As commercial real estate adapts to workforce trends, tax consequences await

The commercial real estate sector continues adapting to workforce trends, as property owners working through office vacancies now face mounting debt maturities and a need for fresh capital to fund loan workouts that banks are offering. As market conditions evolve, lessees and lessors of commercial properties may be considering changes to lease terms, rental rates, tenant concessions, tenant negotiations, renewals and terminations.

Here’s the latest on what we’re seeing in the marketplace and the corresponding tax implications.

Real estate industry trends: Evolving demand and a premium on stability

Several factors continue to compound the challenges facing commercial real estate owners, including increasing costs of capital, mounting debt maturities and excess inventory of commercial real estate space available in the market. Interest rate increases by the Federal Reserve were also a headwind, and although rate cuts may occur later in 2024, interest rates are expected to remain elevated.

The dramatic and seemingly fundamental changes to this sector resulting from evolving workforce arrangements are apparent when looking at office occupancy rates. A frequently cited measure—the Kastle Back to Work Barometer—shows the national average weekly occupancy high-water mark of 99.05% occurred in February 2020, and the national average back-to-work occupancy metric as of late June 2024 was 51.44%. While many businesses have explored return-to-office mandates, they’ve yet to have any real impact.

Low occupancy in office buildings has resulted in carryover effects for retail spaces. Major metros across the U.S. have seen foot traffic decrease in these areas, putting additional stress on commercial retail businesses.

A shift to human-centric workspaces

Employers’ increasing need to attract talent has also affected the commercial real estate industry. Continued low unemployment requires businesses to identify different strategies to recruit talent in what has been a tight labor market.

One strategy to attract talent involves rethinking how to optimize performance through the workspace. Companies are doing this by reconsidering the quantity of space in exchange for a higher quality of space in a more prestigious building and location.

Demand continues to evolve. We’re seeing a flight to quality with Class B office space lessees using the commercial real estate downturn as an opportunity to move into new Class A space delivered at a competitive price with the smaller, more flexible workspace that includes the amenities this workforce demands.

An industry in transition

Commercial real estate leasing is in flux. Although physical offices remain an important touchpoint for employers, businesses continue to refine their remote work policies and improve technology to make employees more efficient outside the office and better connected to work teams in a virtual environment.

While some companies are scaling down their physical footprints and leasing smaller spaces, others are rationalizing the type of spaces they need by assessing the value of capital investments in buildings in addition to technology.

Changing needs for space have shifted bargaining power to lessees. Many real estate owners offer expanded incentives, such as tenant improvement allowances and reduced rents, to secure leases.

In addition, the overall structure of leases is also changing to account for these market trends. We’re seeing leases made for periods longer and shorter than usual as each party attempts to maximize their position in this market.

For existing leases, lessors are increasingly renegotiating leases at favorable rates during the lease period to lock in extensions rather than face potential vacancies. We’ve also seen lessors offer deferred payment plans for lessees, as retaining a tenant in a temporary decline is viewed as a more stable business decision than finding a new tenant.

In light of these developments, more lessees seek to renegotiate to reduce existing rent or even break leases to get a lower rate elsewhere. Lessors of high-demand space are increasingly interested in terminating existing leases to make room for more desirable tenants or free properties for sale. The bottom line is lessors are paying a premium for stability, and lessees are cashing in.

Tax consequences of lease negotiations

As companies look to negotiate or renegotiate lease terms, they should be aware of the potential federal income tax consequences of various lease modifications and incentives. For example, a modification to an existing lease can result in significantly different tax consequences depending on the form (e.g., deferring rent versus abating rent). Additionally, how a tenant improvement allowance is structured may change the income tax treatment of that allowance, including whether the lessee has income and the lessor’s recovery of the allowance.

Recognizing income and expenses

Income is generally recognized under the timing rules of section 451 of the Internal Revenue Code. Cash method taxpayers recognize income in the year an amount is actually or constructively received; accrual method taxpayers typically recognize income upon the earlier of when the amount is earned, due, received, or, in certain cases, recognized in the taxpayer’s financial statement.

Expenses, on the other hand, are generally recognized under the timing rules of section 461. Accordingly, cash method taxpayers recognize expenses when paid and accrual method taxpayers recognize expenses when the liability is fixed and determinable and economic performance occurs.

