Rent-free periods - important accounting and tax issues

Rent-free periods

In today's commercial real estate market, owners of office buildings and shopping centres employ various strategies to attract tenants. One such popular practice is the offering of "rent-free periods", which serve as an attractive incentive for businesses seeking office or retail space. During these periods, tenants can enjoy a temporary exemption from rent payments, often at the beginning of the lease agreement. Nevertheless, this seemingly attractive arrangement may give rise to certain subtle, yet significant, accounting and tax implications that require thorough analysis when planning and implementing lease agreements.

What are the existing legal regulations regarding rent-free periods?

Under the Polish accounting regulations, there is a lack of detailed guidelines as regards the accounting treatment of rent-free periods in commercial real estate lease agreements. However, international regulations, such as IAS 17 "Leases" and the Interpretation by the IFRS Interpretations Committee IFRIC 15 "Operating leases – special promotions", precisely specify how revenue from operating leases should be recognized. According to these standards, revenue from operating leases, including lease agreements, is recognized using the straight-line method throughout the lease term unless another method better reflects the pattern of benefits derived from the use of the leased asset. Therefore, revenue recognition in accounting occurs independently of the timing and the value of payments
received.

From a practical standpoint, when settling a promotional offer that includes a rent-free period for the tenant, it is necessary to determine an even monthly value of revenue. To achieve this, the total rent payable for the entire lease term is divided by the number of months the contract runs. The resulting amount represents the regular monthly rental income and is commonly referred to as "effective rent"

How should the value be recorded in the books?

The way in which this value is recorded in the accounting books depends on the property valuation model chosen by the landlord: i.e. whether it is a cost model or fair value method. If the cost model is applied, the difference between the revenue recognized in a specific period and its actual carrying amount should be included in other active inter-period adjustments and recorded as (non-taxable) rental income, which ensures that the revenue amount for each month reflects the previously calculated effective rent. When valuing an investment property at fair value, the company must account for the accrued assets due to unearned revenue as a separate item in its financial statements. At the end of the fiscal year, these assets should be included in the "Gain or Loss on Investment Property Revaluation" category, which means reducing gains on revaluation or increasing losses in the company's comprehensive income statement.

What are the tax considerations?

The problem discussed above can also give rise to certain tax uncertainties. From a tax perspective, all revenues should be allocated to the accounting periods to which they relate, without applying the concept of "effective rent". Any rent-free periods granted to tenants can, therefore, result in differences between the tax and accounting income.

For tax purposes it is important to identify any potential benefits derived from obtaining the right to rent-free periods. The current position of the tax authorities is generally favourable for companies. The use of rent-free periods is treated as a form of discount and does not generate additional taxable income for either the tenant or the landlord, provided that the total rental payments for the entire lease term do not significantly deviate from market standards.

BPG Polska Audyt sp. z o.o. specializes in accounting and tax advisory services for real estate companies (office buildings, warehouses, shopping centres, photovoltaic farms) owned by both Polish and international investment funds. BPG is a member of the international KRESTON Global network.