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Tax Ramifications of Lease Modifications

Posted on May 11, 2020

You need a haircut, badly, but you were momentarily thinking that there might be a silver lining to the lockdown. With the salons shut, your teenage daughter can’t spend hundreds of dollars getting her hair dyed blue. But as fate will have it, she got hold of a supply of the punk staple Manic Panic temporary hair dye, and now she’s destroyed half the towels in the house. You tried to convince her that this is bad for the environment, or something, but then she threatened to join Extinction Rebellion.

Meanwhile, the other half of the towels are on the floor. Certain family members, who are probably male, appear to be convinced that they live in a Sheraton. So you put one of those irritating little hotel environmental notices in the bathroom. That cut no weight, so you printed up a fake Sheraton bill for $17,657. The miscreant didn’t flinch, looked you straight in the eye and objected that he hadn’t checked out yet, and asked why the coffee machine hasn’t been refilled. You packed a bunch of his clothes in a suitcase and set it outside the front door. Still other male members of the household think they’re at the gym that closed, so you set out a large hamper.

No magic fairies have appeared overnight to deal with the tonnage of used and partially destroyed towels. You have to replace a bunch of towels, and that is harder than it should be. Really good towels are expensive and cheap towels fall apart quickly, making them not so cheap on a per-use basis. The general rule is buy the best you can afford — leaving aside frills like decorative embroidery and monograms. Around here, we like Matouk and Schweitzer Linen, but the habits of your family members may not justify those prices. So here are some things to consider.

Color. Unless you’re really fussy about matching some bathroom décor, white is your best bet. White towels will have to be bleached — many believe that kills germs — or look grungy. But white allows for the best selection. Your next best bet is drab colors that go by names such as “natural” and varieties of sand. Those won’t show stains, except for your daughter’s Manic Panic. Avoid bright or deep colors in cotton. Not only will they fade, but they might not fade evenly. For the daughter, there is such a thing as a makeup towel, and yes, they are black.

Weight. Are you putting the towels in the dryer with each use or air-drying them? The highest weight that can be air-dried in 24 hours is 600 grams per square meter, unless you live in the desert. What are called Turkish-style towels are in the 700-800 gram range. They’re very thick and luxurious, but may feel like rugs to some people.

Fiber. Cotton, but some people are partial to bamboo, which is not cheap. The problem with cheap cotton is that short fibers shed; some of you have had that experience with cheap hotel towels. We read the complaints at a big box store that used to be dependable for bundles of towels, and it was not pretty. You’re going to have to pay more than $10 per towel.

Why aren’t there towel services for civilians like there are for hotels? Why haven’t creative specialist institutional linens suppliers repurposed to supply households willing to pay? They have towels. They have trucks. Until they figure that out, buy some towels, or other soft goods, because the store will be really happy to have the business, which is still likely to be online.

Bricks and mortar — one analyst called it “bricks and mortal” in a Freudian slip — was suffering before the lockdown. Department stores and other commercial tenants want to renegotiate their leases, in the face of landlords worried about paying their lenders. Big stores typically have net leases, under which they pay the landlord a percentage of sales, but their cash positions are so bad that some are asking for outright rent waivers in return for sharing future revenues (The Wall Street Journal, May 5, 2020).

 Neiman-Marcus Department Store
Neiman Marcus, anchor tenant at New York’s $25 billion Hudson Yards development, filed a chapter 11 petition after making a deal with creditors. (Richard B. Levine/Newscom)

Commercial lease modifications are coming. Some retail tenants are threatening to close their stores permanently. Many delinquent tenants are still within their grace periods. Some corporate tenants want their fixed rent to be converted into the equivalent of net leases. Some landlords are willing to negotiate or even lend to tenants; one REIT plans to lend $50 million. Some tenants just want shorter terms for their long-term leases. Although these deals aren’t tax motivated, they could fall into the complicated tax accounting rules for leases of section 467 and its regulations, which Congress created to address the use of leases for tax planning.

