As the economic impacts of COVID-19 continue to unfold and cause financial strain on businesses, commercial tenants may consider pursuing modifications to their lease agreements in order to avoid default for non-payment of rent or other hardships caused by the Coronavirus pandemic. For example, a landlord may agree to defer or waive rent for a period of time in exchange for a longer lease term or a new rent scale. Similarly, as borrowers struggle to make payments on their loans, lenders may agree to modify their loan agreements. While such modifications can succeed in alleviating pressure in the short term, they may come with unintended federal income tax consequences. This update provides a general overview of the potential federal income tax impacts that may occur as a result of lease and loan modifications.
Lease modifications should be analyzed for potential federal tax impacts if the changes to payments, rights, or obligations under the lease create a substantial modification to the lease. The Internal Revenue Code (the Code) classifies a modification as any change to the legal rights or obligations of the landlord or the tenant. The Code further specifies that a modification is substantial if it is economically substantial based on all of the facts and circumstances of the lease modification. If the lease modification is classified as a substantial modification, then the modified lease is considered a new lease and must be evaluated under Section 467 of the Code. Key lease modifications to look out for include modifications to defer, reduce or waive rent or fees, to apply sums as prepaid rents, or to create a new stepped rent schedule.
A lease is considered a Section 467 lease if it is (i) for the use of tangible property, (ii) for which the aggregate payments and considerations over the lease term is more than $250,000, and (iii) contains stepped rent (i.e., increasing or decreasing rents), prepaid rent, or deferred rent. When a lease is classified as a Section 467 lease, it could affect the character and timing of income recognition. Under Section 467, the landlord and tenant are required to recognize rent on an accrual basis (regardless of their regular method) and to recognize interest on deferred rent. This means that revenue is recognized when earned and expenses are recognized when billed, not when cash is received or expended. As such, if a lease is modified to defer rent, the landlord may be required to include scheduled rent in income even though it is deferred, and a tenant may use unpaid rent as a current deduction.
There are, however, opportunities for a landlord and tenant to engage in lease modifications without triggering Section 467. The Treasury Regulations contain safe harbors that allow for certain lease modifications without causing a lease to be considered a Section 467 lease, including: (i) a rent holiday of three months or less, (ii) certain contingent payments (e.g., late payment charges, tax indemnities, variable interest, adjustment based on a reasonable price index, tenant payment of third-party costs, etc.), (iii) change in the amount of fixed rent allocated to a period that combined with all previous changes in the amount of fixed rent allocated to the rental period does not exceed 1% of pre-modification rent, and (iv) change in rental payment solely as a result of refinancing of any indebtedness incurred by the landlord to acquire the property (subject to certain conditions). The landlord and tenant can also rewrite rent allocations in the lease to avoid characterization as a rent deferral. The landlord and tenant should consider attaching a rent allocation schedule to the modified lease. If a lease modification is accompanied by an appropriate allocation, the tax consequences will always follow such allocations.
Because the rules of Section 467 are complex, if a landlord or tenant is considering making any lease modifications, they should ultimately consult their legal and tax advisors.
Similar to lease modifications, loan modifications should be analyzed to determine whether the loan modification constitutes a “significant modification” as defined by Treasury Regulation Section 1.1001-3. A significant modification results in a deemed taxable exchange of the old debt instrument for a new debt instrument. The deemed exchange could, in turn, trigger the recognition of cancellation of indebtedness (COD) income and the accrual of original issue discount (OID) deductions over the remaining term of the debt to the borrower, and immediate gain/loss recognition and OID income to the lender. In addition, if the loan has been securitized in a real estate mortgage investment conduit (REMIC) or fixed investment trust, the significant modification could endanger the favorable tax characterization of the REMIC or fixed investment trust.
A two-step analysis determines whether a significant modification has occurred. First, has there been a modification of the debt instrument? Second, is the modification significant? While the nuances of this analysis are beyond the scope of this article, significant modifications can include changes in yield, extensions of maturity date, changes in collateral (e.g., additions and releases), changes in the borrower (e.g., adding a co-borrower or replacing a borrower), flipping from recourse to nonrecourse or vice versa, and any other modification that is deemed to be “economically significant.”
Similar to the Section 467 rules for lease modifications, the significant modification rules with respect to loan modifications also are complex and can result in material adverse tax implications. Accordingly, lenders and borrowers should consult their legal and tax advisors if they are considering making any loan modifications.
If you have any questions about this legal update or any other COVID-19 related issue, please contact your MMM attorney or an author of this update.