Business Deductions for Rent and Lease Payments

Rent is the payment for using property that the taxpayer does not own. Rent is tax-deductible if the rental serves a business purpose. Rent paid for personal use is not deductible.

Businesses usually rent equipment and property because it requires less cash, which helps small businesses with insufficient credit for large purchases, and because rent can usually be deducted in the tax year when it is paid rather than being amortized or depreciated over several years, as would be necessary for purchases of equipment or property. Fees for safety deposit and post office boxes are also deductible as rent.

Net leases are leases that include rent for space + the payment of associated costs, such as property taxes and insurance, utilities, trash collection, and sewer and water. Net leases are deductible as rent that includes the associated costs: there is no separate deduction for property taxes, insurance, utilities, or the other associated costs.

If a taxpayer rents his home and uses a home office for his business, then the percentage of the rent = area of the business ÷ area of the house is deductible, but limited by business income.

To be deductible, rents must be reasonable, but this rule only applies if the lessor and lessee are related since an arms-length transaction is presumed to be reasonable. The lessor and the lessee are deemed related if they are part of the same family or related through the control of business entities.

If a taxpayer rents to his own corporation, the corporation may deduct the rental payments as business expenses, but the taxpayer cannot treat the income as passive income to offset other passive losses because that is specifically prohibited.

Rent for Employee Parking is Non-Deductible

If rent includes parking, then some of the rent must be reasonably allotted to parking if employees use some parking spaces because that portion is not deductible. The portion of rent for public and handicapped parking, even for employees, is deductible.

The allocable parking spaces for employees is determined by either the number of parking spaces reserved for employees or by the number of spaces used by employees at peak periods divided by the total spaces.

So, if $10,000 of the rent is allotted to parking and employees use 70% of the spaces, then $7,000 (= $10,000 × 70%) is not deductible, so only $3,000 (= $10,000 − $7,000) of that allocation is deductible.

Gift-Leasebacks

If property has already been depreciated, a business owner could give the property to her children and have them lease it back to her, which can be beneficial if the children are in a lower tax bracket. This gives income to the children while also providing an annual deduction for the business. However, it must be a bona fide transaction:

Example: a lawyer transfers property to his children, then rents the property back from them to protect against malpractice lawsuits.

Conditional Sales Contracts

Any rent payments leading to ownership or equity are not deductible. If there is an option to buy with a rental or lease, then whether it is actually a lease or a purchase of property is determined by whether the lease agreement is actually a conditional sales contract, in which case the payments are nondeductible. A conditional sales contract allows the taxpayer to acquire either equity or title in the property after paying a certain amount. If it is not clear from the contract whether the agreement is a lease or a conditional sales contract, then another determining factor is intent, which can be inferred from any of these factors:

Acquiring, Modifying, or Canceling the Lease

The cost of acquiring the lease is deductible over the lease term. If the lease is for the current tax year, any premium paid to get immediate possession is deductible. Otherwise, for a long-term lease, the premium is deductible over the lease term.

If the lease has renewal options, the terms for those renewal periods must be included in the amortization period if less than 75% of the cost is for the lease period before the renewal.

Example: When to Add the Terms of Renewal Periods to the Amortization Period

Case #2

Any cost to modify a lease must be amortized over the remaining lease term.

The cost to cancel a lease can be deducted immediately unless the cancellation is conditioned upon getting a new lease from the same lessor; if so, the termination cost must be amortized over the new lease period.

Improvements to Leased Property

If the lessee makes permanent improvements to lease property, the cost can be depreciated with the Modified Accelerated Cost Recovery System (MACRS) depreciation over the recovery period of the improvement, not over the remaining term of the lease. So if the lessee builds a commercial property building on a leasehold with 10 years remaining on the lease, then the building must be depreciated over its 39-year class life rather than the 10 years remaining on the lease.

Property improvements to a lease acquired through assignment must be capitalized. Part of the capital investment is allotted to the increase in rental value, while the remaining part is allotted to the permanent improvements. The increased rental value is amortized while the improvement costs are depreciated.

Qualified Improvement Property

Qualified improvement property is any improvement to an interior portion of a depreciated commercial building. Property improvements typically depreciated over 39 years can be depreciated over 15 years, or bonus depreciation and/or a Section 179 deduction can be claimed for the property, which includes:

Exterior building features, such as roofs, external doors and windows, and structural framing do not qualify.

Bonus depreciation allows businesses to deduct a percentage of the cost when placed in service. The bonus depreciation rate is phasing down by 20% till 2027:

Motor Vehicle Rentals and Leases

Motor vehicles rented for business use for less than 30 days are immediately deductible. Lease terms exceeding 30 days are deductible if the car was used entirely for business. If there was any personal use, only the portion of business use over total use can be deducted. Advance payments can only be deducted for the period in which they apply.

If a lease has an option to buy, then whether the payments are deductible depends on whether the lease is intended as a lease, depending on:

If the standard mileage rate is not used, then depreciation is separately deductible, but the tax code limits this deduction for a new car. To extend the deduction limit over to leasing, the tax code provides for an inclusion amount that must subtracted from the lease payment deduction if the fair market value (FMV) of the vehicle exceeds a certain amount, adjusted for inflation. The depreciation of new cars is limited for luxury models, so the inclusion amount is an ad hoc contrivance to equate leasing a luxury vehicle with buying one. The inclusion amount is based on the value of the car on the 1st day of the lease. Different inclusion amounts apply to gasoline and electric cars. The objective is to limit the deduction of lease payments to what could be deducted as depreciation if the car were owned; leased vehicles cannot be depreciated.

