Imagine a long-term commercial lease executed a decade ago for five floors of office space at a prestigious New York City address. There is no doubt that the rental amount would be exorbitant, but in return a business would have a foothold and presence in the commercial capital of the world. Today, the same business realizes it only requires two out of the five floors it has leased.
In the current economic climate in the City of New York, this is not a difficult circumstance to imagine. Commercial tenants may find themselves burdened with excess or unutilized commercial space under their current leases. To make matters worse, the underlying leases may have higher rents than prevailing market rents. On a positive note, various options are available to those tenants that find themselves with empty spaces.
A below-market lease may afford a tenant a significant opportunity. To illustrate, consider a 15-year long-term lease executed in 2001, reflecting the prevailing market rates at the time. If the current adjusted rent under that lease is still below current market rates, the tenant may be able to profit from its excess space. If permitted under the lease, the tenant may sublease the excess space at current market rates for a profit. The net profit would be taxed as ordinary income. Depreciation on the tenant's leasehold improvements would continue as before; however, the tenant may be entitled to a deduction for the undepreciated cost of leasehold improvements that are demolished. The tenant's New York City Commercial Rent Tax base would be reduced by the rent received from the subtenant.
The landlord may be willing to buy the lease out (in whole or in part) from the tenant. The sale to the landlord would result in a capital gain to the tenant and New York State and New York City transfer taxes would apply as well. The tenant would be able to write off any undepreciated leasehold improvements associated with the space.
Other less attractive options are available to a tenant with excess office space, but may nonetheless be advantageous over the course of time. Consider a tenant with excess office space that does not find itself in one of the scenarios described above. A tenant in this situation may simply offer the landlord a sufficient cash payment in exchange for termination of the lease or for an assignment of the lease to a third party. If this option is utilized, the cash payment should provide the tenant a number of tax benefits.
Under the current norm, an enterprise would record a liability for costs associated with an exit (e.g., from a lease) when "incurred" and measured at fair value. In the context of a lease, that would be achieved at the time the enterprise has either entered into a contractual arrangement/agreement with the landlord (i.e., a legal obligation) or has abandoned or vacated the premises in whole or in part (constituting a "substantive obligation").
This approach is consistent with the GAAP concept of liabilities as arising from contractual or substantive/moral obligations and not merely from plans. Under current GAAP, the loss, if any, would be measured at fair value - a market-based concept. This varies from prior practice, which permitted discounted or undiscounted cash flows to serve as a basis for loss measurement. The basic mechanics of the measurement requirements would entail initial measurement (other than for those situations where an outright settlement is reached with the landlord, which would be recognized in full upon the "cease use date" of the premises) based on the fair value of the future lease payments for which the enterprise will derive no benefit, reduced by all theoretically available sublease rentals (which means the lease has to permit subleases), utilizing a credit adjusted risk free rate, commencing on the cease use date. Subsequent changes in the obligation/loss arising from reality not conforming to the estimate (e.g., the actual sublease rent received exceeding or being less than projected) would be recognized as current period charges in subsequent income statements.
The accounting for cancellations is not complex, per se; however, the estimation of loss and appropriate estimation of fair value inputs adds a measure of complexity. Companies seeking to avoid continued charges for the termination are well advised to be careful in their initial estimation. To the extent that tax deductions may not be immediately available to a terminating enterprise, tax paying entities would have to deal with setting up deferred tax assets and all the ramifications thereof.
If permitted, a traditional alternative for a tenant with excess office space is a sublease to a third party for a portion, if not the remainder, of the lease term. The tax consequence of this tactic would hinge upon the actual spread between the tenant's lease amount and the subtenant's lease amount. To illustrate, consider a tenant that has leased commercial office space at $75 per square foot. If the tenant decides to sublease this space at $50, the $25 negative differential would be tax deductible. In addition, the new tenant would continue to amortize capital expenditures. Also, if the tenant made any capital improvements for the sub-tenant prior to December 31, 2009, the tenant would be entitled to a bonus depreciation deduction in its first year. In addition, the rent the tenant will receive from the subtenant would serve as a credit (i.e., an offset) against its New York City commercial rental tax obligation.
Probably the least favorable option for any tenant with excess commercial office space is simply to continue with the lease. With this option, the tenant would continue to amortize any capital expenditures as normal, but would be afforded no offsets. Given the difficult economic situation New York is currently experiencing, commercial tenants with excess office space should explore all creative options that may create significant savings and tax benefits.
Finally, a tenant that has filed for bankruptcy may be able to have the lease rejected by the Bankruptcy Court. While the bankrupt tenant may be able to escape liability for future rent obligations, certain landlord protections in the lease such as letters of credit and guarantees by third parties may be triggered.
Published March 31, 2009.
