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Section 467 Rental AgreementsJanuary 21 2011ABA Tax Section – Capital Recovery and Leasing
Section 467 Rental AgreementsJanuary 21 2011ABA Tax Section – Capital Recovery and Leasing
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DisclaimerDisclaimer
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.MATTERS ADDRESSED HEREIN.
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Section 467Statutory Structure
Section 467Statutory Structure
Section 467 rental agreements Section 467 rental agreements defined asdefined as::
Agreements, written or oral, which provide for the use of Agreements, written or oral, which provide for the use of tangibletangible property and are treated as leases for Federal property and are treated as leases for Federal income tax purposes that have:income tax purposes that have:
Aggregate rent in excess of $250,000, AND EITHERAggregate rent in excess of $250,000, AND EITHER
Deferred or prepaidDeferred or prepaid rents, rents, OROR
Increasing or decreasingIncreasing or decreasing rents rentsNote that any rental agreement that requires (or may require) Note that any rental agreement that requires (or may require) contingent payments are generally deemed to have increasing or contingent payments are generally deemed to have increasing or decreasing rents (subject to certain exceptions)decreasing rents (subject to certain exceptions)
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Section 467Three Accrual Methods
Section 467Three Accrual Methods
Basic Method – Just Follow the Lease ProvisionsBasic Method – Just Follow the Lease Provisions
Proportional rental accrualProportional rental accrual
Constant rental accrualConstant rental accrual
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Section 467 Method #1Follow Lease ProvisionsSection 467 Method #1
Follow Lease Provisions
Follow lease provisions if:Follow lease provisions if:
Lease is Lease is neitherneither a disqualified leaseback a disqualified leaseback nornor a disqualified a disqualified long-term lease agreement, long-term lease agreement, andand
Lease provides for “adequate interest on fixed rent”Lease provides for “adequate interest on fixed rent”
Lease provides for “adequate interest on fixed rent” if:Lease provides for “adequate interest on fixed rent” if:
Lease has no deferred or prepaid rent, Lease has no deferred or prepaid rent, oror
Lease has deferred or prepaid rent and provides for interest Lease has deferred or prepaid rent and provides for interest on deferred or prepaid rent at single fixed rate, no lower on deferred or prepaid rent at single fixed rate, no lower than 110% of AFR, and paid or compounded at least than 110% of AFR, and paid or compounded at least annually, with deferred or prepaid rent adjusted at least annually, with deferred or prepaid rent adjusted at least annually to reflect correct amountannually to reflect correct amount
Section 467 Method #1Follow Lease ProvisionsSection 467 Method #1
Follow Lease Provisions
Payment schedules are generally allocations of rent Payment schedules are generally allocations of rent for section 467 purposesfor section 467 purposes
Use rent payment schedule if no separate rent Use rent payment schedule if no separate rent allocation scheduleallocation schedule
For example – rent holiday in payment schedule and no For example – rent holiday in payment schedule and no separate rent allocation scheduleseparate rent allocation schedule
Zero rent allocated to rent holiday periodZero rent allocated to rent holiday period
Generally does not cause rental agreement to fail to allocate rentGenerally does not cause rental agreement to fail to allocate rent
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Section 467Proportional Rental Accrual
Section 467Proportional Rental Accrual
Apply proportional rental accrual Apply proportional rental accrual if:if:
Lease does not provide for “adequate interest on fixed Lease does not provide for “adequate interest on fixed rent” (i.e. prepaid of deferred rent and no adequate rent” (i.e. prepaid of deferred rent and no adequate interest required), interest required), andand
Lease is not a disqualified leaseback or disqualified Lease is not a disqualified leaseback or disqualified long-term lease agreementlong-term lease agreement
Portion of each rental payment will be recharacterized as Portion of each rental payment will be recharacterized as interestinterest
Interest for all purposes of the code (e.g., passive loss Interest for all purposes of the code (e.g., passive loss rules, limits on interest deductions, withholding tax etc.)rules, limits on interest deductions, withholding tax etc.)
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Section 467What is Prepaid or Deferred Rent?
Section 467What is Prepaid or Deferred Rent?
