July 26, 2017
With rents and property values increasing at a rapid rate, landlords are looking for ways to increase rents when locked into long term leases — one method has been to buy out their current tenant leases in order to fill the lease with new tenants at current market rates.
How is this lease termination payment treated by the tenant receiving the payment? The tax treatment is not always obvious. In some cases the tenant can receive favorable capital gain treatment on the lease buy out. Sec 1241 - states that amounts received by a lessee for cancellation of the lease shall be considered as amounts received in exchange for such lease or agreement. Therefore if the lease is a section 1231 asset, the tenant could recognize the lease termination income as capital gain. Generally a lease held for use in a tenant's business is considered section 1231 asset. However in order to receive this treatment the tenant would need to have had the lease over a year and give up all ownership rights to the leases - meaning subleases or other rights of re-entry would not qualify the tenant for capital gain treatment.
How is the treatment to the landlord? It depends on the reason the landlord paid the tenant to vacate the space before the end of the lease.
When a landlord terminates a lease to make the space available to a new tenant — the landlord should amortize the payment over the life of the old tenant's remaining lease. If the landlord is terminating a lease in anticipation of selling the building — the landlord should add the termination payment to the cost of the building. If the payment was required to vacate the space due to build out, the termination payment should be added to the capitalized cost of the improvements.
If you are considering buying or selling a lease please contact your RINA representative for more information.