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Why Lessors Need to Carefully Craft Leasing Agreements

Sep 23rd 2019
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When real estate owners enter into agreements to lease their properties, their advisers routinely craft agreements that include all kinds of boiler-plate provisions. For example, the advisers instruct  their clients to sign agreements that require lessees to return the properties in as good condition as when received or to otherwise bear the cost of their maintenance, restoration, replacement and the like.

I remind clients whose holdings include rental properties of how important it is for lessors to verify that their advisers carefully consider what words they’ll use for return-of-property provisions. Why, clients wonder, should wording matter?  

I explain that the words used could determine the extent to which lessors are entitled to write-offs for depreciation. Put more plainly, Internal Revenue Service spoilsports might mandate that lessors forfeit their depreciation deductions when leasing agreements stipulate that returned properties must be in “first class” condition.

Clients become attentive when I cite a 1978 decision by the Fifth Circuit Court of Appeals (Royal St. Louis, Inc. v. U.S., 578 F.2d 1017). It held that the IRS correctly denied any deduction for depreciation of hotel furnishings and equipment by an owner whose tenant was contractually obligated to maintain them “in first class condition, replacing the same when necessary for such purpose.”

The IRS’s attorneys cut to the chase. They reminded the court that the leasing agreement’s wording for the building itself was much less demanding. The agreement only obligated the lessee to return the building “in good condition, reasonable wear and tear excepted.”

The court zeroed in on the absence of a “wear and tear” exception for the furnishings and equipment. It concluded that the lessor and lessee intended the lessee to assume a greater obligation for such property, “so as to preclude economic loss by the lessor over the period of the lease.”

Consequently, the court agreed with the IRS that the owner can’t claim depreciation write-offs for the furnishings and equipment. It sided with the agency, as the requirement that the lessee restore items showing wear means that the owner stands to get back property that’s in like-new condition when the lease ends.

To soothe my clients, I mention that the IRS doesn’t always have the final say on how leasing agreements should be interpreted. Sometimes, lessors prevail.

They’ve been allowed to keep their depreciation write-offs when the lease agreement obligates the lessee to return the property in good condition, “ordinary wear and tear excepted,” in “at least as good condition” as at the beginning of the lease, or keep it in operating order. But not when the agreement requires the lessee to return property of equivalent value at the end of the lease.

My clients now grasp why they need to be careful when they, or advisors acting on their behalf, insert words into documents like those pesky leasing agreements.

Clients appreciate another admonition: They might also need to be attentive in their choice of words when their thoughts turn to the selection and implementation of easy-to-understand, perfectly legal strategies that enable them to sidestep pitfalls and to take maximum advantage of opportunities to delay, diminish, or deep-six payments of substantial amounts that would otherwise be siphoned off by the outfit that consistently heads the list of the government’s most unpopular agencies.

Another reminder, this one for you, Dear Readers: For lots more on tactics that trim taxes for this year and subsequent ones, read my “tax tidbits” columns. Ten to date and lots more in the pipeline, including one coming soon.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 300 and counting).

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