The Tax Effect of a Lease Termination Payment to a Lessee
This past week, a client called with a question about the potential tax effect of a ground lease termination payment on their long-time leasehold interest. The facts (changed, of course, for privacy reasons): In 1985, ABC Partnership (“ABC”) entered into a 40-year ground lease agreement with a municipality (“City”) to develop and construct an affordable housing community on a parcel owned by the City. Under the terms of the ground lease agreement, ABC would construct and own the improvements during the lease term, but ownership would revert to the City at the end of the 40 years. During the lease term, ABC capitalized and depreciated leasehold improvements such as common area flooring and lighting accessories. The City offered ABC $1,000,000 to terminate the ground lease agreement early.
Under Internal Revenue Code (IRC) Section 1241, an amount received by a lessee for the termination or cancellation of a lease is considered as payment in exchange for the lease. When a lessee pays for and owns improvements to leased property and the lease is terminated or cancelled, the leasehold improvements are treated as if irrevocably disposed of, thereby entitling the lessee to write off the remaining basis in the leasehold improvements in the year of disposition. And because the leasehold improvements are qualifying property that were held for over a year, the treatment would either be a capital gain or an ordinary loss according to IRC Section 1231.
Luckily for ABC, the City’s offer would result in a gain, calculated by taking the $1,000,000 termination payment less the remaining basis of the leasehold improvements. The recapture provisions of IRC Sections 1245 and 1250 would also apply here.
Sources: IRS.gov, Bloomberg Tax, RIA Checkpoint
- Carey M. Heyman, CPA
- Managing Principal of Industry - Real Estate
- CliftonLarsonAllen LLP
- Century City (Los Angeles)
Carey is the Managing Principal of the Real Estate Industry at CLA. He is a trusted advisor with close to 20 years of experience providing accounting, assurance, tax, and consulting services to real estate industry owners, operators, family offices, developers and syndicators. Carey has a strong track record of helping clients build and retain capital by leveraging tax- and cost-saving strategies and employing tax credits and incentives. He also consults with high net worth individuals, large family groups, and owners of closely-held businesses on all aspects of tax planning, estate planning, and retirement planning.
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