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Publication 535 2008 Tax Year

3.   Rent Expense

Table of Contents

Introduction

This chapter discusses the tax treatment of rent or lease payments you make for property you use in your business but do not own. It also discusses how to treat other kinds of payments you make that are related to your use of this property. These include payments you make for taxes on the property, improvements to the property, and getting a lease. There is a discussion about capitalizing (including in the cost of property) certain rent expenses at the end of the chapter.

Topics - This chapter discusses:

  • The definition of rent

  • Taxes on leased property

  • The cost of getting a lease

  • Improvements by the lessee

  • Capitalizing rent expenses

Rent

Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as an expense only if the rent is for property you use in your trade or business. If you have or will receive equity in or title to the property, the rent is not deductible.

Unreasonable rent.   You cannot take a rental deduction for unreasonable rent. Ordinarily, the issue of reasonableness arises only if you and the lessor are related. Rent paid to a related person (defined below) is reasonable if it is the same amount you would pay to a stranger for use of the same property. Rent is not unreasonable just because it is figured as a percentage of gross sales.

Related persons.   For this purpose, the following are considered related persons.

  1. An individual and his or her brothers and sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).

  2. An individual and a corporation if the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.

  3. Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.

  4. A grantor and a fiduciary of any trust.

  5. Fiduciaries of two separate trusts if the same person is a grantor of both trusts.

  6. A fiduciary and a beneficiary of the same trust.

  7. A fiduciary and a beneficiary of two separate trusts if the same person is a grantor of both trusts.

  8. A fiduciary of a trust and a corporation if the trust or a grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.

  9. A person and a tax-exempt educational or charitable organization that is controlled directly or indirectly by that person or by members of the family of that person.

  10. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.

  11. Two S corporations or an S corporation and a regular corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.

  12. An executor of an estate and a beneficiary of the estate unless the sale or exchange is in satisfaction of a pecuniary bequest.

  To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, see Related Persons in Publication 542, Corporations. For rules that apply to transactions between partners and partnerships, see Publication 541, Partnerships.

Rent on your home.   If you rent your home and use part of it as your place of business, you may be able to deduct the rent you pay for that part. You must meet the requirements for business use of your home. For more information, see Business use of your home in chapter 1.

Rent paid in advance.   Generally, rent paid in your trade or business is deductible in the year paid or accrued. If you pay rent in advance, you can deduct only the amount that applies to your use of the rented property during the tax year. You can deduct the rest of your payment only over the period to which it applies.

Example 1.

You are a calendar year taxpayer and you leased a building for 5 years beginning July 1. Your rent is $12,000 per year. You paid the first year's rent ($12,000) on June 30. You can deduct only $6,000 (6/12 × $12,000) for the rent that applies to the first year.

Example 2.

You are a calendar year taxpayer. Last January you leased property for 3 years for $6,000 a year. You paid the full $18,000 (3 × $6,000) during the first year of the lease. Each year you can deduct only $6,000, the part of the lease that applies to that year.

Canceling a lease.   You generally can deduct as rent an amount you pay to cancel a business lease.

Lease or purchase.   There may be instances in which you must determine whether your payments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales contract. Payments made under a conditional sales contract are not deductible as rent expense.

Conditional sales contract.   Whether an agreement is a conditional sales contract depends on the intent of the parties. Determine intent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies. However, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true.

  • The agreement applies part of each payment toward an equity interest you will receive.

  • You get title to the property after you make a stated amount of required payments.

  • The amount you must pay to use the property for a short time is a large part of the amount you would pay to get title to the property.

  • You pay much more than the current fair rental value of the property.

  • You have an option to buy the property at a nominal price compared to the value of the property when you may exercise the option. Determine this value when you make the agreement.

  • You have an option to buy the property at a nominal price compared to the total amount you have to pay under the agreement.

  • The agreement designates part of the payments as interest, or that part is easy to recognize as interest.

Leveraged leases.   Leveraged lease transactions may not be considered leases. Leveraged leases generally involve three parties: a lessor, a lessee, and a lender to the lessor. Usually the lease term covers a large part of the useful life of the leased property, and the lessee's payments to the lessor are enough to cover the lessor's payments to the lender.

  If you plan to take part in what appears to be a leveraged lease, you may want to get an advance ruling. Revenue Procedure 2001-28 on page 1156 of Internal Revenue Bulletin 2001-19 contains the guidelines the IRS will use to determine if a leveraged lease is a lease for federal income tax purposes. Revenue Procedure 2001-29 on page 1160 of the same Internal Revenue Bulletin provides the information required to be furnished in a request for an advance ruling on a leveraged lease transaction. Internal Revenue Bulletin 2001-19 is available at www.irs.gov/pub/irs-irbs/irb01-19.pdf.

