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Accounting and Tax Implications

Plan Ahead

Tax and accounting implications of leasing are usually an after-thought of a transaction. Particularly if a company is not publicly traded, accounting concerns are typically not considered during the real estate occupancy process. Regardless of the company's status, it could be valuable to you to review your current lease situation and plans with regard to new leasing transactions with your tax and accounting advisors before beginning the real estate occupancy process and certainly before making major decisions regarding leasing.

Income Tax Implications
Income Tax implications of both an existing lease and a proposed lease may not drive a transaction, but they can have an important impact on a company's tax situation. In the schedule below, we have reviewed the potential impact of various lease concessions from the tenant's and the landlord's perspective.

Issue
Tenant Impact
Landlord Impact
Free rent The tenant will have less of an expense deduction during the period. The landlord would just report less income, in most cases.
Cash allowance for work The tenant will have to record income in the period that the cash allowance is received, or accrued. (It will depend on the tenant's accounting method - cash or accrual). The tenant would also depreciate the improvements constructed over a 39 year term. FF&E, which is sometimes paid from cash allowances, would be depreciated over 7 years. The tenant would write-off any undepreciated balance at the end of the lease or earlier termination. The landlord will amortize the cash allowance pro-rata over the term of the lease.
Landlord builds improvements for a tenant and the landlord owns the improvements. The tenant would have no tax impact unless it also contributes to the improvements. If the tenant does contribute to the improvements, then it would depreciate the amount contributed over a period of up to 39 years for real property items. If the lease is for less than 39 years then the tenant would write off any undepreciated balance at the end of the lease term or earlier termination of the lease or vacation of the premises. The landlord will depreciate the improvement cost over a 39 year depreciation period. If the tenant leaves early or before 39 years, the landlord has to write-off the improvements when demolished. If another tenant leases the space "as is", then the landlord would just continue depreciating the improvements.
Landlord builds improvements but shifts ownership of the improvements to the tenant. The tenant would have current income to the extent of the cost of the improvements and would have to depreciate the improvements over a period of up to 39 years. The landlord would amortize the cost of the improvements pro-rata over the term of the lease.
Landlord reimburses a tenant's moving costs or professional fees (Rare occurrence in Manhattan) The tenant would record income to the extent costs were reimbursed but would have a corresponding deduction for the expenses paid. (If a company is a cash basis payer, it should ensure that the related costs are paid before year-end.) The landlord would amortize these costs pro-rata over the term of the lease.

Accounting Implications For Public Companies

Typically the most critical issue from the accounting side of a real estate lease is whether or not the lease is an operating or a capital lease. Publicly-traded companies generally prefer not to capitalize leases so as not to have them recorded on their balance sheet. For public companies, the Financial Accounting Standards Board 13 ("FASB 13") explains the requirements for properly reflecting leases in the financial statements of publicly traded companies. FASB 13 has four criteria for determining whether a lease should be an operating or capitalized lease. If any of the four criteria are met, then the lease obligation must be capitalized on the company's balance sheet.

The criteria are:

  • By the end of the lease term, ownership of the leased property is transferred to the lessee.

  • The lease term contains a bargain purchase option.
  • The lease term is substantially (75% or more) equal to the estimated remaining useful life of the leased property.

  • At the inception of the lease, the present value ("PV") of the minimum lease payments, with certain adjustments, is 90% or more of the fair value of the leased property.

Since capitalization of a lease requires that a company record the lease essentially like a purchase, the company's balance sheet would reflect an asset for the property and a liability for the implied debt amount. The amount of the debt is synthetic and it is calculated based on methods described in FASB 13 and other derivative standards and regulations. 

The Securities And Exchange Commission ("SEC") Issued A Letter In February 2005 to Further Clarify Lease Accounting Requirements For Public Companies  

The letter focused on two areas: (i) Leasehold improvements, whether paid for by the landlord or the tenant, but in either case are executed by the tenant, must be amortized on the tenant's financial statements over the shorter of the economic life of the improvements or the lease term; (ii) Free rent periods should be amortized over the lease term on a straight-line basis. From the landlord perspective, incentives should be recorded as deferred rent and amortized against lease expense as opposed to against leasehold improvements. The tenant should reflect cash incentives received from the Landlord as an operating activity and the expenditure of funds for leasehold improvements should be recorded as an investing activity.

There are several other sophisticated lease and acquisition structures, including synthetic leases and swaps. These structures offer either accounting or tax advantages that are beneficial to the appearance of the company's financial statements.

For small, private companies operating on a cash basis, accounting implications are typically not relevant and the real issue is plain old cash flow - meeting the monthly rent obligation. TenantWise's founders have had extensive experience in structuring larger and more complex transactions as well as ones for smaller, private companies. Please contact your TenantWise representative for further assistance.

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