Section 467 Rental Agreements – Back with a Vengeance?

• February 26, 2021
• Carey M. Heyman, CPA

Enacted in the early 1980’s to prevent the abusive use of the accrual basis of accounting (specifically income and deduction timing differences between accrual and cash basis taxpayers), Section 467 is again a hot-button topic thanks to the ongoing COVID-19 pandemic and its impact on sectors like the commercial real estate industry. Up until this point, many have described the environment as akin to the “wild, wild west.” Commercial tenants are continuing to take a “wait and see” approach, with the hope that a return to normalcy (and net income) is just around the corner. Commercial landlords are on the other side of the spectrum, quickly losing patience, but without qualified replacement tenants, are effectively stuck in a never-ending holding pattern. Significant lease modifications may be the best and only option for both parties. And with any newly executed lease or substantial lease modification, a Section 467 analysis will need to be performed.

A Section 467 rental agreement is defined as a written or oral agreement between a lessor and lessee for the use of tangible property with increasing or decreasing rents, or deferred or prepaid rents, and total rents exceeding $250,000. The general focus of Section 467 is on the “matching” of rental income and rental deductions on an accrual basis by lessors and lessees, respectively.

Section 467 defines terms that will hopefully drive the point home:

• “Increasing or decreasing rents” – If the annualized fixed rent allocated to any rental period exceeds the annualized fixed rent allocated to any other rental period during the lease term. Annualized fixed rent is computed by multiplying the fixed rent allocable to the rental period by a number that represents the ratio of one year to the length of the rental period. Free rent or reduced rent at the beginning of the lease term that is for a period of three months or less is disregarded for these purposes.
• “Deferred rent” – If the cumulative amount of rent allocated as of the close of the calendar year exceeds the cumulative amount of rent payable as of the close of the succeeding calendar year.
• “Prepaid rent” – If the cumulative amount of rent payable as of the close of the calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year.

Still a little confused? I don’t blame you. Here’s an example that might help:

Let’s assume that a five-year lease requires no rent in Year 1, rental allocations of $100,000 each in Years 2 through 5, and rental payments of $200,000 each at the end of Years 3 and 4. Because no rent is allocated to Year 1, the absence of a rental payment at the end of Year 2 is not considered a deferral. The rent allocation through the end of the second year ($100,000) is less than the rent paid by the end of the third year ($200,000). And conversely, the rental payment in Year 3 is not considered prepaid because the cumulative payment through the end of Year 3 ($200,000) does not exceed the rental payments allocable through Year 4 ($100,000 x 3 years). So no Section 467 rental agreement, right? Unfortunately not. This is a Section 467 rental agreement because there are increasing rents. The rent allocated to each year after Year 1 ($100,000) is greater than the rent allocated to Year 1 ($0). The lessor and lessee must treat rental amounts consistently and use the accrual basis of accounting, regardless of their respective accounting methods.

Sources: Bloomberg Tax, RIA Checkpoint

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