The COVID-19 pandemic has had a domino effect on the real estate industry. Businesses who have taken a hit as a result of shutdowns may have paid rent late, not paid at all, or renegotiated lease terms with their landlords, including rent deferrals or abatements. These aspects can have unintended tax consequences on both the landlord and tenant.
Landlords recognize income based on their accounting method. Cash and accrual basis landlords will treat deferred rent, unpaid rent, and lease modifications differently.
The following scenarios all assume that a lease is not a Section 467 lease, which will be discussed at the end of this article.
Deferred Rental Income
Cash basis landlords recognize income when received. In the case of late rent, cash basis landlords will recognize income at the time they receive the cash in the future. Accrual basis landlords recognize income when the “all events” test is met. This means income recognition might not necessarily correlate to when cash is received. Under the “all events” test, a landlord recognizes rent when:
1. The right to income is fixed, and
2. The amount can be determined with reasonable accuracy.
Since the lease will state these terms, accrual basis landlords will continue to recognize income according to those schedules even with deferred payments or a non-paying tenant.
Non-paying Tenants
and Worthless Rents
If landlords have nonpaying tenants, cash basis landlords will not recognize any income since no cash is being received. There is no write-off for bad debts since they never recognized income in the first place.
Since accrual basis landlords accrue rental income, they can potentially claim a bad debt expense later on, but cannot simply claim a bad debt based on an estimate of unpaid rent. They can only claim a bad debt expense to the extent the rent receivable becomes fully worthless. Worthless rent receivable is a facts-and-circumstances determination and landlords can only claim wholly worthless bad debts, not partially worthless bad debts.