tax on lease assignment

Assignment of Lease: How It Works and Parties Involved

Jump to section, what is an assignment of lease.

The assignment of lease is a title document that transfers all rights possessed by a lessee or tenant to a property to another party. The assignee takes the assignor’s place in the landlord-tenant relationship.

You can view an example of a lease assignment here .

How Lease Assignment Works

In cases where a tenant wants to or needs to get out of their lease before it expires, lease assignment provides a legal option to assign or transfer rights of the lease to someone else. For instance, if in a commercial lease a business leases a place for 12 months but the business moves or shuts down after 10 months, the person can transfer the lease to someone else through an assignment of the lease. In this case, they will not have to pay rent for the last two months as the new assigned tenant will be responsible for that.

However, before the original tenant can be released of any responsibilities associated with the lease, other requirements need to be satisfied. The landlord needs to consent to the lease transfer through a “License to Assign” document. It is crucial to complete this document before moving on to the assignment of lease as the landlord may refuse to approve the assignment.

Difference Between Assignment of Lease and Subletting

A transfer of the remaining interest in a lease, also known as assignment, is possible when implied rights to assign exist. Some leases do not allow assignment or sharing of possessions or property under a lease. An assignment ensures the complete transfer of the rights to the property from one tenant to another.

The assignor is no longer responsible for rent or utilities and other costs that they might have had under the lease. Here, the assignee becomes the tenant and takes over all responsibilities such as rent. However, unless the assignee is released of all liabilities by the landlord, they remain responsible if the new tenant defaults.

A sublease is a new lease agreement between the tenant (or the sublessor) and a third-party (or the sublessee) for a portion of the lease. The original lease agreement between the landlord and the sublessor (or original tenant) still remains in place. The original tenant still remains responsible for all duties set under the lease.

Here are some key differences between subletting and assigning a lease:

• Under a sublease, the original lease agreement still remains in place.
• The original tenant retains all responsibilities under a sublease agreement.
• A sublease can be for less than all of the property, such as for a room, general area, portion of the leased premises, etc.
• Subleasing can be for a portion of the lease term. For instance, a tenant can sublease the property for a month and then retain it after the third-party completes their month-long sublet.
• Since the sublease agreement is between the tenant and the third-party, rent is often negotiable, based on the term of the sublease and other circumstances.
• The third-party in a sublease agreement does not have a direct relationship with the landlord.
• The subtenant will need to seek consent of both the tenant and the landlord to make any repairs or changes to the property during their sublease.

Here is more on an assignment of lease here .

Parties Involved in Lease Assignment

There are three parties involved in a lease assignment – the landlord or owner of the property, the assignor and the assignee. The original lease agreement is between the landlord and the tenant, or the assignor. The lease agreement outlines the duties and responsibilities of both parties when it comes to renting the property. Now, when the tenant decides to assign the lease to a third-party, the third-party is known as the assignee. The assignee takes on the responsibilities laid under the original lease agreement between the assignor and the landlord. The landlord must consent to the assignment of the lease prior to the assignment.

For example, Jake is renting a commercial property for his business from Paul for two years beginning January 2013 up until January 2015. In January 2014, Jake suffers a financial crisis and has to close down his business to move to a different city. Jake doesn’t want to continue paying rent on the property as he will not be using it for a year left of the lease. Jake’s friend, John would soon be turning his digital business into a brick-and-mortar store. John has been looking for a space to kick start his venture. Jake can assign his space for the rest of the lease term to John through an assignment of lease. Jake will need to seek the approval of his landlord and then begin the assignment process. Here, Jake will be the assignor who transfers all his lease related duties and responsibilities to John, who will be the assignee.

You can read more on lease agreements here .

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Assignment of Lease From Seller to Buyer

In case of a residential property, a landlord can assign his leases to the new buyer of the building. The landlord will assign the right to collect rent to the buyer. This will allow the buyer to collect any and all rent from existing tenants in that property. This assignment can also include the assignment of security deposits, if the parties agree to it. This type of assignment provides protection to the buyer so they can collect rent on the property.

The assignment of a lease from the seller to a buyer also requires that all tenants are made aware of the sale of the property. The buyer-seller should give proper notice to the tenants along with a notice of assignment of lease signed by both the buyer and the seller. Tenants should also be informed about the contact information of the new landlord and the payment methods to be used to pay rent to the new landlord.

You can read more on buyer-seller lease assignments here .

Get Help with an Assignment of Lease

Do you have any questions about a lease assignment and want to speak to an expert? Post a project today on ContractsCounsel and receive bids from real estate lawyers who specialize in lease assignment.

ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.

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I grew up in Beaumont, Texas. I attended Baylor University for college and the The University of Texas School of Law for law school. I gained extensive experience in many areas of transactional law through my former position as corporate counsel at National Western Life Insurance Company and my current position as an Associate at Nance & Simpson, LLP.

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Assignment of Lease

Contract to lease land from a church?

I’m planning on leasing land from a church. Putting a gym on the property. And leasing it back to the school.

Ok; first step is that you will need a leasing contract with the church. Ask them to prepare one for you so you would just need an attorney to review the agreement and that should cost less than if you had to be the party to pay a lawyer to draft it from scratch. You need to ensure that the purpose of the lease is clearly stated - that you plan to put a gym on the land so that there are no issues if the church leadership changes. Step 2 - you will need a lease agreement with the school that your leasing it do (hopefully one that is similar to the original one your received from the church). Again, please ensure that all the terms that you discuss and agree to are in the document; including length of time, price and how to resolve disputes if you have one. I hope this is helpful. If you would like me to assist you further, you can contact me on Contracts Counsel and we can discuss a fee for my services. Regards, Donya Ramsay (Gordon)

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What Are the Tax Implications of the New Lease Accounting Rules?

