A commercial landlord signs a 10-year lease that pays $100,000 per year for the first five years and $200,000 per year for the next five. The tenant signs the same lease. Both sides plan to report rent on a cash basis — what's paid is what's recognized. Both sides are wrong.
Buried in the Internal Revenue Code is Section 467, an anti-abuse rule written in 1984 that quietly overrides the cash method whenever a tangible-property lease has stepped, prepaid, or deferred rent and total payments above $250,000. It can force accrual accounting on parties who otherwise use cash. It can recharacterize part of every rent check as imputed interest. It can recompute the rent schedule at a single level rate that has nothing to do with the dollars actually changing hands. And it can create phantom income — taxable rent the landlord never received in cash — that surprises people every leasing cycle.
If you sign, modify, or even just inherit a multi-year commercial lease, this is one of the most expensive tax provisions you can be unaware of. Here is what it does, when it triggers, and how to keep it from breaking your books.
What Section 467 Actually Does
Section 467 applies to a "Section 467 rental agreement" — an agreement for the use of tangible property (real or personal) that meets two conditions:
- Total rent and consideration exceeds $250,000 over the lease term, and
- The agreement has at least one of: prepaid rent, deferred rent, or increasing/decreasing ("stepped") rent.
When it applies, both lessor and lessee must:
- Use the accrual method to recognize rent — regardless of whether either party is otherwise on the cash basis.
- Match each other dollar-for-dollar in the same period. The landlord's income and the tenant's deduction must move together.
- Impute interest on any built-in deferral or prepayment, treating part of the arrangement as a deemed loan between the parties.
The point is to kill timing arbitrage. Without Section 467, a cash-basis tenant could deduct prepaid rent immediately while an accrual landlord delayed income, or a back-loaded rent schedule could let an accrual tenant claim straight-line deductions that did not match cash. Section 467 collapses both sides onto a present-value-aware accrual.
Stepped Rent: When the Schedule Itself Triggers the Rule
"Stepped rent" is rent that increases or decreases over time — fixed bumps, scheduled escalators, free rent periods, ramp-ups, or back-loaded payments. Almost every commercial lease has at least one of these. As long as total consideration crosses $250,000, Section 467 is in play.
There are two accrual methods that can apply:
Proportional Rental Accrual (the default)
Most non-disqualified Section 467 leases use proportional rental accrual. Each period's rent is allocated by the lease's stated schedule, but the math is adjusted so that the present value of what is accrued matches the present value of what is paid. Imputed interest fills the gap.
The discount rate is 110% of the applicable federal rate (AFR), compounded semiannually, fixed at lease execution, using the AFR matching the lease's maturity (short-, mid-, or long-term).
Constant Rental Accrual (the "punishment" method)
Constant rental accrual is mandatory if the lease is a disqualified leaseback or long-term agreement. Instead of following any allocation schedule, it computes a single, level constant rent that — if paid at the end of every period — would have the same present value as the actual lease payments.
For the 10-year, $100K-then-$200K example above, constant rental accrual would force both parties to recognize roughly $140K–$150K per year (depending on the AFR) regardless of what actually changes hands. The early-year landlord books phantom income the cash never delivered. The early-year tenant gets a deduction larger than its check.
A lease is a disqualified leaseback or long-term agreement if both:
- It is part of a sale-leaseback (the lessee, or a related person, had more than a de minimis interest in the property within the two years before the lease), or the term exceeds 75% of the property's statutory recovery period, AND
- A principal purpose for the increasing rents is tax avoidance.
Safe harbors exist for rents tied to a published price index, CPI, or a fixed percentage of lessee receipts. Ordinary commercial escalators driven by inflation or market terms generally do not flip a lease into disqualified status. The tax-avoidance intent is the lynchpin.
Prepaid and Deferred Rent: The Section 467 Loan
This is where most surprises happen. If the lease front-loads or back-loads rent relative to what is allocated as rent for tax purposes, Section 467 deems a loan to exist between landlord and tenant. Interest accrues on that loan at 110% of the AFR, compounded semiannually.
