COVID-19 ushered in a host of challenges for the global economy. Cash-flow issues plague individuals and businesses alike. Although the CARES Act addressed certain liquidity measures, it did not address rent forbearance or provide specific relief for lessors and lessees. As a result, business-owners are looking to landlords and lessors for relief during these unprecedented times.
Property owners, managers and lessees across the country should assess the tax implications of rent forbearance. The tax consequences vary based on whether or not the rental agreement is modified, rent is forgiven completely, or if the lease is a section 467 rental agreement. An agreement generally qualifies as a section 467 agreement if total lease payments exceed $250,000 and the lease has increasing or decreasing rents or deferred or prepaid rents. Under the general rules, section 467 requires a lessor and a lessee of tangible property to treat rents consistently regardless of their overall method of accounting.
For the purposes of demonstration, assume the following fact pattern: a lessor renegotiated and provided a one month rent holiday for its lessee. Further, assume that lease payments for the entirety of the agreement total less than $250,000, thus section 467 does not apply. Under this fact pattern, the lessor and lessee would not record rental income or expense for the forgone amount.
Next, assume that a lessor and lessee have a rental agreement with rental payments totaling over $250,000 and has increasing rental payments thus qualifying as a section 467 rental agreement. Both parties decide to renegotiate a new agreement that provides the lessee with a rent holiday for a short time period but leaves the remaining agreement on its original terms (minus the rent holiday). If the agreement continues to qualify as a section 467 agreement, the lessor and lessee in this example must account for the income and corresponding rent expense per the terms of the modified agreement and must apply section 467 and the regulations thereunder to the post-modification agreement.
Forgone rent is different from a deferred payment of rent due. Extending payment terms (deferred payment) of rent under a section 467 agreement may still require income inclusion for the lessor and corresponding rent expense by the lessee during the rental periods if there is not an economically substantial change to the lease (i.e., rent may accrue even if no payment is due because of financing terms extended by the lessor). To the extent the deferred payment of rent is later forgiven, it may be more appropriately deemed a discharge of debt and require income inclusion for the lessee and a bad debt deduction for the lessor.
While the above fact patterns are separate and distinct, modifications to rental agreements will likely be far more nuanced, thus requiring careful assessment when evaluating the resulting tax implications. Lessors and lessees should work closely with advisors when revising and evaluating the terms of rental agreements in determining how section 467 applies and how to account for rent forbearance and agreement modifications.