Private businesses implemented new lease accounting rules in 2022, resulting in a major shift in how leases are reported for “book” purposes. While the tax rules for leases haven’t changed, the new accounting rules can have notable implications for how the tax rules play out.

New Accounting Rules

The Financial Accounting Standards Board (FASB) issues standards for organizations that apply U.S. Generally Accepted Accounting Principles (GAAP). In 2016, the FASB released the new lease accounting rules, but their implementation was delayed. Accounting Standards Update (ASU) No. 2016-02,  Leases (Topic 842) , finally went into effect for private companies in 2022.

Under the previous rules, leases were classified as either capital or operating. Lessees reported capital (or finance) leases on their balance sheets as assets and liabilities. Operating leases were recognized on financial statements as rent expense and disclosed in the footnotes.

ASU 2016-02 called for a major shift in how operating leases are reported under GAAP. It requires lessees to recognize right-of-use assets and corresponding lease liabilities for all leases with terms of more than 12 months. The new rules also require additional disclosures about leases. For many organizations, implementing the changes required significant time and effort to review leases and compile the necessary information for the expanded disclosure requirements.

Potential Tax Effects

The new accounting rules don’t affect how leases are treated for federal income tax purposes. Tax law will continue to treat a lease as either:

• A true tax lease.  These arrangements are what would have been considered an operating lease under earlier GAAP. A true tax lease is one where the lessor maintains ownership of the asset and benefits from the associated deductions (for example, for depreciation), and the lessee claims the rent expense for its payments.
• A nontax lease. These were previously called capital leases under GAAP. With a nontax lease, the lessee assumes the risks and rewards of ownership, including tax deductions, and the lessor recognizes interest income.

ASU 2016-02 nonetheless can affect a lessee’s taxes in several ways, including:

Deferred taxes.  With all leases included as assets and liabilities, lessees may have more book-to-tax reconciliation items — or new deferred tax liabilities (DTLs) and deferred tax assets (DTAs).

Under the accounting rules, a lessee doesn’t have any tax basis in the right-to-use asset and lease liability. The excess book basis over tax basis in the right-of-use asset will be a DTL, and the excess book basis over tax basis in the lease liability will be a DTA. The deferred tax balances for nontax leases will be smaller than for true tax leases, as both book and tax will have some basis.

These initial differences are temporary, though, and will reverse over the lease term. The effect of the reversal depends on whether the lease is capital or operating for book purposes.

A capital lease generally will accelerate expense recognition on financial statements because lease liability is based on an effective interest rate calculation. An operating lease, on the other hand, typically will produce a more consistent annual cost because the asset is amortized at a rate intended to allocate the lease cost over the term on a more straight-line basis.

State and local taxes.  The new accounting rules mean that businesses with substantial operating leases are seeing significant increases in their reported assets. This could lead to higher tax liability in states with franchise or other taxes based on net worth. In addition, sales and use taxes might be triggered if a state deems leasing to constitute a purchase transaction.

For businesses with tax nexus in multiple states, the rules also could affect apportionment — or the assignment of a portion of the business’s tax base to a state for taxation there — for both franchise and income taxes. Apportionment formulas vary by state, but they often include a factor for “property.” With leases included on the balance sheet, a business will appear to have more property assets than it actually owns, which could result in a higher taxable portion in those states.

The rules could have property tax implications, too. Some tax authorities may treat right-of-use assets as tangible personal property. Leases could be subject to additional property tax in those jurisdictions.

Foreign taxes.  Depending on how other countries calculate their income taxes, the balance sheet changes could increase a business’s overseas taxation.

Transfer pricing.  The federal tax code requires that transfer pricing on intercompany transactions reflect the pricing that would be involved in an arm’s-length transaction for the same goods, services or intangibles. The inclusion of operating leases as assets on the balance sheet could affect the financial ratios and profit level indicators (for example, return on operating assets) that typically are part of the arm’s-length analysis. In other words, a transfer price that satisfied the arm’s-length standard in the past might not under the new lease accounting rules.

Systematic Approach

The new lease accounting rules under GAAP create book-tax differences that businesses must be prepared to address. The addition of operating leases to balance sheets also might have repercussions for overall tax liability and compliance with transfer pricing requirements. Contact your financial advisors to help establish and maintain the necessary tracking processes and systems to account for these effects.

Legal Aspects of Lease Assignments

A well-structured lease assignment agreement is vital to facilitating a seamless transfer of rights and obligations from the original lessee to the assignee. The agreement must address critical legal aspects, including liability allocation, landlord consent, and dispute resolution mechanisms. Key considerations include the assignor's retained liabilities, the assignee's assumed duties, and the process for obtaining landlord consent. Clearly defining liability and indemnification provisions is also imperative. By understanding the legal intricacies of lease assignments, parties can navigate the process with confidence and mitigate potential risks. As the complexity of lease assignments unfolds, it becomes clear that meticulous planning is necessary to protecting all involved parties.

Table of Contents

Understanding Lease Assignment Agreements

A lease assignment agreement is a contractual document that formalizes the transfer of rights and obligations from the original lessee to the assignee, outlining the terms and conditions of the assignment. This document is vital in facilitating a seamless transfer of interests, avoiding potential disputes, and providing clarity on the responsibilities of all parties involved. A well-structured lease assignment agreement should address key aspects, including the effective date of assignment, rent and payment obligations, and any ongoing liabilities. It is also vital to distinguish between a lease assignment and a lease novation, as the latter involves the replacement of the original lease agreement with a new one, whereas assignment involves the transfer of existing rights and obligations. Additionally, the tax implications of a lease assignment, including assignment taxation, must be carefully considered to guarantee compliance with relevant laws and regulations. By understanding the intricacies of lease assignment agreements, parties can navigate the complexities of lease transfers with confidence, minimizing potential risks and disputes.

