Section 467 has re-emerged as a hot topic due to the economic impact of COVID-19 on real estate. With leases being modified everywhere due to financial hardship, now is the perfect time to review this important tax provision.
What is the section 467 provision, and why is it in the news again?
The Tax Reform Act of 1984 enacted a provision that commercial leases need to be tested under Internal Revenue Code section 467. The intent of this section is to prevent tax sheltering of income that could arise due to differences between cash and accrual basis income taxpayers by placing both lessor and lessee on the same revenue and expense recognition terms (thereby eliminating the timing difference between the two accounting methods).
A contract for the use of tangible property, with increasing or decreasing rents (“stepped rents”), or deferred or prepaid rents, and total rents exceeding $250,000 is a section 467 rental agreement. If there is a tax avoidance motive behind certain “disqualified” sale-leasebacks and long-term leases, they may also fall under section 467.The pandemic’s economic downturn is significantly impacting commercial real estate. This is especially true in the office, retail and industrial sectors as lessors struggle to maintain and attract tenants. Commercial tenants are seeking rent relief and negotiating concessions in efforts to either survive or take advantage of market conditions. When these negotiations result in significant modification of the lease terms, a new section 467 analysis must be performed.
How Section 467 Works
If the changes to the lease arrangement are large enough, section 467 requires the lessee and lessor to use the accrual method of accounting (regardless of their regular method). Moreover, if the lease contains significant prepaid rent or deferred rent, the lease could be deemed to constitute a loan agreement forcing the recognition of interest income and expense.
The results of a lease modification can vary widely, so let’s dig into a simple example to see how it works in practice.
Example: Lease with Deferred Rent
As we look at our example, keep in mind that “deferred rent” under section 467 exists where the cumulative rent allocated at the end of a year is more than the total rent payable at the end of the next year.
Assume a tenant has a 10-year lease in place for $10,000 per month. They ask to defer 24 months of rent, which will be payable in the final year of the lease. In total, $240,000 has been deferred ($120,000 for 2021, and $120,000 for 2022). This modification causes the lease to have deferred rent under section 467 and may require the parties to recognize rental income and expense under the proportional rental accrual approach.
Assume the amount recognized as rent for 2021 under the proportional rental accrual method is $100,000. This means the landlord would recognize $100,000 of gross rents in the current year and be deemed to make a loan back to the tenant in a like amount. Consequently, the tenant would receive a corresponding rental deduction. The $20,000 difference is treated as imputed interest that would be recognized by the parties over the term of the deemed loan.
The rules around section 467 can be complex. With the economic impact of COVID-19 causing renegotiations and commercial lease modifications, any substantial changes need to be assessed to see if the new lease terms require any different accounting treatment as a result of section 467.
We strongly recommend checking with your real estate CPA if you’re making any lease modifications. They can help ensure you’re following section 467 requirements and address any other concerns you might have.
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