Key tax impacts from the new leasing standard

As more private businesses begin implementing the new U.S. GAAP standard under ASC 842, Leases (“ASC 842” or “the standard”), many are discovering that they no longer have easy access to the data needed to compute the most common book/tax differences. Prior to implementing ASC 842, many taxpayers have general ledger accounts such as “Deferred Rent” or “Prepaid Rent” that allow visibility into identifying and computing major/book tax differences. However, under ASC 842, those accounts are going away and have been replaced by a right-of-use asset and corresponding lease obligation onto their balance sheet for fiscal years beginning on or after Dec. 15, 2021, for private companies. The standard also requires companies to take a fresh look at how they are treating leases for GAAP purposes. Thus, the standard not only removes the accounts that used to be used to track book/tax differences—it may create new ones.

Most of the dialogue, articles, CPE courses, etc. have concentrated on the GAAP rules and reporting requirements. Also, most software solutions focus on the GAAP requirements. As a result, some of the tax impacts of the new standard have not been fully considered.

The biggest change under the standard for lessees is that lessees are required to recognize an asset and liability for most leases on its balance sheet, which requires completely changing the journal entries used to report and track the lease expense. The standard does not fundamentally change lease accounting from the lessor’s perspective, but there are some changes that require lessors to look to the new GAAP revenue recognition standard under ASC 606, which in certain instances may impact the new revenue recognition rules under the Tax Cuts and Jobs Act (TCJA). Additionally, lessees subject to the IASB standard, IFRS 16, instead of the GAAP standard, must report all leases as finance leases, which may create new book/tax differences on the tax return.

Tracking for historical book/tax differences is gone

As noted above, the journal entries used to track and record the balance sheet and income statement accounts are changing under the new GAAP and IFRS leasing standards, which will create challenges for continuing to identify and compute the common book/tax differences. To offer a better understanding of what is changing, below are some of the most common book/tax differences and a quick summary of some of the new GAAP requirements for operating leases.

Straight-line rents

One of the most common book/tax differences is for rent deductions. Generally, for operating leases, GAAP requires fixed rent payments to be expensed straight-line over the term of the lease, whereas for federal income tax purposes, generally the rules require taxpayers to deduct rents following the payment schedule for most conventional leases.

Under the former GAAP rules for an operating lease, the difference between the actual payments of rent and the straight-line expense were usually recorded in a Deferred Rent or Prepaid Rent account on the balance sheet, which made it relatively easy to identify for tax purposes.

The new GAAP standard requires a lessee to record a right-of-use asset and a lease liability for all leases with a lease term greater than 12 months.1 There is no more Deferred Rent or Prepaid Rent account. Instead, at the commencement of the lease, the lease liability is equal to the present value of the lease payments.2 The initial right-of-use asset is equal to the lease liability plus any initial direct costs minus any lease incentives received plus any payments made by a lessee to the lessor at or before the lease commencement date.3 Therefore, if there are no initial direct costs, lease incentives, or prepayments, the right-of-use asset equals the lease liability. The straight-line expense will be recorded in the income statement, the lease liability will be reduced by the difference between the cash payment and the interest expense on the lease liability, and the amortization of the right-of-use asset is the difference between the straight-line expense and the interest.4

Thus, a typical journal entry will look something like:

For federal income tax purposes, the tax treatment will depend on whether the lease is subject to Section 467 or the general accrual rules under Section 461. In either case, taxpayers usually deduct rent by following the payment schedule for most conventional leases (leases without a separate rent allocation schedule that do not have provisions that alter the benefits and burdens of ownership) without prepayments. 5 Thus, in the above journal entry, tax would deduct when the cash is paid rather than following the straight-line GAAP expense.

Many small equipment leases—and some commercial real estate leases—are subject to the general rules under Section 461, which require accrual method taxpayers to deduct rent in the year in which the liability meets the all-events test and economic performance rules. Economic performance for rent is met as the leased property is used, i.e. ratably over the period of time the taxpayer is entitled to the use of the property. 6 Therefore, for conventional leases with monthly rent payments, a taxpayer would deduct the rent monthly, while for leases with prepaid rent a taxpayer must spread the deduction ratably over the period of use related to the prepayment.

The Section 467 rules override the general federal income tax rules under Section 461 regardless of whether a taxpayer uses the overall cash or accrual method of accounting—and they often apply to commercial real estate leases and large equipment leases. A Section 467 rental agreement is any rental agreement for the use of tangible property with aggregate payments exceeding $250,000, and under which there are either increasing or decreasing rents and/or there is prepaid or deferred rent. Thus, if a lease agreement has fixed, stepped rents that are not based on the consumer price index (CPI), the lease will be subject to Section 467 if the total payments exceed $250,000.