Prepaid rent case. Tenant pays year 1 = $300,000, but the lease allocates only $100,000 of rent to year 1. The "extra" $200,000 is a deemed loan from tenant to landlord. The landlord owes the tenant imputed interest on the prepayment over the loan's life. Both sides recognize interest income/expense separately from rent.
Deferred rent case. Tenant pays only $20,000 in year 1 but the lease allocates $100,000 of rent to that period. The unpaid $80,000 is a deemed loan from landlord to tenant. The tenant owes the landlord imputed interest until the cash catches up.
In other words: whenever rent paid differs materially from rent allocated, the IRS adds a synthetic interest layer on top of the lease. You cannot escape it by leaving interest off the contract.
Sale-Leasebacks Get Extra Scrutiny
Sale-leasebacks are the original target of Section 467. In a classic structure, an operating company sells real estate to an investor and signs a long-term lease back. If the rent is back-loaded and the term is long, the seller-now-tenant gets large early-year deductions and the buyer-now-landlord defers income — exactly the timing mismatch Section 467 exists to stop.
Two warning lights:
- Lessee had prior interest in the property within the two-year lookback → leaseback test triggered.
- Lease term > 75% of statutory recovery period → long-term test triggered.
Hit either of those and a principal purpose of the rent slope is tax avoidance, and constant rental accrual is mandatory. The IRS does not require you to admit tax avoidance — it can be inferred from the structure, the parties' relative tax positions, and the absence of business reasons for the slope.
Lease Modifications: The Quiet COVID-Era Trap That Never Went Away
The biggest practical risk today is not the original lease but the modification. When pandemic-era rent holidays, deferrals, and renegotiations swept commercial real estate, every substantially modified lease became a candidate for a Section 467 redo.
The mechanics:
- A substantial modification is treated as a new lease executed on the modification date.
- The new lease is re-tested under Section 467 — including the $250,000 threshold and any stepped/prepaid/deferred features.
- If it qualifies, the new lease must apply Section 467 prospectively, with a new AFR fixed at the modification date.
The "substantial modification" bar is low. A rent change is not substantial only if the cumulative change in fixed rent for the period is 1% or less of the previously allocated rent. Above that, treat the change as a new lease.
A safe harbor disregards rent holidays of three months or less, so a one-quarter break does not by itself trip Section 467. Larger deferrals, restructured payment schedules, or term extensions in exchange for relief almost always do.
The most common modification mistake is amending the payment schedule without amending the rent allocation schedule, or vice versa. When the two diverge, every period's gap becomes deemed loan principal, and both sides recognize imputed interest on it for years.
Book vs. Tax: Why ASC 842 Will Not Save You
Under ASC 842, lessors and lessees generally recognize lease income and expense on a straight-line basis over the lease term, regardless of when rent is paid. That book treatment is consistent and clean.
Section 467 follows a different rulebook. For non-disqualified leases on proportional rental accrual, tax rent generally follows the allocation schedule in the lease (with present-value adjustments and imputed interest). For disqualified leases, tax rent follows the constant rental amount.
The result: book straight-line and tax accrual will diverge on almost every meaningful commercial lease. That divergence shows up as a Schedule M-1 (or M-3) book-tax difference on Forms 1120, 1120-S, and 1065, sitting alongside familiar items like depreciation and meals. The deferred-rent or right-of-use balance on the books is not the same as the Section 467 loan on the tax side — and pretending they are will eventually produce a wrong return.
A common workflow:
- Compute book rent for the period under ASC 842 (straight-line).
- Compute tax rent for the period under Section 467 (allocation or constant rental).
- Compute Section 467 imputed interest separately.
- Track the book-tax difference and the Section 467 loan balance in your general ledger so they roll forward year over year without drift.