Assignor and Assignee Rights Obligations

In the context of lease assignments, the assignor and assignee have distinct rights and obligations that govern their respective roles. The assignor, having transferred their interest in the lease, retains certain liabilities, while the assignee assumes specific duties and responsibilities. Understanding these reciprocal obligations is crucial in navigating the complexities of lease assignments.

Assignor's Rights and Liabilities

Upon assigning a lease, the assignor's rights and liabilities are substantially altered, as they are released from primary liability, yet remain secondarily liable for the assignee's performance. This shift in liability has significant implications for the assignor, particularly with regards to tax implications. The assignor may be liable for any outstanding tax obligations incurred prior to the assignment, and may also be subject to tax implications arising from the assignment itself. In addition, the assignor's insurance coverage may also be affected, as the policy may not automatically transfer to the assignee. It is crucial that the assignor reviews their insurance coverage to guarantee that they are adequately protected in the event of any claims or damages arising from the assignee's performance. The assignor's ongoing liability for the assignee's performance highlights the importance of due diligence in selecting a suitable assignee and verifying that the assignment is properly documented. By understanding the assignor's rights and liabilities, parties can better navigate the complex legal landscape of lease assignments.

Assignee's Duties and Obligations

The assignee, as the new lessee, assumes primary liability for performing the lease obligations, including payment of rent, taxes, and insurance premiums, and is responsible for complying with the lease terms and conditions. This includes adhering to the original lease agreement, as well as any subsequent modifications or amendments. The assignee is also bound by the fiduciary standards of a lessee, which entails exercising due care and diligence in fulfilling their obligations under the lease.

As a successor in interest, the assignee may be held liable for any breaches or defaults by the assignor, a concept known as successor liability. This means that the assignee may be responsible for resolving any outstanding issues or disputes that arose during the assignor's tenure. To mitigate this risk, the assignee should conduct thorough due diligence on the lease and the assignor's performance before assuming the lease obligations. By understanding their duties and obligations, assignees can navigate the complexities of lease assignments and minimize potential liabilities.

Landlord Consent and Approval Process

Landlord consent is a critical component of the lease assignment process, as it guarantees that the landlord's interests are protected and that the assignment does not violate the terms of the original lease agreement. This consent process ensures that the landlord is aware of the assignment and has approved the transfer of obligations from the assignor to the assignee.

To facilitate a smooth consent process, the following steps should be taken:

• Review the lease agreement : Identify any clauses that may impact the assignment, such as waiver clauses or silent partners.
• Notify the landlord : Provide the landlord with written notice of the assignment, specifying the terms and conditions of the transfer.
• Obtain consent : Secure the landlord's written consent to the assignment, which may be conditional upon certain requirements.
• Document the process : Maintain a record of all correspondence and agreements related to the consent process.

Lease Term and Condition Amendments

During the lease assignment process, amendments to the original lease terms and conditions may be necessary to reflect the changed circumstances. This is particularly important when the assignee requires modifications to the lease to suit their operational needs. In such cases, the lease agreement should include alteration clauses that permit alterations to the lease terms. These clauses facilitate the parties to agree on changes to the lease, guaranteeing that the modified terms are legally binding.

Term extensions are a common amendment, allowing the assignee to occupy the premises for a longer period. This may be necessary if the assignee requires additional time to fulfill their business objectives. The lease amendment should clearly outline the extended term, including the revised expiration date and any corresponding changes to the rent or other lease obligations. It is vital to obtain the consent of all parties involved in the lease assignment to the amendments, and that the modified lease terms are properly documented to avoid potential disputes. By including alteration clauses and accommodating term extensions, parties can facilitate a smooth handover and a mutually beneficial agreement.

Liability and Indemnification Provisions

Amendments to the lease terms and conditions, such as term extensions, may also raise questions about the allocation of liability between the assignor, assignee, and landlord, highlighting the need for clear liability and indemnification provisions in the assignment agreement.

In considering liability and indemnification provisions, the following key considerations should be taken into account:

• Insurance Coverage : Securing adequate insurance coverage to mitigate potential risks and liabilities.
• Risk Allocation : Clearly defining the allocation of risks and liabilities between the assignor, assignee, and landlord.
• Financial Backing : Obtaining sufficient financial backing to secure the performance of contractual obligations.
• Contractual Protections : Including contractual protections, such as indemnity clauses, to safeguard against potential losses or damages.

Dispute Resolution and Litigation

In the context of lease assignments, disputes and litigation can arise from various sources, including disagreements over liability, indemnification, and contractual obligations. Effective dispute resolution mechanisms, such as mediation and arbitration, can provide an alternative to litigation, offering a more efficient and cost-effective means of resolving disputes. In situations where litigation is unavoidable, developing a well-planned litigation strategy is essential to achieving a favorable outcome.

Mediation and Arbitration

Disputes arising from lease assignments can be effectively resolved through alternative dispute resolution mechanisms, including mediation and arbitration, which offer a more efficient and cost-effective approach to litigation. Mediation, in particular, is a valuable tool for conflict avoidance, allowing parties to engage in open communication and negotiate a mutually beneficial agreement. Neutral evaluation, a process in which a neutral third-party specialist assesses the strengths and weaknesses of each party's case, can also facilitate settlement.