Note that the definition of prepaid or deferred rent under Section 467 is not as broad as is commonly used in books and records. Historically (prior to ASC 842), a taxpayer may record in its books and records deferred or prepaid rent for any month in which payments do not match the book deduction. However, to have deferred or prepaid rent under Section 467 for federal income tax purposes, the regulations require that the payment schedule in the lease agreement not match the rental allocation schedule in the lease agreement. For example, Treas. Reg. Sec. 1.467-1(c)(3)(ii) provides that a rental agreement has prepaid rent if the cumulative amount of rent payable as of the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year. Thus, there is only prepaid rent under Section 467 if the prepayment in calendar year 1 exceeds the amount of rent allocated cumulatively through calendar year 2.

In computing the rent to be accrued each year under Section 467, rents must be allocated in accordance with the applicable Section 467 rental agreement. 7 In most conventional leases, there is no rent allocation schedule separate from the rent payment schedule in the lease. Therefore, in these situations, the lessee generally recognizes an expense in accordance with the rent payment schedule and there is no prepaid or deferred rent under Section 467. 8

The regulations can be daunting to tackle, as they first make the reader determine if any of the special rules apply, such as the constant rental accrual method (which applies if the IRS determines that the lease is disqualified long-term lease or a disqualified leaseback because the IRS has determined that the principal purpose for providing increasing or decreasing rent is the avoidance of federal income tax) or the proportional rental accrual method (which applies if there is prepaid or deferred rent, as described above, without adequate interest), even though these rules rarely apply to conventional lease terms. Under Treas. Reg. Sec. 1.467-1(c)(2)(ii), if there is a rent allocation schedule that is different from the rent payment schedule, then the parties follow the rent allocation schedule, provided the special rules do not apply. Generally, parties may create leases with a rent allocation schedule that is different than the payment schedule if the parties are executing tax planning.

Therefore, for conventional leases with fixed, increasing rents, taxpayers generally would follow the cash payment schedule for federal income tax, but would straight-line the expense for GAAP. Taxpayers face a potentially burdensome tracking issue to reconcile the book/tax differences now that the Deferred Rent and Prepaid Rent general ledger accounts are gone.

Lease incentives

The treatment of lease incentives also has long been a source of book/differences. As noted above, lease incentives are included in the right-of-use asset under the new GAAP standard. Thus, the lease incentive is amortized against the lease expense over the life of the lease. For tax purposes, however, a lease incentive is often taxable to the lessee at the commencement of the lease.

Generally, for federal income tax purposes, a lessee has gross income when it receives a lease incentive from the lessor because it has an accession to wealth—unless the facts indicate that the allowance was intended to be spent on real property improvements owned by the landlord. 9 Thus, incentives for moving expenses, payments to the lessee’s former landlord to terminate its prior lease, and certain tenant construction allowances owned by the lessee are gross income to the tenant upfront.

The tenant bears the burden of proving it does not have an accession to wealth. 10 Whether the improvements are owned by the tenant or the landlord must be determined using tax principles, which generally rely on the benefits and burdens of ownership. 11 If the tenant owns the asset, the lease incentive is gross income when the lessee has a fixed right to the income and it is determinable with reasonable accuracy, which is generally near the commencement of the lease. 12 The tenant will capitalize the leasehold improvement asset and depreciate for tax purposes when placed in service.

However, there are certain safe harbors, such as Section 110, which allow for the lessee to exclude the incentive from income to the extent it is used to construct real property improvements. If the parties intend for the landlord own the improvement upfront, the lease should either specifically reference language from the Section 110 regulations and/or specifically state that the landlord owns the improvements upfront (not just at the end of the lease). Because the landlord owns the improvements, the lessee should not capitalize and depreciate the improvements that are built or purchased with the eligible allowance.

It can be difficult to qualify for the safe harbor in Section 110. The requirements include:

If the Section 110 safe harbor is not met, taxpayers must rely on case law to determine which party has the benefits and burdens of ownership of the improvements. Generally, the IRS will look for specific language in the lease that indicates the landlord intended to own the improvements upfront.

Thus, incentives such as tenant allowances are a very common book/tax difference. Under the new GAAP standard, taxpayers also face a potentially burdensome tracking issue to reconcile the incentive book/tax differences now that the incentives are buried in the right-of-use asset.

Lease terminations

Another difference is the treatment of payments made by a lessor to an existing tenant to incentivize the tenant to terminate its lease. For federal income tax purposes, an amount paid to terminate or facilitate the termination of an existing agreement does not facilitate the acquisition or creation of another agreement unless the lessor and lessee are renegotiating an existing lease agreement. 14 However, if a lessor pays a lessee to terminate an existing lease agreement, the lessor must capitalize the termination payment and amortize over the term of the old lease. 15

There also may be differences if the tenant makes a payment to a lessor to terminate a lease. If the lessee makes a payment to the lessor to terminate a lease and does not owe any back rent and is not terminating the lease in order to enter into another lease or to buy the property, the payment is generally deductible as rent. 16 However, if the lessee makes a payment for back rent for less than the lessee owes, there may be income that needs to be recognized under Section 108 (income from discharge of indebtedness) or under Section 111 (recovery of tax benefit items). Further, if the lessee is terminating a lease to enter into a new lease or buy the property, then the payment will generally be capitalized and pulled into the new lease or cost of the property. 17