Lease will have section allocating rent charge for each year Lease will have section allocating rent charge for each year AND another section specifying when rent is payableAND another section specifying when rent is payable
Rent is Rent is prepaidprepaid if cumulative rent payable through close if cumulative rent payable through close of any year exceeds cumulative rent allocated to all of any year exceeds cumulative rent allocated to all periods through the close of succeeding yearperiods through the close of succeeding year
Rent is Rent is deferreddeferred if cumulative rent allocated to all if cumulative rent allocated to all periods through close of any year exceeds cumulative periods through close of any year exceeds cumulative rent payable as of end of succeeding yearrent payable as of end of succeeding year
Effectively, rent may be deferred or prepaid for one year Effectively, rent may be deferred or prepaid for one year without lease being a Section 467 rental agreementwithout lease being a Section 467 rental agreement
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Deferred Rent vs. Prepaid RentDeferred Rent vs. Prepaid Rent
Deferred RentDeferred Rent
YearYearRent Rent
AllocatedAllocatedRent Rent
PayablePayable
11 $20$20 $0$0
22 $20$20 $15$15
33 $20$20 $20$20
44 $20$20 $30$30
55 $20$20 $35$35
Prepaid RentPrepaid Rent
YearYearRent Rent
AllocatedAllocatedRent Rent
PayablePayable
11 $20$20 $45$45
22 $20$20 $25$25
33 $20$20 $10$10
44 $20$20 $10$10
55 $20$20 $10$10
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Prepaid Rent Example – Proportional Rent Calculation
Prepaid Rent Example – Proportional Rent Calculation
One Payment in Year 1 = $1,800,000One Payment in Year 1 = $1,800,000
Allocated $510,000 yr1; 600,000 yr2; 690,000 yr3Allocated $510,000 yr1; 600,000 yr2; 690,000 yr3
PV of Payment @10% = $1,800,000PV of Payment @10% = $1,800,000
PV @ 10% of allocations = $1, 477,911PV @ 10% of allocations = $1, 477,911
Divide PV of payments by PV of allocations = 1.217935Divide PV of payments by PV of allocations = 1.217935
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Prepaid Rent Example – Total Section 467 Rent and Interest
Prepaid Rent Example – Total Section 467 Rent and Interest
Prepaid Rent Prepaid Rent Proportional MethodProportional Method
YearYear
Rent Rent Allocated Allocated per Leaseper Lease
Sec. 467 Sec. 467 Prop. Rent Prop. Rent
AmountAmountSec. 467 Sec. 467 InterestInterest
Net 467 Net 467 Rent and Rent and
InterestInterestRent Rent
paymentspayments
Sec. 467 Sec. 467 Loan Loan
BalanceBalance
11 510,000510,000 621,147621,147 (180,000)(180,000) 441,147441,147 1,800,0001,800,000 (1,800,000)(1,800,000)
22 600,000600,000 730,761730,761 (135,885)(135,885) 594,876594,876 (1,358,853)(1,358,853)
33 690,000690,000 840,375840,375 (76,399)(76,399) 763,976763,976 (763,997)(763,997)
TotalTotal 1,800,0001,800,000 2,192,2832,192,283 (392,284)(392,284) 1,800,0001,800,000 1,800,0001,800,000
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Deferred Rent Example – Proportional Rent Calculation
Deferred Rent Example – Proportional Rent Calculation
One Payment in Year 3 = $1,800,000One Payment in Year 3 = $1,800,000
Allocated $510,000 yr1; 600,000 yr2; 690,000 yr3Allocated $510,000 yr1; 600,000 yr2; 690,000 yr3
PV of Payment @10% = $1,352,366PV of Payment @10% = $1,352,366
PV @ 10% of allocations = $1, 477,911PV @ 10% of allocations = $1, 477,911
Divide PV of payments by PV of allocations = 0.915053Divide PV of payments by PV of allocations = 0.915053
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Deferred Rent Example – Total Section 467 Rent and Interest
Deferred Rent Example – Total Section 467 Rent and Interest
Deferred Rent Deferred Rent Proportional MethodProportional Method
YearYear
Rent Rent Allocated Allocated per Leaseper Lease
Sec. 467 Sec. 467 Prop. Rent Prop. Rent
AmountAmountSec. 467 Sec. 467 InterestInterest
Net 467 Net 467 Rent and Rent and
InterestInterestRent Rent
paymentspayments
Sec. 467 Sec. 467 Loan Loan
BalanceBalance
11 510,000510,000 466,677466,677 466,677466,677
22 600,000600,000 549,031549,031 46,66746,667 595,698595,698 466,676466,676
33 690,000690,000 631,386631,386 106,237106,237 737,623737,623 1,800,0001,800,000 1,062,3741,062,374
TotalTotal 1,800,0001,800,000 1,647,0941,647,094 152,904152,904 1,800,0001,800,000 1,800,0001,800,000
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Disqualified Leasebacks and Long-term Lease Agreements
Disqualified Leasebacks and Long-term Lease Agreements
LeasebackLeasebackIf tenant had an interest within 2 years of leasing from landlordIf tenant had an interest within 2 years of leasing from landlord
Long-Term Lease AgreementLong-Term Lease AgreementLease term exceeds 75% of statutory recovery period of property; Lease term exceeds 75% of statutory recovery period of property; e.g., e.g.,
Specified statutory recovery period, Specified statutory recovery period, notnot depreciable life of asset depreciable life of asset
For real property, statutory recovery period is 19 yearsFor real property, statutory recovery period is 19 years
Leaseback or Long-Term Lease Agreement is Leaseback or Long-Term Lease Agreement is disqualified ifdisqualified if::
