From a financial standpoint, it might make more sense to rent than to buy property and equipment. Renting may require a smaller cash outlay than buying. Also, the business may not as yet have established sufficient credit to make large purchases but can still gain the use of the property or equipment through renting. If you pay rent to use office space, a store, or other property for your business, or you pay to lease business equipment, you generally can deduct your outlays. In this post we will discuss about: Deducting Rent Payments In General, Rent with An Option to Buy, Tax Deduction For Advance Rents, Gift-leaseback’s Tax Deduction, The Cost of Acquiring or Canceling A Lease, Improvements To Leased Property, Leasing A Car, and Leveraged Leases will close the discussion.
Deducting Rent Payments in General
If you pay to use property for business that you do not own, the payments are rent. They may also be called “lease payments“. Rents paid for property used in a business are deductible business expenses. These include obligations you pay on behalf of your landlord. For example: if you are required by the terms of your lease to pay real estate taxes on the property, you can deduct these taxes as part of your rent payments.
The rents must be reasonable in amount. The issue of reasonableness generally does not arise where you and the landlord are at arm’s length. However, the issue does come up when you and the landlord are related parties, such as family members or related companies. Rent paid to a related party is treated as reasonable if it is the same rent that would be paid to an unrelated party. A percentage rental is also considered reasonable if the rental paid is reasonable.
If the rent payments entitle you to receive equity in or title to the property at the end of some term, the payments are not rent. They may, however, be deductible in part as depreciation.
Rent to Your Corporation
If you rent property to your corporation, the corporation can claim a rental expense deduction, assuming the rents are reasonable. However, you cannot treat the rents as passive income that you could use to offset your losses from other passive activities. The law specifically prohibits you from arranging this type of rental for tax benefit.
Rent with an Option to Buy
Sometimes it is not clear whether payments are to lease or purchase property. There are a number of factors used to make such a determination:
Nature Of The Document – If you have a lease, payments made pursuant to the lease generally are treated as rents. If you have a conditional sales contract, payments made pursuant to the lease are nondeductible purchase payments. A document is treated as a conditional sales contract if it provides that you will acquire title to or equity in the property upon completing a certain number or amount of payments.
Intent Of The Parties – How the parties view the transaction affects whether it is a lease or a conditional sales contract. Intent can be inferred from certain objective factors. A conditional sales contract exists if any of the following are found:
- The agreement applies part of each payment toward an equity interest.
- The agreement provides for the transfer of title after payment of a stated amount.
- The amount of the payment to use the property for a short time is a large part of the amount paid to get title to the property.
- The payments exceed the current fair rental value of the property (based on comparisons with other similar properties).
- There is an option to buy the property at a nominal price as compared with the property’s value at the time the option can be exercised.
- There is an option to buy the property at a nominal price as compared with the total amount required to be paid under the agreement.
- The agreement designates a part of the payments as interest or in some way makes part of the payments easily recognizable as interest.
Example: You lease an office building for a period of two years. The lease agreement provides that at the end of that term you have the option of buying the property and all of the payments made to date will be applied toward the purchase price. In this case, your payments probably would be viewed as payments to purchase rather than payments to lease the property.
Tax Deduction For Advance Rents
Generally, rents are deductible in the year in which they are paid or accrued. What happens if you pay rent in advance? The answer depends on your method of accounting. If you are on the accrual basis, prepaid rent must be capitalized (it cannot be deducted at the time of payment).
Example: LieDharmaPutra Corporation, an accrual basis taxpayer, leases office space from Z Corporation at a monthly rental rate of $2,000. On August 1, 2008, X prepays its office rent expense for the first six months of 2009 in the amount of $12,000. Because economic performance with respect to LieDharmaPutra prepayment of rent does not occur until 2009, Lie’s prepaid rent is not incurred in 2008 and therefore is not properly taken into account in 2008.
If you are on the cash basis, prepaid rent can be immediately deducted provided that prepayments do not extend beyond 12 months.
Example: LieDharmaPutra Corporation uses the cash method of accounting and pays X corporation $12,000 on August 1, 2008, to cover rent for the first six months of 2009. With the 12-month rule, the $12,000 payment is deductible in 2008 because the rights or benefits attributable to Lie’s prepayment of its rent do not extend beyond December 31, 2009.
Security deposits generally are not deductible when paid because the landlord is usually obligated to refund them if the terms of the lease are met. However, if the landlord keeps some or all of the deposit (e.g., because you failed to live up to the terms of the lease), you can then deduct such amount as rent.
Gift-Leaseback’s Tax Deduction
If you own property you have already depreciated, you may want to create a tax deduction for your business by entering into a gift-leaseback transaction. Typically, the property is gifted to your spouse or children, to whom you then pay rent. In the past this type of arrangement was more popular, but the passive loss rules put a damper on deducting losses created by these arrangements. If you still want to shift income to your children [who presumably are in a lower tax bracket than you] while getting a tax deduction for your business, be sure that you meet these requirements:
- You do not retain control over the property after the gift is given.
