The New York University Federal Real Estate and Partnerships Tax Conference on June 26, 2020, offered a wide-ranging discussion of challenges that the coronavirus (COVID-19) pandemic poses for real estate leases. The all-star panel included:
- Blake Rubin, Senior Advisor, EY, Washington DC
- Paul H. Wilner, CPA, Partner, Grossberg Co, Bethesda MD
- Glenn Johnson, Principal, EY, Washington DC
- Brian O’Connor, Partner, Venable, Washington DC
Coronavirus Pandemic Effect on Leases
The coronavirus pandemic is already causing lessors and lessees to grapple with three principal issues:
- Nonpayment of rent
- Modifications to lease agreements
- Lease terminations
These issues are likely to affect more and more taxpayers as the coronavirus, and its economic impact, continues to spread.
Unpaid Rent in the Coronavirus Pandemic
Most real estate leases are Section 467 agreements because the amount of the rent obligation varies over the life of the lease. Different accrual methods may be used for 467 agreements, but the most common is the rental agreement accrual method.
Under this method, rent accrues to both the landlord and the tenant as provided under the agreement. If the agreement does not provide an allocation schedule, the rent accrues when it is payable.
- When the rent is paid
- When the rent is payable
- When economic performance occurs
- When the rent is recognized for financial accounting purposes.
So for an accrual basis taxpayer, unpaid rent may accrue regardless of whether the lease is a 467 agreement or a non-467 agreement. Thus, the landlord may have rental income, and the tenant may have a rent expense deduction, for rent that is not actually paid.
Is Coronavirus a Force Majeure?
Many leases include a force majeure clause (often translated as “Act of God” clause) that frees both parties from their obligations when there is a natural and unavoidable catastrophe. Whether the pandemic qualifies as a force majeure is a legal question of contract law, rather than real estate or tax law.
The answer generally depends on:
- The contract language
- Applicable state and local law
- Government directives where the property is located
- The lessee’s business operations.
Lease Modifications During the Coronavirus Pandemic
When a tenant can’t pay the full amount of rent due, the landlord might agree to modify the lease. Two types of modifications are most common:
- In forbearance, the landlord agrees to delay rent collections, but the tenant still owes the full amount.
- In deferral, the parties change the payment obligation – for instance, the landlord might agree to waive rent entirely for three months.
For a 467 lease, rent generally accrues under forbearance, but not under deferral. In a non-467 agreement, the effect of forbearance and deferral depend on the terms of the lease agreement and the party’s accrual method.
Since a deferral changes the payment obligations, it might constitute a substantial medication of a 467 lease might that causes the modified agreement to be treated as a new lease. This rule is easy to trigger–the threshold for a substantial modification is low, and safe harbors are very limited.
Additional lease modification rules may apply to a real estate investment trust (REIT) and a taxable REIT subsidiary (TRS).
Results of Unpaid Rent
So what happens if deferred rent is never paid? If the rent was accrued, the landlord may have a bad debt deduction, and the tenant may have to reverse any rent expense deduction.
On the other hand, if the landlord agrees to abate or forgive unpaid rent in exchange for an extension of the lease, the landlord might have to amortize the unpaid rent.
Some lessors also treat the abated rent as a loan to the lessee, and/or as an equity investment in the lessee or its business.
Coronavirus and Lease Terminations
Sometimes a lessor or a lessee pays the other party to terminate the lease. A landlord that makes a lease termination payment generally must capitalize it over the remainder of the lease term. For the tenant, the landlord’s payment is income received in exchange for the lease, which is capital gain if the lease was a capital asset for the tenant.
Potential Issue: Coronavirus Losses as Disaster Losses
In a more speculative vein, the webinar also discussed the possibility of treating coronavirus losses as disaster losses. When a loss is attributable to a federally declared emergency, the taxpayer may elect to claim the loss in the year before it is realized. The pandemic is a federal emergency, so as the economic effects spread, some taxpayers may try to treat losses attributable to coronavirus as disaster losses.
To do so, taxpayers will first have to show that the loss is attributable to the pandemic. The standards for this requirement are not clear. Tort concepts might be helpful, but which ones? Does the pandemic have to be a “but for” cause of the loss, or is it enough for it to be a proximate cause?
The scope of the attributable-to test is also unclear – whether it is all or nothing, or whether a disaster loss may be only partially attributable to the federal emergency.
Another issue is whether the pandemic must qualify as a casualty. Deductible losses generally must be attributable to a casualty; however, the statute and regulations do not explicitly require a disaster loss to arise from a casualty. If the casualty requirement applies to disaster losses, it is not clear that the pandemic would qualify, since a casualty must be a sudden event.
Finally, if pandemic losses are disaster losses, it is not clear whether a partnership or the partners is the taxpayer that makes the disaster loss election.
By Kelley Wolf, JD, LLM
Wolters Kluwer is by your side to help you stay up-to-date with tax and compliance changes and support your ability to work remotely. Please visit our Coronavirus (COVID-19) Resource Page for Tax & Accounting Professionals.