AA principal purpose for providing increasing or decreasing rents is principal purpose for providing increasing or decreasing rents is the avoidance of Federal income tax, the avoidance of Federal income tax, andand
IRS decides to treat agreement as disqualifiedIRS decides to treat agreement as disqualified
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Deferred Rent Example – Constant Rental Calculation
Deferred Rent Example – Constant Rental Calculation
One Payment in Year 3 = $1,800,000One Payment in Year 3 = $1,800,000
PV of Payment @10% = $1,352,366PV of Payment @10% = $1,352,366
PV @ 10% of $1 assumed to be payable on the last day PV @ 10% of $1 assumed to be payable on the last day of each accrual period = $2.486852of each accrual period = $2.486852
Divide PV of payments by PV of $1 =Divide PV of payments by PV of $1 =
Constant Rental Factor of $543,806Constant Rental Factor of $543,806
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Deferred Rent Example – Total Section 467 Rent and Interest
Deferred Rent Example – Total Section 467 Rent and Interest
Deferred Rent Deferred Rent Constant RentalConstant Rental
YearYear
Rent Rent Allocated Allocated per Leaseper Lease
Sec. 467 Sec. 467 Constant Constant
Rent Rent AmountAmount
Sec. 467 Sec. 467 InterestInterest
Net 467 Net 467 Rent and Rent and
InterestInterestRent Rent
paymentspayments
Sec. 467 Sec. 467 Loan Loan
BalanceBalance
11 00 543,806543,806 543,806543,806 00
22 00 543,806543,806 54,38154,381 598,187598,187 543,806543,806
33 1,800,0001,800,000 543,806543,806 114,200114,200 658,006658,006 1,800,0001,800,000 1,141,9931,141,993
TotalTotal 1,800,0001,800,000 1,631,4181,631,418 168,581168,581 1,800,0001,800,000 1,800,0001,800,000
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“A” (not THE) Principal Purpose to Avoid Tax“A” (not THE) Principal Purpose to Avoid Tax
Constant rental accrual does not apply unless rental Constant rental accrual does not apply unless rental agreement is disqualifiedagreement is disqualified
To be disqualified, agreement must have To be disqualified, agreement must have aa principal principal purpose of tax avoidancepurpose of tax avoidance
How is the principal purpose test applied?How is the principal purpose test applied?
Agreement will be “closely scrutinized” if reasonable to Agreement will be “closely scrutinized” if reasonable to expect “significant” difference between marginal tax rate expect “significant” difference between marginal tax rate of lessor and lessee at some point during lease term.of lessor and lessee at some point during lease term.
Greater than 10% is significant, taking into account NOLs, Greater than 10% is significant, taking into account NOLs, credit carryovers, AMT and partnership allocations.credit carryovers, AMT and partnership allocations.
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Safe Harbors to Avoid Constant Rental Accrual Treatment
Safe Harbors to Avoid Constant Rental Accrual Treatment
Increasing or decreasing rent is not considered to be Increasing or decreasing rent is not considered to be motivated by tax avoidance where, inter alia:motivated by tax avoidance where, inter alia:
Rent allocated for each year is within Rent allocated for each year is within 10%10% of average annual rent of average annual rent
Where the rental agreement is a long-term agreement and at Where the rental agreement is a long-term agreement and at least 90% of property subject to agreement is real property, least 90% of property subject to agreement is real property, 15%15% variation allowed variation allowed
If 10% test applies, eliminate free rent period < 3 months in If 10% test applies, eliminate free rent period < 3 months in making calculation if concession is at start of leasemaking calculation if concession is at start of lease
If 15% test applies, eliminate free rent period up to 24 months If 15% test applies, eliminate free rent period up to 24 months or 10% of the lease term if commercially reasonableor 10% of the lease term if commercially reasonable
Increase or decrease in rent attributable to a single rent holiday for Increase or decrease in rent attributable to a single rent holiday for one consecutive period if rent holiday is for 3 months or less at one consecutive period if rent holiday is for 3 months or less at beginning of lease term, or does not exceed 24 months and is beginning of lease term, or does not exceed 24 months and is commercially reasonable in locality of use of propertycommercially reasonable in locality of use of property
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Safe Harbors to Avoid Constant Rental Accrual Treatment
Safe Harbors to Avoid Constant Rental Accrual Treatment
Safe Harbors (continued):Safe Harbors (continued):
Increase or decrease in rent attributable to a specified Increase or decrease in rent attributable to a specified contingent rent provision, including:contingent rent provision, including:
A qualified percentage rents provision (rent equal to fixed A qualified percentage rents provision (rent equal to fixed percentage of lessee’s sales receipts or sales)percentage of lessee’s sales receipts or sales)
An adjustment based on a reasonable price indexAn adjustment based on a reasonable price index
A provision requiring lessee to pay costs to a third partyA provision requiring lessee to pay costs to a third party