For rent expenses, economic performance occurs over the associated rental term. Thus, the general rules under sections 451 and 461 may create disparate treatment between lessors and lessees and are further dependent on the taxpayer’s overall method of accounting (i.e., cash or accrual).

Fixed rental income and expenses

Regardless of a taxpayer’s overall method of accounting, special tax rules apply to fixed rental income and expenses arising out of so-called section 467 rental agreements. These rules, intended to create parity between lessors and lessees, aim to match the timing of the lessor’s income and the lessee’s expenses.

A section 467 rental agreement is one with total rent over $250,000 and increasing or decreasing rent amounts. Depending on the allocation of rent within an agreement, fixed rental income and expenses are either recognized in the rental period the rent is allocated to or are recognized over the rental term, with a portion of each rent payment treated as imputed interest income.

In any case, actual receipt and payment of rent under section 467 agreements may occur in a different period than when such amounts are taken into account for tax purposes. Commercial leases often meet the definition of a section 467 rental agreement and are thus required to be accounted for under these special rules.

Amended or renegotiated leases

When companies amend or renegotiate a lease, they may need to change how they recognize the associated revenue or expenses that are affected by the lease modification.

Deferral of previously accrued rental income or expenses may have no impact on when the income or expenses must be recognized, especially where deferral relates to rent amounts that accrued in a prior tax year. Thus, a lessor may be required to recognize accrued but unpaid rent if the payment date is merely deferred, but the rent continues to be allocated to the earlier period.

A lessee may be happy to recognize the rental expense in this scenario, but the lessor will likely be unhappy to find out that income must be recognized where no payment is received.

On the other hand, where rent is abated rather than deferred, the timing of recognition is more likely to change, given that the underlying rights of the parties are changing. In this case, if, for example, rent is abated in earlier periods in exchange for higher rent in later periods, the parties may have to take into account adjustments for any previously recognized income or expenses and defer later recognition of the abated amounts to the periods in which the higher rent accrues.

Of course, an already complex area can be further complicated by failure to consider how and if lease modifications affect the allocation of rent to specific periods. Rent allocation, payment schedules and interest provisions within a section 467 rental agreement are all factored into the appropriate section 467 method. Any modifications that alter one of these may result in unanticipated or more complex tax results.

Lease terminations

Lease terminations and rent shortfalls can have unintended tax consequences, including the timing of when termination payments are recovered, as well as potentially unfavorable rules regarding income inclusion for accrued but unpaid rent.

Lessor-paid termination payments may be required to be capitalized and recovered over the remaining term of the lease or, in some cases, over the term of a replacement lease. As discussed above, depending on the rent allocation within a lease, a lessor and lessee may have to take into account rental income and expenses despite a lessee’s failure to pay rent. Fortunately, many of these consequences can be avoided or mitigated by involving a tax advisor during the negotiation process.

Inducements and tenant improvement allowances

The current tenant-favorable market may result in more flexible and/or favorable inducements to tenants, including rent holidays and tenant improvement allowances. Generally, determining the tax consequence of inducements to the lessor and lessee requires not only understanding the impact of section 467 but also understanding which party maintains the benefits and burdens of ownership of underlying improvements.

Depending on the length of a rent holiday, this, by itself, could cause the rental agreement to fall under the rules of section 467, which may or may not be favorably compared to general section 451 and 461 rules, depending on the taxpayers’ overall accounting methods.

Treatment of tenant improvement allowances, on the other hand, is generally outside the scope of section 467 and may rely on judicially promulgated determinations of which party has the benefits and burdens of ownership of the improvement.

Often, the requirements surrounding the use of the allowance (e.g., for real property or personal property improvements) dictate whether the lessee has income from the allowance and corresponding depreciable basis in the improvements as well as the lessor’s recovery of the allowance (through amortization over the lease term or as the depreciable basis in the underlying improvement).

Real estate trends: Guarding against unintended tax consequences

Analysts may disagree about where the market is heading, but everyone agrees that the market is changing—commercial leasing transactions are evolving to fit a changing workforce and economy. The tax-technical issues and taxpayer concerns described above are just a small sample of ramifications stemming from those changes.

Companies can be more prepared for unintended tax consequences by planning lease transactions with an eye on tax. Ultimately, the desired tax treatment of any transaction may require giving up rights that a company’s attorneys would typically seek to retain. So although tax considerations rarely drive business decisions, companies should include their attorneys and tax advisors in any lease negotiation to ensure optimal legal and tax outcomes.