This article looks at the tax hazards and opportunities of lease renegotiation. Section 467 is a timing rule. Timing is everything, in taxation as in life. Here the question is, what is the timing of items of income in a lease? But the preceding question is, at what point in the lease renegotiation should one consult the tax adviser? Make sure that the landlord or tenant talks to you before committing to any changes, even if no one has any cash or any expectation of a tax liability for 2020. And yes, to use that hokey tax practice phrase, section 467 can be a trap for the unwary.

As an aside, REIT landlords got the dividend relief they were looking for in Rev. Proc. 2020-19, 2020-22 IRB 1. REITs have to pay out 90 percent of their taxable income as dividends (section 857(a)(1)). To allow REITs and RICs to conserve cash, the IRS permitted a package of 90 percent equity and 10 percent cash to qualify for the dividends paid deduction for dividends declared on or before April 1, 2020, for tax years ending on or before December 31, 2020. Technically, REITs and RICs are permitted to limit unit holders’ safe harbor cash limitation percentage to 10 percent in a cash-or-shares election (Rev. Proc. 2017-45, 2017-35 IRB 216).

Background

It is very easy to fall into section 467. Most commercial leases don’t start out as section 467 rental agreements, but could become them when substantially modified to produce stepped rent, deferred rent, or prepaid rent.

Readers may associate section 467 with LILOs and SILOs, but it also touches ordinary changes to normal commercial deals. There are tax avoidance section 467 regulations, but those are not relevant (reg. sections 1.467-3 through 1.467-7). The question is whether there were substantial modifications to a lease, made for business reasons, that change the timing of recognition of rent payments so that imposing a new special accounting method is warranted. Most of the rules are in regulations that were drafted at a time when policymakers were obsessed with identifying the time value of money and recognizing it (T.D. 8820; 64 F.R. 23187-23229).

First, was there a substantial modification of the lease? What is substantial? A modification is any change to the legal rights or obligations of the landlord or the tenant (reg. section 1.467-1(f)(5)(i)). A modification is substantial if it is “economically substantial” based on all the facts and circumstances, using concepts of reg. section 1.1001-3 (reg. section 1.467-1(f)(5)(ii)). All agreements between the landlord and tenant are taken into account, including side letters.

Technically, a substantially modified lease is bifurcated into a pre-modification lease and a post-modification lease. If there is a substantial modification, then the post-modification lease is treated as a new lease that is tested under section 467 (reg. section 1.467-1(f)). A pre-modification lease can be a section 467 lease or not, but the testing is done on only the post-modification lease. Here we assume that the $250,000 total payments threshold is met (section 467(d)(2); reg. section 1.467-1(c)(4)). All landlord options are treated as exercised in determining the length of the lease term (reg. section 1.467-1(h)(6)).

In testing for a substantial modification, certain contingent features are ignored. Congress contemplated typical practices like late payment charges, tax indemnities, loss payments, residual conditions, variable interest, and tenant payment of third-party costs (section 467(b)(5); reg. sections 1.467-1(c)(2)(iii)(B)(3) through (8) and 1.467-1(f)(6)(ii)). That means a landlord could waive a tenant’s lease obligation to pay common charges or passthrough property taxes, according to lawyers at Cozen O’Connor in an April 10 client alert. But the addition of net lease features and price indexes would not be ignored; those would be substantial modifications.

Landlord refinancing is a safe harbor as long as the landlord and the tenant are unrelated and the lease was changed only as necessary to match the financing (reg. section 1.467-1(f)(6)(i)). There is a safe harbor for a small change in the amount of fixed rent allocated to a rental period. The change, when combined with all previous changes in the amount of fixed rent allocated to the rental period, must not exceed 1 percent of the fixed rent allocated to that rental period before the modification (reg. section 1.467-1(f)(6)(iii)).

A substantial modification isn’t the end of the world. And the parties have control over the modifications that are made. Yes, the regulations are circular. Yes, they are poorly organized. You’re not seeing things. A change that is a substantial modification could turn out to be harmless when the lease is tested for whether it is a section 467 rental agreement.

Planners can use section 467 affirmatively. “So most advisors don’t recognize that the section 467 regulations are not a problem — and may be a planning opportunity — if the practitioner takes the time to understand them,” said Richard M. Lipton of Baker McKenzie.

