In reaction to the COVID-19 situation, landlords and tenants are starting to discuss rent deferral packages. Typically, these packages involve modifying the existing lease to provide for a deferral in rent for April, May and June of 2020, with a payback of the deferred amounts occurring over a number of subsequent months during the remaining lease term. There may, however, be an unexpected tax consequence to both landlords and tenants depending on how these deferral packages are structured. This alert is intended to make our clients aware of Section 467 of the Internal Revenue Code and provide a basic understanding of what types of deferral packages would trigger unexpected tax consequences under IRC Section 467.
To simplify our discussion, we examine a hypothetical lease with a 5 year term (2020 through 2024), with a single rental payment of $100 per year which is allocable to each year (meaning that $100 is attributable to the lease of the space each year, regardless of when it is actually paid). Under a typical commercial lease, with each $100 payment due on January 1 (or if monthly payments were due on the first day of each month during that year) this typical lease would not be considered a “Section 467 Rental Agreement” (discussed below) and, therefore, it would not be subject to IRC Section 467.
IRC 467 (d)(1)(A) defines a “Section 467 Rental Agreement” as a lease “under which there is at least one amount allocable to the use of property during a calendar year [year 1 in our example below] which is to be paid after the close of the calendar year following the calendar year in which such use occurs [year 2 in our example below]”. IRC 467 (d)(1)(A), emphasis added.
If our hypothetical lease was modified so that no payment of rent was due for year 1, but $200 was due for year 2 (with $100 due for each subsequent year 3, 4 and 5), then the modified lease would not be considered a “Section 467 Rental Agreement” and, therefore, it would not be subject to IRC Section 467. The reason for this is that the amount deferred in year 1 was paid back in year 2.
If, however, our hypothetical lease was modified so that no payment of rent was due for year 1 and no payment of rent was due for year 2, but $300 was due for year 3 (with $100 due for each subsequent year 4 and 5), then the modified lease would be considered a “Section 467 Rental Agreement” and, therefore, it would be subject to IRC Section 467. The reason for this is that the amount deferred in year 1 was paid back in year 3, not year 2.
While this simplified example helps demonstrate what to lookout for, we know that each lease and each rent deferral package may not lend itself to such a clear evaluation. But if the rent deferral package being contemplated involves rental payable in 2020 being deferred and repaid in whole or in part after 2021, we encourage our clients to discuss any such rent deferral package with their accountant or with one of our attorneys at Seward and Kissel to determine if IRC Section 467 is triggered, and if so, what the tax consequences would be.
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