Tax Relief for Real Estate Property Owners with Uncollectable Rent Accruals in the Wake of COVID-19 by Arthur J. Lieberman
Posted on February 19, 2021
The ongoing COVID-19 pandemic continues to be a burden on the cash flow of commercial and residential real estate owners and their tenants. Many landlords have seen their rent receivables explode as a result of executing rent-forbearance agreements with struggling tenants, but they may not be certain if they will ever be able to collect those deferred rent amounts. In these cases, questions arise whether an accrual method landlord must pay current income tax on these doubtful rent accruals. While the tax code requires accrual for tax purposes in most cases, relief is available to taxpayers for those amounts in which collectability is doubtful on the date the rent accrues.
Real estate property owners use either the cash or accrual method of accounting to report income and expenses on their tax returns. Under the cash method of accounting, property owners include income at the time they actually receive a tenant’s rental payment, regardless of the actual due date. Consequently, a cash method property owner will not be affected adversely by unpaid rent accruals. By contrast, accrual method property owners report rental income when the “all events test” is satisfied, regardless of when the tenant actually pays the rent.
Satisfaction of the “all events test” occurs in the tax year when “all the events have occurred to fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.” Under normal circumstances, this “all events test” does not cause significant mismatches between an accrual method property owner’s income and collections. However, we are not living in normal times, and rent forbearances made in response to the COVID-19 pandemic have created substantial mismatches between accruals and collections. Without any relief from the “all events test”, accrual basis property owners may find themselves liable on unpaid rent accruals even when ultimate collectability of those accruals is doubtful.
Over the years, the courts have established a “doubtful collectability exception” to the accrual method of accounting for revenue recognition. Courts have determined that it is inappropriate to tax a taxpayer on amounts whose collection is reasonably in doubt on the day it accrues, even though those amounts are certain and unquestionably due the taxpayer. If an amount is of doubtful collectability, or if the taxpayer is reasonably certain collection will not occur on the day the amount accrues, accrual for tax purposes is not required. Accrual method property owners must evaluate each receivable individually to determine whether the “doubtful collectability exception” to the accrual method may apply.
When evaluating whether the “doubtful collectability exception” applies, both the level and time of uncertainty of ultimate payment must be considered.
The level of uncertainty refers to the likelihood of ultimate payment based on all facts and circumstances outside the actual delay in receipt. For example, a tenant’s temporary financial difficulty to make rent payments is not sufficient for a landlord to claim the “doubtful collectability exception” to the accrual method of accounting. Rather, the landlord must demonstrate the tenant is financially unstable or insolvent, and consequently, the ultimate collection of the unpaid amount is improbable. A tenant’s bankruptcy filing can be evidence of doubtful collectability particularly with respect to long-term contracts, such as leases. Note, however, that it is unlikely that the “doubtful collectability exception” could ever apply for rent receivables that have not been reserved against for financial accounting purposes.
The timing of uncertainty refers to a Supreme Court ruling requiring that uncertainty must be present at the time of accrual for taxpayers to claim the “doubtful collectability exception.” Uncertainty arising after the date of accrual must be accounted for under the bad debt rules, which generally require a charge off for accounting purposes – in addition to evidence of uncollectability – in order to sustain a tax deduction.
As the COVID-19 pandemic endures, real estate property owners should meet with their advisors and CPAs to evaluate each receivable of each tenant to determine whether the “doubtful collectability exception” may apply to prevent the accrual of unpaid rental income on their 2020 income tax returns.
About the Author: Arthur J. Lieberman is a director with the Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs, where he works with real estate companies and closely held businesses on deal structuring, tax planning, tax research, tax controversies and compliance issues. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.