Second, if the lease was substantially modified, has it become a section 467 rental agreement? A lease of tangible property is a section 467 rental agreement if it has increasing or decreasing rents, deferred rent, or prepaid rent. Increasing or decreasing rent — called stepped rent — means that the annualized fixed rent allocated to any one period exceeds the annualized fixed rent allocable to any other period, ignoring an initial rent holiday of three months (reg. section 1.467-1(c)(2)(i)).

Deferred rent is present when the cumulative amount of rent allocated at the close of a calendar year exceeds the cumulative amount of rent payable at the close of the succeeding calendar year. Prepaid rent is present when the cumulative amount of rent payable at the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year (section 467(d)(1); reg. section 1.467-1(c)(3)).

The aforementioned modification safe harbors also apply to determine whether a rental agreement has stepped rent, making it a section 467 agreement (section 467(a)(5); reg. section 1.467-1(c)(2)(iii)(B)). In addition, rent can be determined as a percentage of the tenant’s sale or receipts, or indexed to a price index, without these contingent features mattering (reg. section 1.467-1(c)(2)(iii)(B)(1) and (2)). If a contingent feature qualified for a safe harbor, it is not taken into account in determining whether the agreement has stepped rent.

Section 467 is an accounting method for leases. When a lease is substantially modified, tested, and determined to be a section 467 agreement, the statute requires economic accrual of additional current rent and interest on deferred rent (section 467(b)(1)). And if the parties don’t change their accounting, the IRS could argue they were using an impermissible method. An automatic change is provided (reg. section 1.467-9).

The landlord has to pay tax on imputed interest, regardless of its accounting method, using the section 467 method (discussed below). So a cash-method landlord that agreed to defer rent would be taxed ratably on that deferred rent, plus interest, in advance of receipt. The tenant would be required to accrue additional rent and interest expense, even if it is on the cash method.

If a lease becomes subject to section 467, the landlord and tenant must use the accrual method for recognizing rent and interest on deferred rent, regardless of their regular methods. Section 467 would require accrual of deferred rent with deemed interest (section 467(a); reg. section 1.467-2(c), (d)). A tenant would accrue extra rent deductions and interest expense (reg. section 1.467-1(e)). Economic performance is deemed to occur as prescribed by the section 467 rules (reg. sections 1.461-1(a)(2)(iii)(E), 1.461-4(d)(3)(ii)(B)).

In the hierarchy of accounting methods, the specific trumps the general (Prabel v. Commissioner, 91 T.C. 1101 (1988) (reviewed opinion), aff’d, 882 F.2d 820 (3d Cir. 1989)). But the final section 467 regulations state otherwise. Thus, the final regulations explicitly provide that the commissioner may apply other concepts, such as clear reflection of income, transfer pricing, and the substance-over-form doctrine to determine the income and expense from a lease and proper allocation of fixed rent (sections 446(b), 482; reg. section 1.467-1(a)(5)).

If a tenant made a payment to a landlord to modify a lease, the tenant would amortize the payment over the term of the lease and it would be ordinary income to the landlord. Likewise, a tenant that received a payment from a landlord to modify a lease would have ordinary income, and the landlord would amortize the payment over the term of the lease. As it happens, payments to modify leases are not common.

Deferred Rent

The most commonly requested modifications are rent deferrals, reductions, and backloading. Some commercial tenants are negotiating deals that call for a few years of rent waivers followed by a return to fixed rent. Some landlords ask for extensions of leases in return for deferrals. Some landlords build interest charges into rent deferrals.

A normal commercial lease has a rent allocation schedule. Rent is usually allocated to tax periods according to the allocation schedule. “A rental agreement specifically allocates fixed rent if the rental agreement unambiguously specifies, for periods no longer than a year, a fixed amount of rent for which the lessee becomes liable on account of the use of the property during that period” (reg. section 1.467-1(c)(2)(ii)(A)(2)). A substantial rewrite of the allocation schedule is a substantial modification unless it qualifies for a narrow safe harbor (reg. section 1.467-1(f)(6)(iii)).

