Section 467: Tax Treatment for Rental Agreements

Section 467 of the Internal Revenue Code addresses potential tax avoidance in rental agreements. It targets timing mismatches where a cash-basis landlord reports income only when paid, while an accrual-basis tenant deducts expenses as they are incurred. This mismatch can lead to significant tax deferral. To prevent this, Section 467 requires both the landlord (lessor) and tenant (lessee) in a qualifying agreement to use the accrual method of accounting. This ensures rental income and deductions are recognized in a synchronized manner over the lease term, reflecting the agreement’s economic substance rather than just its payment schedule.

Identifying a Section 467 Rental Agreement

To fall under Section 467, a rental agreement for tangible property must have total expected payments exceeding $250,000 over the lease term. This threshold focuses the regulations on substantial leasing arrangements. The calculation includes all rental payments and any other consideration for the property’s use.

In addition to the monetary test, the agreement must include either “deferred rent” or “stepped rent.” A lease has deferred rent if rent allocated to one calendar year is not scheduled for payment until after the close of the following calendar year. For example, if rent for year one is not due until year three, the agreement contains deferred rent.

The other trigger is “stepped rent,” where rent increases or decreases over the lease term. This happens if the annualized fixed rent for any period differs from that of another period. For instance, a lease with rent at $80,000 for the first two years and $120,000 for the last three has stepped rent.

Not all rent changes create stepped rent. Regulations provide safe harbors for commercially reasonable adjustments. These include rent increases tied to a reliable third-party index like the Consumer Price Index (CPI) or based on a percentage of the lessee’s gross receipts. Increases that pass along third-party costs, such as property taxes, are also excluded, as is a rent holiday of three months or less at the start of a lease.

Calculating Rent and Interest under Section 467

When a lease is identified as a Section 467 rental agreement, both parties must report rental income and expenses on an accrual basis. They must also account for imputed interest on any deferred or prepaid rent. The cumulative difference between accrued rent and paid rent creates a “Section 467 loan,” which accrues interest at 110% of the Applicable Federal Rate (AFR).

Proportional Rental Accrual

Proportional rental accrual is the default accounting method for most Section 467 agreements, used when a lease has deferred or prepaid rent without adequate stated interest. With this method, the rent accrued for a period is based on the amounts allocated in the lease agreement. Interest must also be calculated on the deferred or prepaid rent balance.

To illustrate, consider a three-year lease with total rent of $300,000. The agreement allocates $100,000 of rent to each year, but all $300,000 is payable in a lump sum at the end of year three. In year one, the lessor would recognize a portion of the rent and imputed interest income on the unpaid amount, even though no cash was received. The lessee would recognize a corresponding rental expense and interest expense.

This method recharacterizes a portion of future payments into current rent and interest. The calculation involves determining the present value of all payments and allocated rents to find the proportional amount to accrue each year. The process repeats annually, with interest calculated on the growing loan balance of unpaid rent and previously accrued interest.

Constant Rental Accrual

Constant rental accrual, or “rent leveling,” is a stricter method required in situations suggesting a tax avoidance motive. It mandates spreading the total rent evenly over the lease term, regardless of the payment schedule in the agreement. This results in a constant amount of rent being reported as income and expense each period.

This method calculates a single, constant rental amount whose present value equals the present value of all actual payments. It overrides the lease’s rent schedule to smooth out any back-loaded or front-loaded rent. This approach is reserved for disqualified leasebacks and long-term agreements, which are considered to have a higher risk of tax manipulation.

Disqualified Leasebacks and Long-Term Agreements

Leasebacks and long-term agreements face stricter rules if a principal purpose of the rent structure is tax avoidance. When these conditions are met, the agreement is “disqualified.” Parties must then use the constant rental accrual method, which levels the rent recognized over the lease term.

A “leaseback” is a rental agreement where the lessee or a related party had an ownership interest in the property within the two years before the lease date. This includes prior ownership or options to purchase the property.

A “long-term agreement” is a lease with a term exceeding 75% of the property’s statutory recovery period (the asset’s depreciable life). For example, since nonresidential real property has a 39-year recovery period, a lease longer than 29.25 years is considered long-term.

For an agreement to be disqualified, a principal purpose of its rent schedule must be tax avoidance. The IRS examines all facts and circumstances to determine intent. A key factor is a difference in tax brackets between the lessor and lessee, such as a high-tax lessor agreeing to a back-loaded rent schedule with a tax-exempt lessee to defer income.

Tax Consequences on Disposition of Property

When a lessor disposes of a property subject to a Section 467 agreement, a special recapture rule can apply. This rule prevents the conversion of ordinary rental income into a capital gain. It targets long-term agreements and leasebacks with increasing rent that used the proportional accrual method instead of the constant rental accrual method.

Upon disposition, the lessor must recharacterize a portion of the gain from the sale as ordinary income. This “recapture amount” is the lesser of the gain realized on the sale or the “prior understated inclusion.” The gain on the sale is calculated after reducing it by other recapture amounts, such as depreciation recapture under Section 1245.

The prior understated inclusion is the key part of the calculation. It is the cumulative amount of rent and interest the lessor would have reported under the constant rental accrual method, minus the amount actually reported using the proportional method. This difference represents the income deferred due to the back-loaded rent structure.

For example, a lessor sells a property for a $200,000 capital gain. The property was subject to a long-term Section 467 agreement with increasing rent. If rent leveling had been applied, the lessor would have recognized an additional $45,000 in ordinary income. Since $45,000 is less than the $200,000 gain, the lessor must treat $45,000 of the gain as ordinary income and the remaining $155,000 as capital gain.