Tax Treatment Of Lease Terms Part 3: Lease Termination Payments From Landlord To Tenant

There are many issues which landlords and tenants must negotiate in commercial leasing transactions. In the first two parts of this article, which deals with the tax treatment of important lease terms, we discussed lease inducement payments and tenant construction allowances. In this part, and the next, we will briefly discuss the importance of lease termination payments.

Tax Treatment Of Lease Terms Part 3: Lease Termination Payments From Landlord To Tenant

Generally, I.R.C. § 263 disallows a current deduction for amounts chargeable to capital account. The applicable Tax Regulations provide that a taxpayer must capitalize amounts paid to another party to terminate a lease of real property between the taxpayer-lessor and the lessee. However, these regulations fail to discuss whether the payment is a nondeductible capital expenditure or whether it is amortizable and, if so, for what period is it capitalized into the cost of the building?

In most cases, a lessor’s tax treatment is dependent upon the underlying reason for which a landlord makes a lease termination payment. If a landlord makes a payment to a tenant to vacate before the end of the lease term, the landlord may not take a deduction in the year in which the lease termination payment is made. The landlord generally recovers a lease termination payment made to the lessee over the remaining term of the terminated lease.

The original position of the IRS, which the district court had upheld, was that the payment should be amortized over the longer term of the new lease that the landlord obtained in place of the old lease. However, following In re Miller, 101 BTA 383, the Ninth Circuit held that the lease termination payment was amortizable over the shorter unexpired term of the canceled lease.

The IRS continues to assert the aforementioned position that when a lessor terminates a lease to make the space available for a new tenant, the lessor should amortize the payment over the life of the new tenant’s lease (Wells Fargo Bank & Union Trust Co., 163 F.2d 521 (9th Cir. 1947); Latter, T.C. Memo. 1961-67).

If the landlord is terminating the lease early in anticipation of selling the building, the landlord should add the termination payment to the cost of the building (Shirley Hill Coal Co., 6 B.T.A. 935 (1927)). If the tenant is required to vacate the space due to construction, the lessor should add the termination payment to the capitalized cost of the improvements (Keiler, 285 F. Supp. 520 (W.D. Ky. 1967)).

While I.R.C. § 1241 does not determine whether the lease is a capital asset, it does govern the tenant’s treatment of a lease termination payment. Amounts received by a lessee for the cancellation of a lease are considered as amounts received in exchange for the lease or agreement. § 1231 determines whether the tenant may treat the lease as a capital asset. If so, the tenant may recognize the income as capital gain.

Frequently, lease agreements do not address all of the pertinent issues which occur when a landlord and tenant wish to terminate a commercial lease. If you are a Tri-State commercial landlord or tenant with questions about lease termination payments or other tax issues incidental to a commercial lease agreement, call THE TAX EXPERTS at the Thorgood Law Firm For a FREE consultation call 212-490-0704.

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