The COVID-19 pandemic has had a significant impact on landlords. Many tenants have struggled to meet their financial obligations, often resulting in late or unpaid rent or negotiated lease modifications. As the end of 2020 quickly approaches, landlords should review the tax implications of their leasing activities.

Cash versus accrual

The tax impact of late rent depends on your method of accounting for tax purposes — typically either cash or accrual. If you’re using the cash method, rental income is recognized when it’s received (actually or constructively), and expenses are deductible when paid. If you’re on the cash method and tenants miss rental payments this year, you’re not subject to tax until they actually make the missed payments.

If you’re using the accrual method, rental income is recognized when it’s earned and expenses are deductible when they’re incurred, regardless of the timing of cash receipts or payments. When is income earned? The IRS applies the “all events test,” under which income is earned when 1) all events have occurred that fix your right to receive income, and 2) the amount can be determined with reasonable accuracy. 

Most leases are clear when it comes to the amount and timing of rental payments. So, if you’re on the accrual basis and tenants miss rental payments this year, you’ll likely recognize income according to the schedule set forth in the lease, regardless of when the payments are actually made (although, as discussed below, you may be entitled to a bad debt deduction for rent that becomes uncollectible).

Some leases are subject to special accounting rules, regardless of the landlord’s usual method of accounting. (See “Lease modifications: Watch out for Sec. 467.”)

Writing off bad debts

The bad debt deduction is relevant only to accrual-basis landlords. Cash-basis landlords aren’t taxed on rent until it’s received, so there’s no danger of paying tax on income that’s never received. If you’re using the accrual method, however, you may be required to recognize rental income when it’s earned, even if it’s never paid. To avoid tax on this “phantom income,” landlords can claim a business bad debt deduction.

To qualify for the deduction, you must establish that the receivable has become worthless (for example, if there’s no reasonable expectation of payment under the relevant facts and circumstances). There’s no special test for determining whether a receivable is worthless. It’s up to you to identify and document the factors that support your claim, such as:

Often, the last factor provides the best evidence of worthlessness. Which steps are “reasonable”? Again, it depends on the relevant facts and circumstances. In some cases, for example, it would be reasonable to pursue your remedies in court and attempt to enforce a judgment against the tenant. But you need not incur the expense of litigation if there’s reason to believe that doing so would be fruitless.

Modifying or terminating leases

Some landlords accommodate struggling tenants by modifying leases (such as by lowering or deferring rent or decreasing the amount of leased space) or letting tenants out of leases. It’s important to understand the tax implications of these actions. 

For example, costs associated with lease modifications (such as legal fees) generally must be capitalized and amortized over the remaining lease term rather than expensed. And any early termination fees paid by a tenant (including forfeited security deposits) are generally taxed when received.

What about unamortized expenses, such as leasehold improvements you made for a tenant? If the lease is terminated, you can write off these expenses immediately if the improvements are “irrevocably disposed of or abandoned.” Generally, that means physically removing the improvements, unless you can show that the improvements were so highly customized for the departing tenant that they would be unusable by a future tenant.

Act now

If you’re a landlord dealing with late or unpaid rent, or if you’ve modified or terminated leases this year, it’s a good idea to review the tax implications as soon as possible. There may be actions you can take before year’s end, such as documenting collection efforts or removing leasehold improvements, to preserve valuable tax deductions.

Sidebar: Lease modifications: Watch out for Sec. 467

The tax treatment of rental income generally depends on your accounting method (cash or accrual). But be aware of Internal Revenue Code Section 467, which may require you to use the accrual method for certain leases, regardless of your regular accounting method.

The rules are complex, but in general Sec. 467 applies to leases that call for total payments over $250,000 and provide for prepaid, deferred or stepped (increasing or decreasing) rent. In addition to accelerating the recognition of rental income in some cases, Sec. 467 may also require you to treat certain deferred rent arrangements as loans, requiring you to recognize interest income.

Even if a lease isn’t subject to Sec. 467, if lease modifications are substantial enough, it may be deemed a new lease that could trigger Sec. 467 if the modifications result in significant deferred or stepped rent.