Several years ago, many companies were enticed to enter into long-term commercial lease agreements with rent-free occupancy (or reduced rent) periods or tenant improvement allowance clauses. Undoubtedly, lessees were eager to lock themselves into these terms. However, with the economic downturn, the market for commercial space has deteriorated significantly. Tenants and landlords are both in a tough situation. Many companies are experiencing financial hardships and necessary downsizing. Tenants find themselves unable to meet their lease obligations and are forced to cancel or walk away from their leases early. Landlords, who at one point had anticipated fixed income, now have no tenants and no reliable cash flow; on top of that, they may not find new tenants to fill their spaces.
In the hopes of recovering lost income, landlords are turning to the courts to seek damages for breach of contract. As a result, the landlord may receive a judgment or settlement for early lease termination. This leads to the tax question, “How does a lessor treat the judgment or settlement payment?” As with most tax questions, the answer is, “It depends.” More specifically, the treatment depends on the origin and nature of the underlying claim.
Recovery of Lost Rent
An amount of cash received due to a cancellation of the lease from a lessee is generally considered rental income in the year received regardless of the lessor’s accounting method. Although the payment may compensate the lessor for future rental payments (had the lease not been cancelled), the amount should not be discounted nor amortized. The rationale for this treatment is that cash is received today and not over the term of the lease. As such, no gain or loss is incurred even if there is a difference between the present value of future payments and the lease termination payment. The income is ordinary income, which is further categorized as passive income for many taxpayers. The income is not capital gain or loss as the payment does not relate to a sale, disposition, exchange or involuntary conversion. Clearly, with a recovery of lost rent, none of these events have taken place.
Reimbursement for Tenant Improvements
Lease agreements often require the tenant to restore the premises to the original condition upon termination of the lease. If the tenant fulfills this obligation and transfers the ownership of the improvements to the landlord upon termination, the improvements are not taxable to the landlord as long as the improvements are not in lieu of rent.
The example in the regulations (under Section 109) relating to this issue involves a lease agreement of 50 years with the tenant’s commitment to construct an office building on raw land for a maximum value of $500,000. The annual land lease payment of $10,000 would begin on the date of completion of the office building. In addition, $100,000 would be placed in escrow for the payment of the rental. The lease provides that all improvements made by the lessee on the leased property would become the absolute property of the landlord upon the termination of the lease by forfeiture and that the lessor would become entitled to the remaining balance in escrow, if any.
Five years later, the tenant completes the construction of the building and begins paying rent out of the escrow funds. Five years after that, the tenant defaults on the lease, when the improvements had a value of $100,000. The improvements become the property of the landlord and the remaining $50,000 of the escrow funds are released to the landlord. Under the provisions of section 109, the $100,000 of improvements are excluded from gross income as they were not in lieu of rent, and the escrow funds of $50,000 were rental income. The landlord does not receive basis in this case and thus would not have a depreciation expense associated with the improvements. In fact, the lessee would capitalize the cost of improvements and write off the remaining balance (if any) when the lease terminates.
If the improvements were in lieu of rent, the landlord would recognize rental income upon the receipt of tenant improvements; the landlord would create basis in the tenant improvements and depreciate them over a 39-year period (and a shorter life for the portion of the improvements allocated to personal property). If the landlord makes a claim and receives a cash settlement because the tenant did not restore the lease space to its original condition, that payment is currently taxable to the landlord even if the landlord uses 100% of the proceeds to make those improvements.
With respect to any leasehold improvements made and paid for by the landlord, the landlord may have a gain or loss upon termination of the lease. For example, if a tenant suddenly terminates a lease when the landlord still has remaining depreciable basis in the leasehold improvement (unrecovered costs), the landlord may write off the unrecovered costs on the disposed of or abandoned property. This applies only to improvements that were constructed for a specific tenant and cannot be used by subsequent tenants.
Payments Attributable to Repairs
Payments attributable to repairs are included in gross income in the year received and expensed in the year the repairs are paid or accrued, dependent on the landlord’s tax method. If no monies have changed hands and the tenant pays for the repairs directly, the tenant simply deducts the cost and the landlord has no income to report.
Generally, a lease agreement will include a termination clause, which explicitly states who is responsible for performing and paying the tenant improvements and repairs. If the lease agreement does not fully disclose these matters, the tax authorities will consider the surrounding facts and circumstances, and the intent of the two parties (the lessor and lessee) to determine the character of the settlement. Any settlement payment attributable to lost rent, reimbursements to the landlord for tenant improvements and repairs are treated as rental income in the year received.
Unfortunately, many of the current lease terminations are due to circumstances that the tenant cannot control. Therefore, there is not enough time for communication with the landlord to iron out the details of the termination clause. The ideal situation for the landlord would be for the tenant to make the required improvements before handing over the keys to minimize litigation and potential income from the settlement. This may be a difficult task as the tenants cannot fund these improvements.
When considering planning options, the landlord should consider the nature of the income. Lease termination income treated as rental income is passive income that can be utilized to offset losses from other passive activities. In that respect, the tax burden may be lessened. If a loss is generated from a decrease in revenue due to a tenant vacancy, a further opportunity may come from the chance to currently recognize the loss. This could be accomplished by disposition of the passive activity or claiming real-estate professional status.
This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.