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August 26, 2020

Amid the current economic crisis driven by COVID-19, there have been several changes to existing leases to allow landlords to address the needs of their tenants while still maintaining real estate enterprises. With these changes, certain key considerations should be taken into account.


How to Record Changes to Leases for GAAP Purposes – Historical Cost

When changes to leases are negotiated it is important to understand the accounting options available.  Each option results in different outcomes for financial reporting. The options include:

  1. Rent deferrals
  2. Rent waivers
  3. Lease term extensions
  4. Variable rent payments (e.g. % rent)

Rent deferrals involve allowing the tenant to not make payments in the period they are due, but rather pay them at a later point of the lease.  Rent waivers absolve the tenant from having to pay the rent for the period being waived.  Lease term extensions generally involve deferring rent for a period of time and extending the lease out past its initial lease term.  Variable rent payments allow the tenant to pay a portion of earnings and then the remaining unpaid portion is subject to one of the earlier options.

With all of the above options comes the need to understand when the revenue should be recorded. In addition, depending on when rental revenue is recorded it is necessary to assess the collectability of outstanding receivables. In the current environment, there is added emphasis on reviewing accounts receivable and allowance for doubtful accounts. In addition, if leases are modified, it may be necessary to apply full lease modification under GAAP.

How Changes to Leases and Rental Revenue Affect Fair Value of Real Estate

When rental and lease terms change, it is important to ensure fair value reporting is considered and that, for fair value reporting purposes, rental income is not being double counted.  For example, if rent is being recorded when it is originally due but the tenant has been granted a deferral of payment the risk to fair value reporting is that both of those items will be incorporated in fair value models.

It should be noted that if a lease term is being extended, that should be incorporated into the cash flow model for both lease payment purposes as well as for lease turnovers. One thing to consider is if lease terms are being extended it will likely delay the rent from being stepped-up to market when the lease expires.

Tax Implications from Changes to Leases

As a result of the lease modifications discussed earlier, the taxpayer will need to assess whether changes to payments, rights or obligations under the lease amount to a substantial modification under the Internal Revenue Code.  The Code considers a modification economically substantial based on the underlying facts and circumstances.

Once a modification is deemed substantial, the lease is considered a new lease and must be evaluated under Section 467 of the Code.  Section 467 is a relatively esoteric and technical section of the Code and its applicability is beyond the scope of this alert.  Suffice it to say, income recognition may be impacted under Section 467 in direct contradiction to the express terms of the underlying lease agreement.  As the 467 rules are complex, landlords and tenants considering lease modifications should consult their legal and tax advisors.

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