  In general, Revenue Procedure 2001-28 provides that, for advance ruling purposes only, the IRS will consider the lessor in a leveraged lease transaction to be the owner of the property and the transaction to be a valid lease if all the factors in the revenue procedure are met, including the following.

  • The lessor must maintain a minimum unconditional “at risk” equity investment in the property (at least 20% of the cost of the property) during the entire lease term.

  • The lessee may not have a contractual right to buy the property from the lessor at less than fair market value when the right is exercised.

  • The lessee may not invest in the property, except as provided by Revenue Procedure 2001-28.

  • The lessee may not lend any money to the lessor to buy the property or guarantee the loan used by the lessor to buy the property.

  • The lessor must show that it expects to receive a profit apart from the tax deductions, allowances, credits, and other tax attributes.

  The IRS may charge you a user fee for issuing a tax ruling. For more information, see Revenue Procedure 2008-1, on page 1 of Internal Revenue Bulletin No. 2008-1. Internal Revenue Bulletin 2008-1 is available at www.irs.gov/pub/irs-irbs/irb08-01.pdf.

Leveraged leases of limited-use property.   The IRS will not issue advance rulings on leveraged leases of so-called limited-use property. Limited-use property is property not expected to be either useful to or usable by a lessor at the end of the lease term except for continued leasing or transfer to a lessee. See Revenue Procedure 2001-28 for examples of limited-use property and property that is not limited-use property.

Leases over $250,000.   Special rules are provided for certain leases of tangible property. The rules apply if the lease calls for total payments of more than $250,000 and any of the following apply.

  • Rents increase during the lease.

  • Rents decrease during the lease.

  • Rents are deferred (rent is payable after the end of the calendar year following the calendar year in which the use occurs and the rent is allocated).

  • Rents are prepaid (rent is payable before the end of the calendar year preceding the calendar year in which the use occurs and the rent is allocated).

These rules do not apply if your lease specifies equal amounts of rent for each month in the lease term and all rent payments are due in the calendar year to which the rent relates (or in the preceding or following calendar year).

  Generally, if the special rules apply, you must use an accrual method of accounting (and time value of money principles) for your rental expenses, regardless of your overall method of accounting. In addition, in certain cases in which the IRS has determined that a lease was designed to achieve tax avoidance, you must take rent and stated or imputed interest into account under a constant rental accrual method in which the rent is treated as accruing ratably over the entire lease term. For details, see section 467 of the Internal Revenue Code.

Taxes on Leased Property

If you lease business property, you can deduct as additional rent any taxes you have to pay to or for the lessor. When you can deduct these taxes as additional rent depends on your accounting method.

Cash method.   If you use the cash method of accounting, you can deduct the taxes as additional rent only for the tax year in which you pay them.

Accrual method.   If you use an accrual method of accounting, you can deduct taxes as additional rent for the tax year in which you can determine all the following.

  • That you have a liability for taxes on the leased property.

  • How much the liability is.

  • That economic performance occurred.

  The liability and amount of taxes are determined by state or local law and the lease agreement. Economic performance occurs as you use the property.

Example 1.

Oak Corporation is a calendar year taxpayer that uses an accrual method of accounting. Oak leases land for use in its business. Under state law, owners of real property become liable (incur a lien on the property) for real estate taxes for the year on January 1 of that year. However, they do not have to pay these taxes until July 1 of the next year (18 months later) when tax bills are issued. Under the terms of the lease, Oak becomes liable for the real estate taxes in the later year when the tax bills are issued. If the lease ends before the tax bill for a year is issued, Oak is not liable for the taxes for that year.

Oak cannot deduct the real estate taxes as rent until the tax bill is issued. This is when Oak's liability under the lease becomes fixed.

Example 2.

The facts are the same as in Example 1 except that, according to the terms of the lease, Oak becomes liable for the real estate taxes when the owner of the property becomes liable for them. As a result, Oak will deduct the real estate taxes as rent on its tax return for the earlier year. This is the year in which Oak's liability under the lease becomes fixed.

Cost of Getting a Lease

You may either enter into a new lease with the lessor of the property or get an existing lease from another lessee. Very often when you get an existing lease from another lessee, you must pay the previous lessee money to get the lease, besides having to pay the rent on the lease.

If you get an existing lease on property or equipment for your business, you generally must amortize any amount you pay to get that lease over the remaining term of the lease. For example, if you pay $10,000 to get a lease and there are 10 years remaining on the lease with no option to renew, you can deduct $1,000 each year.

The cost of getting an existing lease of tangible property is not subject to the amortization rules for section 197 intangibles discussed in chapter 8.

