Unexpected Tax Consequences of Commercial Lease Modifications
In a prior Kleinberg Kaplan client alert, we noted that COVID-19 related economic disruptions have caused both landlords and tenants to consider restructuring their commercial lease arrangements. Tenants that enter into discussions with landlords seeking rent relief may be successful. However, landlords and tenants should be aware that they could run into unexpected tax consequences in connection with those lease modifications.
Landlords and tenants should consider whether the modification may cause a lease that was previously not subject to Section 467 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), to become subject to those provisions. Section 467 generally requires economic accrual of taxable income and deductions on leases with imputed interest (thus causing “phantom income” for a landlord on the cash method of accounting who may be required to accrue income in advance of receipt of deferred rent).
Section 467 may apply to a lease that was not previously subject to Section 467 if there is a “substantial modification” of the lease. For this purpose, a modification is any change to the legal rights or obligations of the landlord or the tenant. Generally, a modification is considered substantial if the legal rights and obligations that are altered and the degree to which they are altered is “economically substantial.”
There are certain safe harbors for modifications that are, per se, not substantial, such as adjustments to lease terms resulting from debt refinancing of the landlord to acquire the leased property, and changes in certain types of contingent lease payments (e.g., CPI adjustments, expense pass-throughs and late payment provisions). Accordingly, it may not always be clear whether a modification is treated as a “substantial modification.”
Tax Consequences of a Substantial Modification
If the changes to a lease trigger a “substantial modification,” then the modified lease is treated as a new lease which must be analyzed to determine whether the new lease is subject to Section 467.
If there is a “substantial modification,” the Treasury regulations effectively bifurcate the lease provisions into pre- and post-modification items. Generally, Section 467 principles are applied at the time of the modification only with respect to the post-modification items.
The new lease will generally be subject to Section 467 if the lease is for the use of tangible property that has increasing or decreasing rents (i.e., stepped rents) or provides for certain prepaid or deferred rents. If the lease calls for total payments of $250,000 or less, Section 467 is not applicable.
If subject to Section 467, the landlord and tenant must use the accrual method for recognizing rent and may also be required to recognize interest for amounts remaining unpaid from prior years. Rents are allocated pursuant to the terms of the lease. Because in a typical lease, there is only one allocation to the periods in the lease term (i.e., the payment schedule), there may often be no consequence to being treated as subject to Section 467, assuming payments are made according to the payment schedule. If the lease is restructured so that the rental allocations diverge from the payment schedule (e.g., if monthly rental payment are deferred and payable at the termination of the lease), then Section 467 may apply to require economic accrual of rent with an interest factor. The treatment of a portion of rent as interest may have implications as to the deductibility of such portion, particularly in light of the TCJA changes to the limitations on the deduction of interest under Section 163(j) of the Code.
Further, if the pre-modification lease was subject to Section 467, and there is a “substantial modification,” there can be unexpected and adverse consequences relating to the pre-modification deemed Section 467 loan.
Treatment of Payments Pursuant to a Modification
If a tenant makes a payment to a landlord to modify a lease, the payment will generally be amortized over the term of the lease for the tenant and taxable as ordinary income to the landlord. If a tenant received a payment from a landlord for modifying a lease, the amount would generally be considered ordinary income for the tenant and the landlord would amortize the payment over the term of the lease.
Before entering into any lease modification that changes the accrual or payment terms of rents under the lease, tenants and landlords should consult their legal counsel to weigh the potential tax consequences.
The rules of Section 467 are complex and can result in significant financial consequences for tenants and landlords. Kleinberg Kaplan’s attorneys are well-versed in commercial lease restructurings and the related tax implications. If you are considering a change to your lease, contact your regular Kleinberg Kaplan attorney or those listed below to help you navigate these issues.