A look at the new accounting rules for leases
Earlier this year, the Financial Accounting Standards Board (FASB) released its much-anticipated update on the proper treatment of leases under US Generally Accepted Accounting Principles (GAAP). The revised standard — known as Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) — will apply to all organizations that lease assets such as real estate, vehicles, and construction and manufacturing equipment. While real estate lessors will experience little change when it comes to accounting for those leases, they could be affected if they lease vehicles, equipment or other property from other organizations.
What lessees need to know
Currently, lessees account for a lease based on whether it’s a capital (also known as finance) lease or an operating lease. They recognize capital leases (for example, a lease of equipment for nearly all of its useful life) as assets and liabilities on their balance sheets. Operating leases (for example, a lease of office or retail space for 10 years) aren’t recognized on lessees’ balance sheets and show up on financial statements only as a rent expense and disclosure item.
Under ASU 2016-02, lessees must recognize assets and liabilities for all leases with terms of more than 12 months, whether capital or operating. Lessees will report the right to use the leased asset on the balance sheet as an asset and the obligation to pay rent, discounted to its present value, as a liability.
A lessee’s recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee will still depend primarily on its classification as a capital or operating lease:
Capital leases. Lessees will amortize right-to-use assets separately from interest on the lease liability on the statement of comprehensive income. On the statement of cash flows, they’ll classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities.
Operating leases. Lessees will recognize a single total lease cost, computed so that the cost of the lease is allocated over the lease term on a generally straight-line basis. They will classify all cash payments within operating activities on the statement of cash flows.
The new standard also requires lessees to make additional disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows related to leases, including information about variable lease payments and options to renew and terminate leases.
What lessors need to know
The new standard won’t bring much change to lessors’ financial reporting. But it does include some “targeted improvements” intended to align lessor accounting with both the lessee accounting model and the revised revenue recognition guidance published in 2014 (ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606)).
For example, lessors might need to recognize some lease payments they receive as liabilities if the collectibility of the lease payments is uncertain. Users of financial statements will have more information about lessors’ leasing activities and exposure to credit and asset risk related to leasing.
A contract may come with both lease and service contract components (for example, maintenance services). Under ASU 2016-02, organizations will continue to separate the lease components from the nonlease components, and the standard provides additional guidance on how to do so.
The consideration in the contract is allocated to the lease and nonlease components on a relative standalone basis for lessees. For lessors, the consideration is allocated according to the guidance in the revenue recognition standard. Consideration related to nonlease components isn’t considered a lease payment, so it’s excluded from the measurement of lease assets or liabilities.
Public companies must adopt the new standard for interim and annual periods beginning after December 15, 2018. All other organizations will need to comply for annual periods beginning after December 15, 2019, and for interim periods beginning a year later. Early adoption is permitted. We can help you make the necessary preparations to ensure your financial reporting is in compliance by the applicable effective date.
Sidebar: How ASU 2016-02 could affect real estate lease negotiations
Although the new lease standard — Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) — won’t have much effect on real estate lessors’ financial statements, lessors could find that it changes their lease negotiations. Because specific lease terms will play a direct role in determining lessees’ reporting responsibilities, lessees may be driven by different motivations than in the past.
For example, lessees could request lower fixed rent and higher variable costs in the form of percentage rent or common areas maintenance charges, as lessees can exclude most variable lease payments when measuring lease assets and liabilities (other than those that depend on an index or a rate or are in substance fixed payments). Moreover, some organizations might forgo property leasing altogether, opting to buy because they’ll end up with similar leverage on their balance sheets as they would from leasing.
Former shareholders liable in land sale
The US Tax Court has ruled that shareholders in a C corporation who had transferred all of the corporation’s cash to a third party, without paying corporate taxes on a land sale, were liable for the unpaid taxes. Sounds bad, right? Not completely: The court also found that, under applicable state law, they were liable only for the amount of benefit they received from the transfer.
The corporation sold land it owned in Nebraska to the city of Lincoln for about $471,000 in June 2003. After the sale, the corporation’s only asset was cash.
While in negotiations with the city, the shareholders were contacted by a company offering to buy their shares in exchange for the corporation’s cash on hand. It would pay the value of the cash, less an amount representing about two-thirds of the corporation’s estimated tax liability. The deal would leave the shareholders with more money than they’d receive if they simply dissolved the company and received the land sale proceeds in redemption of their shares.
