Maximizing deductions when acquiring real property leases.

The acquisition of real property leases continues to provide tax planning opportunities. While leases are not intangibles amortizable under Sec. 197, changes enacted by the Revenue Reconciliation Act of 1993, as well as recent cases and rulings, have affected the deductions associated with such leases. Maximizing these deductions depends on how adjusted basis is allocated to assets, whether an acquisition is made by a lessor or lessee and whether assets and payments are properly classified. This article reviews the issues raised by the 1993 legislation and recent decisions and the deductions currently available, and offers planning strategies.

For financial and tax reasons, many businesses prefer to lease property rather than to purchase it. Although generally, the tax rules associated with leasing are straightforward, when a taxpayer purchases property burdened with a lease or a lessee acquires or cancels a lease, the tax results are not as simple. In addition, decisions made when the lease is acquired will affect subsequent deductions.

Allocation of Purchase Price

Under Sec. 1060(b), when trade or business property is acquired, purchasers and sellers must allocate the purchase price to the property and report it to the Service.(1) If leased real estate is included in the acquisition, the courts have permitted allocation of the purchase price to leases with favorable terms,(2) as well as to goodwill for an existing mobile home park(3) or a shopping center.(4) After the Revenue Reconciliation Act of 1993 (RRA '93), however, the allocation of purchase price to such intangibles was restricted.

Purchasers of leased real estate become lessors; the tax treatment of their lease acquisition costs and Sec. 197 intangibles (including goodwill) may differ from the treatment accorded lessees. The House Committee Report(5) accompanying the RRA '93 (House Report) suggested the following tax treatment of lessors and lessees:

Lease acquisition costs Sec. 197 intangibles

Lessor Include as part of cost Include as part of cost

of acquired building of acquired building

Lessee Separate, amortizable Separate, amortizable

asset limited to asset

"premium" value

(i.e., present value of

fair market value (FMV)

rent over the lease term

less present value

of rent to be paid

over lease term)

Given these rules, planning is needed to maximize the potential remaining deductions.

Acquired Leases

Sec. 197, enacted by the RRA '93, permits acquired intangibles held in connection with a trade or business or in an investment activity to be amortized over 15 years. Under Sec. 197 (e) (5), however, an interest in an existing lease of tangible property is not a Sec. 197 intangible.

In discussing Sec. 197(e) (5), the House Report stated that a lessor's lease acquisition costs that are part of an acquisition of property should be included in the property's cost a lessee's cost of acquiring an interest in an existing lease should be treated under Sec. 178 and Regs. Sec. 1.162-11 (a), not Sec. 197. Although acquired leases are not Sec. 197 intangibles, the House Report stated that the lessee's deduction of lease acquisition costs continues to be governed by Sec. 178. Under this section, the lessee can assign a cost to the acquired lease and amortize it. Therefore, the exclusion of an acquired lease from the definition of "Sec. 197 intangibles" is not significant for the lessee, just for the lessor.

Sec. 167 (c) (2), as amended by RRA '93, provides statutory support for the change reflected in the House Report. Under that section, when acquired property is subject to a lease:

[] No portion of the adjusted basis can be allocated to the leasehold interest.

[] The entire adjusted basis is to be taken into account in determining any depreciation on the property subject to the lease.

Thus, the lessor's lease acquisition costs must be included in the cost of the underlying depreciable real estate.

Purchasers of leased real estate may find it more advantageous to acquire leased property after leases have been canceled; thus, the buyer can ask the seller to negotiate a cancellation of existing leases prior to the sale of the property. If the seller is a corporation, the conversion of possible capital gain on the sale of the property to ordinary income from a lease cancellation may have minimal effect. The purchaser would then pay less for the property and negotiate a new lease with smaller lease payments, resulting in a lower basis in the property and less income. In effect, the purchaser will be in the same position as if he could amortize the cost of the favorable lease. For this to succeed, the lease cancellation and the property sale must be independent transactions.

