What Is the Tax Treatment of Lease Termination Payments?
Understand the tax logic behind lease termination payments. Whether you pay or receive funds, the character of the transaction depends on which side of the lease you are on.
A lease termination payment occurs when a landlord or tenant pays the other party to end a lease agreement before its scheduled expiration. This transaction is common in commercial real estate when a business’s needs change, requiring it to relocate, downsize, or expand. The tax consequences of such a payment depend on which party makes the payment and which receives it.
For the landlord, the payment might be treated as a replacement for rent, while for the tenant, it could be viewed as the sale of a property right. These differing treatments impact how the income or expense is reported for tax purposes.
Tax Consequences for the Landlord (Lessor)
The tax rules for a landlord, or lessor, involved in a lease termination depend on whether they are the recipient or the payer of the fee. Each scenario leads to a different outcome for tax reporting, influencing the landlord’s taxable income.
When the Lessor Receives a Payment
When a landlord receives a payment from a tenant to cancel a lease, the IRS views this money as a substitute for future rental payments. The entire amount is treated as ordinary income and must be reported in the year it is received.
For example, if a tenant pays $30,000 to terminate a lease, that full amount is ordinary income for the landlord and is not treated as a capital gain. An exception might occur if a portion of the payment is designated to cover repair costs, in which case that part could be treated as a return of capital.
When the Lessor Makes a Payment
When the landlord pays the tenant to vacate the property, the tax treatment depends on the landlord’s motivation. If the payment is so the property can be leased to a new tenant, the landlord must capitalize the payment. This cost is then amortized, or gradually deducted, over the remaining term of the original terminated lease.
For instance, if a landlord pays $20,000 to end a lease with four years remaining, they would deduct $5,000 per year for four years. If the payment is made so the landlord can use the property for their own business or to sell it, the payment is added to the property’s cost basis, reducing the capital gain upon a future sale.
Tax Consequences for the Tenant (Lessee)
For the tenant, or lessee, the tax implications of a lease termination payment are also determined by whether they are making or receiving the payment. A tenant’s payment is often a business expense, while receiving a payment can result in more favorable tax treatment.
When the Lessee Makes a Payment
When a business tenant makes a payment to a landlord to cancel a lease, the payment is considered an ordinary and necessary business expense under Internal Revenue Code Section 162. This amount is fully deductible in the year it is paid.
If the payment is connected to acquiring a new property from the same landlord or is part of a deal to purchase the leased property, the tax treatment may change. The payment might need to be capitalized and added to the cost of the new lease or property rather than being immediately expensed.
When the Lessee Receives a Payment
When a tenant receives a payment from the landlord to vacate, Internal Revenue Code Section 1241 treats the payment as an amount received in exchange for canceling the lease. This means the transaction is considered a sale of the tenant’s leasehold interest.
For a business, a leasehold is often a Section 1231 asset, which is property used in a trade or business. As a result, any gain from the payment is treated as a long-term capital gain if the tenant held the lease for more than one year. This is favorable as capital gains are taxed at lower rates than ordinary income.
Related Financial and Reporting Considerations
Unamortized Lease Acquisition Costs
When a landlord acquires a tenant, they often incur costs such as broker’s commissions and legal fees. These expenses are capitalized and amortized over the life of the lease. If the lease is terminated early, any remaining unamortized portion of these acquisition costs can be written off and deducted in the year of termination.
For example, if a landlord paid $10,000 in commissions for a 10-year lease and terminates it after six years, the remaining $4,000 can be deducted immediately. This deduction is taken against ordinary income, helping to offset the income recognized from a tenant’s termination payment.
Treatment of Leasehold Improvements
Leasehold improvements are modifications made by the tenant to the leased space. For the tenant, the adjusted basis of any leasehold improvements they made is used to calculate the total gain or loss from the “sale” of the lease when they receive a termination payment.
For the landlord, tenant-made improvements that are left behind generally do not result in taxable income, as per Internal Revenue Code Section 109. The landlord acquires the improvements with a zero basis. An exception exists if the improvements were made by the tenant in lieu of paying rent, in which case the value of the improvements could be considered rental income.
Information Reporting
The party making a lease termination payment of $600 or more in the course of a trade or business must issue Form 1099-MISC to the recipient and the IRS. If a tenant pays a landlord to terminate a lease, the payment is treated as a substitute for rent and is reported by the tenant in Box 1, “Rents.” If a landlord pays a tenant to cancel a lease, the landlord must also issue a Form 1099-MISC for the payment.