What Is Revenue Ruling 87-26 for Lease Cancellations?
Learn how a lease cancellation payment is treated as a sale for the tenant and a capital expenditure for the landlord, impacting tax outcomes for both parties.
IRS Revenue Ruling 87-26 provides guidance on the tax implications when a landlord pays a tenant to cancel a commercial lease. For the tenant, the Internal Revenue Service (IRS) views this transaction as selling their leasehold interest back to the landlord, not as a substitute for future rent.
This characterization dictates the nature of the income received, as the ruling treats the payment as proceeds from the ‘sale or exchange’ of a property interest. This moves the income into the capital gains category instead of ordinary income, which often has different tax consequences.
Tax Treatment for the Tenant
When a tenant receives a payment to vacate a property, Section 1241 of the Internal Revenue Code specifies the funds are amounts received in exchange for the lease. This transaction results in a capital gain or loss for the tenant, rather than ordinary income, which is important because long-term capital gains are often taxed at lower rates.
The leasehold itself is a capital asset. If the lease was used in the tenant’s trade or business and held for more than one year, it qualifies as a Section 1231 asset. This classification allows for favorable tax treatment where a net gain is treated as a long-term capital gain, while a net loss is an ordinary loss.
The holding period of the lease determines the tax outcome. To qualify for lower long-term capital gains rates, the tenant must have held the lease for more than one year. If held for one year or less, any gain is considered short-term and taxed at the same rates as the tenant’s ordinary income.
Calculating the Gain or Loss
To determine the financial impact, the tenant must calculate their gain or loss using a specific formula: the amount realized from the cancellation minus the tenant’s adjusted basis in the lease. The ‘amount realized’ is the total payment received from the landlord, including cash and the fair market value of any property.
The ‘adjusted basis’ represents the tenant’s investment in the lease. The initial basis starts with any amount the tenant paid to acquire the lease. This cost is then increased by any capital improvements the tenant made to the property, which are significant, permanent upgrades, not routine repairs.
From this total, the tenant must subtract any amortization deductions they have already claimed. For example, if a tenant paid $50,000 to acquire a lease and made $20,000 in capital improvements, their initial basis is $70,000. If they had taken $21,000 in amortization deductions, their adjusted basis would be $49,000, and a $100,000 cancellation payment would result in a $51,000 capital gain.
Tax Treatment for the Landlord
The tax rules for the landlord who makes the cancellation payment are different from those for the tenant. The payment is not a substitute for rental income but is a capital expenditure, not an expense that can be immediately deducted. This treatment is because the cost provides a benefit that extends beyond the current tax year.
How the landlord recovers this capital expenditure depends on the purpose for canceling the lease. If the goal is to enter into a new lease with a different tenant, the payment must be capitalized and amortized. The landlord deducts the cost over the term of the new lease, not the remaining term of the canceled one.
If the landlord cancels the lease to sell the property, the payment is added to the property’s basis, which reduces the landlord’s taxable capital gain upon sale. If the property is not re-leased and is instead used for the landlord’s own business, the payment is amortized over the remaining term of the original, canceled lease.