Goodwill and Other Sec. 197 Intangibles

Sec. 197 (f) (8) provides that Sec. 197 does not apply if the incremental value from goodwill or any other amortizable Sec. 197 intangible is "properly taken into account in determining the cost of property which is not a section 197 intangible." For example, a shopping center is acquired by a lessor in a good location with established tenants. Does Sec. 197(f) (8) bar an allocation of part of the cost to goodwill? If it does, then the cost will be assigned either to the building, which can be depreciated straight-line over 39 years under the modified accelerated cost recovery system (MACRS), or to land, which is not amortizable. If there is no bar, the cost allocated to goodwill is amortizable over 15 years under Sec. 197. How goodwill is "properly taken into account" when tangible property is purchased must be determined before Sec. 197(f) (8) can be applied.

Prior to enactment of the RRA '93, Goodman(6) and Muserlian(7) held that shopping centers and mobile home parks, like other businesses, have the usual elements of goodwill--i.e., prominence, identity and reputation. No precise value was assigned by those courts to the goodwill in those cases (there was no need, because it was nonamortizable). However, these cases suggest that goodwill, prior to the enactment of the RRA '93, could have been properly accounted for as a separate asset when it was acquired with rental real estate.

It appears that the House Report failed to consider these cases, because it provides that no goodwill, going concern value or other Sec. 197 intangible arises from the purchase of rental real estate (e.g., office buildings, apartment buildings and shopping centers) and, instead, allocates the entire cost to acquired assets whose basis is recoverable under present law (i.e., nonamortizable land or buildings with a 39-year depreciable life). Given the cases, the conclusion in the House Report is questionable.

Regardless of whether the statement in the House Report is an appropriate interpretation of present law, other planning options may exist. For instance, the purchaser might argue that the property being acquired is not rental property, so that the statement in the House Report would no apply. Letter Ruling 95020378 held that, in applying Regs. Sec. 1.512(b)-i(c)(5), hotels are not rental property, because they provide services to occupants that are not customarily rendered in connection with the rental of rooms or other space for occupancy. Similarly, other properties may qualify as nonrentals.

While the lessee who is acquiring either leases or leasehold improvements for use in a trade or business (but not for the production of rental income) should not be troubled by Sec. 197(f) (8), the lease agreement should be structured to support the lessees assignment of value to the Sec. 197 intangible. For instance, when renting space in a shopping center, a lessee should consider negotiating for a covenant not to compete restricting the lessor from renting to the lessee's competitors. Value assigned to such a covenant, a Sec. 197 intangible, may be amortized over a 15-year period. This period may be shorter than either the amortization period for lease acquisition losts or the depreciation period for leasehold improvements.

Allocation Under Sec. 1060

The House Report suggested that the Treasury consider modifying the purchase price allocation rules under Secs. 338 (b) (5) and 1060 so that all amortizable Sec. 197 intangibles are included as Class IV assets and allocated a portion of the purchase price only if the value of Classes 1, II and III is less than the purchase price.(9) Again, the lessee has an advantage; because Sec. 197(e) (5) provides that an interest in an existing lease of tangible property is not a Sec. 197 intangible, the lessee may allocate value to the acquired lease and amortize the acquisition cost under Sec. 162. In making the allocation, however, the lessee must be aware of yet another limitation imposed by the House Report.

When a lessee acquires a lease along with other intangibles, the House Report limits the portion of the purchase price allocable to the amortizable lease acquisition cost to prevent the shifting of costs from Sec. 197 intangibles to other lease acquisition costs that potentially could be amortized more quickly. A lessee can allocate a portion of the price to acquisition costs only if the present value of the rent actually to be paid under the acquired lease is less than the present value of the current the market rent. In limiting this allocation congress is following a line of cases recognizing that a portion of the cost of acquiring leased property can be attributed to the leasehold itself when the lease has a "premium value."(10)

Under the House Report, the allocation formula is as follows:

Lesser of: Present value of the FMV rent for the lease term

or

FMV of tangible property on the acquisition date

Minus: Present value of the rent reasonably expected

to be paid for the lease term

Equals: Amortizable lease acquisition cost

In this formula, the present value of the FMV rent for the lease term is presumed to be less than the FMV of the tangible property when the lease term is shorter than the tangible property's economic useful life.

This limitation applies if any other intangible is acquired either in the same or in a related transaction, and eliminates the possibility of acquiring the lease separately from the other assets in a series of transactions with one vendor.