The parties executed a sales agreement in August 2003. As part of the transaction, the corporation transferred its cash on hand to the purchaser’s attorney’s trust account the day before closing. The next day, the attorney distributed the cash to an account in the name of the corporation and, the following day, to an account held by the purchaser.
The sales agreement between the purchaser and the shareholders provided that the purchaser would pay all taxes due for 2003, but the purchaser failed to do so. The IRS subsequently determined a deficiency of $145,923 (plus about $58,000 in penalties) in the corporation’s federal income tax and sued the shareholders for the unpaid taxes.
Section 6901 of the Internal Revenue Code authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid taxes. To do so, though, the agency must first establish that:
• The transferee is liable for the transferor’s debt under the applicable state or federal law and
• The target is a “transferee.”
The Tax Court found that the transfer of the corporation’s cash to the attorney’s trust account was fraudulent with respect to creditors under Nebraska’s Uniform Fraudulent Transfer Act (which has been adopted by most states) because the corporation didn’t receive “reasonably equivalent value” in exchange for it and the transferor (the corporation) became insolvent as a result of the transfer. Because the shareholders benefited from the transfer, they were liable to the IRS, which was a creditor of the corporation. And because they were liable to the IRS, the court said, they were transferees under Section 6901.
Despite its finding that the IRS could pursue the shareholders for the corporation’s unpaid taxes, the court didn’t award the IRS the approximately $204,000 it sought. Instead, the court found that the shareholders were collectively liable for only the benefit they received from the transfer — the difference between the after-tax amount they would have received if they’d liquidated the corporation (and paid the taxes) and the amount they received in the sale for their shares. That amount came to about $59,000, so the shareholders ultimately paid substantially less than the unpaid taxes due.
Factors to consider when purchasing property
Even though today’s real estate market has improved, you can still find investment properties at bargain prices. But, as with any real estate investment, the price may be too good to be true. Therefore, you’ll need to consider more than just the purchase price.
Who are the tenants?
What may seem like a bargain property can come with a high vacancy rate. Finding new tenants can be time consuming and costly, especially if you need to first renovate the vacant space. Even if the property has a relatively low vacancy rate, examine existing leases for any troublesome terms and evaluate the financial standing of every tenant.
Before purchasing a multitenant property, review existing leases. Then compile a current rent roll that summarizes key details for every tenant, including move-in date, security deposit, escalation clause, expiration date, outstanding rent balance, and options to extend or purchase. Watch for tenants who are behind on their payments, leases nearing expiration and rent rolls that differ greatly from the seller’s income statement.
How about zoning?
Most lenders won’t extend a property loan unless it’s zoned for your intended use. Check to see if zoning authority records suggest any plans to change the property’s permitted uses, and if existing approvals and permits are transferable. If not, it could be difficult to obtain any required variances or permits.
Property located in special public financing or redevelopment zoning areas may be subject to land-use restrictions. On the upside, these properties may be eligible for property tax abatements and income tax credits for rehabilitation.
What are the maintenance and carrying costs?
If the property is distressed, it’s likely that routine maintenance and repairs have been neglected. If so, you’ll need sufficient capital to bring the property up to speed, possibly leaving you unable to market vacancies for some time.
Regardless of the property’s vacancy rate, you must pay its carrying costs — property taxes, mortgage payments, insurance and so forth. If a building is off the market because it needs maintenance or code compliance work, you may have to shoulder carrying costs without offsetting rental income for a while.
Are there judgments, claims or liens?
The seller of a bargain-priced property may have fallen behind on obligations to contractors and other third parties. In such cases, you may incur costs to locate lien holders and obtain releases. Code enforcement fines could also come into play.
Verify certain contractual obligations of third parties, too. Check to see if the warranties, guarantees, indemnities and rights under the original construction contracts are assignable.
What about environmental issues?
Cleanup costs and liability for lurking environmental issues can pile up quickly. Often anyone who’s owned the property may be jointly or severally liable for cleanup. Determine the applicable federal, state and local environmental regulations, including those that could limit future uses. Review any environmental reports, notices of violations and pending litigation.
Lenders typically require a Phase I Environmental Site Assessment, which requires an analysis of a property’s past and current uses, looking for environmental conditions that could create liability for the buyer. The assessment generally covers underlying land and any physical improvements to property.
