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Rent holidays no picnic for lessors.

Given the state of today's real estate market, lessors have to resort to various strategies to get people to lease property. However, some inducements, such as rent holidays or stepped rent (in which the rents paid increase in succeeding years), will cause rental agreements to fall within the purview of section 467.

Section 467 was part of the Tax Reform Act of 1984 and was designed to keep taxpayers from exploiting rental arrangements in which most (or all) of the payments are due in later years. Previously, a cash basis lessor could defer income until payment was received, while an accrual basis lessee could deduct an amount for rent properly allocable to each year of the lease (even though the amount was not payable until a later year). Not only was the lessor allowed to defer income, but he or she also could convert ordinary income into capital gain, if the property (or lease) was sold at a price reflecting the higher rents due in the later years. To do away with this perceived abuse, Congress enacted rules requiring rent charged in a deferred arrangement to be "leveled" over the length of the agreement.


A section 467 agreement is any rental agreement for the use of tangible property (real or personal) in which either

* Rent is deferred for more than one year and is stated as being allocable to a specific calendar year.

* There is increasing (or decreasing) rent.

These provisions apply only to rental agreements with total payments (cash plus the fair market value of property) that exceed $250,000.


Generally, if a lease comes under section 467, the lessor and the lessee must account for the rental income and deductions in accordance with the lease terms. If any rental payments are due after the end of a rental period, interest must be attributed to these payments on a present value basis; as such, a portion of the lease payments may be recharacterized as interest over the lease term. (Regulations will provide different methods for determining this amount, depending on the type of lease involved. ) The total amount of rent and interest recognized for the entire lease term should equal the total amount of payments under the lease.

This rent accrual is treated as any other debt owed by an accrual basis taxpayer. Thus, both lessors and lessees will be subject to the rules governing bad debt deductions, discharge of indebtedness and the tax benefit rule.


If the section 467 agreement has no rent allocation, it may be subject to constant rent provisions. These special rules apply if the agreement is tax motivated and is either a disqualified leaseback (a leaseback to any person who had an interest in the property within the previous two years) or a long-term lease agreement (one with a lease term longer than 75% of the leased property's statutory recovery period).


The test of whether an agreement is tax motivated is a facts-and-circumstances one, with the burden on the taxpayer to show the market conditions or business reasons that justify rent increases. Factors that may indicate a tax avoidance motive include

* The disparity of the tax brackets of the lessor and the lessee.

* An option to renew at rents significantly less than the amounts in the original lease's later years.

* If the lessee is a tax-exempt organization placed between two taxable parties.

Factors that will not affect tax avoidance include

* Changes in amounts paid determined by the consumer (or other appropriate) price index.

* Rents that are based on a percentage of lessee receipts or that reflect the lessee's obligation under the lease to pay certain lessor costs.

* Reasonable rent holidays based on local commercial practice (but generally not exceeding 12 months).


Agreements subject to these special rules (that is, tax motivated and either disqualified leasebacks or longterm lease arrangements) must accrue a constant rental amount in each tax year. This is the amount that, if paid at the close of each lease period, would have a present value equal to the present value of the aggregate payments required under the lease.

For a discussion of these agreements and other developments, see the Tax Clinic department, edited by Michael Klein, in the July 1992 issue of The Tax Adviser.

Nicholas J. Fiore, editor

The Tax Adviser

Ed. note: The material discussed provides general information. Before you take any action on this area, the appropriate code sections, regulations, causes and rulings shoule be examined.
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Title Annotation:from The Tax Adviser
Author:Fiore, Nicholas J.
Publication:Journal of Accountancy
Date:Jul 1, 1992
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