Tax Implications of Lease Incentives and Contract Terminations

By
8/11/2016

In the property boom and bust cycle, when the supply of property outstrips demand, the market favours tenants because there are plenty of properties around.

If the rental conditions surrounding your property are not as favourable as those provided by other landlords, you run the risk of losing your tenant to other landlords who are more willing to provide more generous lease incentives. This holds true regardless of whether your investment is a residential or commercial property.

Meanwhile, there may be a number of circumstances in which you as the landlord may wish to negotiate with your tenant to terminate the lease. For instance, you may want to move into one of your properties that is tenanted before the existing lease has expired. Similarly, your tenant may approach you to terminate the lease early because, for instance, they have to relocate for work. 

If the lease in question does not specifically provide a contractual termination clause that is acceptable to the party seeking to terminate the lease, the parties may negotiate to find a mutually acceptable way out, which will usually involve the party who wants to terminate the lease providing  financial compensation to secure the agreement of the other party. 

This articles looks at the taxation implications of lease incentives and lease termination payments from the perspective of the landlord of an investment property.

Lease incentives

There are number of ways in which a landlord may provide a lease incentive to a tenant. 

While lease incentives are arguably more common in relation to commercial properties, it is not unheard of for landlords of residential properties to offer lease incentives to their tenants, especially when competition between landlords for tenants is fierce.

Types of lease incentives may include:

• Rent-free period 

If a landlord provides a rent-free period to a tenant, the foregone rent is neither assessable as income nor tax deductible to the landlord, as there is no income derived or expense incurred by the landlord under this arrangement. 

However, despite not having received any rent during the rent-free period, the landlord may still claim rental expenses incurred on the property that are attributable to this period (eg body corporate fees, council rates, loan interest, etc), provided the rent-free period is offered for the purpose of securing future rent from the property. This is because the expenses will still be taken to have been incurred in the course of producing the landlord’s assessable income.

• Cash payment 

If the landlord provides a lease incentive payment to the tenant in the form of cash without receiving anything in return, the cash outlay will generally be tax deductible to the landlord in the income year in which it is incurred.

However, if the landlord provides the lease incentive payment to the tenant as a fit-out contribution or directly acquires fit-out for the tenant, the tax treatment of the payment will depend on whether the landlord will assume and retain ownership of the fit-out. The fit-out may be provided for in the lease or under a separate agreement between the landlord and the tenant. 

If the landlord assumes and retains ownership of the fit-out, the fit-out contribution or costs directly incurred by the landlord will need to be reasonably dissected between repairs, depreciating assets and capital works, as these different categories of costs are treated differently under the tax law.
 
Generally speaking, if the cost relates to restoring something to 
its original condition due to wear and tear caused by past and present tenancies (eg repainting certain walls) but is not related to ‘initial repairs’, eg to fix defects that were present when the landlord first acquired the property, it will be immediately tax deductible. 

If the cost relates to a free-standing functional unit as part of the fit-out, eg providing a standalone bookshelf for the tenant to use, the cost will need to be depreciated over the effective life of the unit. 

If the cost relates to capital works, such as structural improvements that are permanently affixed to the building and land or that constitute the replacement of part of the property in its entirety, eg erecting new walls to create new offices or replacing an entire roof, then the cost will need to be claimed as a capital works deduction, which is generally claimed at a rate of 2.5% per year on a straight-line basis.

Accordingly, if it is within the control of the landlord, it may generally be preferable to maximise the landlord’s tax position by contributing to fit-out work that constitutes repairs first, followed by depreciating assets, and finally capital works. 

If a landlord provides a rent-free period to a tenant, the foregone rent is neither assessable as income nor tax deductible to the landlord

If the landlord does not assume ownership of the fit-out or initially have ownership of the fit-out but immediately surrenders their ownership once the fit-out is completed, the cost of the fit-out will become tax deductible to the landlord. 

If the landlord has had ownership of the fit-out for some time, the fit-out costs will need to be dissected as discussed above and claimed by the landlord as a tax deduction upfront or progressively claimed under the depreciating assets or capital works deduction rules. 

Finally, if the landlord loses ownership of the fit-out at a subsequent point in time, the remaining written-down value of the depreciating assets may be then claimed as a tax deduction. However, the remaining capital works deductions will effectively remain in the cost base of the property and will not be tax deductible, unless the capital works are dismantled or otherwise destroyed at or before that time. 

Lease termination payments 

If a landlord wishes to get out of a lease before it expires, the first port of call is to review the lease to determine their rights and obligations associated with terminating the lease.

However, if the penalties associated with breaking the lease, financial or otherwise, are not palatable or the lease is silent on early termination, the landlord may wish to consider approaching the tenant to negotiate a mutually acceptable outcome. 

In the majority of cases where the landlord and tenant have successfully negotiated mutually acceptable lease termination terms, a lease termination payment, also known as a lease surrender payment, will invariably be involved.
If the landlord owns the property as a passive investment and is not carrying on a business, the lease termination payment they make to the tenant is generally not tax deductible. However, the amount of the payment can be added to the cost base of the property. 

If the property is sold in future, the lease termination payment will have the effect of reducing any capital gain derived, which may reduce the landlord’s CGT exposure


This means that if the property is sold in the future, the lease termination payment will have the effect of reducing any capital gain derived, which may reduce the landlord’s capital gains tax (CGT) exposure. Naturally, this treatment will only provide a tax benefit if the property is sold in the future. If the property is never sold, the payment will never give rise to a tax break. 

On the other hand, if the landlord owns the property in the course of carrying on a business (eg they have multiple properties and tenancies that are managed in a business-like manner as a property leasing business), rather than adding the lease termination payment to the cost base of the property they can write the payment off at 20% per year over five years instead, provided that the payment is for the purpose of terminating a lease and is not for the purpose of entering into a new lease with the same tenant under similar terms. 

However, the lease surrender payment may be wholly tax deductible when is it incurred if the property leasing business regularly involves entering into and surrendering leases as a normal incidence of its business and lease surrender payments are a part of the normal ebb and flow of the business.

Receiving a lease termination payment

In the opposite case, where a tenant is trying to get out of a lease and approaches the landlord to negotiate a lease termination, the payment received by the landlord will either be treated as a taxable capital gain or as assessable income in their hands, depending on whether they own the property as a passive investor or in the course of carrying on a business. 

If the landlord owns the property as a passive investment and is not carrying on a business, the lease termination payment will likely be treated as a capital gain in 
their hands. 

Provided that the landlord has held the lease for at least 12 months, the landlord that owns the property may qualify for the 50% CGT discount if they are an individual or a trust. If the landlord is a self-managed superannuation fund and it is not in pension mode, the 33.33% CGT discount will apply instead. However, if the landlord is a company, no CGT discount will be available.

If the landlord owns the property in the course of carrying on a business, the lease termination payment will simply be treated as assessable income that will be taxed in the usual manner as other income, ie no CGT discount will apply regardless of the type of the entity that is involved. 


 

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