Acquisition Costs

If merely a lease, and not real property, is being acquired, lease costs must be identified, capitalized and amortized ratably over the lease term.(11) However, a fee paid to a lessee to cancel an existing lease is amortized over the unexpired lease term,(12) whether or not the lessor demolishes the building. If a fee is paid to enable either the lessor or lessee to enter into a more favorable lease, the cancellation fee must be amortized over the period of the new lease.(13) If a lease is canceled and the lessee does not enter into a new lease for the same premises, the lessee can deduct currently any unamortized acquisition costs.(14)

Because lease acquisition costs must be amortized rather than expensed, proper identification of such costs is essential. Amortizable lease acquisition costs include cancellation payments for a prior sublease,(15) assumption of delinquent property taxes,(16) loss on sale of furniture and fixtures purchased to obtain a lease assignment,(17) fees for drafting a lease assumption,(18) broker and agent commissions(19) and "rent-up" fees.(20) When costs are incurred to acquire a lease, they are part of the lease purchase price, and amortizable over the remaining term.(21)

Lessee's Amortization Period

Sec. 178 defines the length of the lease term for purposes of the lessee's amortization deduction. The term excludes lease renewal options (and any other period for which the parties reasonably expect the lease to be renewed) if 75% or more of the lease acquisition cost is attributable to the lease term remaining at the acquisition date. The term remaining at the acquisition date does not include any period for which the lease may subsequently be renewed, extended 6r continued.

Regs. Sec. 1.178-1 (b) (5) (i) indicates that in appropriate. circumstances, the computation may be performed by applying the principles used to measure the present value of an annuity. This will normally increase the amount of cost allocated to the current period by deemphasizing the final years of renewal options. rent,

Leasehold Improvements

Importance of Classification

Leasehold improvements, whether created or acquired by the lessee or the lessor, are capitalized and depreciated under Sec. 168(i)(8). The classification of such improvements is critical in determining both the method and recovery period--e.g., if the leasehold improvement is classified as commercial real estate, it is required to be depreciated straight-line over 39 years, using the mid-month convention. However, the classification of property is uncertain. For example, is a convenience store used to market gas and other consumer goods commercial real estate?

Normally, a convenience store would be classified as commercial real estate and depreciated straight-line over 39 years (if placed in service after May 12, 1993). The Service, however, recently noted that mixed-use convenience stores qualify for a 15-year MACRS recovery period using 150% declining balance as an improvement used to market petroleum products if they are primarily used in petroleum marketing. A convenience store meets this primary use test if both of the following are met:

[] 50% or more of the gross revenues generated are derived from gasoline sales.

[] 50% or more of the building's floor space (including restrooms, counters and other areas allocable to traditional service station "services") are devoted to marketing petroleum.(22)

Because a car wash qualifies as space used in marketing petroleum products, combining a car wash with the convenience store may enable this primary use test to be met.

Customized Improvements

If leasehold improvements are customized for a lessee, the lessee can maximize deductions by acquiring those improvements that are tangible personal property and not structural components or buildings. The lessee can expense the cost of such property under Sec. 179. However, because Sec. 179 (d) (5) may render a noncorporate lessor ineligible to expense the cost, the lessee should share enough of the cost to maximize the Sec. 179 deduction and, if not all costs will qualify for Sec. 179, should be required to pay those costs that would qualify.

Conversion of Property From Personal Use

If a lessor converts leasehold improvements from personal to rental use, the basis subject to depreciation may be limited. Under Regs. Sec. 1.167(g)-1, depreciable basis is the lesser of adjusted basis or FMV at the time of conversion. The FMV should be established by an appraisal at the time of conversion.(23) If, however, the lessee is granted a purchase option, the purchase price set in the option is the FMV at the date of conversion.(24) Consequently, if the purchase price set in the option is less than the appraised FMV, perhaps the option should not be granted, because the depreciation deduction will be reduced.

