Published: Spring 2000
CNYC thanks Joel E. Miller.
Esq. for the following guest article. Mr. Miller is a tax
attorney in private practice in Queens, New York. In this
article, he sounds a warning about certain leasing arrangements
that have been used in the past to try to skirt 80/20 problems
under Section 216 of the Internal Revenue Code.
Past practice was for housing cooperatives seeking to maximize
rents that they collected on commercial areas without endangering
their "80/20" status (and thus losing the ability
for shareholders to take homeowner deductions), to create
a short tax year during which the lessee of the commercial
space would make a large initial payment. The cooperative
would "fail" 80/20 during that short year and shareholders
would lose their homeowner deductions for that time. However,
for the remaining years of the lease, the 80/20 balance would
be restored, as would the homeowner deductions. Here Mr. Miller
points out a common misconception concerning the continued
effectiveness of this device.
A DANGEROUS MISCONCEPTION
In 1984, Congress added Section 467 to the Internal Revenue Code. That section was designed to put an end to certain abuses involving tangible property leases that provided for the payment of uneven rent over the term. In general, it provides rules that govern the year in which rental payments must be taken into account for income tax purposes, regardless of when paid. The section was not aimed at housing cooperatives in particular, but it did not exclude housing cooperatives, and there is no reason to believe that it does not apply to housing cooperatives.
Notwithstanding that they were not Congress's target, housing cooperatives with valuable commercial space have long been using an uneven rent device, namely a large up-front payment in an effort to escape multi-year disqualification under the 80/20 rule of Internal Revenue Code Section 216(b)(1)(D). A housing cooperative considering such an approach must be concerned about Section 467. The statute did not apply directly to front-loaded (as opposed to back-loaded) rents, but it did authorize the Treasury to adopt regulations that would apply similar rules "where the amount paid under the agreement for the use of property decreases during the term," which arguably applies to prepaid rents. In 1996, the Treasury issued proposed regulations under Section 467, and the proposed regulations expressly covered prepaid rent, as well as decreasing rents. The proposed regulations contained three different sets of rules, each applicable to a separate class of covered leases. For present purposes, it is not important to examine the details of those three sets of rules or to consider exactly what leases are in each class. What is important is to be aware that the proposed regulations said that the first two sets of rules would be applicable only to leases entered into after the final regulations were issued, whereas the third set of rules would apply to any lease entered into after the date of the proposed regulations.
Here is where the confusion came in. The third set of rules applies only if the lease involved is either a leaseback or a "long-term agreement", which, in the case of real property, means for more than 14.25 years. Thus, a housing cooperative (which would not normally be entering into a leaseback) could, even after the issuance of the proposed regulations, take in any amount of prepaid rent without worrying about any of the Section 467 rules, so long as the term of the lease was no longer than 14 years and 3 months.
But that remained true only until the final regulations were issued, which occurred in May of 1999. At that time, the first two sets of rules did go into effect, and, where the second set applies, prepaid rent must be taken into account over the life of the lease regardless of the length of the lease. Unfortunately, many cooperatives seem to be under the impression that they are still safe so long as the term of a new lease is less than 14 years. But that is not correct. To repeat, a lease with a term of not more than 14.25 years is, as it always was, not subject to the third set of rules, but it may be subject to the second set, and, if it is, prepaid rent may have to be taken into account in later years, thus resulting in disqualification in those later years.
A final note of warning: The tax law always had, and still has, a general
rule that prepaid rent has to be taken into account for income tax purposes
no later than the time that it is received, even if the lessor is using
an accrual method of accounting, and some people who know only a little
about tax are under the impression that that rule still applies in all
circumstances. But the regulations that became effective last year provide
specifically that, where applicable, the Section 467 rules override the
general prepaid-rent rule. Also, some people believe that reporting income
too early can never be objectionable. But that is also wrong. There is
no option as to when rent is to be taken into income-tax account. The
bottom line is that housing cooperatives can no longer comfortably use
the prepaid rent device, even where the lease term is under 14 years.