Then when the substantially modified lease is tested under section 467, the lease allocation schedule governs allocation of payments. This is evident in the definition of deferred rent, which exists if the cumulative amount of rent allocated as of the close of a calendar year exceeds the cumulative amount of rent payable as of the close of the succeeding calendar year (reg. section 1.467-1(c)(3)(i)). Allocated rent is the rent allocated to any period that begins or ends in the calendar year (reg. section 1.467-1(c)(3)(iii)).

So rewrite your rent allocation schedule. It sounds crazy that it should be that simple, but landlords and tenants cut deals without paying attention to that aspect. The regulations make clear that an allocation schedule will generally be respected for allocations of rent. Even rent payments are not required as long as there is an appropriate allocation.

Uneven payments become relevant when there is no allocation, at which point stepped or deferred rent must be determined. Reg. section 1.467-1(c)(2)(ii)(B) states: “If a rental agreement does not provide a specific allocation of fixed rent (for example, because the total amount of fixed rent specified is not equal to the total amount of fixed rent payable under the lease), the amount of fixed rent allocated to a rental period is the amount of fixed rent payable during that rental period.”

An example in the regulations explains the importance of getting the allocation schedule consistent with the parties’ deal. A and B sign a four-year lease providing for rent accruing at $100,000 per year. Under the lease, rent is payable at $100,000 at the end of the second year, $100,000 at the end of the third year, and $200,000 at the end of the fourth year. No rent is due in the first year. Rent is allocated at $100,000 each calendar-year rental period (reg. section 1.467-1(c)(3)(iv), Example 1).

Well, gee, hasn’t there been a deferral of the first year’s rent? Should interest be accrued on the deferred payment? Nope. Under the regulations, the rental agreement does not have stepped or deferred rent. The example explains that a rental agreement has deferred rent if, at the close of a calendar year, the cumulative amount of rent allocated exceeds the cumulative amount of rent payable as of the close of the succeeding year.

The deferral test works off comparison of cumulative payables to allocated rent. Thus, the lease is not a section 467 agreement because it does not have deferred rent or stepped rent. “The rent allocation schedule is the ‘trump card’ under the section 467 regulations, so if a lease modification is accompanied by an appropriate allocation, the tax consequences will always follow such allocations,” Lipton explained.

In the example, there is no deferred rent because the rent allocated to the first year ($100,000) does not exceed the cumulative rent payable as of the end of the second year ($100,000). Likewise, the rent allocated to the second year and preceding years ($200,000) does not exceed the cumulative rent payable as of the end of the third year ($200,000). The rent allocated to the third year and preceding years ($300,000) does not exceed the cumulative rent payable as of the end of the fourth year ($400,000). The rent allocated to the fourth year and preceding years ($400,000) does not exceed the cumulative rent payable as of the end of the succeeding year ($400,000).

If a landlord wants to grant a tenant a two-year rent deferral, does it have to fit precisely into this example? Not necessarily. Many landlords want to defer current rent and tack it onto the end of the lease, which could have a balloon payment or be extended for a period equal to the deferral. Would a new schedule with a deferral followed by regular payments throughout the rest of the term have a deferred rent problem? It depends on how the numbers come out when allocated rents are compared with cumulative payables.

If the numeric result is off, then it is possible for the parties to build in adequate stated interest on deferred rent to avoid having to use the government’s method (reg. section 1.467-2(c)(3)). The stated interest must be no lower than 110 percent of the AFR, paid or compounded at least annually, with the amount of deferred fixed rent on which interest is charged adjusted annually to reflect the amount of deferred fixed rent no earlier than the preceding adjustment and no later than the succeeding adjustment. The tenant may well want an interest deduction to carry back against prior years’ income.

Oh no, the landlord and the tenant made a deal to defer rent without consulting the tax adviser! The section 467 loan rules would create a deemed loan for a section 467 agreement with deferred rent. Essentially that means that the government, not the parties, will prescribe the interest charges. The landlord would be treated as earning interest income, and the tenant would be treated as paying interest, which may be subject to section 163(j).

As Lipton explained, “The section 467 loan rules create a planning opportunity for landlords who want to defer taxable income and for tenants who want to defer deductions and/or create interest deductions in the case of prepaid rent, or vice versa in the case of deferred rent, because the regulations mandate recharacterization of the payments as a loan in the appropriate circumstances.”

