Business Deductions for Rent and Lease Payments
Rent is the payment for the use of property that the taxpayer does not own. 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 plus 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 will only apply 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, then the corporation may deduct the rental payments as business expenses, but the taxpayer cannot treat the income as passive income that can be used to offset other passive losses because that is specifically prohibited.
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 advantageous 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:
- the rent must be reasonable
- the business owner cannot have any control over the property after the gift
- the leaseback must be in writing
- there must be a clear business purpose for the 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 the following factors:
- the portion of each payment allocated to equity
- the agreement treats a portion of the payments as interest
- all payments total more than what the property would cost
- the lease payments exceed the fair market value (FMV) of the rent
- the presumption is that the excess portion of the rent payment is applied to equity
- the agreement stipulates a date for the transfer of title
- the agreement provides an option to buy the property at a nominal price, a price substantially less than the full price
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, then any premium paid to obtain immediate possession is deductible. Otherwise, for a long-term lease, the premium is deductible over the term of the lease.
If the lease has renewal options, then 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: A $10,000 lease allocates $7000 to the current lease term plus $3000 for renewal options. The current lease period is 10 years and the renewal options are for 3 years each. Since $7000 is less than 75% of $10,000, the 2 additional renewal periods must be added to the term of the initial lease, so the cost must be amortized over 16 years.
Any payments to change lease provisions is amortized over the remaining lease term.
Generally, the cost to cancel a lease can be deducted immediately, unless the cancellation is conditioned upon obtaining a new lease from the same lessor, in which case the termination costs must be amortized over the new lease period.
Improvements to Leased Property
If the lessee makes permanent improvements to lease property, then 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 allocated to the increase in rental value, while the remaining part is allocated to the permanent improvements. The portion allocated to the increased rental value is amortized while the portion allocated to the improvements is depreciated.
Leaseholds, Restaurants, and Retail Properties
There are special rules for qualified leaseholds, restaurant, and retail improvements. 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 building interior 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 for either equipment used for the preparation of 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 that started after August 5, 1997 for retail space is not taxable as long as 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.
Motor Vehicle Rentals and Leases
Motor vehicle rentals 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, then 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:
- intent of the parties
- whether any portion of the payments are allocated to equity
- whether interest is paid, and
- whether the fair market value of the car is less than either the lease payment or option payment when the option is exercised.
The tax code limits the amount that can be depreciated for a new car. To extend the limit over to leasing, the tax code provides for an inclusion amount that must be added to the taxpayer's income. 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.
The inclusion amount only applies to leases longer than 30 days and only on 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, must be added to income if the lease exceeds the following amounts, which was greatly increased by the Tax Cuts and Jobs Act passed at the end of 2017.
|2018 - 2020||$50,000|
|Source: Inclusion Amount|
Prior to 2018, the applicable FMV's were much lower, and the FMV's for cars differed slightly from trucks and vans:
|2013 - 2017||$19,000|
|2011 - 2012||$18,500|
|2013 - 2017||$19,500|
|2011 - 2012||$19,000|
Example: If, according to the IRS table, the inclusion amount is $19,000 for the year and the car was leased for 90 days and used exclusively for business, then the inclusion amount that must be added to income = 90 ÷ 365 × $19,000 ≈ $4685.
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, which will be based on guidelines provided in Revenue Procedure 2001-28. To be deductible as rent, the leveraged lease must satisfy the following requirements:
- the lessor:
- must have a minimum 20% at risk equity investment in the property for the lease term
- expects to earn a profit; the leveraged lease is not just for the tax deductions, credits, allowances, and other tax attributes
- the lessee:
- has no contractual right to buy the property at less than FMV when the lease ends
- does not lend any money nor guarantees a loan to enable the lessor to buy the property
- does not invest in the property
If the lessee is considered the owner of the property, 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 the following are true: rents increase or decrease during the lease; rents are deferred, meaning payable after the calendar year or they are prepaid, meaning that they applied to a future calendar year. 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 that were received as part of acquiring the lease must be capitalized and amortized over the remaining lease term.
Deducting Rent Payments
Previous to 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 limited to 2% of adjusted gross income (AGI), 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.
Example 1: You prepay rent for 2020 in December 2019. If you are on the accrual basis, then the payment is deductible in 2020; if on a cash basis, the payments can be deducted in 2019.
Example 2: If you prepay $21,000 for a 3-year lease at the beginning of your tax year, then, whether you are on the accrual basis or cash basis, only $7000 can be deducted for each tax year.