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IRS ruling denies rent leveling to tenant.

Sec. 467, enacted as part of the Deficit Reduction Act of 1984, prescribes rules for both cash and accrual lessors and lessees on the timing of rental income/deductions. This provision applies to leases that call for increasing rent amounts over their terms, if the total payments due are more than $250,000. If Sec. 467 applies, there are two possible treatments: (1) allocation in accordance with the terms of the lease or (2) a reallocation to a "constant rental amount."

Under the first treatment, rent is included by the lessor and deducted by the lessee according to the lease terms. The second treatment is called rent leveling. This treatment generally requires both the lessor and the lessee to treat the rent as accruing ratably over the term of the lease (with a present value assumption built in), and is mandated if one of three tests is met:

1. The lease is a long-term lease (for real estate, more than 14.25 years), and there is a tax avoidance motive in the allocation of payments under the lease.

2. The lease is part of a sale-leaseback, and there is a tax avoidance motive.

3. The rent agreement does not provide an allocation of rent among time periods. Note that rent leveling is generally favorable to lessees, because the reallocated amount is generally higher than the rent paid during the early part of the lease.

IRS Letter Ruling (TAM) 9352002 has clarified the Service's interpretation of when Sec. 467 requires rent leveling. The IRS ruled that the payment schedule in the lease involved was an allocation of payments among time periods. The Service also ruled that the fact that rents increased, in and of itself, did not indicate a tax avoidance motive. Thus, rent leveling did not apply, and the payment schedule determined the timing of the lessee's deductions over the lease term.

In the letter ruling, the lessee sought a Sec. 467 reallocation of its lease payments that would increase its deductions over the amount paid (as set forth in the lease payment schedules). The IRS stated that the leases were Sec. 467 rental agreements because there were increases in the amount of rent paid under the agreements, and each lease involved total payments of more than $250,000 for the use of the property.

The leases provided that onetwelfth of the amount due per year was due on the first day of each month. The rent due under the leases increased in periodic intervals, generally every four to five years. The leases did not contain any other provisions allocating rent to particular periods. The taxpayer had argued that the lease provisions setting monthly payments were not allocations for Sec. 467 purposes, and that Sec. 467 required a "reallocation."

The Service rejected the taxpayer's arguments. Sec. 467 and its legislative history gave no explicit guidance as to exactly what an "allocation" was. However, the IRS defined "allocation" as the common understanding that rent payment schedules allocate rents to particular periods of time. The Service noted that Sec. 467 and its legislative history indicated that the payment of rent could differ from its allocation, but that the legislative history suggested that payment and allocation of rent could also be the same.

The IRS also rejected the argument that the leases were disqualified leaseback or long-term agreements under Sec. 467(b)(4). The fact that rents increased under the leases, in and of itself, was insufficient to establish that the principal purpose for providing increasing rents was tax avoidance, a necessary requirement for leases to be Sec. 467 disqualified leascback or long-term agreements.

This TAM reaches an unfavor able result for lessees, who generally must treat the rent as level for financial statement purposes, and who would benefit from bigger current deductions through a reallocation. Conversely, the result is favorable for lessors, because there was no reallocation requiring lessors to report as income more rent than they receive during the early part of the lease.

Advance planning in structuring the lease terms could have led to more favorable tax treatment.

From Vicki Howe, J.D., Jim Banks, CPA, and Jim Connor, J.D., Washington, D.C.
COPYRIGHT 1994 American Institute of CPA's
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Copyright 1994, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Connor, Jim
Publication:The Tax Adviser
Date:Apr 1, 1994
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