Question of the Month
Question: If I pay a three-year lease up front, can I accrue the expense over the three years or do I load it all on the front end? Is it the same treatment for landowners?
Answer provided by Kennedy & Coe tax expert, Paul Stuckwisch
Summary:
- Section 467 of the tax code applies in the situation described only if prepayment is required up front.
- When Section 467 does not apply, then the result will be full income recognition for the lessee and a deduction for the lessee of one third of the payment in each of the years of the lease term. This is the result regardless of the accounting method of either the lessor or the lessee.
- Landlords typically must report the income for the year the payment is received unless the lease stipulates payment amounts based on deferred or prepaid rents.
- Cash basis renters typically cannot claim prepaid rent as a deduction unless there is a clear business purpose and the deduction does not distort income results for the current year.
- If you use accrual accounting, you are required to accrue the payment over the life of the lease.
- If you use the cash method, you can deduct payments for periods of one year or less with legitimate business reasons for early payment. Any longer period requires treatment just like the accrual method.
If the lease agreement calls for regular periodic payments such that it does not fit the definition of a Sec. 467 lease as discussed below, then any prepayment received by the lessor is reportable currently in income regardless of the method of accounting of the lessor following the rule laid out in Reg. 1.61-8(b).
The lessee, on the other hand, can't generally deduct prepaid rent for future periods in the current year unless there was a clear business purpose for doing so and the deduction will not cause a material distortion of the lessee's income in the year of prepayment. An accrual method lessee is required to allocate the portion of the payment relating to future periods to the year in which the periods occur, deducting currently only that portion relating to periods within the current year.
A cash method lessee, however, can deduct payments on a lease for periods of one year or less if there was a business purpose for making the payment within the current year. Longer periods will require capitalization of the portion of the payment relating to the future periods, just like an accrual method lessee.
The question specifically refers to paying upfront on a three year lease. As long as the prepayment is not called for in the lease agreement itself, then the result will be full income recognition for the lessee and a deduction for the lessee of one third of the payment in each of the years of the lease term. This is the result regardless of the accounting method of either the lessor or the lessee.
If, however, the lease agreement is negotiated such that it specifically calls for a prepayment for the entire period, then it will meet the definition of a Sec. 467 lease due to the provision for prepaid rent. A Sec. 467 rental agreement is defined in Reg. 1.467-1(c) as one that provides either for increasing or decreasing rents or for deferred or prepaid rents. Basically, the Sec. 467 rules are designed to break payments out as partially rent and partially interest and allocate those payments out over the period of the lease. The methods of accounting of the lessor and lessee will not matter in this analysis.
In the situation described in the question, where the lessee pays upfront for a three year lease, there is presumed prepaid rent since the amount paid in the first year exceeds the rent allocated by the end of the second year. Assuming that the agreement doesn't call for interest to be paid on the prepaid amount, let alone adequate interest, the upfront payment will have to be allocated as rent paid by the lessee over the three years offset by interest paid by the lessor over the three years. (I am also assuming the lease agreement is not a disqualified leaseback or a long term lease where the term exceeds the remaining useful life of the underlying property, each of which is subject to different rules.)
The calculation of rent attributable to a given period (the proportional rent amount) is equal to:
- Fixed rent allocated for period x (Present value of fixed rent and interest payable)/(Present value of fixed rent allocated to each period)
- Where present value is determined based upon a discount rate equal to 110% of the applicable AFR rate.
To illustrate, let's assume the lease was for $3,000,000 over the three years, all payable upfront, and allocated evenly among the three years. Let's further assume that 110% of the applicable AFR is 10%.
Then the present value of fixed rent and interest payable would be the $3,000,000 due currently.
The present value of fixed rent allocated to each period would be $1,000,000/1.1 + $1,000,000/(1.1)^2 + $1,000,000/(1.1)^3 or $909,090.91 + $826,446.28 + $751,314.80 or $2,486,851.99.
Thus, each year would be allocated $1,000,000 x $3,000,000/$2,486,851.99 or $1,206,344.41 of rent, reportable by the lessor and deductible by the lessee.
Offsetting this would be interest on the deemed loan by the lessee to the lessor.
At the end of the first year, 10% of $3,000,000 would be due, or $300,000.
As of the beginning of the second year, the loan would be $3,000,000 less the first year's rent of $1,206,344.41 plus the first year's interest of $300,000 or $2,093,655.59.
Ten percent of this would be $209,365.56.
As of the beginning of the third year, the loan would be $3,000,000 less two years of rent and plus accrued interest or $1,096,676.74. Ten percent of this would be $109,667.67. All interest would be income to the lessee and an interest expense deduction to the lessor.
By year:
- Year 1 - $1,206,344.41 rent income less $300,000.00 interest expense = net $906,344.41 of income.
- Year 2 - $1,206,344.41 rent income less $209,365.56 interest expense = net $996,978.85 of income.
- Year 3 - $1,206,344.41 rent income less $109,667.67 interest expense = net $1,096,676.74 of income.
- Total - $3,619,033.23 rent income less $619,033.23 interest expense = net $3,000,000 of income.
Again, these Sec. 467 provisions would only apply if the agreement specifically called for prepayment. Otherwise, the simpler but harsher rules described above would apply.
