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, we will conclude our discussion of lease termination payments.
As mentioned earlier in this series of blogs, there are two types of lease termination payments: (1) payments made by the landlord to the tenant and (2) payments made by the tenant to the landlord. Part three addressed payments made by the landlord to the tenant. This final section will consider lease termination payments made by a tenant to a landlord.
When a landlord receives lease termination payments from a tenant, these amounts are recognized as taxable income to the landlord as a substitute for rental payments. If a tenant is required to pay a fee to terminate a lease prior to the end of the stated lease term, a landlord should only require a payment for the actual and reasonable loss incurred.
Otherwise, the possibility exists that a lessor could recognize capital gain treatment on the receipt of a lease termination payment if I.R.C. § 1234A applies. Pursuant to § 1234A, any gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation related to property which is, or when acquired would be, a capital asset in the hands of the taxpayer, must be treated as gain or loss from the sale of a capital asset.
For the payment to qualify under § 1234A, the property must be a capital asset rather than an asset used in a trade or business. If it is an asset used in a trade or business, it is considered § 1231 property and, pursuant to § 1221, does not therefore qualify as a capital asset. For the property to be qualified as a capital asset, the landlord must perform only minimal activities relating to the property, which should be held for investment purposes.
The deductibility of a tenant’s lease termination payment hinges upon the reason for the early termination of the lease. If termination occurs because the lease is no longer profitable, the payment is fully deductible under I.R.C. § 162. However, if the tenant is terminating to acquire new property, it accordingly capitalizes and amortizes the termination payment.
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 New York 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 www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