The section 467 loan rules require use of the proportional rental accrual method to impute interest on deferred payments. The parties would have to present-value all the payments due under the modified lease, using a discount rate of 110 percent of the AFR, and allocate them to periods. Then the payments would be bifurcated between rent and interest according to a fraction, the numerator of which is the present value of the fixed rent payment allocated to the period and the denominator of which is the present value of all payments under the lease. The result is subtracted from the payment allocated to the period, and the difference is treated as interest (reg. section 1.467-2(c), (d)).

Prepaid Rent

How can there be prepaid rent when neither side has any cash? Landlords may require a commercial tenant to post a letter of credit in the amount of a year’s worth of rent or more.

What if the tenant is delinquent, and the landlord calls the letter of credit and reduces rent so that the letter covers the first few years of the lease? That would be prepaid rent, a substantial modification that would trigger section 467 testing. The modified lease would be a section 467 agreement because of the prepayment. The landlord would like to spread the prepayment over the portion of the lease that the amount would cover. But because the landlord kept the prepayment and has no obligation to return any portion, it would be required to take the entire prepayment as income in the year it called the letter of credit, Cozen O’Connor lawyers explained.

What if the parties want to structure prepaid rent to ensure that it would be spread over the lease term? Effectively the tenant is lending to the landlord. But the lease has to be drafted so that the prepayment is allocated to rental periods. An interest charge should be built in because prepaid rent is a loan if the landlord can’t retain it in all events. The tenant must have the right to recover unearned rent on an early termination of the lease.

The result turns on whether the landlord can retain the prepayment no matter what. If the landlord gets to keep the prepayment, the entirety would be includable by the landlord and deductible by the tenant in the year paid. Cozen O’Connor lawyers explained that the IRS might interpret the prepayment as a failure to allocate rent under the lease. The lawyers recommend that the agreement be drafted to give the tenant the right to recover unearned prepaid rent in the event of a lease termination, including a disavowal of the lease by the tenant’s bankruptcy trustee.

A prepayment may also occur in a situation when a landlord did a special build-out for a tenant and needed to recoup the cost. That lease would start life as a section 467 agreement, with spreading of the prepayment required if it were recoverable by the tenant. Under the proportional rental accrual method, the prepayment would be present-valued and allocated between rent and interest. The landlord would be deemed to pay the tenant interest on a prepayment, and the tenant would be deemed to pay the landlord additional rent of the same amount (reg. section 1.467-2(c)).

Convert to Net Lease

Some corporate tenants want their fixed rent to be converted into the equivalent of the net leases by means of lower monthly rent plus a share of revenue.

Thus, the lease would be substantially modified to build in a contingent feature that would not, standing alone, make the lease a section 467 agreement. The rules, however, emphasize allocation of rent payments. If the fixed rent in the new modified lease is allocated properly to periods of use and payable on a schedule, that’s a good start because there would be no stepped rent. Only the modified lease would be tested under the rules.

What about that new share of the revenue for the landlord? The addition of this contingent feature would be a substantial modification because it is not on the excepted list for modifications (reg. section 467-1(f)(6)(ii)). But again, a change that is a substantial modification could be harmless when the lease is tested for whether it is a section 467 agreement.

When the new lease is tested for section 467, this contingent feature wouldn’t make the lease a section 467 agreement because it would be disregarded (reg. section 1.467-1(c)(2)(iii)(B)(1)). To be disregarded, it would have to be qualified in that it must call for a fixed percentage of the tenant’s receipts or sales throughout the lease term. There can be differing percentages for different floors or departments of a department store or fixed dollar hurdles (reg. section 467-1(h)(8)).

But what does Sam Zell think? The investor nicknamed Grave Dancer believes that the long-term impact of the coronavirus lockdown will be worse than the Depression, telling Bloomberg Television, “We’re all going to be permanently scarred by having lived through this.” Readers’ parents and grandparents who lived through the prewar period became thrifty tightwads, which was bad for retail. “Just like we won’t see a lot of retailers reopen, I think we’ll see a lot of hotels that basically can’t reopen,” Zell said, adding that the ensuing bankruptcies will clear the market and enable price discovery.

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