Rent control and rent subsidization rules in many cities create situations where tenants often pay rents significantly below market rates. As a result, lease buyout payments to the lessee by the lessor are common. Since these payments can be substantial, it is important to understand the tax treatment for both the lessee and the lessor.

Rent control and similar rent subsidization situations are common in many major cities in the United States. Combined with elevated urban real property values, the guidelines can create substantial variances between the fair market rent and the rent actually paid by the tenant, also known as the lessee. Therefore, landlords, also known as lessors, may often offer these lessees significant cash incentives to vacate their apartment and cancel the lease. After cancellation of the lease, the rent controlled or subsidized rental can be newly leased at higher fair market rents. This process is known as a lease buyout.

Lessor Treatment

The lessor making the payment is required to capitalize the amount of the buyout payment -- it may not be immediately claimed as a deduction for income tax purposes. The buyout payment may then be deducted over multiple future periods through amortization. The amortization period varies dependent on the use of the space subsequent to the buyout. If the property is immediately leased under more favorable terms for the lessor, the buyout is to be amortized over the life of the subsequent lease. However, if the property is subsequently renovated before it is re-leased, the buyout would typically be considered part of the real property and must be deducted over the associated life of the real property, typically 27.5 or 39 years.

Lessee Treatment

The Internal Revenue Code and subsequent interpretive case law have established that a tenant buyout can be considered a capital gain if the underlying rental property is itself a capital asset. This is highly beneficial because long-term capital gains are taxed at special reduced income tax rates. Unfortunately, the majority of rent control and rent subsidization rules apply only to individual income taxpayers who are using their leased property for personal use. The IRS does not allow these taxpayers to claim capital gains treatment on the lease buyout payment. Instead, the amount of the payment must be recognized as ordinary income in the year received.

Tenant Improvements

It is possible for the lessee to partially, or even fully, avoid the ordinary income treatment of the lease buyout payment if all or a portion of the payment can be categorized as a reimbursement for tenant improvements. Typically, because rent control lessees are entitled to renew leases over multiple years, they may make substantial investments to improve the value of their leased property, since in their eyes, their long-term renewal rights are nearly tantamount to ownership. If the buyout payment is structured to allow for a reimbursement of these improvements, the portion of the buyout categorized as a reimbursement may not need to be recognized by the lessee as ordinary income.