Take it slow
Finally, remember to check the crime rate, median income of tenants, rental rates of comparable properties and unemployment rate for the past few years to help estimate the neighborhood’s future property values. With the improved real estate market, you may have the urge to act quickly when you come across a bargain-priced property. But take the time to review all the factors discussed and perform thorough due diligence. Failure to do so could result in that bargain price evaporating and costing you more in the long run.
Are you familiar with the term the “Internet of Things” (IoT)? Generally, it refers to the networking of physical objects — such as mobile devices, vehicles and buildings — embedded with electronics, software, sensors and internet connectivity to collect, exchange and apply data. Information technology research firm Gartner predicts that smart commercial buildings will be the highest user of the IoT until 2017, at which point smart homes will take the lead globally, with just over one billion connected objects in 2018. There’s no denying that the IoT is changing the real estate industry, but how?
IoT and commercial real estate
Commercial buildings are increasingly adopting the IoT to improve tenant satisfaction (and, in turn, retention), reduce energy costs, and improve spatial management and building maintenance. For example, wireless sensors can provide cost-effective enhanced security for individual units, and elevators can recognize tenants’ voices when they request floors. Gartner estimates that security cameras, security webcams and indoor LEDs will represent 24% of the IoT market for smart commercial buildings in 2016.
The IoT also facilitates the collection of critical data that can give building owners a holistic view of facilities management and energy usage, allowing, for example, lights and heat to be turned off in spaces not currently in use. One company has launched an Uber-like service for cleaners, helpers and handymen, so owners can use an app to deploy such services on an as-needed basis.
The rich data also can aid real estate investors in their decision making. Investors can more easily compare properties and uncover areas ripe for savings.
IoT and residential real estate
As indicated by Gartner’s research, the IoT is rapidly gaining ground in homes, too. Consumer IoT applications include smart TVs and other appliances, smart thermostats and home security systems. Small Bluetooth-powered devices known as beacons can be mounted almost anywhere to track residents’ movements to automatically turn on lights or music. Beacons can also transmit information about the activities of an older adult to a caregiver or monitoring service. Homebuilders that make smart devices standard in their homes may have a competitive advantage over less tech-savvy competitors.
Additionally, the IoT is coming into play before consumers move into their homes. For example, real estate agents and development salespeople can use 3D printer technology to produce scale models of architects’ plans for potential buyers. In addition, various software applications let consumers experiment with interior decorating options before a home has even been constructed.
The future is now
If you haven’t already gotten onboard the rocket ship that is the IoT, now is the time. Learning more about some of these technologies and using them in your real estate portfolio can help propel you ahead of other businesses. The IoT is bringing homes and commercial buildings ever closer to the world envisioned by the creators of The Jetsons, and you don’t want to be left behind.
Neil A. Sonenberg is a Partner with the firm’s Real Estate Group. Neil brings 35 years of experience serving the real estate industry, including commercial building owners, operators and developers, residential rentals, apartment building operators, building maintenance services, co-op and condominium boards, and Common Interest Realty Associations. His expertise includes analysis of lease escalation and real estate reduction analysis (certiorari), as well as attest services to manufacturers and distributors.
A summa cum laude graduate of the State University of New York at Albany with a Bachelor of Science degree in Accounting, Neil is a member of the American Society of Certified Public Accountants (AICPA), the Building Owners and Managers Association, and the New York State Society of Certified Public Accountants (NYSSCPA). He has also served on various NYSSCPA committees and has lectured to the Real Estate Cooperative Board. In addition, he serves as the Treasurer of Yeshiva Central Queens School and board member of Young Israel of Hillcrest.
Neil believes that life isn’t all about debits and credits, and finds that spending time with his wife, children and grandchildren – Gavi and Liana Rose – makes his rigorous work schedule all the more rewarding. He resides with his family in Hillcrest, New York.
Marks Paneth LLP has served the real estate industry for more than 100 years. We assist many of the industry’s premier commercial and residential real estate owners, developers, builders, REITs (real estate investment trusts) and property managers. With more than 100 professionals including 16 partners who focus on the real estate industry, we bring deep expertise to every engagement.
For Further Information
If you have any questions, please contact William Jennings, Partner-in-Charge of the Real Estate Group, at 212.503.8958 or firstname.lastname@example.org or any of the other partners in the Marks Paneth Real Estate Group.
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2016 Tax Deadline Calendar
We've developed a useful summary of various tax deadlines occurring in calendar year 2016. Please review and let us know if you have any questions or, if you have missed a deadline, whether you would like to discuss late filing procedures and options.