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Topics This chapter discusses: • The definition of rent • Taxes on leased property • The cost of getting a lease • Improvements by the lessee • Capitalizing rent expenses Useful Items You may want to see: Publication 538 Accounting Periods and Methods 544 Sales and Other Dispositions of Assets 946 How To Depreciate Property See chapter 13 for information about getting publications and forms. Rent Rent is any amount you pay for the use of prop- erty you do not own. In general, you can deduct rent as an expense only if the rent is for prop- erty you use in your trade or business. If you have or will receive equity in or title to the prop- erty, the rent is not deductible. Unreasonable rent. You can’t take a rental deduction for unreasonable rent. Ordinarily, the issue of reasonableness arises only if you and the lessor are related. Rent paid to a related person is reasonable if it is the same amount you would pay to a stranger for use of the same property. Rent isn’t unreasonable just because it is figured as a percentage of gross sales. For examples of related persons, see Related per- sons in chapter 2 of Pub. 544. Rent on your home. If you rent your home and use part of it as your place of business, you may be able to deduct the rent you pay for that part. You must meet the requirements for busi- ness use of your home. For more information, see Business use of your home in chapter 1. Rent paid in advance. Generally, rent paid for use of property in your trade or business is de- ductible in the year paid or incurred. If you are an accrual method taxpayer and pay rent in ad- vance, you can deduct only the amount of rent that applies to your use of rented property dur- ing the tax year. You can deduct the rest of the rent payment only over the period to which it applies. If you are a cash method taxpayer, you may deduct the entire amount of rent you paid in advance in the year of payment if the pay- ment applies to right to use property that does not extend beyond the earlier of 12 months after the first date you have the right to use the prop- erty or the end of the tax year following the year in which you paid the advance rent. If your pay- ment applies to the right to use property beyond this period, then you must capitalize the rent payment and deduct it over the period to which it applies. Example 1. You are an accrual method cal- endar year taxpayer and you lease a building at 538 544 946 a monthly rental rate of $1,000 beginning July 1, 2018. On June 30, 2018, you pay advance rent of $12,000 for the last 6 months of 2018 and the first 6 months of 2019. You can deduct only $6,000 for 2018, for the right to use prop- erty in 2018. You deduct the other $6,000 in 2019. Example 2. Assume the same facts as Ex- ample 1, except you are a cash method calen- dar year taxpayer. You may deduct the entire $12,000 payment for 2018. The payment ap- plies to your right to use the property that does not extend beyond 12 months after the date you received this right. If you deduct the $12,000 in 2018, you should not deduct any part of this payment in 2019. Example 3. You are either a cash or ac- crual calendar year taxpayer. Last January, you leased property for 3 years for $6,000 per year. You pay the full $18,000 (3 x $6,000) during the first year of the lease. Because this amount is a prepaid expense that must be capitalized, you can deduct only $6,000 per year, the amount al- locable to your use of the property in each year. Canceling a lease. You generally can deduct as rent an amount you pay to cancel a business lease. Lease or purchase. There may be instances in which you must determine whether your pay- ments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales con- tract. Payments made under a conditional sales contract are not deductible as rent expense. Conditional sales contract. Whether an agreement is a conditional sales contract de- pends on the intent of the parties. Determine in- tent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies. However, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true. • The agreement applies part of each pay- ment toward an equity interest you will re- ceive. • You get title to the property after you make a stated amount of required payments. • The amount you must pay to use the prop- erty for a short time is a large part of the amount you would pay to get title to the property. • You pay much more than the current fair rental value of the property. • You have an option to buy the property at a nominal price compared to the value of the property when you may exercise the op- tion. Determine this value when you make the agreement. • You have an option to buy the property at a nominal price compared to the total amount you have to pay under the agree- ment. • The agreement designates part of the pay- ments as interest, or that part is easy to recognize as interest. Leveraged leases. Leveraged lease trans- actions may not be considered leases. Lever- aged leases generally involve three parties: a lessor, a lessee, and a lender to the lessor. Usually, the lease term covers a large part of the useful life of the leased property, and the lessee's payments to the lessor are enough to cover the lessor's payments to the lender. If you plan to take part in what appears to be a leveraged lease, you may want to get an ad- vance ruling. • Revenue Procedure 2001-28 contains the guidelines the IRS will use to determine if a leveraged lease is a lease for federal in- come tax purposes. • Revenue Procedure 2001-29 provides the information required to be furnished in a request for an advance ruling on a lever- aged lease transaction. These two revenue procedures can be found in I.R.B. 2001-19, which is available at IRS.gov/pub/irs-irbs/irb01-19.pdf. For advance ruling purposes only, the IRS will consider the lessor in a leveraged lease transaction to be the owner of the property and the transaction to be a valid lease if all the fac- tors in the revenue procedure are met, including the following. • The lessor must maintain a minimum un- conditional “at risk” equity investment in the property (at least 20% of the cost of the property) during the entire lease term. • The lessee may not have a contractual right to buy the property from the lessor at less than FMV when the right is exercised. • The lessee may not invest in the property, except as provided by Revenue Procedure 2001-28. • The lessee may not lend any money to the lessor to buy the property or guarantee the loan used by the lessor to buy the prop- erty. • The lessor must show that it expects to re- ceive a profit apart from the tax deduc- tions, allowances, credits, and other tax at- tributes. The IRS may charge you a user fee for issu- ing a tax ruling. For more information, see Rev- enue Procedure 2018-1, available at IRS.gov/irb/2018-1_IRB#RP-2018-1. Leveraged leases of limited-use prop- erty. The IRS won’t issue advance rulings on leveraged leases of so-called limited-use prop- erty. Limited-use property is property not ex- pected to be either useful to or usable by a les- sor at the end of the lease term except for continued leasing or transfer to a lessee. See Revenue Procedure 2001-28 for examples of limited-use property and property that isn’t limi- ted-use property. Leases over $250,000. Special rules are pro- vided for certain leases of tangible property. The rules apply if the lease calls for total pay- ments of more than $250,000 and any of the fol- lowing apply. • Rents increase during the lease. • Rents decrease during the lease. • Rents are deferred (rent is payable after the end of the calendar year following the calendar year in which the use occurs and the rent is allocated). Chapter 3 Rent Expense Page 11