Option to renew.   The term of the lease for amortization includes all renewal options plus any other period for which you and the lessor reasonably expect the lease to be renewed. However, this applies only if less than 75% of the cost of getting the lease is for the term remaining on the purchase date (not including any period for which you may choose to renew, extend, or continue the lease). Allocate the lease cost to the original term and any option term based on the facts and circumstances. In some cases, it may be appropriate to make the allocation using a present value computation. For more information, see Regulations section 1.178-1(b)(5).

Example 1.

You paid $10,000 to get a lease with 20 years remaining on it and two options to renew for 5 years each. Of this cost, you paid $7,000 for the original lease and $3,000 for the renewal options. Because $7,000 is less than 75% of the total $10,000 cost of the lease (or $7,500), you must amortize the $10,000 over 30 years. That is the remaining life of your present lease plus the periods for renewal.

Example 2.

The facts are the same as in Example 1, except that you paid $8,000 for the original lease and $2,000 for the renewal options. You can amortize the entire $10,000 over the 20-year remaining life of the original lease. The $8,000 cost of getting the original lease was not less than 75% of the total cost of the lease (or $7,500).

Cost of a modification agreement.   You may have to pay an additional “rent” amount over part of the lease period to change certain provisions in your lease. You must capitalize these payments and amortize them over the remaining period of the lease. You cannot deduct the payments as additional rent, even if they are described as rent in the agreement.

Example.

You are a calendar year taxpayer and sign a 20-year lease to rent part of a building starting on January 1. However, before you occupy it, you decide that you really need less space. The lessor agrees to reduce your rent from $7,000 to $6,000 per year and to release the excess space from the original lease. In exchange, you agree to pay an additional rent amount of $3,000, payable in 60 monthly installments of $50 each.

  You must capitalize the $3,000 and amortize it over the 20-year term of the lease. Your amortization deduction each year will be $150 ($3,000 ÷ 20). You cannot deduct the $600 (12 × $50) that you will pay during each of the first 5 years as rent.

Commissions, bonuses, and fees.   Commissions, bonuses, fees, and other amounts you pay to get a lease on property you use in your business are capital costs. You must amortize these costs over the term of the lease.

Loss on merchandise and fixtures.   If you sell at a loss merchandise and fixtures that you bought solely to get a lease, the loss is a cost of getting the lease. You must capitalize the loss and amortize it over the remaining term of the lease.

Improvements by Lessee

If you add buildings or make other permanent improvements to leased property, depreciate the cost of the improvements using the modified accelerated cost recovery system (MACRS). Depreciate the property over its appropriate recovery period. You cannot amortize the cost over the remaining term of the lease.

If you do not keep the improvements when you end the lease, figure your gain or loss based on your adjusted basis in the improvements at that time.

For more information, see the discussion of MACRS in Publication 946, How To Depreciate Property.

Assignment of a lease.   If a long-term lessee who makes permanent improvements to land later assigns all lease rights to you for money and you pay the rent required by the lease, the amount you pay for the assignment is a capital investment. If the rental value of the leased land increased since the lease began, part of your capital investment is for that increase in the rental value. The rest is for your investment in the permanent improvements.

  The part that is for the increased rental value of the land is a cost of getting a lease, and you amortize it over the remaining term of the lease. You can depreciate the part that is for your investment in the improvements over the recovery period of the property as discussed earlier, without regard to the lease term.

Capitalizing Rent Expenses

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.

Indirect costs include amounts incurred for renting or leasing equipment, facilities, or land.

Uniform capitalization rules.   You may be subject to the uniform capitalization rules if you do any of the following, unless the property is produced for your use other than in a business or an activity carried on for profit.

  1. Produce real property or tangible personal property. For this purpose, tangible personal property includes a film, sound recording, video tape, book, or similar property.

  2. Acquire property for resale.

However, these rules do not apply to the following property.

  1. Personal property you acquire for resale if your average annual gross receipts are $10 million or less for the 3 prior tax years.

  2. Property you produce if you meet either of the following conditions.

    1. Your indirect costs of producing the property are $200,000 or less.

    2. You use the cash method of accounting and do not account for inventories.

Example 1.

You rent construction equipment to build a storage facility. If you are subject to the uniform capitalization rules, you must capitalize as part of the cost of the building the rent you paid for the equipment. You recover your cost by claiming a deduction for depreciation on the building.

Example 2.

You rent space in a facility to conduct your business of manufacturing tools. If you are subject to the uniform capitalization rules, you must include the rent you paid to occupy the facility in the cost of the tools you produce.

More information.   For more information on these rules, see Uniform Capitalization Rules in Publication 538 and the regulations under Internal Revenue Code section 263A.

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