Capital Lease Criteria for Tax Purposes

As Theme 842 is adopted, taxpayers should review their methods of accounting for income tax for items related to leasing, including the characterization of leases (i.e., sale, lease or financing), the timing of section 467 rental income or expenses, the treatment of tenant improvement deductions and the treatment of lease acquisition costs. A change in the method of tax accounting may provide a more appropriate or advantageous tax treatment. To change an accounting policy for lease, sale and financing transactions, taxpayers would be required to file an automatic change of method in accordance with Section 6.03 of the 2019-43 Revenue Procedure (or successor). The change in accounting policy under the Revenue Procedure 2019-43 allows the reclassification of leases (existing and new) with a historical catch-up adjustment. To make this change, taxpayers must file Form 3115 with the IRS in Covington, KY and attach a copy of Form 3115 to a timely tax return (including extensions). There are no IRS user fees associated with a method change as part of the automatic procedures. Companies that have mischaracterized a lease for income tax purposes can use the automatic procedures of rev. Proc. Change 2019-43. The modification is made with an adjustment in accordance with § 481 (a) and is suitable for the protection of the audit. Taxpayers can also generally automatically change the accounting policy for tenant improvement allowances, section 467 leases, and rent acquisition costs with adjustment and audit protection under section 481(a).

Lessors continue to classify leases as a type of operation, direct financing or distribution under Topic 842. The classification of a capital lease and an operating lease can have significant tax implications. Not all tax situations are created equal, so you need to determine which classification is most advantageous for your business. For example, it should be noted that the tax benefits of accelerated depreciation and Article 179 are taken into account in advance. This means that there will be fewer deductions for future taxable income in the form of depreciation. This, along with other factors, should be taken into account when deciding on the right lease for your business. The purpose of this article is to provide a general overview of how capital leases can be recorded and reported in relation to operating leases. It also briefly addresses growing concerns about related party lease transactions between private foundations and “disqualified persons”. An operating lease does not involve a transfer of ownership and, during the lease, the terms do not match the qualifications of a capital lease, or the company renting the property determines in advance that it does not intend to use the full contract if the lease is considered a capital lease. The determination of a lease type must be disclosed in the corporation`s annual financial statements.

Tenant Improvement Allowances: For accounting purposes, payments from the landlord to the tenant for the tenant`s rental or improvement allowances reduce the consideration for the contract, effectively reducing the right of use. The tenant`s rental or improvement allowance is recorded on a straight-line basis over the period during which the right of use is amortized. A capital lease is a lease in which the lessor finances only the leased asset and all other ownership rights are transferred to the tenant. Therefore, the asset is recorded as the tenant`s property in its general ledger as a capital asset. The lessee may recognise the interest portion of a capital lease payment only as an expense, as opposed to the amount of the total lease payment in the case of the most frequent capital lease. Leases subject to section 467: Section 467 generally applies to landlords and tenants if (1) the leases are for the use of tangible property; (2) the total rent under the agreement exceeds $250,000; and (3) the lease provides for increasing or decreasing rent or prepaid or deferred rent, subject to limited exceptions (for example. B, a three-month rental leave at the beginning of a rental period). Present value. The present value of the minimum payments required under the lease is at least 90% of the fair value of the asset at the beginning of the lease. Property. Ownership of the property is transferred from the lessor to the tenant until the end of the lease term; or Many taxpayers apply clear line standards to determine the classification of leases for accounting purposes. On the other hand, leases for tax purposes are characterized on the basis of all the facts and circumstances that exist at the time of performance of a contract.

Whether a leasing transaction is a genuine lease – and not, for example, a contract of sale or financing – depends on whether sufficient benefits and ownership charges have been transferred to the buyer or tenant. Section 467 requires landlords and tenants to report rental income and expenses using one of three methods: constant rent reserve, proportionate rent allowance, or lease carry-forward under section 467. Most leases under section 467 are subject to the section 467.467 lease delimitation method, which results in rental income or expenses when rent payments are due and payable under the contract. Thus, rental income and expenses are almost never reported linearly, as they are for accounting purposes. .