A Worked Example
Ten-year lease of office space, no prior owner-tenant relationship, total payments $1.5M, no tax-avoidance intent. Rent schedule:
- Years 1–5: $100,000 per year, paid in arrears
- Years 6–10: $200,000 per year, paid in arrears
This is a Section 467 rental agreement (over $250K total, stepped rent). It is not a disqualified leaseback or long-term agreement (no prior interest, no tax-avoidance purpose, and only modest divergence from market). Proportional rental accrual applies.
Because rent is allocated as paid (the schedule itself is the allocation), and payments equal allocations in every period, there is no Section 467 loan and no imputed interest. Both parties simply accrue $100K in years 1–5 and $200K in years 6–10 — even if both are cash-basis taxpayers.
Now change one thing: tenant prepays $500,000 at signing as an inducement, applied against years 6–10 rent. The lease still allocates rent the same way. The $500,000 is prepaid rent under Section 467. A Section 467 loan from tenant to landlord arises, and over the lease term the landlord recognizes imputed interest expense to the tenant on the unpaid balance, computed at 110% of the long-term AFR.
Now flip it again: same lease, but the parties are related (sale-leaseback) and term is 80% of statutory recovery period. Add any whiff of tax-avoidance intent on the back-loading, and the lease becomes a disqualified long-term agreement. Constant rental accrual applies. Both parties report roughly $150,000 of rent per year — including in year 1, when only $100,000 changes hands. The $50,000 gap becomes Section 467 loan principal.
Same dollars in the lease. Three very different tax outcomes.
Where Bookkeeping Earns Its Keep
Section 467 is one of those provisions where the rule is in the tax code but the damage is done in the general ledger. By the time a CPA looks at your books in March, the lease has been running for months. If your accounting system does not separately track:
- Book straight-line rent (ASC 842)
- Tax rent under Section 467 (allocation or constant rental)
- Section 467 loan principal and imputed interest
- The Schedule M-1 (or M-3) reconciliation between book and tax rent
…then someone will be backfilling spreadsheets to prepare your return — and almost certainly carrying a balance forward incorrectly into the next year. Plain-text, version-controlled accounting makes these parallel ledgers easier to maintain, because each rent period gets its own discrete journal entry, the imputed-interest schedule is just a calculation, and you can diff your tax basis against your book basis at any cutoff.
Practical Checklist for Any Lease Over $250,000
- Read the rent schedule, not just the headline. Identify every step, escalator, free-rent period, prepayment, and deferral. Each one is a Section 467 trigger.
- Check total payments over the term. Under $250K and you can skip Section 467 entirely. Over $250K, run the full analysis.
- Test for disqualified status. Was there a prior interest in the property? Is the term over 75% of statutory recovery? Is the rent slope hard to justify on business grounds? If yes, expect constant rental accrual.
- Decide if the lease "allocates" rent. If the allocation schedule in the lease matches the payment schedule, your Section 467 work is much simpler.
- Compute the Section 467 loan. Any gap between rent paid and rent allocated to date is the loan principal. Accrue 110% of AFR interest on it, semiannually compounded.
- Reconcile book to tax. Document the difference between ASC 842 straight-line book rent and Section 467 tax rent. This is your M-1 entry — and it will repeat every year.
- Re-test on every modification. Anything more than 1% movement in allocated rent, or anything more than a three-month rent holiday, triggers a new-lease analysis as of the modification date.
Keep Your Lease Accounting Audit-Ready
Section 467 is the kind of rule that does not announce itself — it just shows up on examination, with interest. Clean, transparent records of every rent payment, every allocation period, and every modification turn a potential restatement into a routine reconciliation. Beancount.io provides plain-text, version-controlled accounting that makes parallel book-and-tax ledgers, imputed-interest schedules, and lease modifications easy to trace and audit — no black boxes, no vendor lock-in. Get started for free and see why developers, controllers, and tax professionals are switching to plain-text accounting for the leases that quietly run their business.