Demolition, Retirement or Abandonment

Often, the interior space of property is customized for a commercial lessee. Because such leasehold improvements are required to be depreciated over their recovery lives, they often will be abandoned, retired or demolished before being fully depreciated. Property abandoned without a sale or exchange generally will result in an ordinary loss(25); however, if the property is retired or demolished, a deduction may be denied.(26) For instance, if the lessee pays to cancel the lease, and abandons the improvements, the lessee may deduct the cancellation cost and the cost of the improvements in the year of cancellation.(27) The deduction may be denied, however, if the lessee chooses to demolish the improvements before the lease expires in order to remodel the space. Because the lessor has a continuing interest in the underlying property, a deduction may be challenged.(28)

In Rev. Proc. 95-27,(29) the Service established a safe harbor for demolitions occurring after June 5, 1995 (or, at the election of the taxpayer, for all open tax years). Under the procedure, the costs of making structural modifications to a building (other than a certified historic structure) are not treated as nondeductible demolition costs under Sec. 280B if both of the following tests are met:

[] 75% or more of the building's existing external walls are retained in place as internal or external walls.

[] 75% or more of the building's existing internal structural framework is retained in place.

Modifications of historic structures will not be treated as demolition for Sec. 280B purposes if they meet the above tests and the modification is part of a certified rehabilitation under Sec. 47 (c) (2) (B).

Alternatively, the loss may be currently deductible if it does not arise from the demolition. In DeCou,(30) a real estate developer was allowed to deduct currently an abnormal retirement loss arising prior to demolition. The Sec. 280b(a) (1) disallowance provision did not apply because the loss was not caused by the demolition; rather, the retirement was attributable to major defects in the building's structure and electrical wiring. Similarly, if a lease expires on property on which customized leasehold improvements have been installed, causing the improvements to lose their usefulness, an abandonment loss could be claimed under Regs. Sec. 1.167(a)-8. The expiration of the lease, not the subsequent demolition, was the cause of the loss.

Prop. Regs. Sec. 1.168-6 permits an abandonment loss when a taxpayer irretrievably discards an asset, but denies it when a structural component of real property is merely retired. While this denial is not supported by the Code (either currently or when the regulations were proposed in 1984), it appeals to be an extension of Regs. Sec. 1.167(a)-8(a) (3) (iii), which permitted a deduction for a normal retirement from a multiple asset account only under limited circumstances. A deduction for an abnormal retirement is permitted under Regs. Sec. 1.167(a)-8(b); this requires a showing by the taxpayer that "the withdrawal of the asset was due to a cause not contemplated in setting the applicable depreciation rate." Under MACRS and the accelerated cost recovery system, the distinction between normal and abnormal retirement became meaningless, because the taxpayer was no longer able to select the applicable depreciation rate. For these reasons, early retirements should now be viewed as abnormal and an abandonment loss can be claimed by either a lessor or a lessee.

Because the lessor's ability to claim a loss for leasehold improvements on the expiration of a lease is not clear, the better position is to have the lessee make the improvements. A lessee can take a loss if forced to abandon improvements at the expiration of the lease; however, care must be taken to ensure that the improvements are not characterized as rent paid by the lessee.

Leasehold Improvements as Rent

While leasehold improvements made by a lessee are capitalized and depreciated, under Sec. 109, the lessor who. receives such improvements at the termination of the lease does not recognize income. However, if leasehold improvements are made in lieu of rent, the lessor recognizes income on the receipt of such improvements and can depreciate its basis in them; the lessee will deduct rent rather than depreciation. In determining if leasehold improvements were made in lieu of rent Regs. Sec. 1.61-8 (c) provides that the intention of the parties controls, as indicated by the lease terms and the surrounding circumstances.

For example, if a lease contains both the rent due and the lessor's promise to credit the leasehold improvements made by the lessee against it, the cost of such improvements will be classified as a rent payment.(31) The intent to abate rent will be evident in the lease, and a direct offset will have been made. Similarly, if a lessor credits rent paid toward its assumed obligation to make leasehold improvements, the improvements will be considered a substitute for rent.(32) If, instead, a lessor were to increase the rent to compensate for leasehold improvements it made, the cost reimbursement will still be classified as rent(33) In Beecham Inc,(34) a district court held that payments by a lessee to a lessor to compensate for customizing space for the lessee was not rent because customization added little or nothing to the value of the real estate. Thus, if customized improvements add little or nothing, the lessor should argue that payments for them are not rent. The lease terms should be consistent with this tax treatment.

