M id A tlantic Real Estate Journal — Tax Issues/Accounting —Financial Digest — July 23 - August 19, 2021 — 11A T ax I ssues /A ccounting
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By By Ashley Kettler, CPA, Withum Tax Consequences of Lease Modifications under COVID-19
T
he COVID-19 pandem- ic has had a domino effect on the real estate industry. Businesses who
unpaid rent. They can only claim a bad debt expense to the extent the rent receiv- able becomes fully worthless. Worthless rent receivable is a facts-and-circumstances determination and landlords can only claim wholly worth- less bad debts, not partially worthless bad debts. Factors to support worthless rent re- ceivable include, but are not limited to: • Tenant shut their doors permanently, • Tenant filed bankruptcy or is insolvent, or • Landlord made all rea -
sonable efforts to collect un- paid rent. Modifying Rental Agree- ments Fees associated with modi- fying an existing lease (for example, legal fees) must be capitalized and amortized over the remaining term of the lease. If there is a sub- stantial lease modification, landlords and tenants could accidentally trigger the need to comply with IRC Section 467. If the lease is modified under a formal agreement in writing then an accrual ba-
sis landlord would recognize income according to the new payment schedule. Lease Terminations Lease termination pay- ments paid by the tenant to the landlord are considered a substitute for rent and should be included in the landlord’s taxable income in the year received. Landlords cannot simply write off landlord-owned leasehold improvements if a tenant vacates the premises. Landlord-owned leasehold improvements can only be written off when the asset is
continued on page 12A IRC Section 467 Issues Section 467 applies to leases that have total of $250,000 rent payments and prepaid rent, deferred rent, or in- actually demolished. Tenants can write off the remaining basis of their tenant-owned leasehold improvements at the time a lease is terminated. Any unamortized fees ini- tially capitalized with the original lease (such as leasing commissions or lease acquisi- tion costs) can be written off by the landlord if a lease is terminated.
have taken a hit as a re- sult of shut- downs may ha v e p a i d rent late, not paid at all, or renegotiated lease terms wi th the i r
Ashley Kettler
landlords, including rent de- ferrals or abatements. These aspects can have unintended tax consequences on both the landlord and tenant. Landlords recognize income based on their accounting method. Cash and accrual basis landlords will treat deferred rent, unpaid rent, and lease modifications dif - ferently. The following scenarios all assume that a lease is not a Section 467 lease, which will be discussed at the end of this article. Deferred Rental Income Cash basis landlords recog- nize income when received. In the case of late rent, cash ba- sis landlords will recognize in- come at the time they receive the cash in the future. Accrual basis landlords recognize income when the “all events” test is met. This means in- come recognition might not necessarily correlate to when cash is received. Under the “all events” test, a landlord recognizes rent when: 1. The right to income is fixed, and 2. The amount can be de- termined with reasonable accuracy. Since the lease will state these terms, accrual basis landlords will continue to recognize income according to those schedules even with deferred payments or a non- paying tenant. Non-paying Tenants and Worthless Rents If landlords have nonpaying tenants, cash basis landlords will not recognize any in- come since no cash is being received. There is no write-off for bad debts since they never recognized income in the first place. Since accrual basis land- lords accrue rental income, they can potentially claim a bad debt expense later on, but cannot simply claim a bad debt based on an estimate of
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