Lease Buy-Out: Tax Free or Taxable?

Posted by Lee Reams II on

An interesting situation arises when a landlord makes an offer to a tenant to buy out the tenant’s lease. This recently occurred when an apartment building was changing hands and the new landlord wanted all the current tenants out. The new landlord is offering the tenants $35,000 to move out plus giving them three months free rent and also telling them this is all tax free. 

So, is either the $35,000 or the three months of free rent taxable income to the tenants? We need to first look at Code Section 61, which provides that a taxpayer’s gross income includes all income from whatever source derived, except as otherwise provided by law. A taxpayer’s Section 61 gross income is not limited to the actual receipt of gain, but also includes the receipt of any economic benefit unless excluded by law. See Glenshaw Glass Co. v. Commissioner, 348 U.S. 426 (1955). 

Stotis v. Commissioner, T.C. Memo. 1996-431, involves the case of a residential leasehold. Mr. Stotis, the petitioner, leased space in an apartment building that he used as a residence. The landlord, desiring to use the real estate for other purposes, entered into a surrender agreement with the petitioner whereby the petitioner exchanged his right in the property for a cash payment. The Tax Court held that the petitioner’s leasehold interest in a residence was a capital asset, and that the petitioner’s sale of the leasehold interest constituted a sale or exchange, taxable as capital gain.

Further, a taxpayer’s interest in a leasehold is either a capital asset under Section 1221 or real property used in a trade or business under Section 1231. Either way the sale of a leasehold interest is treated as a long-term capital gain if held over one year.

Thus, in such situations as this, it appears the FMV of the free rent and the cash payment, per Sec 61, constitute gross taxable income to the taxpayer.  However, it also appears the character of the income is a capital gain.  

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