Key benefits of mediation and arbitration in lease assignment disputes include:

• Cost savings : Mediation and arbitration can substantially reduce the financial burden of litigation.
• Time efficiency : Alternative dispute resolution mechanisms can resolve disputes more quickly than traditional litigation.
• Flexibility : Mediation and arbitration allow parties to craft creative solutions tailored to their specific needs.
• Confidentiality : Alternative dispute resolution mechanisms can maintain confidentiality, protecting sensitive business information.

Litigation Strategies

While alternative dispute resolution mechanisms can be effective in resolving lease assignment disputes, litigation may be necessary when negotiations break down or the parties' interests are fundamentally at odds, requiring a more formal and adversarial approach to dispute resolution. In such cases, a well-crafted litigation strategy is vital to achieving a favorable outcome.

Effective litigation strategies in lease assignment disputes involve careful trial preparation, including thorough document review, witness preparation, and specialized testimony. Skilled attorneys must develop a deep understanding of the lease agreement, assignment terms, and relevant legal precedents to build a compelling case. In the courtroom, effective advocacy and persuasive storytelling are vital to persuading judges and juries. Courtroom tactics, such as strategic questioning and evidence presentation, can greatly impact the outcome of the case. Additionally, attorneys must be prepared to respond to unexpected developments and adapt their strategy accordingly. By combining meticulous preparation with adept courtroom skills, parties can increase their chances of success in lease assignment litigation.

Frequently Asked Questions

Can a lease assignment be terminated by the landlord?.

A lease assignment can be terminated by the landlord if the assignee breaches Landlord obligations or if the Lease duration is exceeded, allowing the landlord to regain possession of the property.

Is a Lease Assignment the Same as a Sublease?

A lease assignment and sublease differ in contractual distinctions, as an assignment transfers all rights and liabilities, whereas a sublease creates a new, separate agreement, shifting liability between parties.

What Happens to the Security Deposit in a Lease Assignment?

In a lease assignment, the security deposit typically remains with the original landlord, who is responsible for refunding the deposit to the assignor. Alternatively, the deposit can be transferred to the assignee, facilitating a smooth handover and avoiding potential disputes over deposit refunds.

Can an Assignee Assign the Lease Again to Another Party?

In a successive assignment, an assignee may reassign the lease to another party, but this secondary assignment does not extinguish the original assignee's privity obligations, which remain intact and binding.

Is a Lease Assignment Considered a Novation of the Original Lease?

A lease assignment is not inherently a novation of the original lease, as it does not extinguish the original contractual obligations; rather, it transfers rights and duties, with the assignee assuming liability, while the assignor remains liable, pending contractual or legal precedent modifications to lease obligations.

A lease assignment agreement is a contractual arrangement where the original tenant (assignor) transfers their rights and obligations to a new tenant (assignee). This agreement outlines the terms and conditions of the assignment, including the effective date, rent, and lease duration.

Assignor and Assignee Rights and Obligations

The assignor and assignee have distinct rights and obligations. The assignor is released from liability, while the assignee assumes the lease obligations. The assignee is entitled to occupy the premises and enjoy the benefits of the lease.

Landlord consent is typically required for a lease assignment. The landlord may withhold consent if the assignee lacks financial stability or has a poor credit history. The approval process may involve a thorough review of the assignee's credentials.

A lease assignment may involve amendments to the original lease terms and conditions. The parties may renegotiate the lease duration, rent, or other provisions to reflect the changed circumstances.

Lease assignment agreements often include liability and indemnification provisions to protect the parties from potential claims. The assignor and assignee may agree to indemnify each other against breaches of the lease terms.

Disputes arising from lease assignments can be resolved through alternative dispute resolution mechanisms, such as arbitration or mediation. Litigation may be necessary in cases where the parties fail to resolve their disputes amicably.

Lease assignments involve complex legal considerations. Careful attention to the assignment agreement, landlord consent, and lease term amendments is essential to ensure a smooth transfer of lease rights and obligations.

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Navigating the assignment of a commercial lease

Special circumstances can require a tenant or a landlord to assign a commercial lease. Find out the most common situations for a commercial lease assignment and whether it's right for your situation.

Find out more about real estate and business

by   Ronna L. DeLoe, Esq.

Ronna L. DeLoe is a freelance writer and a published author who has written hundreds of legal articles. She does...

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Updated on: January 9, 2024 · 3 min read

Tenant's assignment of a commercial lease

Getting the landlord's consent, contents of a tenant's assignment agreement, landlord's assignment of a commercial lease.

If you're running a business, you may find yourself in a situation where you need to break a commercial lease. As a tenant, one option is to assign the lease, which means removing yourself completely from the lease and transferring it to a third party.

There are also instances when a landlord may need to assign a commercial lease, such as when a property is sold. In doing so, you sell the building with any leases intact, which requires assigning your right to collect rent to the new owner.

There are many reasons a tenant may want to get out of a commercial lease, including not being able to afford the rent and needing less or more space. Because it's unlikely a landlord will simply let you walk away from your commitment, you should check what your lease says about early termination. Most commercial leases require the tenant to pay rent for the rest of the term and possibly additional fees for breaking the lease.

Assignment of the lease is another alternative to breaking it. In doing so, you give the new tenant, known as the assignee, the right to occupy the premises in your place for the remainder of your lease term.

Almost all assignments of commercial leases by the tenant need the landlord's consent, so check your original lease for any such language. As with a residential lease, a landlord cannot unreasonably withhold consent for you to assign the lease. However, it's up to you as the assignor, or original tenant, to ensure that your assignee is reliable, responsible, and can pay the rent—or you may end up being held financially liable.

If the tenant assigns a commercial lease to a new tenant without the landlord's permission, the landlord can sue the original tenant for breaking the lease. The landlord can also collect damages against one or both tenants if he can show that the assignee isn't a good-paying tenant or doesn't have the type of business he wants in the building. He can also end the lease and evict the new tenant.

