Frequently Overlooked Tax Issues in Leases

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By Philip J. Holthouse, Esq. and Kevin A. Cordano, CPA  

Holthouse Carlin & Van Trigt LLP, Los Angeles, CA

A variety of tax issues surface in leasing transactions, but frequently they are not identified early in the process. Below, we have identified and briefly summarized some of these traps and opportunities for parties to a lease.

Book/Tax Differences  

For corporations with GAAP financial statements, all too often tax planners and tax return preparers do not identify part or all of the "Schedule M" adjustments that must be made to convert GAAP treatment of leases to proper tax accounting.  The potential adjustments include the treatment of leasehold improvements, the timing of rental income or deductions, and related expenditures.

Timing Differences  

Taxpayers and their advisors may miss the requirement that even accrual basis lessors are generally taxed on prepaid rents upon receipt. Further, a variety of timing issues arise for both lessors and lessees with respect to the pass through of common area maintenance and other expenses.

Capitalization/Amortization of Lease Related Costs  

Although the tax treatment of many costs related to a lease typically follows the financial accounting treatment, taxpayers should be alert to common costs required to be capitalized and amortized over the lease term (for example, legal fees and brokerage commissions).

Passive Loss Issues  

Lessors should be on guard to identify certain rents that will be treated as non-passive income for purposes of §469, such as certain rents paid under land leases or rents paid to related pass-through entities.

Related Party Rules  

Related party leases may give rise to a variety of potential tax issues, including deferrals of deductions under §§267 or 707, harsher rules or IRS scrutiny for sale leasebacks, transfer pricing concerns, disguised dividends and disguised gifts.

Lease Term versus Tax Recovery Periods  

Although the relevant statutory changes date back several decades, tenants continue to be surprised that they are not able to depreciate the cost of their improvements over shorter lease terms rather than longer tax recovery periods.

Writing Off Undepreciated Tenant Improvements upon the Termination of a Lease  

Tax return preparers for landlords, particularly in the case of office and retail buildings, are well-advised to request annually a breakdown of any tenant departures, so that they can explore potential write-offs of undepreciated tenant improvements, as well as lease commissions and other costs, in the case of early lease terminations.

Affirmatively using §467 to Accelerate Rent Deductions  

Cash basis tenants may be able to substantially accelerate tax deductions for rent by crafting the lease to allocate rents §467.

For more information, in the Tax Management Portfolios, see Holthouse, 593 T.M., Real Estate Leases, and in Tax Practice Series, see ¶1230, Rents and Royalties and ¶2210 Rents and Royalties.