- The leaseback is in writing and the rent charged is reasonable.
- There must be a business purpose for the leaseback. (For example, where a doctor transferred the property in which his practice was located to his children in fear of malpractice suits, this was a valid business reason for leasing rather than owning the property).
There are other factors to consider before entering into a gift-leaseback. Consider the impact of the kiddie tax if your children are subject to it. It is strongly suggested that you consult with a tax adviser before giving business property to your children and then leasing it back for use in your business.
The Cost of Acquiring, Modifying, or Canceling a Lease
The Cost of Acquiring a Lease – When you pay a premium to obtain immediate possession under a lease that does not extend beyond the tax year, the premium is deductible in full for the current year. Where the premium relates to a long-term lease, the cost of the premium is deductible over the term of the lease. The same amortization rule applies to commissions, bonuses, and other fees paid to obtain a lease on property you use in your business. What is the term of the lease for purposes of deducting lease acquisition premiums when the lease contains renewal options? The tax law provides a complicated method for making this determination. The term of the lease for amortization purposes includes all renewal option periods if less than 75 percent of the cost is attributable to the term of the lease remaining on the purchase date. Do not include any period for which the lease may be renewed, extended, or continued under an option exercisable by you, the lessee, in determining the term of the lease remaining on the purchase date.
Example: You pay $10,000 to acquire a lease with 20 years remaining on it. The lease has two options to renew, for five years each. Of the $10,000, $7,000 is paid for the original lease and $3,000 for the renewal options. Since $7,000 is less than 75 percent of the total cost, you must amortize $10,000 over 30 years (the lease term plus the two renewal option periods).
Example: The circumstances are the previous example, except that $8,000 is allocable to the original lease. Since this is not less than 75 percent of the total cost, the entire $10,000 can be amortized over the original lease term of 20 years.
The Cost of Modifying a Lease – If you pay an additional rent to change a lease provision, you amortize this additional payment over the remaining term of the lease.
The Cost of Canceling a Lease – If you pay to get out of your lease before the end of its term, the cost generally is deductible in full in the year of payment. However, where a new lease is obtained, the cost of canceling the lease must be capitalized if the cancellation and new lease are viewed as part of the same transaction.
Example: A company leased a computer system for five years. To upgrade its system, the company canceled the original lease and entered into a new one with the same lessor. Because the termination of the old lease was conditioned on obtaining a new lease, the cost of termination had to be capitalized (i.e., added to the cost of the new lease and deducted ratably over the term of the new lease).
Improvements to Leased Property
If you add a building or make other permanent improvements to leased property, you can depreciate the cost of the improvements using “Modified Accelerated Cost Recovery System (MACRS)” depreciation. Generally, the improvements are depreciated over their recovery period, a time fixed by law. They are not depreciated over the remaining term of the lease.
Example: You construct a building on land you lease. The recovery period of the building is 39 years. When the building construction is completed, there are 35 years remaining on the lease. You depreciate the building over its recovery period of 39 years, not over the 35 years remaining on the lease.
If you acquire a lease through an assignment and the lessee has made improvements to the property, the amount you pay for the assignment is a capital investment. Where the rental value of the leased land has increased since the beginning of the lease, part of the capital investment is for the increase in that value; the balance is for your investment in the permanent improvements. You amortize the part of the increased rental value of the leased land; you depreciate the part of the investment related to the improvements.
Special Rule for Leasehold and Qualified Restaurant Improvements [For U.S]
Leasehold and qualified restaurant improvements can be amortized over 15 years instead of depreciated over 39 years. The break applies in 2008 and 2009, but U.S. Congress may extend the break beyond 2009.
To qualify for the 15-year write-off, all of the following requirements must be met:
[-]. The improvement is made pursuant to the terms of a lease to the interior of nonresidential property.
[-]. The lease is not between related parties. Except that where 50 percent ownership usually is required, in this case, 80 percent ownership applies.
[-]. The building (or portion of the building to which the improvement is made) is occupied exclusively by the lessee or sublessee.
[-]. The improvement is a structural component that would otherwise qualify for 39-year depreciation.
[-]. The improvement is placed in service more than three years after the date the building is first placed in service.
For restaurant improvements to qualify for the 15-year recovery period, more than 50 percent of the building’s square footage must be devoted to the preparation of meals to be consumed on the premises. Also, the building must have been in service for at least three years.
Certain types of improvements specifically do not qualify for the 15-year write-off.
These include the enlargement of the building, elevators and escalators, structural components that benefit a common area, and internal structural framework.
This special rule also applies to restaurant improvements. To qualify as a restaurant, more than 50 percent of the building’s square footage must be devoted to the preparation of meals and seating for the serving of meals on the premises. As in the case of general leasehold improvements, qualified restaurant property must be placed in service more than three years after the building is first placed in service.