Assignment of a commercial lease is almost always accompanied by a written agreement to preserve both the tenant's and landlord's rights. Some states require written assignment agreements . Many commercial assignment agreements contain provisions for the:

• Payment of fees to the landlord for having another business substitute for yours
• Assignor's and assignee's names, addresses, and business names
• Landlord's name, address, and business name
• Amount of the new tenant's rent and the dates for payment
• Date of the agreement
• Date the assignment is effective
• Date the lease ends
• The landlord's, assignor's, and assignee's signatures

Assignment agreements usually don't contain a provision releasing the assignor from paying rent, meaning that you, as the assignor, are held responsible for payment. Even so, assignment can be a financially responsible option for a tenant who's going out of business or who needs new space immediately.

Sometimes a commercial landlord needs to sell his property. After the new owner, or assignee-buyer, buys the property subject to existing leases, the assignor-landlord assigns the leases to the new owner, who can then collect rent. The assignor-landlord notifies tenants by sending a notice of sale, a notice of assignment of lease, or a notification on letterhead listing the assignee-buyer's address for payment of rent.

Unless the lease states otherwise, you, as landlord, can sell your property to anyone, but make sure to get a hold harmless clause , also known as an indemnity clause, in your contract of sale. Such clauses protect you from liability to the tenant if the buyer doesn't perform her duties as a landlord. Otherwise, as the original landlord, you're still liable for your obligations to the tenant, such as keeping the premises habitable.

Under the right circumstances, assignment of a commercial lease can work for both landlords and tenants. If you need assistance with your assignment agreement, consider using an online service provider to prepare it for you.

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Key tax impacts from the new leasing standard

• Introduction

Tracking for historical book/tax differences is gone

Substantial modifications/rent concessions, interest on finance leases, interest limitation under section 163(j), other items to consider, beyond federal tax, lessors may have to accelerate income.

As more private businesses begin implementing the new U.S. GAAP standard under ASC 842,  Leases  (“ASC 842” or “the standard”), many are discovering that they no longer have easy access to the data needed to compute the most common book/tax differences. Prior to implementing ASC 842, many taxpayers have general ledger accounts such as “Deferred Rent” or “Prepaid Rent” that allow visibility into identifying and computing major/book tax differences. However, under ASC 842, those accounts are going away and have been replaced by a right-of-use asset and corresponding lease obligation onto their balance sheet for fiscal years beginning on or after Dec. 15, 2021, for private companies. The standard also requires companies to take a fresh look at how they are treating leases for GAAP purposes. Thus, the standard not only removes the accounts that used to be used to track book/tax differences—it may create new ones. Most of the dialogue, articles, CPE courses, etc. have concentrated on the GAAP rules and reporting requirements. Also, most software solutions focus on the GAAP requirements. As a result, some of the tax impacts of the new standard have not been fully considered. The biggest change under the standard for lessees is that lessees are required to recognize an asset and liability for most leases on its balance sheet, which requires completely changing the journal entries used to report and track the lease expense. The standard does not fundamentally change lease accounting from the lessor’s perspective, but there are some changes that require lessors to look to the new GAAP revenue recognition standard under ASC 606, which in certain instances may impact the new revenue recognition rules under the Tax Cuts and Jobs Act (TCJA). Additionally, lessees subject to the IASB standard, IFRS 16, instead of the GAAP standard, must report all leases as finance leases, which may create new book/tax differences on the tax return.

As noted above, the journal entries used to track and record the balance sheet and income statement accounts are changing under the new GAAP and IFRS leasing standards, which will create challenges for continuing to identify and compute the common book/tax differences. To offer a better understanding of what is changing, below are some of the most common book/tax differences and a quick summary of some of the new GAAP requirements for operating leases.

Straight-line rents

One of the most common book/tax differences is for rent deductions. Generally, for operating leases, GAAP requires fixed rent payments to be expensed straight-line over the term of the lease, whereas for federal income tax purposes, generally the rules require taxpayers to deduct rents following the payment schedule for most conventional leases. Under the former GAAP rules for an operating lease, the difference between the actual payments of rent and the straight-line expense were usually recorded in a Deferred Rent or Prepaid Rent account on the balance sheet, which made it relatively easy to identify for tax purposes. The new GAAP standard requires a lessee to record a right-of-use asset and a lease liability for all leases with a lease term greater than 12 months. 1  There is no more Deferred Rent or Prepaid Rent account. Instead, at the commencement of the lease, the lease liability is equal to the present value of the lease payments. 2  The initial right-of-use asset is equal to the lease liability plus any initial direct costs minus any lease incentives received plus any payments made by a lessee to the lessor at or before the lease commencement date. 3  Therefore, if there are no initial direct costs, lease incentives, or prepayments, the right-of-use asset equals the lease liability. The straight-line expense will be recorded in the income statement, the lease liability will be reduced by the difference between the cash payment and the interest expense on the lease liability, and the amortization of the right-of-use asset is the difference between the straight-line expense and the interest. 4 Thus, a typical journal entry will look something like:

For federal income tax purposes, the tax treatment will depend on whether the lease is subject to Section 467 or the general accrual rules under Section 461. In either case, taxpayers usually deduct rent by following the payment schedule for most conventional leases (leases without a separate rent allocation schedule that do not have provisions that alter the benefits and burdens of ownership) without prepayments. 5  Thus, in the above journal entry, tax would deduct when the cash is paid rather than following the straight-line GAAP expense. Many small equipment leases—and some commercial real estate leases—are subject to the general rules under Section 461, which require accrual method taxpayers to deduct rent in the year in which the liability meets the all-events test and economic performance rules. Economic performance for rent is met as the leased property is used,  i.e.  ratably over the period of time the taxpayer is entitled to the use of the property. 6  Therefore, for conventional leases with monthly rent payments, a taxpayer would deduct the rent monthly, while for leases with prepaid rent a taxpayer must spread the deduction ratably over the period of use related to the prepayment. The Section 467 rules override the general federal income tax rules under Section 461 regardless of whether a taxpayer uses the overall cash or accrual method of accounting—and they often apply to commercial real estate leases and large equipment leases. A Section 467 rental agreement is any rental agreement for the use of tangible property with aggregate payments exceeding $250,000, and under which there are either increasing or decreasing rents and/or there is prepaid or deferred rent. Thus, if a lease agreement has fixed, stepped rents that are not based on the consumer price index (CPI), the lease will be subject to Section 467 if the total payments exceed $250,000. Note that the definition of prepaid or deferred rent under Section 467 is not as broad as is commonly used in books and records. Historically (prior to ASC 842), a taxpayer may record in its books and records deferred or prepaid rent for any month in which payments do not match the book deduction. However, to have deferred or prepaid rent under Section 467 for federal income tax purposes, the regulations require that the payment schedule in the lease agreement not match the rental allocation schedule in the lease agreement. For example, Treas. Reg. Sec. 1.467-1(c)(3)(ii) provides that a rental agreement has prepaid rent if the cumulative amount of rent payable as of the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year. Thus, there is only prepaid rent under Section 467 if the prepayment in calendar year 1 exceeds the amount of rent allocated cumulatively through calendar year 2. In computing the rent to be accrued each year under Section 467, rents must be allocated in accordance with the applicable Section 467 rental agreement. 7  In most conventional leases, there is no rent allocation schedule separate from the rent payment schedule in the lease. Therefore, in these situations, the lessee generally recognizes an expense in accordance with the rent payment schedule and there is no prepaid or deferred rent under Section 467. 8 The regulations can be daunting to tackle, as they first make the reader determine if any of the special rules apply, such as the constant rental accrual method (which applies if the IRS determines that the lease is disqualified long-term lease or a disqualified leaseback because the IRS has determined that the principal purpose for providing increasing or decreasing rent is the avoidance of federal income tax) or the proportional rental accrual method (which applies if there is prepaid or deferred rent, as described above, without adequate interest), even though these rules rarely apply to conventional lease terms. Under Treas. Reg. Sec. 1.467-1(c)(2)(ii), if there is a rent allocation schedule that is different from the rent payment schedule, then the parties follow the rent allocation schedule, provided the special rules do not apply. Generally, parties may create leases with a rent allocation schedule that is different than the payment schedule if the parties are executing tax planning. Therefore, for conventional leases with fixed, increasing rents, taxpayers generally would follow the cash payment schedule for federal income tax, but would straight-line the expense for GAAP. Taxpayers face a potentially burdensome tracking issue to reconcile the book/tax differences now that the Deferred Rent and Prepaid Rent general ledger accounts are gone.

Lease incentives

The treatment of lease incentives also has long been a source of book/differences. As noted above, lease incentives are included in the right-of-use asset under the new GAAP standard. Thus, the lease incentive is amortized against the lease expense over the life of the lease. For tax purposes, however, a lease incentive is often taxable to the lessee at the commencement of the lease. Generally, for federal income tax purposes, a lessee has gross income when it receives a lease incentive from the lessor because it has an accession to wealth—unless the facts indicate that the allowance was intended to be spent on real property improvements owned by the landlord. 9  Thus, incentives for moving expenses, payments to the lessee’s former landlord to terminate its prior lease, and certain tenant construction allowances owned by the lessee are gross income to the tenant upfront. The tenant bears the burden of proving it does not have an accession to wealth. 10  Whether the improvements are owned by the tenant or the landlord must be determined using tax principles, which generally rely on the benefits and burdens of ownership. 11  If the tenant owns the asset, the lease incentive is gross income when the lessee has a fixed right to the income and it is determinable with reasonable accuracy, which is generally near the commencement of the lease. 12  The tenant will capitalize the leasehold improvement asset and depreciate for tax purposes when placed in service. However, there are certain safe harbors, such as Section 110, which allow for the lessee to exclude the incentive from income to the extent it is used to construct real property improvements. If the parties intend for the landlord own the improvement upfront, the lease should either specifically reference language from the Section 110 regulations and/or specifically state that the landlord owns the improvements upfront (not just at the end of the lease). Because the landlord owns the improvements, the lessee should not capitalize and depreciate the improvements that are built or purchased with the eligible allowance. It can be difficult to qualify for the safe harbor in Section 110. The requirements include:

• The allowance must be spent on qualified long-term real property
• The lease must be for retail space and run for 15 years or less
• The lease must contain language expressly from the regulation (e.g. the “allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee’s trade or business at the retail space”)
• The lessee must attach an information statement to the tax return in the year the allowance is received
• The lessor must capitalize and depreciate the improvements. 13

If the Section 110 safe harbor is not met, taxpayers must rely on case law to determine which party has the benefits and burdens of ownership of the improvements. Generally, the IRS will look for specific language in the lease that indicates the landlord intended to own the improvements upfront. Thus, incentives such as tenant allowances are a very common book/tax difference. Under the new GAAP standard, taxpayers also face a potentially burdensome tracking issue to reconcile the incentive book/tax differences now that the incentives are buried in the right-of-use asset.

