7766. If a real estate lease provides for deferred or stepped rent, when is rental income includable?Nuco Employeercline202014-07-14T18:16:00Z2014-07-14T18:16:00Z47614344Summit Business Media3610509514Site Map/Investments/Real Estate/Deferred RentTaxFactsDefaultArticle2005-05-04T00:00:00Z122601230-00-tf2.xml1230.00;#1928;#0x010100C568DB52D9D0A14D9B2FDCC96666E9F2007948130EC3DB064584E219954237AF3900242457EFB8B24247815D688C526CD44D009C4E67E972694125ABDA91AC61F5E51FTax Facts 2If a real estate lease provides for deferred or stepped rent, when is rental income includable?45800.0000000000TaxFactsDefaultArticle2010-01-14T23:02:15ZSBMEDIA\moss-admin7766. If a real estate lease provides for deferred or stepped rent, when is rental income includable?Lessors and lessees under certain deferred or stepped payment lease agreements entered into after June 8, 1984, are required to report rental income and expense as they accrue, as well as interest on rent accrued but unpaid at the end of the period.IRC Sec. 467(a). Agreements are subject to this rule if at least one amount allocable to the use of property during a calendar year is to be paid after the close of the calendar year following the calendar year in which the use occurs, or if there are increases in the amount to be paid as rent under the agreement.IRC Sec. 467(d)(1). However, the rule does not apply unless the aggregate value of the money and other property received for use of the property exceeds $250,000.IRC Sec. 467(d).As a general rule, rents will accrue in the tax year to which they are allocable under the terms of the lease.IRC Sec. 467(b)(1). Regulations provide that the amount of rent taken into account for a taxable year is the sum of: (1) the fixed rent for any rental period that begins and ends in the taxable year, (2) a ratable portion of the fixed rent for any other rental period beginning or ending in the taxable year, and (3) any contingent rent that accrues during the taxable year.Treas. Reg. §1.467-1(d).In either of two situations, rent will be deemed to accrue on a level present value basis (“constant rental amount”) instead of under the terms of the agreement:(1)if the rental agreement is silent as to the allocation of rents over the lease period; or(2)if the rental agreement is a “disqualified leaseback or long-term agreement.” A disqualified leaseback or long-term agreement is an agreement that provides for increasing rents and one of the principal purposes for increasing rents is tax avoidance and the lease is either (a) part of a leaseback transaction, or (b) for a term in excess of 75 percent of the “statutory recovery period” for the property subject to the lease.IRC Sec. 467(b). The statutory recovery period is essentially the period provided for depreciation under ACRS, except that a 15-year period may be substituted for 20-year property, and a 19-year period may be used for residential rental property and nonresidential real property.IRC Sec. 467(e)(3). A leaseback transaction is one involving a lease to any person who had an interest in the property (or related person) within the two-year period before the lease went into effect.IRC Sec. 467(e)(2).Under regulations, certain rent increases are not considered made for tax avoidance purposes: for example, increases determined by reference to price indices, to rents based on a percentage of lessee receipts, to reasonable rent holidays, or to changes in amounts paid to unrelated third persons.IRC Sec. 467(b)(5); Treas. Reg. §1.467-1(c)(2).A constant rental amount is the amount that, if paid as of the close of each lease period under the agreement, would result in an aggregate present value equal to the present value of the aggregate payments required under the agreement.IRC Sec. 467(e)(1). Regulations provide a formula to facilitate the computation of the constant rental amount.See Treas. Reg. §1.467-3(d).If property subject to a leaseback or a lease longer than 75 percent of the recovery period is not subject to rent leveling (i.e., there is no tax avoidance purpose or no stepped rent) and the rent accrues according to the terms of the agreement, any gain realized by the lessor on disposition of the property during the term of the agreement will be treated as recaptured ordinary income to the extent that the amount which would have been taken into account by the lessor if the rents had been reported on a constant rental basis is more than the amounts actually taken into account. Before this calculation is made, gain realized by the lessor on the disposition is reduced by the amount of any gain treated as ordinary income on the disposition under other IRC provisions: for example, depreciation recapture.IRC Sec. 467(c). Regulations provide for certain exceptions from recapture and provide for carryover of the ordinary income “taint” where the property is transferred and the transferor’s basis carries over to the transferee.Treas. Reg. §1.467-7(c).Regulations provide comparable rules for agreements calling for decreasing rates and rules applicable to contingent payments.Treas. Regs. §§1.467-1(c), 1.467-3(c).Present value will be determined at the rate of 110 percent of the applicable federal rate (AFR), compounded semiannually. The AFR used is that in effect at the time the lease is entered into for debt instruments having a maturity equal to the term of the lease.IRC Sec. 467(e)(4). See General Explanation–TRA ’84, p. 287, fn. 22. See Q 515 for an explanation of the applicable federal rate.While these rules apply generally to leases entered into after June 8, 1984, there are exceptions. One of these is for an agreement entered into pursuant to a written agreement binding on June 8, 1984, and at all times thereafter. A limited exception applies to certain plans existing on or before March 15, 1984.P.L. 98-369 (TRA ’84) Sec. 92(c)(2). The regulations apply to disqualified leasebacks and long-term agreements entered into after June 3, 1996, and for other rental agreements entered into after May 18, 1999.Treas. Reg. §1.467-9(a).