Sec. 467 rental agreements.

• Author: Kolovos, James

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...