If you enter into a lease after August 5, 1997, for retail space for 15 years or less and you receive a construction allowance from the landlord to make additions or improvements to the space, you are not taxed on these payments provided they are fully used for the purpose intended.
Tax Deduction For Leasing a Car
If you lease a car for business use, the treatment of the rental costs depends upon the term of the lease. If the term is less than 30 days, the entire cost of the rental is deductible. Thus, if you go out of town on business and rent a car for a week, your rental costs are deductible.
If the lease term exceeds 30 days, the lease payments are still deductible if you use the car entirely for business. If you use it for both business and personal purposes, you must allocate the lease payments and deduct only the business portion of the costs. However, depending on the value of the car at the time it is leased, you may be required to include an amount in gross income called an inclusion amount (explained later).
If you make advance payments, you must spread these payments over the entire lease period and deduct them accordingly. You cannot depreciate a car you lease, because depreciation applies only to property that is owned.
Lease with an Option to Buy
When you have this arrangement; are you leasing or buying the car? The answer depends on a number of factors:
- Intent of the parties to the transaction.
- Whether any equity results from the arrangement.
- Whether any interest is paid.
- Whether the fair market value (FMV) of the car is less than the lease payment or option payment when the option to buy is exercised.
If the factors support a finding that the arrangement is a lease, the payments are deductible. If, however, the factors support a finding that the arrangement is a purchase agreement, the payments are not deductible.
If the car price exceeds a certain amount (which is adjusted periodically for inflation) and you do not use the standard mileage rate to account for expenses, you may have to include in income an amount called an inclusion amount. The law seeks to equate buying with leasing. Since there is a dollar limit on the amount of depreciation that can be claimed on a luxury car that is owned, the law also requires an amount to be included in income as an offset to high lease payments on a car that is leased. In essence, the inclusion amount seeks to limit your deduction for lease payments to what it would be if you owned the car and claimed depreciation.
The inclusion amount, which is simply an amount that you add to your other income, applies if a car is leased for more than 30 days and its value exceeds a certain amount. The inclusion amount is added to income only so long as you lease the car. Inclusion amounts are based on the value of the car as of the first day of the lease term. If the capitalized cost of the car is specified in the lease agreement, that amount is considered to be the car’s fair market value. At the start of the lease, you can see what your inclusion amount would be for that year and for all subsequent years. The inclusion amount is based on a percentage of the FMV of the car at the time the lease begins. Different inclusion amounts apply to gas-driven cars and to electric cars.
Fair market value is the price that would be paid for the property when there is a willing buyer and seller (neither being required to buy or sell) and both have reasonable knowledge of all the necessary facts. Evidence of fair market value includes the price paid for similar property on or about the same date.
The inclusion amount applies only if the FMV of the car when the lease began was more than $18,000 in 2003, $17,500 in 2004, $15,200 in 2005 and 2006, $15,500 in 2007, and $18,500 in 2008. Different thresholds applied to cars leased prior to 2003.
Example: The inclusion amount for your car is $500. You used the car only six months of the year (a leap year). You must include in income $250 (183 ÷ 366 of $500). The full amount applies if the car is leased for the full year and used entirely for business. If the car is leased for less than the full year, or if it is used only partly for personal purposes, then the inclusion amount must be allocated to business use for the period of the year in which it was used. The allocation for part-year use is made on a day-by-day basis.
Remember that if you use your car for commuting or other non-business purposes, you cannot deduct that allocable part of the lease.
If you are the lessee in a transaction referred to as a leveraged lease, you generally can deduct your lease payments.
Leveraged lease is a three-party transaction in which the landlord (lessor) obtains financing from a third party and in which lease payments are sufficient to cover the cost of repaying the financing. Also, the lease term generally covers the useful life of the property.
It is important that the lessor, and not the lessee, be treated as the owner of the property if lease payments are to be deductible. The lessor is treated as the owner if he or she has a minimum amount at risk (at least 20 percent) during the entire term of the lease and the lessee does not have a contractual right to buy the property at its FMV at the end of the lease term. Other factors that are necessary to show that the lessor and not the lessee is the owner of the property are that the lessor has a profit motive (apart from tax benefits), the lessee does not lend money to the lessor, and the lessee does not invest in the property.
If you are about to become the lessee of a leveraged lease and want to be sure that you will not be treated as the owner [which means your rental expenses would not be deductible], you can ask the tax office for an advance ruling on the issue [however, the tax office will not issue an advance ruling on leveraged leases of so-called limited use property]. There is a user fee for this service. It may be advisable to seek the assistance of a tax professional in obtaining the ruling.
Limited use property not expected to be either useful to or usable by a lessor at the end of the lease term except for continued leasing or transfer to the lessee or a member of a lessee group.
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