If leasehold improvements are rent, the amount of such income must be determined. If the cost of the improvements is a direct credit against rent, that cost is the measure of the income.(35) If, however, the lessor knows the cost will not reflect the value of the improvements to the lessor, the lease agreement should provide for a discounted value to be credited against the rent. The lessee's cost is unreimbursed to the extent the actual cost exceeds the FMV; this amount should be capitalized and depreciated.(36)

The structure of the lease payments also affects the timing of their deductibility or taxability. Regardless of the lessor's accounting method, the lessor includes advance rent payments in taxable income when received, under Regs. Sec. 1.61-8(b).(37) A lessee on the cash method may deduct advance rent payments currently only if the useful life of the property lease does not exceed one year,(38) under Regs. Secs. 1.162-11 (a) and 1.461-1 (a) (1); otherwise, such payments are amortized over the life of the lease or deducted in the year for which the advance payment is specifically made.(39) A lessee on the accrual method normally deducts advance rent either ratably over the lease period or as paid if the rent is based on usage of or income from the property, under Regs. Sec. 1.4614 (d) (3).

These rules accelerate the inclusion of rent payments and delay their deduction. Thus, lease agreements should clearly identify advance rent from payments made by a lessee for leasehold improvements. If not clearly identified, a lessee's payments for leasehold improvements may be classified as advance rent, with the following results:

[] The lessor would recognize rent income currently; if the lessee were purchasing leasehold improvements, the lessor would offset the payments against its cost.

[] The lessee would deduct advance rent ratably over the lease term; if the payment were for leasehold improvements, the lessee would deduct depreciation over a period which could be shorter than the lease term.

Because advance rent payments, generally, are amortized ratably over the lease term, the lease agreement should separately state payments for items such as repairs and common advertising. While deduction of these payments, under the economic performance rule, will be delayed until the repairs are actually made or the promotional service is rendered, the deduction may be substantially faster than a ratable deduction of advance rent over the lease period.40

Conclusion

Lessors and lessees are treated differently for tax purposes. A lessee may assign cost to a lease that it acquires and amortize it; a lessor who acquires leased real property cannot assign basis to the leases. Sec. 179 may be available to a lessee, but not a lessor. A lessee may deduct remaining basis in leasehold improvements when the lease is terminated; the tax consequences to the lessor are uncertain. The lease terms may cause leasehold improvements to be treated as rent, accelerating taxable income to the lessor, yet provide no immediate tax benefit to the lessee. These tax results are triggered by choices made by the lessor and the lessee during their lease negotiations. These parties should consider the tax results (summarized in Table 1 on p. 170) prior to negotiating their lease agreement and plan to maximize deductions arising from the lease.

[TABULAR DATA 1 OMITTED]

