Generally, the timing of when the income from a rental payment is reportable and when the expense of a rental payment is deductible depends on the taxpayer's method of accounting. If a taxpayer is on the accrual method of accounting, a deduction for rental expenses will generally be allowed in the year that (1) the amount of the liability can be determined with reasonable accuracy and (2) all event have occurred to fix the liability. On the other hand, a taxpayer who is on the cash method of accounting must report income from rental payments in the year that the income was received.
In the real estate leasing context, these method of accounting rules often resulted in a mismatch of income and deductions. This potential mismatch created an opportunity to gain tax advantage, or even attain something that resembled an interest free loan. For instance, in the case of a rental agreement calling for a deferral of rental payments, an accrual method lessee could deduct the amount of rent due for a particular year, even though that rent had not been paid, while a cash method lessor would not have to report income until later in the lease term, when the rental payments were received.
In 1984, Congress, concerned about the potential for abuse, amended the Internal Revenue Code by adding section 467, relating to deferred payments for the use of property. Section 467 applies whenever a lease agreement provides for (1) deferral of at least one rental payment for the use of property during a calendar year until after the close of the calendar year following the calendar year in which the property was used or (2) increases in the amount to be paid as rent under the agreement, unless the total payments under the lease do not exceed $250,000.
Section 467 operates to put the lessor and lessee on the same schedule. In most cases, the lessor and the lessee are both required to report consistent amounts of income and deductions, computed on the accrual method (regardless of their overall methods of accounting), and giving effect to the allocation of rental payments under the lease. In addition, a portion of any deferred rental payment may be recharacterized as interest (also accounted for on the accrual method), in order to reflect the deferral between the accrual method), in order to reflect the deferral between the accrual date and the payment date.
In some cases, section 467 operates more radically and may impose an allocation of rents differing from that stated in the lease (a so called "constant rental method" or "rent leveling"), in addition to mandatory use of the accrual method for the level rent and imputed interest thereon. These rules apply in the case of real property (1) when the parties' allocation has as one of its principal purposes the avoidance of taxes and either (a) the transaction is a leaseback transaction or (b) the lease is for a period of more than 14.5 years ("long-term agreement"); or (2) when the lease provides for no stated allocation of rents. Congress directed the Treasury Department to prescribe regulations providing, among other things, safe harbors under which certain common lease terms, such as "reasonable rent holidays," would not be viewed as indicative of tax avoidance.
For 12 years after the enactment of section 467, Treasury failed to propose any Regulations under that provision and many questions associated with its operation remained unclear. Then, within a period of about four months during this past spring and summer, there was a flurry of activity on the section 467 front. On June 3, 1996, Treasury issued proposed Regulations under section 467, which would generally be applicable to all rental agreements entered into after the date the final Regulations are published and to leasebacks and long-term leases entered into after June 3, 1996. Meanwhile, two recent cases, one in the Court of Federal Claims, Piccadilly Cafeterias Inc. v. United States (Aug. 19, 1996), and the other in the Tax Court, Republic Plaza Properties Partnership v. Commissioner (Sept. 16, 1996), illustrate the application of section 467 to existing leases not covered by the Regulations.
In Piccadilly, the taxpayer was a lessee trying to invoke section 467 in order to accelerate its rental expense deductions under the "rent leveling" method. Under each of the taxpayer's long-term leases, the amount of fixed rent payable by the taxpayer was scheduled to increase at specified intervals during the term of the lease. The leases called for conventional monthly rent payment schedules, but did not specifically "allocate" any rental payments to use of the property during any specific period. For each of 1985 and 1986, the taxpayer had deducted as rental expenses the amount of the fixed rent actually paid during that year. In 1987, however, before the rent increases under the leases became effective, the taxpayer determined the amount of its rental deduction under section 467, by allocating total rent on a straight-line basis over the term of the lease.
The main issue in the case was whether the rent payment schedule was an "allocation" of rent. If the schedule constituted an "allocation," the rent leveling provisions of section 467 would not apply to reallocate rental expense from later years into 1987. However, if the payment schedule was not an "allocation," the taxpayer would have been entitled to a larger deduction during the earlier years of the lease.
The court held that the rental payment schedule was an "allocation" of rent under the lease agreement and therefore, that rent leveling was inapplicable. The court asserted that a rent payment schedule could act as an "allocation" for section 467 purposes, even though the parties did not, in so many words, "allocate" rent to any period. The Court was also influenced by section 467's genesis as an anti-abuse measure and was unsympathetic to the taxpayer's attempt to use the provision to create "phantom" deductions (although a consistent application of rent leveling, with the taxpayer's lessors, being required to report "phantom" income, might have satisfied this concern). In any event, the court's resolution seems correct on the facts of this case and the result in Piccadilly would likely be unchanged under the proposed Regulations.
In Republic Plaza Properties, the taxpayer, in this case a lessor, leased a commercial office building in Denver, Colo., to another party for a term of 24 years and 11.5 months. The rental agreement provided that rent should be paid by the lessee on dates specified in a schedule in the agreement. However, the rent for the first 11.5 months was zero and all fixed rent was allocated over the remaining 24 years of the lease term. One of the issues presented was whether an 11.5-month rent-free period was a reasonable "rent holiday," so that the allocation of rents would not be considered to have a tax avoidance purpose.
The court held that 11.5 months was a reasonable "rent holiday" in this case, that there was thus no tax avoidance purpose, and that rent leveling under section 467 accordingly did not apply. In coming to its decision, the court relied on the taxpayer's experts, as well as the standard practice in the Denver office rental market at the time the lease was entered into.
The outcome of this case might also have been the same under the proposed Regulations, which state that a determination as to whether tax avoidance is a principal purpose for providing increasing rent is based on all of the "facts and circumstances." While the proposed Regulations also provide for a safe harbor that automatically allows rent holidays of up to 24 months in some cases, the rental agreement in this case would, for technical reasons, not fall under that safe harbor; therefore, all of the facts and circumstances of the rent holiday would have to be analyzed, much as the court did in Republic Plaza Properties.
Some significant strides have now been taken in developing a more lucid understanding of the practical application of section 467, and the issuance of proposed Regulations will further resolve many of the complexities of this provision. However, the Regulations are still only in proposed form and they do not address all of the unanswered questions. Owners and lessees, as well as their attorneys and accountants, need to be sensitive to situations involving section 467 and must recognize that its application, even in light of the additional guidance now available, may sometimes be surprising.