by Chris Moss CPA
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For any of you out there who have converted a commercial lease to a purchase your accountant has likely capitalized the cost to terminate the lease increasing your basis in the property buy out. Most likely your business income tax return was also prepared based on these capitalized costs in accordance with IRS Code Section 167 or perhaps amortized underSection 197. However, there is good news in recent Court rulings regarding Federal income tax rent deductions when you convert your lease to a purchase and pay large upfront lease termination fees that you can deduct in full in the year you paid those fees. But watch out for the IRS Lease to Buy Audit sure to come your way requiring you to capitalize all those expenses in accordance with Code Section 167. So if you are leasing a building or warehouse with a lease to buy option in your future plans, and you want to take advantage of this new Court approved tax deduction when you exercise your lease to buy options, stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out where lease to buy tax deductions are trending in 2015 and how to protect your expense in lieu of additional rent deductions from being disallowed during an IRS Lease to Buy Audit.
IRS regulations require capitalization of all acquisition costs to purchase a building whether it be amortization underSection 197 Intangible, or depreciation under Section 167 and also require capitaliziation if the property you are purchasing is “subject to a lease”. So it would not surprise me if most accountants capitalize the cost of lease buy out conversion under IRS Code Section 167(c)(2).
But ABC Beverage Corporation which makes and distributes soft drinks and other non-alcoholic beverages at its bottling plant in Hazelwood, Missouri took a different approach. On its 1997 tax return ABC claimed a business expense deduction of $6.25M which they claimed on their tax return was the buyout cost of the lease negotiated with the Landlord in lieu of additional rent over the term of the lease. The Government audited ABC and commenced an IRS Lease to Buy Audit disallowing the enter $6.25M deduction sending ABC a bill for $2.5M in back taxes. ABC paid the tax and then brought suit for refund in ABC Beverage vs United States 577 F Supp 2d 935 (WD Michigan 2008).
ABC’s argument to District Judge Paul Maloney was that their buy out was similar to 6th Circuit’s Opinion in Cleveland Allerton Hotel, Inc. v. Commissioner, 166 F.2d 805 (6th Cir. 1948). In that case Cleveland had a lease with roughly 80 years left on the term. Cleveland purchased the building after negotiating a buy out with the Landlord and claimed a tax deduction as business rent expense claiming when the IRS audited that the deduction was not to purchase real estate but to be “relieve them of an important rental obligation” which could accurately be measured by the difference between the fair value of the real estate and what Cleveland paid to purchase the property.
The Government in Cleveland claimed under IRS Code Section 167 or in the alternative Section 197 the deduction should have been capitalized as part of the purchase price to acquire the property. But Circuit Judge Simons found for Cleveland opining that Cleveland is not a third person investor buying real estate, but rather had a liability in a lease it wished to extinguish and it simply paid liquidated damages to the Landlord for release from its long term lease not to buy the property but to allow the lease to be terminated. District Judge Maloney found for ABC as did Judge Simons rule for Cleveland, and the Government appealed to the 6th Circuit in ABC Beverage Corp. v. U.S., 113 AFTR 2d 2014-2536 (CA6 2014).
The Government’s main argument on appeal was that Section 167 required that property “subject to a lease” was required to be capitalized, further arguing that ABC should simply depreciate or amortize the deduction as required bySection 167 or Section 197. The Government supported its position citing Woodward v Commissioner, 397 U.S. 572 (1970), Commissioner v Idaho Power Co., 418 U.S. 1 (1974), and INDOPCO, Inc. v Commissioner, 503 U.S. 79 (1992)and finally asking the 6th Circuit to overturn the out of date 65 year old Cleveland case. But Circuit Judge Cole opines that the facts in all those cases are not controlling and therefore do not warrant the Court to overturn Cleveland.
Circuit Judge Cole after review of all the evidence found that the Cleveland and ABC expense was a cost to extinguish liability to the Landlord prior to the purchase of the property and Congress did not intend Section 167 to apply to these specific facts. Absent other indication from Congress, the Court ruled that property was not “acquired subject to a lease” if the purchase extinguished the lease. ABC’s purchase was not acquired subject to a lease and therefore ABC wins, IRS loses.
OK now what does this say to all of you out there with lease to buy options? First, your tax attorney needs to have the language inserted in the lease to buy option prior to executing your lease that any additional expense in lieu of continued rent will be tax deductible as what I would call additional rent to extinguish lease citing the ABC case law in the applicable lease paragraph allowing for the buy out to purchase the building. Second, have your tax attorney include in your tax return his contemporaneously prepared opinion on why Section 167 does not apply to your specific facts and perhaps even include the applicable lease provision in the tax return prior to filing. Finally sit back and enjoy your new real estate purchase including your fully deductible additional rent to extinguish lease which has allowed you to substantially reduce your income tax. You can now relax knowing you have contemporaneously created facts and Court rulings and Opinions supporting and bullet proofing your tax return to win the likely IRS Lease to Buy Audit coming your way soon.
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Chris Moss CPA Tax Attorney