FEDERAL INSIGHT By Glenn Johnson and Joe Sebik Non-Level Rents: Issues and Opportunities M OST LEASING PROFESSIONALS are familiar with the general parameters that lease rents should fall within a range of between 90% and 110% of the annualized average rents to comply with what are oft en called the “level-rent” tax safe harbor rules, also oft en called the “90/110” rules. However, what happens when the rents fall outside those parameters? And can structuring a lease to intentionally fall outside those parameters be a useful lease-structuring tool? under the lease to be determined by the Section 467 proportional rental accrual method where the lessor would recognize rental income and interest deductions over the term of the lease (rather than recognizing the entire amount of the rent paid into income when payable/received). When compared to a lease payment that complies with the 90/110% parameters, such a large initial payment also tends to enhance the yield to the lessor since although cash is received, it may not be tax-able upfront. Background As lease structurers sought to maximize the tax benefi ts associated with tax leases, rental payments were deferred as much as possible. Th is prompted the IRS to challenge the deferrals and became the im-petus behind Internal Revenue Code Section 467. Section 467 provides the parameters of what types of rental structures were acceptable and how unacceptable structures may be recharacterized for tax purposes. Essentially the recharacterization by the IRS involves classifying the amounts paid/received outside of the straight-line allocation schedule to be considered a loan (the “Section 467 loan”) and loan repayments as between the lessee and the lessor, as the case may be. For instance, if a lease with no allocation schedule called for an ini-tial rental payment of 20% of the asset cost and the 90/110% parameter indicated that a payment of no more than 5% was acceptable, the entire excess rent paid over the straight-line amount could be recharacterized by the IRS as a loan from the lessee to the lessor. If the IRS applied the Section 467 constant rental accrual method, Section 467 would determine the timing of the rental income/deductions by the parties (not the timing of the payments under the lease). Once the Section 467 rules were released, lessors and lessees de-termined that they could now intentionally structure leases to their advantage while being in conformity with Section 467. Basics of the Tax Law While the actual tax law and regulations that address the non-level rents are very complex, in basic terms the rules are applied as follows: 1. Section 467 applies to lease transactions where the total rental pay-ments exceed $250,000 and the lease has increasing or decreasing rent. 2. Rent allocation schedules must be within 90% and 110% of the aver-age annualized rents of the lease, not counting an allowable three-month initial rent holiday, to satisfy the 90/110% safe harbor. For real estate leases, the rents may vary as between 85% and 115%. If the rents vary outside the acceptable parameters, the IRS may classify the lease as a section 467 rental agreement that is subject to constant rental accrual. Alternatively, the parties to the lease could establish an allocation schedule that satisfi ed the 90/110% safe harbor, and the initial diff erence between the rent paid and the allocation schedule is treated as a Section 467 loan. 3. Once the 467 loan is created, interest accrues at a rate of no less than 110% of the Applicable Federal Rate for a similarly termed instru-ment, a rate published by the U.S. Treasury. Th e basic 467 tax loan structure can benefi t many lease structures, particularly when the credit of the underlying lessee may be inad-equate to support the term of the lease. However the structure is much more complicated than that summarized previously and it takes much more to calculate the payments, ensure that it is within reasonable tax parameters, document and administer the transaction. Nonetheless the structure may be another very useful tool to have in your leasing toolbox. A more extensive article on Section 467 is available at www. elfaonline.org/Advocacy/Fed/ . ■ Glenn Johnson is a Principal in E&Y’s national tax practice. Joe Sebik is a Director of Tax Reporting at Siemens Corp. Both are members of the ELFA’s Federal Tax Committee. Usefulness of a Section 467 Lease Structure Section 467 leases have recently arisen in smaller transactions, for in-stance within smaller solar energy leases as well as cell tower leases. In both cases the lessee is oft en a special purpose entity (SPE) owned by a developer and reliant on a single revenue contract, for instance on a power purchase agreement (PPA) selling solar energy to a single off -taker. Since the SPE’s principal asset is the PPA, and the owner of the SPE (the developer) oft en has few fi nancial resources themselves, a lessor must rely on the solar assets it owns and the PPA to repay its investment. With a Section 467 structure, lessors may now structure leases to enhance the credit profi le of such a transaction; for instance, when the ability of the lessee (the SPE) to pay a lease over an extended period is in question, a large advance rent payment may mitigate some of that risk. For example, if a lease called for 20% of rent due under the lease to be paid on the commencement of the lease and the remainder of the rent to be paid over the lease term, the parties could include an allocation schedule in the lease that satisfi ed the 90/110% safe harbor that allocated all the rent due, including the prepaid rent, over the lease term. Because the lease contained a payment schedule that was dif-ferent than the allocation schedule, the lease likely had prepaid rent that would result in the timing of the rental income and deductions 38 NOVEMBER/DECEMBER 2015 EQUIPMENT LEASING & FINANCE MAGAZINE