Sec. 467 rental agreements.

With depressed real estate market conditions affecting many areas of the country, some lessors are offering inducements (such as rent holidays or step rents) to facilitate the leasing of properties. As a resuit, rental agreements should be analyzed to determine if they fall under the purview of Sec. 467. If they do, complex accrual rules that give rise to material and unexpected tax consequences may apply. Additionally, with careful planning, a rental agreement can be structured to benefit the tax position of both the lessor and the lessee.

A Sec. 467 rental agreement is defined as any rental agreement for the use of tangible property under which either (11 there is at least one amount stated in the agreement as being allocable to the use of property during a calendar year that is to be paid after the close of the calendar year following the year in which such use occurs, i.e., the rent is deferred for more than one year and the rent is stated in the agreement as being allocable to a specific calendar year, or (2) there are increases in the amount to be paid as rent under the agreement, i.e., stepped rent (Sec. 467(d)(11).

Sec. 467 applies only to rental agreements with aggregate payments (cash plus the fair market value of other property) exceeding $250,000 (Sec. 467(d)(2)). Although this $250,000 threshold may, at first glance, appear to exempt many rental agreements from Sec. 467, it is relatively small when compared to rents paid in most commercial real estate lease transactions. After considering the terms of typical multi-year rental agreements and the price charged per square foot, it becomes apparent that most commercial real estate rental agreements will fall under Sec. 467.

Generally, if a lease is considered a Sec. 467 rental agreement, the lessor and the lessee must account for the rental income and deduction in accordance with the lease terms; if there are any rental payments due after the close of a rental period, they must impute interest on any such rental payments on a present value basis (Sec. 467(b)(1)). The present value and imputed interest rules can resuit in a recharacterization of a portion of lease payments as interest over the lease term. However, the total amount of rent and interest recognized under Sec. 467 for the entire lease term should equal the total amount of the payments under the lease.

Example: A lease agreement entered into on January 1 with a term of three calendar years provides for no rent for the first year (i.e. a rent holiday) and rent of $250,000 and $500,000 for years 2 and 3, respectively, payable at the end of each such year. This is a Sec. 467 rental agreement because the second condition exists, i.e., stepped rents. (Note that the first condition does not exist because none of the rent paid in years 2 or 3 is stated in the agreement as being allocable to year 1.) However, because there is no deferral of rent, both the lessor and lessee would determine the amount of rental income or deductions strictly in accordance with the terms of the agreement. The rental income and deduction for years 1, 2 and 3 would be zero, $250,000 and $500,000, respectively. This result may be advantageous to the lessor and possibly to a lessee such as a start-up company that wants to defer deductions to later years when it anticipates taxable income. However, it is important to keep in mind that this result occurs only when no rent is allocated to the first year, meaning that, in the event of a lease termination at the end of the first year, the lessee would owe no rent for that year.

A different result would occur, however, if the lease agreement provides that $250,000 of rent is to be allocated to each of the three years, but payable in the same amounts and at the same times as indicated. That is because the $250,000 of rent allocable to year 1 is effectively deferred until the close of year 3 due to the rent holiday. Under Sec. 467(b)(1)(B), the deferred rent of $250,000 allocated to year 1 is taken into account to the extent of its present value. Assuming that the appropriate discount rate (of 110% of applicable Federal rate (AFR)) is 12% compounded semiannually, rent for year 1 would be $198,023. No adjustments would be made to year 2 rent; however, interest of $24,476 on the deferred rent from year 1 would be included in income and deducted (of course, $250,000 of year 2 rent would also be taken into account). In year 3, only $250,000 of rent and an additional $27,501 of interest on the deferred rent from year 1 would be taken into account.

This example illustrates that by changing the terms of the rental agreement, the lessee was able to accelerate $198,023 of rent deductions into year 1. In addition, this deduction would be allowable to a cash-basis lessee without payment of cash. The lessor would also have to accelerate rental income; however, this might not be a bad result if the lessor were in a net operating loss position or had suspended passive loss carryovers that could offset this income.

The situations discussed in the example generally apply to all Sec. 467 rental agreements in which the parties have allocated the rents payable to the periods covered. However, if such an allocation is not made, if the agreement is a tax-motivated "disqualified leaseback" (i.e., a leaseback to any person who had an interest in the property within two years of the leaseback), or if the agreement is a tax-motivated "long-term lease agreement" (i.e., if the term of the agreement exceeds 75% of the property's statutory recovery period as set forth in Sec. 467(e)), the constant rental provisions of Sec. 467(b)(2), (3)and (4) would apply.

Under the constant rental provisions, there is accrued for each tax year that portion of the "constant rental amount" allocable to each period (Sec. 467(b)(2)). The constant rental amount is the amount which, if paid as of the close of each lease period under the agreement, would result in an aggregate present value equal to the present value of the aggregate payments required under the agreement (Sec. 4671e)(1)). In other words, the constant rental amount is determined by "leveling" the rents. Thus, if the constant rental provisions apply to the agreement, Sec. 467 rewrites the lease as it affects the allocation of rent.

The constant rental provisions of Sec. 467 provide little flexibility for deferring or accelerating rental income and deductions without altering the basic economics of the deal. The rental income and deduction recognized are based solely on the present value of rental payments required to be made under the rental agreement.

Regulations under Sec. 467 have not yet been published. Many questions and issues remain unresolved. The Conference Report to the Deficit Reduction Act of 1984 (which enacted Sec. 467)dictates that regulations are to be issued that will provide fin addition to other safe harbors) de minimis rules allowing a "reasonable" annual percentage fluctuation of rents above or below the lease's average rent amount and a safe harbor for "reasonable" rent holidays. (See also Sec. 467(b)(5).) However, Sec. 467(b)(5)essentially provides that these safe harbors will apply only to disqualified leasebacks and long-term lease agreements, and not to leases that fall under the constant rental provisions by reason of a failure to allocate rents in the agreement to the periods covered. As a result, pitfalls may exist. For example, due to market conditions, a cashbasis lessor may enter into an agreement that gives a lessee a reasonable rent holiday. If this agreement does not allocate rents to specific periods, the lessor may find itself being taxed on deferred rents simply because the rent holiday could trigger the application of Sec. 467 by constituting a stepped-rent structure.

Sec. 467 has broad applicability and is an extremely complex provision. Many problems and issues may be resolved if and when Sec. 467 regulations are issued. Careful structuring of rental agreements is vital to avoid pitfalls and to provide benefits to parties involved in the lease agreement. From James Kolovos, CPA, Rochester, N.Y.