The current economic downturn caused by the COVID-19 pandemic has greatly impacted the commercial real estate industry. Even the most seasoned experts are left scratching their heads, trying to determine which direction the real estate market is heading. Taking matters into their own hands, tenants and landlords are modifying leases that were in place prior to COVID-19 in an effort to make leasing agreements beneficial to both parties.
However, simply editing the agreement won’t cut it. You may find yourself entangled with the highly-complex IRC Sec. 467, which all leases are subject to testing under. This exclusive Property Matters issue shares the critical information you need to know before adjusting existing agreements to avoid real estate tax pitfalls in this uncertain time.
From an accounting perspective, certain lease modifications may not cause any reporting changes; however, current income tax rules are not as lenient. Landlords and tenants must take a close look at newly agreed upon terms to determine if this could impact their commercial real estate taxation.
Fortunately, most leases are not subject to the complexities within IRC Sec. 467 and historically both parties have recorded the rental streams on a cash basis. Unfortunately though, along with lease modifications comes the provision to retest the leases. If significant deferred, prepaid and/or stepped rent provisions occur, it may give rise to a Sec. 467 lease, leading to a very unfavorable result. Both parties, for tax purposes, would now recognize the rental income and expenses under the accrual method.
Further analysis would be needed to determine if the new lease should be treated as a loan, which brings with it a possible interest income and expense component to be factored into the lease payments. These changes can lead to more complexities than benefits, so the regulations must be addressed during the lease analysis.
In the event that the lease calls for total payments greater than $250,000, and the modification provisions mentioned above are in play, the focus is then turned to the regulations which loosely define what is deemed to be considered as an economically substantial modification. Facts and circumstances will typically weigh in, as well as the economic environment during the time that the lease is modified, to determine what would be considered “substantial.” This aspect is extremely important, especially when looking at the safe harbors in the code to see if there is a new Sec 467 lease.
To say that Sec 467 is complex would be an understatement. More often than not, the parties involved only set up a 467 lease with a purpose in mind. Given these uncertain times and the understanding that most are trying to emerge from this pandemic in as tax favorable position as possible, Friedman’s advisors are here to guide you through this intricate leasing concept.