Prior to the enactment of Internal Revenue Code Section 467, a landlord receiving a payment of prepaid rent would recognize income upon receipt of the prepayment. The tenant making the prepayment, on the other hand, would have an intangible asset that would be amortized over the duration of the lease term. Section 467 enables the landlord and tenant to avoid this generally undesirable result by creating a framework under which they can agree as to how rent will be allocated. However, a lease must satisfy certain specific requirements in order for its allocation of rent to be respected under Section 467. A recent Chief Counsel Advice issued by the IRS illustrates a common pitfall that can cause an allocation of rent to fail.
Background
Section 467 generally governs the income tax treatment of leases with either increasing or decreasing rents. For a lease that is subject to Section 467, the landlord and tenant can agree to make a “specific allocation of fixed rent,” in which case the rental income for the landlord and deduction for the tenant will generally be determined based on the allocation (as adjusted, in certain cases, to take into account present values). The Treasury Regulations provide that a lease “specifically allocates fixed rent” if it “unambiguously specifies, for periods no longer than a year, a fixed amount of rent for which the lessee becomes liable on account of the use of the property during that period.” In addition, the total amount of fixed rent allocated must be equal to the total amount of fixed rent payable over all periods.
