Implications:

Tax and accounting implications of leasing are usually an after-thought of a transaction. Particularly if a company is not publicly traded, accounting concerns are typically not considered during the real estate occupancy process. Regardless of the company's status, it could be valuable to you to review your current lease situation and plans with regard to new leasing transactions with your tax and accounting advisors before beginning the real estate occupancy process and certainly before making major decisions regarding leasing.

Tax Implications

Tax implications of both an existing lease and a proposed lease may not drive a transaction, but they can have an important impact on a company's tax situation. In the attached schedule, we have reviewed the potential impact of various lease factors from the tenant's and the landlord's perspective. For example, if a landlord provides a cash allowance to a tenant for work, the tenant must record the cash allowance as income in the year received or accrued (depends on the tenant's accounting method). Further, the tenant must record as an asset the work performed in the space and depreciate it over the appropriate period. For real estate improvements, the depreciation period is 39 years. FF & E is depreciated over seven years. Also, companies that have invested heavily in the construction of their existing space and need to sublet, may not realize that they will have a significant write-off upon leaving the space. This information will probably not override the importance associated with executing an important business or strategic decision, but it is useful in understanding the true overall cost of a major relocation, for example.

 

Issue	Tenant Impact	Landlord Impact
Free rent	The tenant will have less of an expense deduction during the period.	The landlord would just report less income, in most cases.
Cash allowance for work	The tenant will have to record income in the period that the cash allowance is received, or accrued. (It will depend on the tenant's accounting method - cash or accrual). The tenant would also depreciate the improvements constructed over a 39 year term. FF&E, which is sometimes paid from cash allowances, would be depreciated over 7 years. The tenant would write-off any undepreciated balance at the end of the lease or earlier termination.	The landlord will amortize the cash allowance pro-rata over the term of the lease.
Landlord builds improvements for a tenant and the landlord owns the improvements.	The tenant would have no tax impact unless it also contributes to the improvements. If the tenant does contribute to the improvements, then it would depreciate the amount contributed over a period of up to 39 years for real property items. If the lease is for less than 39 years then the tenant would write off any undepreciated balance at the end of the lease term or earlier termination of the lease or vacation of the premises.	The landlord will depreciate the improvement cost over a 39 year depreciation period. If the tenant leaves early or before 39 years, the landlord has to write-off if the improvements are demolished. If another tenant leases the space "as is", then the landlord would just continue depreciating the improvements.
Landlord builds improvements but shifts ownership of the improvements to the tenant.	The tenant would have current income to the extent of the cost of the improvements and would have to depreciate the improvements over a period of up to 39 years.	The landlord would amortize the cost of the improvements pro-rata over the term of the lease.
Landlord reimburses a tenants moving costs or professional fees (Rare occurance in Manhattan)	The tenant would record income to the extent costs were reimbursed but would have a corresponding deduction for the expenses paid out. (If a company is a cash basis payer, it should ensure that the related costs are paid out before year-end.)	The landlord would amortize these costs pro-rata over the term of the lease.

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Accounting Implications

Typically the biggest issue from the accounting side of a real estate lease is whether or not the lease is an operating or a capital lease. Publicly-traded companies often do not want their leases to be capitalized and recorded on their balance sheet. For public companies, the issue most commonly referred to with regard to real estate relates to FASB 13. (The Financial Accounting Standards Board ("FASB") promulgates accounting standards for public companies. These standards lay out how publicly companies must portray accounting information in their financial statements.) FASB 13 is the main standard dealing with real estate and includes four criteria. If any of the four are met, then the lease obligation must be capitalized on the company's balance sheet.

The criteria are:

• By the end of the lease term, ownership of the leased property is transferred to the lessee.
• The lease term contains a bargain purchase option.
• The lease term is substantially (75% or more) equal to the estimated remaining useful life of the leased property.
• At the inception of the lease, the present value ("PV") of the minimum lease payments, with certain adjustments, is 90% or more of the fair value of the leased property.

FASB 13 is a critical issue for publicly-traded companies wanting to avoid debt on its balance sheet. Since capitalization of a lease requires that a company record the lease essentially like a purchase, the company's balance sheet would reflect an asset for the property and a liability for a debt amount. The amount of the debt is a synthetic amount that is calculated based on methods described in FASB 13 and other derivative standards and regulations. In any case, companies typically try to structure large lease transactions in such a way that they not run afoul of FASB 13. There are several other complicated lease and acquisition structures, including synthetic leases and swaps. These structures offer either accounting or tax advantages that are beneficial to the appearance of the company's financial statements. For small companies operating on a cash basis, accounting implications are not that relevant and the real issue is plain old cash flow - meeting the monthly rent obligation. TenantWise's founders have had extensive experience in structuring larger and more complex transactions. Please contact your TenantWise representative for further assistance.