The Impact of the New Tax Act on Leasing Transactions
| Jurisdiction | United States,Federal |
| Citation | Vol. 14 No. 6 Pg. 974 |
| Pages | 974 |
| Publication year | 1985 |
1985, June, Pg. 974. The Impact of the New Tax Act on Leasing Transactions
The Tax Reform Act of 1984 ("Act")(fn1) substantially modified the tax rules applicable to many leasing transactions. The Act added new § 467 to the Internal Revenue Code of 1954 ("Code"), which deals solely with leasing transactions. Generally, for covered lease agreements entered into after the effective date,(fn2) Code § 467 modifies the tax treatment by (1) requiring the economic accrual of lease payments by both the landlord and the tenant (regardless of their chosen method of accounting) and (2) eliminating the potential for conversion of ordinary income into capital gain.
In enacting Code § 467, Congress targeted lease transactions in which the timing of rental payments was structured primarily for tax avoidance purposes and which, except for the tax considerations, had no sound economic basis for the timing of the rental payments. In particular, the objectives of the new law were (1) to eliminate mismatching between the lessor and lessee based on their accounting methods where rent is accrued but not required to be paid; (2) to smooth out "stepped rents" in unjustified circumstances; and (3) to prevent the conversion of ordinary income into capital gain.(fn3)
The types of transactions to which Code § 467 is intended to apply may be illustrated by the following three examples:
A landlord and a tenant enter into a three-year lease which requires a single payment of $300,000 on the last day of the lease. The lease does not specify to which periods (months or years) the lease payment applies. The landlord is a cash-basis taxpayer, and the tenant is an accrual-basis taxpayer. For tax purposes, in years one and two the tenant has rent expense of $100,000 in each year while the landlord has no income. In year three, the landlord has rent income of $300,000 and the tenant has rent expense of $100,000.
This structure allows the the accrualbasis tenant to take deductions in years in which it is not required to make any payments, while the landlord has no corresponding income. Congress believed that such a result is unacceptable and that, at a minimum, a matching of the timing of income and expense should be required.
A lease provides that the rent begins at a certain level and increases at a fixed rate each year ("stepped rent"). The rent in the initial years of the lease is very low and in the latter years, very high. Congress believed that the effect of such a rent structure was to "back-load" rentals, which allowed a landlord to delay income to the later years of the lease with no economic justification other than the tax considerations.
A corollary of backloading of rent is that a landlord could sell a leased property in mid-term of a backloaded lease and obtain long-term capital gains treatment on the sale while a significant portion of the value (and gain) was attributable to unearned rent. This amounted to a conversion of rental income (treated as ordinary income for tax purposes) into capital gain.
Furthermore, the purchaser might be a tax-exempt entity, in which case the backloaded rent would never be reported as taxable income. Alternatively, the purchaser might allocate a portion of the purchase price to the favorable lease (favorable because of the backloaded rent) and amortize the allocated amount against the backloaded rent.
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