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• Rents are prepaid (rent is payable before the end of the calendar year preceding the calendar year in which the use occurs and the rent is allocated). These rules do not apply if your lease specifies equal amounts of rent for each month in the lease term and all rent payments are due in the calendar year to which the rent relates (or in the preceding or following calendar year). Generally, if the special rules apply, you must use an accrual method of accounting (and time value of money principles) for your rental expenses, regardless of your overall method of accounting. In addition, in certain cases in which the IRS has determined that a lease was designed to achieve tax avoidance, you must take rent and stated or imputed interest into ac- count under a constant rental accrual method in which the rent is treated as accruing ratably over the entire lease term. For details, see sec- tion 467. Taxes on Leased Property If you lease business property, you can deduct as additional rent any taxes you have to pay to or for the lessor. When you can deduct these taxes as additional rent depends on your ac- counting method. Cash method. If you use the cash method of accounting, you can deduct the taxes as addi- tional rent only for the tax year in which you pay them. Accrual method. If you use an accrual method of accounting, you can deduct the taxes as ad- ditional rent for the tax year in which you can determine all the following. • That you have a liability for taxes on the leased property. • How much the liability is. • That economic performance occurred. The liability and amount of taxes are deter- mined by state or local law and the lease agree- ment. Economic performance occurs as you use the property. Example 1. Oak Corporation is a calendar year taxpayer that uses an accrual method of accounting. Oak leases land for use in its busi- ness. Under state law, owners of real property become liable (incur a lien on the property) for real estate taxes for the year on January 1 of that year. However, they don’t have to pay these taxes until July 1 of the next year (18 months later) when tax bills are issued. Under the terms of the lease, Oak becomes liable for the real estate taxes in the later year when the tax bills are issued. If the lease ends before the tax bill for a year is issued, Oak isn’t liable for the taxes for that year. Oak cannot deduct the real estate taxes as rent until the tax bill is issued. This is when Oak's liability under the lease becomes fixed. Example 2. The facts are the same as in Example 1, except that, according to the terms of the lease, Oak becomes liable for the real es- tate taxes when the owner of the property becomes liable for them. As a result, Oak will deduct the real estate taxes as rent on its tax return for the earlier year. This is the year in which Oak's liability under the lease becomes fixed. Cost of Getting a Lease You may either enter into a new lease with the lessor of the property or get an existing lease from another lessee. Very often when you get an existing lease from another lessee, you must pay the previous lessee money to get the lease, besides having to pay the rent on the lease. If you get an existing lease on property or equipment for your business, you generally must amortize any amount you pay to get that lease over the remaining term of the lease. For example, if you pay $10,000 to get a lease and there are 10 years remaining on the lease with no option to renew, you can deduct $1,000 each year. The cost of getting an existing lease of tan- gible property is not subject to the amortization rules for section 197 intangibles discussed in chapter 8. Option to renew. The term of the lease for amortization includes all renewal options plus any other period for which you and the lessor reasonably expect the lease to be renewed. However, this applies only if less than 75% of the cost of getting the lease is for the term re- maining on the purchase date (not including any period for which you may choose to renew, extend, or continue the lease). Allocate the lease cost to the original term and any option term based on the facts and circumstances. In some cases, it may be appropriate to make the allocation using a present value calculation. For more information, see Regulations section 1.178-1(b)(5). Example 1. You paid $10,000 to get a lease with 20 years remaining on it and two op- tions to renew for 5 years each. Of this cost, you paid $7,000 for the original lease and $3,000 for the renewal options. Because $7,000 is less than 75% of the total $10,000 cost of the lease (or $7,500), you must amortize the $10,000 over 30 years. That is the remain- ing life of your present lease plus the periods for renewal. Example 2. The facts are the same as in Example 1, except that you paid $8,000 for the original lease and $2,000 for the renewal op- tions. You can amortize the entire $10,000 over the 20-year remaining life of the original lease. The $8,000 cost of getting the original lease was not less than 75% of the total cost of the lease (or $7,500). Cost of a modification agreement. You may have to pay an additional “rent” amount over part of the lease period to change certain provi- sions in your lease. You must capitalize these payments and amortize them over the remain- ing period of the lease. You can’t deduct the payments as additional rent, even if they are described as rent in the agreement. Example. You are a calendar year taxpayer and sign a 20-year lease to rent part of a build- ing starting on January 1. However, before you occupy it, you decide that you really need less space. The lessor agrees to reduce your rent from $7,000 to $6,000 per year and to release the excess space from the original lease. In ex- change, you agree to pay an additional rent amount of $3,000, payable in 60 monthly install- ments of $50 each. You must capitalize the $3,000 and amortize it over the 20-year term of the lease. Your amor- tization deduction each year will be $150 ($3,000 ÷ 20). You can’t deduct the $600 (12 × $50) that you will pay during each of the first 5 years as rent. Commissions, bonuses, and fees. Commis- sions, bonuses, fees, and other amounts you pay to get a lease on property you use in your business are capital costs. You must amortize these costs over the term of the lease. Loss on merchandise and fixtures. If you sell at a loss merchandise and fixtures that you bought solely to get a lease, the loss is a cost of getting the lease. You must capitalize the loss and amortize it over the remaining term of the lease. Improvements by Lessee If you add buildings or make other permanent improvements to leased property, depreciate the cost of the improvements using the modified accelerated cost recovery system (MACRS). Depreciate the property over its appropriate re- covery period. You can’t amortize the cost over the remaining term of the lease. If you don’t keep the improvements when you end the lease, figure your gain or loss based on your adjusted basis in the improve- ments at that time. For more information, see the discussion of MACRS in chapter 4 of Pub. 946. Assignment of a lease. If a long-term lessee who makes permanent improvements to land later assigns all lease rights to you for money and you pay the rent required by the lease, the amount you pay for the assignment is a capital investment. If the rental value of the leased land increased since the lease began, part of your capital investment is for that increase in the rental value. The rest is for your investment in the permanent improvements. The part that is for the increased rental value of the land is a cost of getting a lease, and you amortize it over the remaining term of the lease. You can depreciate the part that is for your in- vestment in the improvements over the recov- ery period of the property as discussed earlier, without regard to the lease term. Page 12 Chapter 3 Rent Expense