Lease terminations

Another difference is the treatment of payments made by a lessor to an existing tenant to incentivize the tenant to terminate its lease. For federal income tax purposes, an amount paid to terminate or facilitate the termination of an existing agreement does not facilitate the acquisition or creation of  another  agreement unless the lessor and lessee are renegotiating an existing lease agreement. 14  However, if a lessor pays a lessee to terminate an existing lease agreement, the lessor must capitalize the termination payment and amortize over the term of the old lease. 15 There also may be differences if the tenant makes a payment to a lessor to terminate a lease. If the lessee makes a payment to the lessor to terminate a lease and does not owe any back rent and is not terminating the lease in order to enter into another lease or to buy the property, the payment is generally deductible as rent. 16  However, if the lessee makes a payment for back rent for less than the lessee owes, there may be income that needs to be recognized under Section 108 (income from discharge of indebtedness) or under Section 111 (recovery of tax benefit items). Further, if the lessee is terminating a lease to enter into a new lease or buy the property, then the payment will generally be capitalized and pulled into the new lease or cost of the property. 17

Normally, substantial changes to lease agreements are somewhat unusual on a large scale, however COVID-19 has caused many rental agreements to be modified. These modifications affect both tenants’ and property owners’ GAAP and tax accounting. Common changes can take the form of any of these:

• Reduced rent
• Rent forgiveness,
• Extension of lease,
• Deferral of rent payments (during or after lease terms)
• A combination of these things.

GAAP provides specific guidance on whether to treat changes as rent concessions or rent modification. The allowance to account for these as concessions or modifications is dependent on the evidence of an “enforceable right” to the concession ( i.e ., if the laws in the jurisdiction governing the lease could create a legally enforceable right to a concession). If this enforceable right exists and there are no other terms of the lease that have been changed, the situation can be considered a concession as opposed to a lease modification. The Financial Accounting Standards Board (FASB) staff recently issued a staff Q&A addressing the accounting for lease concessions related to the effects of the COVID-19 pandemic under ASC 842. 18  The FASB staff states that the published guidance on lease modification standards was written with routine lease changes in mind and not for the novel and widespread concessions granted in response to the COVID-19 pandemic. Due to these special circumstances, the staff believes that under both ASC 840 and ASC 842, the entity may elect to treat qualifying lease concessions as if they were based on enforceable rights and obligations and may choose to apply or not to apply modification accounting for the qualifying concession. Two criteria must be met to be considered a qualifying concession. First, the concession must be related to COVID-19. Second, there cannot be a substantial increase in the lessee’s obligation or the lessor’s rights under the contract. For example, the total payments required by the modified contract must be substantially the same as, or less than, the total payments required by the original contract. One of the more common lease concessions is a deferral of rent that changes the timing of the rental payments, but not the amount of these payments. The FASB staff noted there could be multiple approaches to accounting for deferrals under both ASC 842 and ASC 840. One approach is to continue to account for the lease as if no deferral has been provided. A lessee should record a payable and a lessor should record a receivable for rental payment deferred. If these criteria are not met, then under ASC 842, the rent concession is a modification. Both lessee and lessor must first determine if a lease modification should be treated as a new lease or as a continuation of the current lease. An entity accounts for a modification that is not considered a separate contract as a continuation of the existing lease and should reassess the lease classification, analyzing all modified terms and conditions and updating all inputs as of the effective date of modification. There are important tax implications of changes to lease agreements. Treatment of Section 467 and non-Section 467 leases differ. If a change is considered a lease modification under Section 467 it could lead to a change in the remaining lease from being subject to Section 461 to being subject to the rules of Section 467. For example, a substantial modification under Section 467 rental agreement would be considered a new, separate lease from the old agreement. Due to these circumstances, determining what qualifies as a substantial modification is very important, as under a lease modification the categorization of the lease would have to be re-evaluated. A modification is considered substantial only if, based on all the facts and circumstances, the legal rights or obligations that are altered and to the degree to which they are altered are economically substantial. Typically, for Section 467 leases, the fixed rent for a rental period is the amount of the fixed rent allocated to the rental period under the rental agreement. Therefore, the income or expense is recognized in the period that it is allocated. Certain modifications to an existing lease could turn a lease that did not have increasing or decreasing rents—and thus was subject to Section 461—into a Section 467 rental agreement due to the uneven rents caused by the rent deferrals. If rents are significantly prepaid or deferred, the taxpayer may be required to use the proportional method of recognition. Certain modifications could trigger the deferred rent provisions, requiring the use of the proportional method under Section 467 instead. If the leases are not Section 467 leases, then entities must evaluate the recognition rules under Section 451 for income and Section 461 for expense to determine the appropriate timing for recognizing the new payment schedule.

As described above, the treatment of deferred rent, lease incentives and initial direct costs may create new book/tax differences in some circumstances, even though for many leases, there were already differences under the old rules. Another possible new book/tax difference is interest on finance leases. Under the standard, the initial measurement of the right-of-use asset and lease liability is the same for operating and finance leases, while the expense recognition and amortization of the right-of-use asset differ significantly. Finance leases will reflect a front-loaded expense pattern similar to current capital leases. 19  Unlike operating leases, the interest expense on the lease liability and the amortization of the right-of-use asset (generally straight line) will be reflected separately on the income statement. Under the standard (and for IFRS as well), the income statement will include interest expense on the lease. Thus, if any leases were formerly characterized as operating leases for book purposes but are now finance leases for book purposes, the amount of the book/tax differences may change due to the interest computation. This is a particularly notable issue for leases subject to IFRS 16, as all leases are treated as finance leases. As noted below, it is also important to make sure that the book interest on the finance lease is reversed for leases that are true leases for federal income tax purposes.

