Proposed regulations on "sec. 467 rental agreements."

Proposed regulations under Sec. 467 would require both parties (lessor and lessee) to a "Sec. 467 rental agreement" to accrue rental income and expense, regardless of either party's regular accounting method. The proposed regulations apply to rental agreements with total payments in excess of $250,000, when the agreement does not specify equal amounts of rent throughout the term or the rent payments are deferred or prepaid. Rent adjustments based on a reasonable price index, or on the lessee's obligation to pay taxes, insurance and maintenance on the property, may be disregarded in determining total payments.

For rental agreements with total payments of $2 million or less (determined on the same basis discussed above), when all payments are due in the year to which the rent relates, or in the preceding or subsequent year, the only effect of Sec. 467 is to require that the rent be taken into account in the tax year to which it relates. If the rent has a greater prepayment or deferral, the regulations require interest to be imputed, but generally do not require rent to be leveled. For disqualified leasebacks or long-term agreements that have a principal purpose of tax avoidance, the Service may impose rent-leveling. Taxpayers may not apply the rent-leveling rules to themselves.

Sec. 467 Rental Agreement

Defined

Sec. 467 defines a Sec. 467 rental agreement as any rental agreement for the use of tangible property with total payments aggregating more than $250,000, in which there are increases in the amount to be paid under the agreement or there is deferred rent. The proposed regulations expand Sec. 467 to agreements calling for prepaid rent or decreases in the amounts to be paid under the agreement, thus broadening the universe of rental agreements subject to the mandatory accrual method of accounting.

The proposed regulations would provide limited relief from the definition of a Sec. 467 rental agreement by permitting rent holidays of three months or less to be ignored in determining whether there is increasing or decreasing rent.

A rental agreement characterized as a Sec. 467 rental agreement affects how and when the parties take into account the rental payments anticipated by the lease. The characterization may also affect the nature of any gain if the lessor disposes of the leased property before the lease terminates. There are three possible rent-recognition methods that may apply to a Sec. 467 rental agreement: 1. "According to the agreement" applies when rents increase or decrease, but there is no prepaid rent or deferred rent without adequate interest. 2. Proportional rental method applies when rent is prepaid or deferred. This rule recognizes there is an implicit loan (by the lessor or the lessee) in the agreement and allocates (recognizes) rent in proportion to the rental payment schedule chosen by the parties, after identifying the appropriate imputed interest element. 3. "Constant rental amount" or "rent-leveling" applies in limited circumstances and ignores the interperiod rent allocation chosen by the parties in favor of a level-rent structure with the appropriate imputed interest element.

Allocation of Rent

Rental agreements that provide for the specific allocation of fixed rent, regardless of when actual payments are due, will be respected in determining the gross rental income allocable to each period. To qualify as a specific allocation, the rental agreement must unambiguously specify, for periods of no longer than a year, a fixed amount of rent for which the lessee becomes liable on account of the use of property during that period. Prop. Regs. Sec. 1.467-1(c), however, would require the "proportional rental method" and, thus, would require interest to be imputed, if the specific allocation of rent in the rental agreement does not match the timing of the payments and there is no provision for adequate interest on any deferred or prepaid rent.

Contrary to the statute, which "levels" the rent in agreements that fail to allocate rent, the proposed regulations deem rent in such agreements to be allocated according to the payment schedule. Thus, the proposed regulations would limit the application of rent-leveling to disqualified leasebacks or long-term arrangements (discussed below). Under the rent-leveling (constant rental amount) method, rent is deemed allocated to each rental period so that the present value of the allocated amounts equals the present value of the actual amounts paid.

The Proportional Rental

Method - Imputing Interest on

Sec. 467 "Loans"

A Sec. 467 loan generally is deemed to arise in rental agreements providing for deferred or prepaid rent. Thus, any rental agreement in which the timing of the required payments is inconsistent with the allocation of fixed rent to specific periods potentially may be recharacterized, in part, as a Sec. 467 loan. When a rental agreement contains a deemed Sec. 467 loan, a portion of the fixed rent is recharacterized as interest. Prop. Regs. Sec. 1.467-4(a)(2) provides that a rental agreement does not have a deemed Sec. 467 loan if (1) there is no deferred or prepaid rent or (2) there is deferred or prepaid rent, but the rental agreement contains adequate interest. Adequate interest is generally stated interest at a rate equal to or greater than 110% of the applicable Federal rate. Rental agreements that do not meet either of these two requirements generally would be required to recharacterize and potentially reallocate fixed rents allocable to an accrual period using the "proportional rental method" because they are deemed to contain a Sec. 467 loan. The proportional rental method imputes interest on the deemed loan and recharacterizes the fixed rental amount in proportion to the rent allocation chosen by the parties, but not "leveled," using present-value concepts.

Disqualified Leasebacks or Long-Term

Agreements - Rent-Leveling

Required

If the rental agreement is a disqualified leaseback or long-term agreement that has increasing or decreasing rents, a principal purpose of which is tax avoidance, the fixed rent for each rental period is redefined as the constant rental amount. A rental agreement is a disqualified leaseback if it involves a leaseback to any person who had an interest in the property (other than a de minimis ownership interest) at any time within two years before the lease to that person or a related person. A long-term agreement is a rental agreement for a term in excess of 75% of the property's statutory recovery period. Such agreements are considered disqualified if all of the following factors are present: * The total payments on the rental agreement exceed $2 million (disregarding adjustments based on reasonable price indices and payments the lessee is obligated to make to third parties). * A principal purpose of providing increasing or decreasing rents is to avoid Federal income tax. * The IRS determines it is appropriate to treat the Sec. 467 rental agreement as a disqualified leaseback or long-term agreement.

Under Prop. Regs. Sec. 1.467-3(c), the Service's determination of whether tax avoidance is a principal purpose for increasing or decreasing rental payments in a leaseback or long-term agreement is to be based on all the facts and circumstances. To provide taxpayers with guidance, however, general safe harbors are proposed. A principal purpose of tax avoidance will not be found if. * The rent allocated to any calendar year does not vary from the average rent allocated to all other calendar years by more than 100%, or * The increases or decreases in rent are attributable to one or more of the following provisions: 1. Payments tied to the lessee's receipts, provided the percentage remains fixed over the term of the lease. 2. An adjustment based on a reasonable price index. 3. A requirement that the lessee pay third-party costs (i.e., taxes, insurance and maintenance). 4. A rent holiday that does not exceed the lesser of 24 months or 10% of the lease term and a substantial business purpose for the rent-holiday provision.

It appears that only the Service can require a taxpayer to use the constant-rental method. Thus, taxpayers cannot structure a rental agreement with the intention of applying the constant-rental method to achieve a result that differs from the lease agreement. The constant-rental method is applied only at the Service's discretion.

This provision would apply to all leases entered into after June 3, 1996. However, the IRS may argue that the regulations represent a reasonable interpretation of the statute, and thus, attempt to impose similar rules for earlier years.

Related Issues

* The regulations provide rules for recharacterizing gain on the disposition of leased property and leases. These apply to require "recapture" if there is a leaseback or long-term lease involving increasing rents, but do not provide rules for modification of lease agreements. * The regulations specifically do not address lease stripping. Notice remains in place. * The regulations do not address lease-inducement payments paid by the lessor to the lessee.

IRS Audit Activity

The regulations contain rules similar to those of the Services Industry Specialization Program paper for the retail industry. The IRS appears to be more active in applying these rules to lessees than to lessors, to delay rental expense deductions. Although the rules apply to both lessee and lessor, the Service is not obligated to assert them against both parties.