The deadline has passed to elect Section 475 MTM for tax year 2020, but it’s still possible to do so for 2021. In this article, we’ll cover the basics about when and how to make the election.

Section 475 Basics

Eligible traders have the option to make a Section 475 election, which allows mark-to-market (MTM) accounting and treatment of trading gains and losses on commodities and securities as ordinary income. Without the election, traders use the cash method of accounting and are taxed on capital gains and losses when they are realized, with losses subject to the $3,000 limitation.

MTM accounting allows traders to offset losses against every type of income, including wages; in years where they have heavy losses, they are not subject to the loss limitations. MTM accounting also works the other way, so if you have large unrealized gains in your positions, then you’ll have to recognize those even though you haven’t liquidated those positions. Another benefit is that it exempts securities trades from wash sale loss adjustments. 

Making the election is generally a good idea at the outset of operations or for existing taxpayers who have new losses from trading year-to-date up to the election deadline, giving ordinary loss treatment to these transactions. You can revoke the election in future years subject to certain rules.

Making the Election

Existing individual taxpayers need to file a Section 475 election statement with their return or extension by April 15, 2021. Then a Form 3115 needs to be filed with the 2021 tax return.

Conclusion

The Section 475 election can be a great benefit for active traders; however, the rules are complex so it’s best to consult with your CPA if are considering the election.

The Tax Reform Act of 1984 enacted a provision that commercial leases need to be tested under Internal Revenue Code section 467. The intent of section 467 is to prevent tax sheltering of income that could arise due to differences between cash and accrual basis income taxpayers by placing both the lessor and lessee on the same revenue and expense recognition terms, thereby eliminating the timing difference between the two accounting methods.

COVID and the Avalanche of Lease Modifications

Section 467 is re-emerging as a hot topic due to the economic fallout of COVID-19. The economic downturn is significantly impacting commercial real estate; especially in the office, retail and industrial sectors as lessors struggle to maintain and attract tenants. Commercial tenants are seeking rent relief and negotiating concessions in an effort to either survive or take advantage of the market conditions. In either case, when these negotiations result in a significant modification of the lease terms, it requires that a new section 467 analysis be performed.

How Section 467 Works

If the changes to the lease arrangement are large enough, section 467 requires the lessee and lessor to use the accrual method, regardless of their regular accounting method. Moreover, if the lease contains significant prepaid rent or deferred rent, the lease could be deemed to constitute a loan agreement forcing the recognition of interest income and expenses. 

A contract for the use of tangible property, with increasing or decreasing rents, or deferred or prepaid rents, and total rents exceeding $250,000 is a section 467 rental agreement. The results of a lease modification can vary widely, so let’s dig into an example to see how it works in practice. 

Example 1: Lease with Rent Allocations and Payments

Assume we have a five-year lease with rental allocations and payments as follows:

•          Year 1: Zero rent payment and no rent allocation
•          Year 2: $150,000 rent allocation, but no rent payments
•          Year 3: $150,000 rent allocation and $300,000 in payments
•          Year 4: $150,000 rent allocation and $300,000 in payments
•          Year 5: $150,000 rent allocation, but no rent payments

Since there is no rent due for year one, the fact that there is no rental payment in year two is not considered deferred rent. Similarly, the rent allocation through the end of year two of $150,000 is less than the rent paid by the end of year three, so there is no deferred rent at this point. Moving into year three, the first payment of $300,000 is not considered pre-paid rent because it is less than the total rental payment allocations through the following year four of $450,000.

On the surface, this lease arrangement appears to skirt the section 467 test; however, that is not the case. Any lease that “specifically allocates” fixed rent can cause a disconnect between the timing of the allocation and actual cash payments, causing section 467 issues. The escalating rent schedule causes this lease to qualify, forcing both the lessor and lessee to use the accrual basis of accounting for the lease, regardless of their respective accounting methods generally applied.

Example 2: Lease with Deferred Rent

As we look at our next example, keep in mind that “deferred rent” under section 467 exists where the cumulative rent allocated at the end of a year is more than the total rent payable at the end of the next year. 

Let’s assume a tenant holds an eight-year lease with rental costs of $50,000 per month. Due to COVID-19, they secure a lease modification for a deferral of 24 months’ rent, payable at the end of the lease. In total, $1.2 million in rent has been deferred (24 x $50k) under section 467.

Assume that the landlord recognizes $500,000 in gross rental income under the accrual method. Since the tenant doesn’t need to pay the rent for the first year of deferral, a deemed loan of $600,000 to the tenant is created. The tenant receives a rent expense deduction for $500k (same as the landlord’s take), with the $100,000 in payment deferred treated as imputed interest and recognized over the life of the loan.

Conclusion

The rules around section 467 can be complex, but the important thing to keep in mind is that with the economic impact of COVID-19 causing renegotiations and commercial lease modifications, any substantial changes need to be assessed to see if the new lease terms require any different accounting treatment as a result of section 467.