What Is a Section 467 Rental Agreement?
Understand the tax principles of Section 467 rental agreements, which align income and expense reporting with a lease's economic substance, not its cash payments.
A Section 467 rental agreement is a lease contract for tangible property subject to special tax rules in the Internal Revenue Code. The purpose is to align the timing of a landlord’s (lessor) rental income with the tenant’s (lessee) rental expense, preventing mismatches from different accounting methods. The regulations require both parties to use a form of accrual accounting for the agreement. This ensures reported rent reflects the economic reality of the lease, addressing uneven payment structures that could otherwise create tax deferral advantages.
Identifying a Section 467 Rental Agreement
A lease is classified as a Section 467 rental agreement if the total payments for using the property exceed $250,000 over the lease term. This threshold limits the rules to significant rental arrangements. The agreement must also have a specific payment or rent allocation structure.
One trigger is deferred rent, which occurs if a payment for one calendar year is not scheduled to be paid until after the end of the following calendar year. For example, rent for use of a property in 2025 that is not due until 2027 is considered deferred rent.
The rules also apply if the agreement has prepaid rent, which is the inverse of deferred rent. An agreement is also subject to these rules if it has increasing or decreasing rent, often called “stepped” rent. This condition is met if the annualized rent for any rental period differs from the annualized rent for another.
Calculating Rent and Interest Accrual
Once an agreement is identified, the lessor and lessee determine the rent to report each year using an accrual method. The default method is proportional rental accrual. Under this method, the rental income or expense for a period is based on the rent allocations specified directly within the lease agreement.
Any deferred or prepaid rent is treated as a “Section 467 loan” between the parties that accrues interest, which is accounted for separately from the rent. The lessor recognizes imputed interest income and the lessee recognizes imputed interest expense. The interest is calculated using 110% of the applicable federal rate (AFR).
A stricter method, constant rental accrual or “rent leveling,” is required for agreements with a tax avoidance purpose, such as disqualified leaseback or long-term agreements. A leaseback is where the lessee previously owned the property. A long-term agreement’s term exceeds 75% of the property’s statutory recovery period.
Under constant rental accrual, a single, level rent amount is calculated for each lease period based on the present value of all payments. This method overrides the lease’s rent schedule. It forces a smooth recognition of income and expense over the lease term, preventing tax benefits from structured rent payments.
Tax Reporting for Lessors and Lessees
The lessor reports the rental income determined under the applicable accrual method as gross rental income. This is done on Schedule E (Form 1040) for individuals, Form 1120 for corporations, or Form 1065 for partnerships. Any imputed interest income from the Section 467 loan is reported separately as interest income.
The lessee reports the calculated rental expense as a deduction on business tax forms, such as Form 1120, Form 1065, or Schedule C (Form 1040). The imputed interest expense on the loan is also deductible and reported as an interest expense on the corresponding business tax forms.
Recapture Rules on Property Disposition
Special recapture rules apply if a lessor disposes of property subject to a Section 467 agreement before the lease ends. These rules apply mainly to leaseback and long-term agreements using the proportional rental accrual method. They are designed to prevent the conversion of ordinary income into a more favorably taxed capital gain.
The recapture provision recharacterizes a portion of the gain on the sale from capital gain to ordinary income. The amount recaptured is the additional rent the lessor would have reported if the constant rental accrual method had been used, over the rent actually reported using the proportional method. This difference is sometimes referred to as the “prior understated inclusion.”