Trouble in Lease Land

The lender will probably have the right to consent to “material changes,” which include any lease modification that: 1) reduces the rent stream; 2) downsizes the tenant's premises; or 3) gives the tenant the right to terminate the lease. The landlord will have to convince the lender that it is in the best interest of the project to retain the tenant with these modifications.

The lender may be willing to agree to changes that do not require giving the landlord additional funds, but may not be willing to increase allowance payments or provide funds for the landlord to perform the tenant's build out.

Tax Considerations

Many of the foregoing techniques can have significant tax consequences to both the landlord and the tenant. Landlords and tenants should consult with their tax advisors early in the workout process. Federal income tax issues that should be analyzed include, but are not limited to the following.

Income vs. Reimbursement

Each party will need to determine whether a particular payment between a landlord and tenant (e.g., construction allowances and termination fees) is income to the recipient that must be recognized in the year of receipt, or whether such payment can be deferred or characterized as a reimbursement.

Deductible vs. Capitalized

Each party will also need to determine whether a particular payment between a landlord and tenant is deductible by the payor or whether such payment is required to be capitalized and depreciated or amortized (and the applicable depreciation or amortization period).

Participating Rents

The parties also need to consider whether certain “participating rents”(for example, percentage rent or relief based on gross sales) will: 1) create “unrelated business taxable income” for direct or indirect tax exempt investors; or 2) generate non-qualifying income for a real estate investment trust.

Section 467

Another concern is whether the prepayment or deferral of rents, or rents that fluctuate from year to year, will cause a lease to be subject to Section 467 of the Internal Revenue Code. Code Section 467 imposes on landlords and tenants a formula for determining the income and deductions that must be accrued in connection with a lease, which income and deductions may not match the actual cash payments contemplated by the terms of the lease.

Local Tax Issues

The income tax rules in most states will generally follow federal principles. One purely local issue will be the possibility of transfer taxes or reassessments of property taxes in connection with an extension, termination or an assignment of the lease.

Litigation Concerns

A primary goal of negotiating a lease workout is to resolve the parties' disputes amicably and avoid litigation. However, much of these negotiations will take place in the context of one or more defaults under the lease by either the landlord or the tenant. It is a good idea for each party to understand the rights and remedies available under law arising from such defaults, to gauge the necessity and benefits of any proposed compromise. Having a litigator review the lease early on, to assess the available remedies and the likelihood of recovery, may be very cost effective.

Conclusion

When financial problems affect the ability of a retail landlord or tenant to perform its lease obligations, both parties can be mutually benefited by working out a solution that keeps the tenant operating and paying rent. By understanding the lease workout methods available and their corresponding consequences, retail landlords and tenants can tailor their agreements to alleviate the financial strain on the tenant and maximize the occupancy of the center.

M. Rosie Rees is a partner in the Chicago office of Pircher, Nichols & Meeks, a national full-service law firm that specializes in real estate and related industries. Associates Michael Soejoto and Marisa Doherty assisted in the preparation of this article.

Parts One and Two of this article discussed a variety of methods to keep the tenant operating. The conclusion herein addresses lender issues and tax considerations.

Lender Issues

Once the landlord has decided to modify a lease for a troubled tenant or a troubled center, it must first check its loan documents. The landlord may find that certain concessions it wants to give are not permitted under the loan documents without the lender's consent. The parties might then tailor the lease modifications either to avoid the need for consent or make consent easier to obtain.

The lender will probably have the right to consent to “material changes,” which include any lease modification that: 1) reduces the rent stream; 2) downsizes the tenant's premises; or 3) gives the tenant the right to terminate the lease. The landlord will have to convince the lender that it is in the best interest of the project to retain the tenant with these modifications.

The lender may be willing to agree to changes that do not require giving the landlord additional funds, but may not be willing to increase allowance payments or provide funds for the landlord to perform the tenant's build out.

Tax Considerations

Many of the foregoing techniques can have significant tax consequences to both the landlord and the tenant. Landlords and tenants should consult with their tax advisors early in the workout process. Federal income tax issues that should be analyzed include, but are not limited to the following.

Income vs. Reimbursement

Each party will need to determine whether a particular payment between a landlord and tenant (e.g., construction allowances and termination fees) is income to the recipient that must be recognized in the year of receipt, or whether such payment can be deferred or characterized as a reimbursement.

Deductible vs. Capitalized

Each party will also need to determine whether a particular payment between a landlord and tenant is deductible by the payor or whether such payment is required to be capitalized and depreciated or amortized (and the applicable depreciation or amortization period).

Participating Rents

The parties also need to consider whether certain “participating rents”(for example, percentage rent or relief based on gross sales) will: 1) create “unrelated business taxable income” for direct or indirect tax exempt investors; or 2) generate non-qualifying income for a real estate investment trust.

Section 467

Another concern is whether the prepayment or deferral of rents, or rents that fluctuate from year to year, will cause a lease to be subject to Section 467 of the Internal Revenue Code. Code Section 467 imposes on landlords and tenants a formula for determining the income and deductions that must be accrued in connection with a lease, which income and deductions may not match the actual cash payments contemplated by the terms of the lease.

Local Tax Issues

The income tax rules in most states will generally follow federal principles. One purely local issue will be the possibility of transfer taxes or reassessments of property taxes in connection with an extension, termination or an assignment of the lease.

Litigation Concerns

A primary goal of negotiating a lease workout is to resolve the parties' disputes amicably and avoid litigation. However, much of these negotiations will take place in the context of one or more defaults under the lease by either the landlord or the tenant. It is a good idea for each party to understand the rights and remedies available under law arising from such defaults, to gauge the necessity and benefits of any proposed compromise. Having a litigator review the lease early on, to assess the available remedies and the likelihood of recovery, may be very cost effective.

Conclusion

When financial problems affect the ability of a retail landlord or tenant to perform its lease obligations, both parties can be mutually benefited by working out a solution that keeps the tenant operating and paying rent. By understanding the lease workout methods available and their corresponding consequences, retail landlords and tenants can tailor their agreements to alleviate the financial strain on the tenant and maximize the occupancy of the center.

M. Rosie Rees is a partner in the Chicago office of Pircher, Nichols & Meeks, a national full-service law firm that specializes in real estate and related industries. Associates Michael Soejoto and Marisa Doherty assisted in the preparation of this article.