(1) See Temp. Regs. Sec. 1.1060-1T(b)(2) and (h) (applicable asset acquisitions); Regs. Sec. 1.355-3(b) and (c), Example (12). (2) The 1220 Realty Co., TC Memo 1962-67, rev'd in part and aff'd in part, 322 F2d 495 (6th Cir. 1963) (63-2 USTC 19703). (3) Leonard Goodman, 512 F Supp 155 (E.D. Mich. 1981) (47 AFTR2d 81-1473, 81-1 USTC 19375), aff'd in unpublished opinion, 6th Cir., 12/27/82. (4) Petere. C. Muserlian, 932 F2d 109 (2d Cir. 1991) (67 AFTR2d 91-912, 91-1 USTC [paragraph]50, 204), aff'g TC Memo 1989-493. (5) H. Rep. No. 103-111, 103d Cong., 1st Sess. 769 (1993), 1993-3 CB 345 (hereinafter, "House Report"). Under Sec. 197(f) (6), sublessors and sublessees are treated the same as lessors and lessees, respectively. (6) Goodman, note 3. (7) Muserlian, note 4. (8) IRS Letter Ruling 9502037 (10/19/94). (9) House Report, note 5, p. 776, 1993-3 CB 352. (10) See Mary Young Moore, 207 F2d 265 (9th Cir. 1953) (44 AFTR2d 470, 53-2 USTC [paragraph]9563), cert. denied; Midler Court Realty, Inc., 61 TC 590 (1974), acq. 1974-2 CB 3, aff'd, 521 F2d 767 (3d Cir. 1975) (36 AFTR2d 75-5567, 75-2 USTC [paragraph]9650); Metro Auto Auction of Kansas City, Inc., TC Memo 1984-440. (11) See Regs. Sec. 1. 1 62-11 (a); Charles E Bachman, 21 BTA 36 (1930); D.N & E. Walter & Co., Inc., 4 BTA 142 (1926). (12) Peerless Weighing and Vending Machine Corp., 52 TC 850 (1969); but see Federated Department Stores, Inc., DC Ohio, 1994 (74 AFTR2d 94-5519, 94-2 USTC [paragraph]50,430), aff'g 135 B.R. 950 (Bankr. DC Ohio, 1992) (92-1 USTC [paragraph]50,097). (13) Phil Gluckstern's, Inc., TC Memo 1956-9; The Montgomery Co., 54 TC 986 (1970). (14) Oliver Iron Mining Co., 13 TC 416 (1949). (15) Home Trust Co., 65 F2d532 (8th Cir. 1933) (12 AFTR 825,3 USTC [paragraph]1103). (16) John D. Fackler, 39 BTA 395 (1939). (17) Rev. Rul. 68-260, 1968-1 CB 86. (18) The Denver & Rio Grande Western Railroad Co., 32 TC 43 (1959), acq. 1959-2 CB 4, aff'd on other grounds, 279 F2d 368 (10th Cir. 1960) (5 AFTR2d 1278, 60-2 USTC [paragraph]9540). (19) George W Griffiths, 25 BTA 1292 (1933), aff'd, 70 F2d 946 (7th Cir. 1934) (14 AFTR 225, 1934 CCH [paragraph]9195); John A: Lemos, TC Memo 1973-117. (20) Rev. Rul. 81-161, 1981-1 CB 313. (21) Zenith Sportswear Co., Inc., 28 TC 455 (1957). (22) See ISP Coordinated Issue Paper: Petroleum & Retail Industry (IRS, 1995). (23) Ronald S. Adams, TC Memo 1995-142. (24) Patrick O. Higgins, TC Memo 1995-139. (25) Regs. Sec. 1.165-2 (b); see Louisville & Nashville Railroad Co., 641 F2d 435 (6th Cir. 1981) (47 AFTR2D 81-772, 81-1 USTC [paragrap] 9212), aff'g, rev'g and rem'g 66 TC 962 (1976). (26) See Prop. Regs. Sec. 1.168-6(b); Sec. 280B. (27) See Regs. Sec. 1.167(a)-8; Alexander J. Cassatt, 137 F2d 745 (3d Cir. 1943) (31 AFTR 576, 43-2 USTC [paragraph] 9579). (28) Section 322 of The Contract With America Tax Relief Act of 1995, H.R. 1215, as enacted by the House Ways and Means Committee, would allow a deduction on disposition or abandonment. (29) Rev. Proc. 95-95, IRB 1995-23, 11. (30) Charles H. DeCou, 103 TC 80 (1994). (31) your Health Club, Inc., 4 TC 385 (1944), acq. 1945 CB 7. (32) Isidore Brown, 220 F2d 12 (7th Cir. 1955) (47 AFFR 244, 55-1 USTC [paragraph] 9258), aff g 22 TC 147 (1954); Barbara E. McBride, TC Memo 1987-94. (33) David G. Satterfield, TC Memo 1975-203; Rev. Rul. 70-146,1970-1 CB 18. (34) Beecham, Inc., DC Tenn., 1973 (32 AFTR2d 73-5916, 73-2 USTC [paragraph] 9719). (35) Brown, note 32. (36) See Preston Wilson, TC Memo 1961-135. (37) Sec. 467 provides for mandatory use of the accrual method by both the lessee and lessor when aggregate rent equals or exceeds $250,000 and rent is deferred. (38) See Stephen A. Keller 79 TC 7 (1982); Martin J. Zaninovich, 616 F2d 429 (9th Cir. 1980) (45 AFTR2d 80-1442, 80-1 USTC [paragraph] 9342), rev'g 69 TC 605 (1978). (39) Keller, id.; Lola Cunningham, 39 TC 186 (1962). (40) See Regs. Sec. 1.4614 (d) (2) and (7), Examples 5 and 6.