A provision requiring payment of late payment chargesA provision requiring payment of late payment charges
A tax indemnity provisionA tax indemnity provision
A variable interest rate provisionA variable interest rate provision
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Section 467 and Lease ModificationsSection 467 and Lease Modifications
If a lease is “substantially modified,” it is treated as a new If a lease is “substantially modified,” it is treated as a new agreement made on the date of modificationagreement made on the date of modification
New determination must be made as to whether lease is a Section New determination must be made as to whether lease is a Section 467 rental agreement, and whether proportional rental accrual or 467 rental agreement, and whether proportional rental accrual or constant rental accrual applyconstant rental accrual apply
Safe harbors – not a substantial modification if:Safe harbors – not a substantial modification if:Change in rent solely result of lessor refinancing debt incurred to Change in rent solely result of lessor refinancing debt incurred to acquire property,acquire property,
Change in rent in any rental period does not vary by more than 1% Change in rent in any rental period does not vary by more than 1% from original rent in that period, orfrom original rent in that period, or
Change in rent due to lessee’s obligations to pay third-party costs Change in rent due to lessee’s obligations to pay third-party costs and certain other types of contingent paymentsand certain other types of contingent payments
Change in lessor or lessee generally not a substantial modificationChange in lessor or lessee generally not a substantial modification
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Section 467 RecaptureSection 467 Recapture
If a lessor transfer property subject to a leaseback or long-If a lessor transfer property subject to a leaseback or long-term agreement (not disqualified) and the lease has some term agreement (not disqualified) and the lease has some amount of back-loaded rent,” the lessor must recapture as amount of back-loaded rent,” the lessor must recapture as ordinary income an amount of gain on the sale equal to the ordinary income an amount of gain on the sale equal to the income it would have received if the lease had been income it would have received if the lease had been subject to constant rental accrual over the income it subject to constant rental accrual over the income it actually reportedactually reported
Section 467 Method ChangesSection 467 Method Changes
Automatic consent generally available for change to Automatic consent generally available for change to use rent allocation methoduse rent allocation method
App. Sec. 20.01 of Rev. Proc. 2008-52, as modified by Sec. 2.24 App. Sec. 20.01 of Rev. Proc. 2008-52, as modified by Sec. 2.24 of Rev. Proc. 2009-39 (automatic change # 136)of Rev. Proc. 2009-39 (automatic change # 136)
Not applicable to taxpayers required to use constant rental Not applicable to taxpayers required to use constant rental accrual method or proportional rental accrual methodaccrual method or proportional rental accrual method
Must attach to Form 3115 copy of one of section 467 rental Must attach to Form 3115 copy of one of section 467 rental agreements to be covered by change (or at least rent allocation agreements to be covered by change (or at least rent allocation pages)pages)
No audit protection if IRS determines section 467 rental No audit protection if IRS determines section 467 rental agreement is disqualified leaseback or long-term agreementagreement is disqualified leaseback or long-term agreement
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Section 467 Method ChangesSection 467 Method Changes
Automatic consent (cont.)Automatic consent (cont.)
Generally see when taxpayers have been inadvertently Generally see when taxpayers have been inadvertently following bookfollowing book
Taxpayer recognizes deferred rent on straight-line basis over Taxpayer recognizes deferred rent on straight-line basis over term of rental agreement even though required to use rent term of rental agreement even though required to use rent allocation method under section 467allocation method under section 467
All other changes generally non-automaticAll other changes generally non-automatic
Rev. Proc. 97-27Rev. Proc. 97-27
Section 481(a) adjustment spread periodSection 481(a) adjustment spread period
Unfavorable (positive) adjustment – 4 yearsUnfavorable (positive) adjustment – 4 years
Favorable (negative) adjustment – 1 yearFavorable (negative) adjustment – 1 year
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Contact InformationContact Information
Kevin Juran – KPMG LLP, 212 872-5826, Kevin Juran – KPMG LLP, 212 872-5826, [email protected]
Natalie Tucker – RSM McGladrey Inc., 904 680-7209, Natalie Tucker – RSM McGladrey Inc., 904 680-7209, [email protected]
Glenn Johnson – Ernst & Young LLP, 202 327-6687, Glenn Johnson – Ernst & Young LLP, 202 327-6687, [email protected]
Katherine Breaks – KPMG LLP, 202 533-4578, [email protected] Breaks – KPMG LLP, 202 533-4578, [email protected]
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