The inclusion amount only applies to leases longer than 30 days, to luxury vehicles exceeding a certain FMV, adjusted for inflation, on the 1st day of the lease, and to the portion of the lease allocable to business use. The portion of the lease allocated to personal use, including commuting, is not deductible. The allocation for time is based on the number of days of business use. Inclusion amounts, based on IRS tables, reduce the deduction of lease payments by the amount of the inclusion.

FMV on 1st Day of Lease to Determine the Inclusion Amount for Cars, Trucks, and Vans
Year Lease Started Vehicle FMV
2024 $62,000
2023 $60,000
2022 $56,000
2021 $51,000
2018 - 2020 $50,000

Source: IRS Publication 463, Inclusion Amount

Leveraged Leases

Payments for leveraged leases are generally deductible, but because leverage leases are often used in tax avoidance schemes, special rules apply. A leveraged lease involves 3 parties: lessor, lessee, and a lender to the lessor. The lease term covers most of the useful life of the leased property and the lessee's payments are enough to cover the lessor's payments to the lender.

A taxpayer who wants to use a leveraged lease should get an advance ruling from the IRS. To be deductible as rent, the leveraged lease must satisfy these requirements:

If the lessee is considered the property owner, then the lease payments will not be deductible. The IRS may come to such a conclusion for limited use property: property not expected to be useful to the lessor after the lease ends.

Uniform Capitalization Rules

The direct costs and some of the indirect costs for certain production or resale activities may be subject to uniform capitalization rules, in which case, the cost must be included in the tax basis of the property rather than being claimed as a current deduction. These costs are recovered through depreciation, amortization, or as the cost of goods sold. Indirect costs include renting equipment, facilities, or land.

Uniform capitalization rules apply to the production of real or tangible personal property, or property acquired for resale. However, exceptions exist for acquired personal property for resale if the average annual gross receipts do not exceed $25 million (previously: $10 million) for the 3 prior tax years. An exception also exists for the production of property if the indirect costs do not exceed $200,000 or the taxpayer uses the cash method of accounting and has no inventories. So if you rent a building to produce business equipment, then the rent must be included in the cost of the equipment produced, if the business is subject to the uniform capitalization rules.

Leases Exceeding $250,000

For leases over $250,000, the taxpayer may have to use the accrual method of accounting, regardless of the accounting method otherwise used, if any of these are true:

These rules have been enacted to prevent tax avoidance schemes based on leases. IRC §467

Any payment for an existing lease must be deducted over the remaining lease term. So if the lease, with 10 years remaining, cost $10,000, then the taxpayer can only deduct $1000 annually. Amortization rules for §197 intangibles does not apply to acquiring a lease of tangible property.

Any losses on merchandise or fixtures received as part of acquiring the lease must be capitalized and amortized over the remaining lease term.

Deducting Rent Payments

Before the 2017 Tax Cuts and Jobs Act (TCJA), employees could deduct rent payments on Form 2106, Employee Business Expenses. Rents, including for a home office, were itemized expenses subject to a 2% AGI floor, but the 2017 TCJA eliminated this deduction.

For the self-employed, information on leased cars is reported on Form 4562, Depreciation and Amortization. Schedule C, Profit or Loss from Business has separate lines for reporting rents and leases for vehicles, machinery, and equipment and another line for other business property. Cars leased for more than 30 days are reported on Part 4 of Schedule C if Form 4562 is not required.

Deducting rent payments for a home office is figured on Form 8829, Expenses for Business Use of Your Home. Farmers calculate the home office deduction using the worksheet in IRS Publication 587.

Generally, rental payments by partnerships or limited liability companies are not reported as separate items to the business owners. However, if an owner claims a home office deduction, then the deduction is calculated on the worksheet in IRS Publication 587. The rental deduction along with other home office expenses is then entered on Schedule E, Supplemental Income and Loss. Rent payments are also not passed on to shareholders of S corporations.

Prepaid rents can be deducted when paid by a cash basis taxpayer if the prepayment period does extend more than 1 year after the tax year in which the rent was paid, but an accrual basis taxpayer must capitalize the cost and deduct it when performance has been accomplished for the respective period.

Security deposits are not deductible when paid because the deposit is usually refunded if the lease terms are fulfilled. But if the landlord keeps any of the deposit, that amount is deductible as rent.

Example: When Prepayments Are Deductible on a Cash Basis or Accrual Basis

Example 1:

Example 2:

Historical Notes

Leaseholds, Restaurants, and Retail Properties

Special rules apply to qualified leaseholds, restaurant, and retail improvements made before 2018. Improvements to leaseholds, restaurants, and retail establishments, by either the landlord or tenant, can be depreciated over 15 years rather than the 39-year class life of the building. This rule applies to leasehold improvements to the interior of the building and retail improvements to the interior building open to the public for retail. In both cases, the improvements must have been made more than 3 years after the building was placed in service and cannot involve enlargement of the space, elevators or escalators, or internal framework or structural components for common areas. Restaurant improvements also qualify if more than 50% of the improvement costs are either for equipment used to prepare meals to be consumed at the restaurant or for seating.

A construction allowance for making additions or improvements for a lease not exceeding 15 years for retail space is not taxable if the allowance is used for the purpose intended.

Leasehold improvements qualify for a 50% bonus depreciation. Restaurant and retail improvements will also qualify if they qualify as leasehold improvements.