In this blog post, we will explain how deferred rent affects income tax under current lease accounting rules. We want to stress that this blog post covers it and income taxes under CURRENT rules of lease accounting (Topic 840). In a subsequent post, we will cover income taxes under Topic 842, which is the new lease accounting rules.
Before we delve into an example, let us recall the definition of deferred rent:
It is the liability that is created as a result of the difference between the actual cash paid and the straight-line expense recorded on the financial statements.
One of the basic principles of Topic 740 (Income Taxes) is that deferred taxes have to be recognized for temporary differences between the financial statements and tax returns. To put it another way, these deferred taxes are recognized for future tax consequences of events recorded in either the financial statements or the tax return, but not yet in both. Deferred tax liabilities are recorded for taxable temporary differences while deferred tax assets are recorded for deductible temporary differences.
The vast majority of the time, the deferred rent recorded is the difference between the straightline rent recognized for book purposes and the rent deductible for tax purposes (which is usually the cash paid). Under CURRENT GAAP for lease accounting, a lessee would generally record a deferred tax asset for the deferred rent liability recorded on the books. In addition, initial direct costs (IDC) are capitalized for tax purposes unless they are de minimus (meaning that they do not exceed $5,000 in the aggregate for US Federal purposes).
To demonstrate how deferred rent works in practice, let’s work through a simple illustrative example:
- Lessee leases a building from a lessor, and the lease is classified as an operating lease.
- Lease term is 10 years.
- Rent payments are $100,000 in the first year, escalating 3% per year. Payments are made in arrears.
- Lessee incurred $10,000 in initial direct costs (IDC) related to the lease.
- Lessee has a tax rate of 30%
- Assume the lease is a true tax lease for income tax purposes and that rent is deductible as paid for tax purposes.
In Yr 1, the lessee will make the following entries:
Note 1: Total lease payments of 1,146,388 + 10,000 IDC divided by 10 years.
Note 2: 10,000 IDC divided by 10 years.
Note 3: The deferred rent in this example is a plug that will make the entry balance, or it can be calculated as the straight-line expense less the cash paid each year. (Deferred rent here equals total lease payments of 1,146,388 divided by 10 years less cash paid of 100,000).
At the end of the first year, the Lessee’s deductible expenses for tax purposes is 101,000 (actual cash paid plus Year 1 amortization of the IDC), as a result, the lessee would record a current tax benefit of 30,300 (101,000 X 30%). The journal entry to record this is:
|Income Taxes Payable||30,300|
|Current Income tax expense||30,300|
As noted in the second paragraph of this post, deferred taxes have to be recognized for temporary differences between the financial statements and tax returns. The lessee’s deductible expenses for tax purposes is 101,000; while lease expense for book purposes is 115,639 (see note 1 above). The deferred rent of 14,639 constitutes a temporary difference that needs to be tax-effected to determine the associated deferred tax asset. The deferred rent would be multiplied by the tax rate to give the following entry:
|Deferred Tax Asset4||4,392|
|Deferred Income Tax Expense||4392|
Note 4: Deferred rent of 14,631 multiplied by tax rate of 30%.
Based on the entries above, note that the total income tax benefit is 34,692, which equals 30% of the recorded book expense of 115,639.
Once again, the entries above reflect the journal entries for deferred rent and the related tax effect under current lease accounting rules. In a subsequent post, we will explain the tax effect of leases under topic 842.
This article was contributed by LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact here.
If you liked this post, consider reading the following: How To Transition From Current to the New Lease Accounting Rules: A Comprehensive Example.