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, kjuran@kpmg.com

Natalie Tucker – RSM McGladrey Inc., 904 680-7209, Natalie Tucker – RSM McGladrey Inc., 904 680-7209, natalie.tucker@mcladrey.com

Glenn Johnson – Ernst & Young LLP, 202 327-6687, Glenn Johnson – Ernst & Young LLP, 202 327-6687, glenn.johnson@ey.com

Katherine Breaks – KPMG LLP, 202 533-4578, kbreaks@kpmg.comKatherine Breaks – KPMG LLP, 202 533-4578, kbreaks@kpmg.com

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