The acquisition of real property leases continues to provide tax planning opportunities. While leases are not intangibles amortizable under Sec. 197, changes enacted by the Revenue Reconciliation Act of 1993, as well as recent cases and rulings, have affected the deductions associated with such leases. Maximizing these deductions depends on how adjusted basis is allocated to assets, whether an acquisition is made by a lessor or lessee and whether assets and payments are properly classified. This article reviews the issues raised by the 1993 legislation and recent decisions and the deductions currently available, and offers planning strategies.
For financial and tax reasons, many businesses prefer to lease property rather than to purchase it. Although generally, the tax rules associated with leasing are straightforward, when a taxpayer purchases property burdened with a lease or a lessee acquires or cancels a lease, the tax results are not as simple. In addition, decisions made when the lease is acquired will affect subsequent deductions.
Allocation of Purchase Price
Under Sec. 1060(b), when trade or business property is acquired, purchasers and sellers must allocate the purchase price to the property and report it to the Service.(1) If leased real estate is included in the acquisition, the courts have permitted allocation of the purchase price to leases with favorable terms,(2) as well as to goodwill for an existing mobile home park(3) or a shopping center.(4) After the Revenue Reconciliation Act of 1993 (RRA '93), however, the allocation of purchase price to such intangibles was restricted.
Purchasers of leased real estate become lessors; the tax treatment of their lease acquisition costs and Sec. 197 intangibles (including goodwill) may differ from the treatment accorded lessees. The House Committee Report(5) accompanying the RRA '93 (House Report) suggested the following tax treatment of lessors and lessees:
Lease acquisition costs Sec. 197 intangibles
Lessor Include as part of cost Include as part of cost
of acquired building of acquired building
Lessee Separate, amortizable Separate, amortizable
asset limited to asset
(i.e., present value of
fair market value (FMV)
rent over the lease term
less present value
of rent to be paid
over lease term)
Given these rules, planning is needed to maximize the potential remaining deductions.
Sec. 197, enacted by the RRA '93, permits acquired intangibles held in connection with a trade or business or in an investment activity to be amortized over 15 years. Under Sec. 197 (e) (5), however, an interest in an existing lease of tangible property is not a Sec. 197 intangible.
In discussing Sec. 197(e) (5), the House Report stated that a lessor's lease acquisition costs that are part of an acquisition of property should be included in the property's cost a lessee's cost of acquiring an interest in an existing lease should be treated under Sec. 178 and Regs. Sec. 1.162-11 (a), not Sec. 197. Although acquired leases are not Sec. 197 intangibles, the House Report stated that the lessee's deduction of lease acquisition costs continues to be governed by Sec. 178. Under this section, the lessee can assign a cost to the acquired lease and amortize it. Therefore, the exclusion of an acquired lease from the definition of "Sec. 197 intangibles" is not significant for the lessee, just for the lessor.
Sec. 167 (c) (2), as amended by RRA '93, provides statutory support for the change reflected in the House Report. Under that section, when acquired property is subject to a lease:
 No portion of the adjusted basis can be allocated to the leasehold interest.
 The entire adjusted basis is to be taken into account in determining any depreciation on the property subject to the lease.
Thus, the lessor's lease acquisition costs must be included in the cost of the underlying depreciable real estate.
Purchasers of leased real estate may find it more advantageous to acquire leased property after leases have been canceled; thus, the buyer can ask the seller to negotiate a cancellation of existing leases prior to the sale of the property. If the seller is a corporation, the conversion of possible capital gain on the sale of the property to ordinary income from a lease cancellation may have minimal effect. The purchaser would then pay less for the property and negotiate a new lease with smaller lease payments, resulting in a lower basis in the property and less income. In effect, the purchaser will be in the same position as if he could amortize the cost of the favorable lease. For this to succeed, the lease cancellation and the property sale must be independent transactions.
Goodwill and Other Sec. 197 Intangibles
Sec. 197 (f) (8) provides that Sec. 197 does not apply if the incremental value from goodwill or any other amortizable Sec. 197 intangible is "properly taken into account in determining the cost of property which is not a section 197 intangible." For example, a shopping center is acquired by a lessor in a good location with established tenants. Does Sec. 197(f) (8) bar an allocation of part of the cost to goodwill? If it does, then the cost will be assigned either to the building, which can be depreciated straight-line over 39 years under the modified accelerated cost recovery system (MACRS), or to land, which is not amortizable. If there is no bar, the cost allocated to goodwill is amortizable over 15 years under Sec. 197. How goodwill is "properly taken into account" when tangible property is purchased must be determined before Sec. 197(f) (8) can be applied.
Prior to enactment of the RRA '93, Goodman(6) and Muserlian(7) held that shopping centers and mobile home parks, like other businesses, have the usual elements of goodwill--i.e., prominence, identity and reputation. No precise value was assigned by those courts to the goodwill in those cases (there was no need, because it was nonamortizable). However, these cases suggest that goodwill, prior...