Long-Term Lease? Are You Accounting for It Properly? Part II

Process: Why should I care if I use cash basis accounting? First and foremost, it is important to outline that all leases subject to § 467 will be computed on the accrual method of accounting. Therefore, the average monthly payments must be calculated regardless of your accounting method.

How to calculate

1. Calculate all monthly payments from inception to the lease’s final period. *If you are going to exercise a lease extension option, include the lease extension and the additional fixed rate increases (if any).
2. Divide the total rent number found in step one by the number of periods in the lease from its inception. *If an extension was used in your first calculation, include these months.
3. Annualize the accrual payments.

The impact of deferred and prepaid rent
The importance of the actual calculation comes from the recognition of income and expenses where lessors will pick up the accruals in income and the lessees will deduct the same amount in expenses. While a traditional lease agreement would recognize income and expenses when cash changes hands, as noted in the chart below in the rent payable column, a § 467 lease would allocate the rental income and expenses on the accrual basis; regardless of how much cash was exchanged in the current period. Therefore, equalized payments are all the more important where a lessor may recognize income earlier even if there is deferred rent. Additionally, this same situation would allow the lessee to deduct the accrual payments as a rent expense earlier than the original lease agreement would describe.

On the other hand, prepaid rent has the opposite effect where both rental income and expense would initially be lowered for both parties as outlined in the table below; hence why proper attention to the accruals is necessary. Furthermore, accruals can be a possible bargaining chip when negotiating your lease.

Loans and interest related to deferred or prepaid rent
If you have a § 467 lease, the lease must provide for adequate interest on fixed rent. Therefore, if the lease has deferred or prepaid rent, then there should be an allocation of interest based on at minimum 10% of the allocated fixed rent of the said period. While this is quite technical, the simplest way to view the impact from the code is if you have prepaid rent, you are considered to be loaning money to the lessor and vice versa for deferred rent. Ultimately, the code is attempting to rectify any attempts to avoid proper allocations.

Contingent rent with this type of lease
Certain contingent rent rate hikes are disregarded when factoring in the $250,000 minimum payment threshold for § 467 leases. That said, it is important to note that if the classification of § 467 is reached, then the contingent rate accrued to the current taxable year does count toward rental income and expenses. While this will only apply to taxpayers on the cusp of the requirement, it could be vital to understand when to factor in certain contingent rate hikes, and which contingencies are disregarded. Below is a list of the disregarded factors that should not be taken into consideration for the $250,000 threshold requirement.

• Qualified percentage rents provision
• Adjustment based on reasonable price index
• Provisions:
  • for lessees paying third-party costs
  • for payment of late payment charges
  • for loss payment
  • for qualified TRAC
  • for residual condition
  • for tax indemnity
  • for variable interest rate

One of the most common disregarded contingent rent items applied to leases can be seen in the adjustment based on reasonable price index. Take for example the usage of the Consumer Price Index (CPI) as the defining factor for rental increases or decreases. Since these increases tend to trace inflation or deflation that occurs over the period of the lease term, it is considered to be disregarded. That said, if the lease agreement stated an increase of 3% + CPI, then you would only factor in the percentage increase that would be known for the $250,000 limit.

It is important to understand the intricacies of these leases; especially, when it comes to recognizing if certain thresholds are met. Leases are a huge cost to organizations with many potential tax consequences. To learn more about appropriate lease accounting, contact Aprio today.