15, 2021. If your company has a Dec. 31, 2022 year-end, this standard needs to be implemented on your current year-end financial statements and you need to be aware of the tax implications of this change.
Read our whitepaper on FASB Topic 842 for more information on how to identify a lease, an overview of the changes and next steps you should take.
Tax Implications of ASC Topic 842
For tax purposes, leases are treated in one of two ways:
- True tax lease – In this situation, the lessor maintains ownership of the asset and recognizes depreciation and rental income. Meanwhile the lessee deducts rental payments (similar to operating leases under prior GAAP guidance).
- Non-tax lease – The lessee is the tax owner of the asset and claims related depreciation and interest deductions. The lessor is treated as selling the property and recognizes gain equal to the present value of the lease payments (less its basis in the lease’s property) and recognizes interest income (similar to capital leases under previous GAAP guidance).
ASC 842 does not impact how leases are treated for federal income tax purposes. There were no changes made to the IRS tax code by Congress. But while the income tax treatment of leases hasn’t changed, lessors and lessees may find that certain existing leases/sales/financing transactions may be misclassified for GAAP purposes and/or for federal income purposes. This could trigger a change in accounting methods to modify existing related transactions or change its tax treatment.
When implementing systems to track your leases under ASC 842, it’s important to evaluate the lease accounting structure in the following areas for compliance with tax rules.
- Characterization of the lease
- Timing of income and expense
- Tenant improvement allowances
- Lease acquisition costs
You should also determine if a change in accounting method is available for a more favorable tax treatment of the lease.
The main change to ASC Topic 842 is that ALL leases must now be included in the balance sheet. Operating leases are now accounted for in the same manner as finance leases. The total future rent payables under liabilities and the value of the right of use for the asset leased listed under assets, which will result in book-to-tax reconciliation items. More specifically, this will result in new deferred tax liabilities and deferred tax assets.
This change is temporary and will reverse over the life of the lease. And since the right-of-use asset and related lease liability are measured in the same manner under the new guidance, the initial measurement of the temporary differences will generally be the same (regardless of the lease classification).
The manner in which the initial temporary differences reverse, however, depends on whether the lease is classified as a finance or operating lease under the new standard. For finance leases, ASC Topic 842 will generally result in an accelerated expense recognition for financial statement purposes. This is due to the lease liability being based on an effective interest rate calculation. Also, if any impairment is created for a right-of-use asset for book purposes, it will need to be reversed for tax purposes.
Tenant improvement (TI) Allowances
In some leases, the lessor may provide the lessee with tenant improvement allowances for the lessee to use to improve the leased property. The most important factor in determining the tax treatment of tenant improvement allowances is the tax ownership of the leasehold improvement.
In general, when the lessor retains the resulting leasehold improvements, they may depreciate the assets whereas the lessee generally does not recognize income from the tenant improvement allowance and does not have a depreciable interest in the improvements.
In contrast, when the lessee ownsthe leasehold improvement, they generally recognize the allowance as income and have a depreciable interest in the improvement.
IRC Sec. 110 provides a limited exclusion from a lessee’s gross income for a lessor’s payment of a “qualified lessee construction allowance.” A qualified lessee construction allowance must relate to a short-term lease of retail space and be used to construct or improve qualified long-term real property used in the retail space.
Lease Acquisition Costs
Both book and tax require the capitalization of lease acquisition costs. However, Regs. Sec. 1.263(a)-4 provides that certain internal costs (e.g., employee compensation and overhead) and de minimis costs are not required to be capitalized for tax purposes.
State and Other Taxes
Adopting the new lease standard could also impact other non-income-based taxes, such as franchise and net worth taxes. ASC Topic 842 means that these taxes are based on GAAP net worth (since right-of-use assets and lease liabilities will be on the balance sheet).
Implementation of the new leasing standard may impact your franchise tax base, levied at the state level, since all lease transactions must be recorded on the balance sheet. Additionally, the property factor used to calculate many state apportionment factors (for both income and franchise tax purposes) is determined by using an average value for owned property or a multiple of net annual rent. Under ASC Topic 842, companies might have to change the way they get this information — especially if the right-of-use asset is recorded in the same balance sheet account or line item as other owned property.
Companies should also consider whether there will be any sales and use tax impact. Those with off-shore leases might also watch how ASC Topic 842 affects the foreign jurisdictions in which they operate, as well as transfer pricing arrangements.
As you prepare to adopt the new lease accounting standard, make sure to check the related tax consequences and opportunities. Your real estate CPA — with their knowledge of ASC Topic 842 — is your most valuable resource in these efforts.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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