A common question business owners ask is how the new interest limitation interacts with the leasing rules. Effective for tax years starting in 2018, Section 163(j) limits the deduction for business interest to the sum of these three amounts:

• Business interest income
• Thirty percent of the taxpayer’s adjusted taxable income for the tax year
• The taxpayer’s floor plan financing interest for the tax year

Any interest not deductible because of the Section 163(j) limitation is carried forward indefinitely (with some restrictions for partnerships). The IRS and Treasury issued final regulations under Section 163(j) that includes amounts treated as interest under a Section 467 rental agreement in the definition of interest for purposes of the limitation. 20  Generally, this type of interest arises with leases that have unconventional terms, such as a lease with a rent holiday that exceeds 24 months, or a lease that specifically provides two separate rent schedules: one that allocates rent to each year of the lease and one that provides for a deferred or prepaid payment schedule that is different than the allocation. The book interest computed on leases that are finance leases for GAAP (or IFRS) is not interest for federal income tax purposes if the lease is a true lease for tax. (Remember that for operating leases, GAAP only reports rent expense in the income statement, so there will not be interest expense on operating leases.) However, if the lease is a sale/financing for federal income tax purposes, then the purported rent payments would have to be split between interest and payment on the loan. Whether a lease is a sale/financing for tax rather than a true lease depends on the facts and circumstances and does not automatically match the GAAP (or IFRS) treatment. 21

With the standard, renewed attention should also be placed on the following items, if applicable:

• Lease classification: While GAAP defines leases as either operating or finance, the federal income tax rules define leases as either a true lease (also known as: operating lease) or a sale/financing arrangement (somewhat similar to a finance lease). Federal income tax laws list numerous factors to consider when determining the classification of a lease that should be analyzed.
• Sale/leaseback transactions: There are likely book-to-tax adjustments that exist when this transaction occurs as GAAP and tax treatment generally will differ in whether a sale actually occurs and when the resulting gain/loss on the sale gets recognized.

There are a variety of state and foreign tax impacts, including:

• State apportionment for income taxes: The computation of the property factor may be impacted to the extent that the property factor is computed based on the GAAP basis of property if the right-of-use asset is included in plant, property and equipment. Additionally, certain states include a multiple of rent expense incurred for the year in the property factor.
• Franchise and net worth taxes: The new standard may impact the net worth of a company to the extent the tax is based on GAAP net worth due to the inclusion of the right-of-use asset and the lease liability in the balance sheet.
• Personal property or real estate taxes: In jurisdictions that impose property taxes on personal and real property, businesses will need to determine if the right-of-use asset constitutes property subject to the local property tax.
• Sales and use tax: Determine whether any applicable jurisdiction takes the position that a right-of-use asset is the equivalent of a purchase of such an asset from the lessor, thereby resulting in an immediate sales tax imposition on a purchase transaction.
• Foreign income taxes: To the extent that a company operates in foreign jurisdictions that base their local income tax liability on accounting income, the company will need to evaluate the impact of the new lease standard on foreign income tax expense.
• Transfer pricing: Transfer pricing rules may require that related parties reflect an arm’s-length price regardless of what the treatment is for GAAP purposes.

Under ASC 842, a lessor should allocate the contract consideration to the separate lease and non-lease components in accordance with the transaction price allocation guidance in ASC 606 ,  Revenue from Contracts with Customers . 22 Generally, lessors recognize fixed, increasing rents straight-line over the term of the lease under ASC 842. The federal income tax rules are the same under Section 467 for lessors as for lessees, and therefore there will generally be a book/tax difference due to the difference between the book straight-line and the tax payment schedule. For leases that are not subject to Section 467, the lease income would be subject to Section 451. For accrual basis taxpayers with applicable financial statements (AFS), Section 451(b) generally requires that taxpayers recognize income no later than when it is recognized in their AFS. The final regulations under Treas. Reg. Sec. 1.451-3 illustrate that taxpayers that have an enforceable right to the income accelerated in the AFS under the straight-line method if the contract were cancelled, would have to accelerate the income for federal income tax purposes as well.

These are some of the most common book/tax differences on operating and finance leases and, as illustrated, taxpayers may have issues going forward with identifying the appropriate book/tax differences due the new GAAP reporting requirements. Additionally, as part of the implementation of ASC 842, a taxpayer may discover that it was not appropriately following the federal income tax rules. In that case, the taxpayer must change an impermissible method of accounting for the treatment of any of these items by filing a Form 3115,  Application for Change in Method of Accounting . Certain changes may be eligible under the automatic method change procedures.

For more information, contact:

Principal, Washington National Tax Office Principal, Grant Thornton Advisors LLC

Sharon Kay is a subject matter specialist in Grant Thornton’s Washington National Tax Office with 20 years of tax experience. She primarily advises clients on federal income tax issues such as tangible and intangible asset capitalization and recovery, inventories, income and expense recognition, and certain business credits.

Washington DC, Washington DC

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David Murdock

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David has 19 years of experience in taxation with an emphasis in corporate income tax compliance, income tax provision (ASC 740) and Strategic Federal Tax Services, which include R&D Tax Credit, UNICAP (Inventory Capitalization), Cost Segregation/Fixed Asset Solutions, and comprehensive Credit, Methods and Periods palnning.

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1 Paragraph 842-20-25-1 of ASC 842. 2 Paragraph 842-20-30-1 of ASC 842. 3 Paragraph 842-20-30-5 of ASC 842. 4 Paragraphs 842-20-25-6 through 842-20-35-6 of ASC 842. 5 Treas. Reg. Sec. 1.467-1(d)(2)(iii) and (c)(2)(ii). 6 Treas. Reg. Sec. 1.461-4(d)(3). 7 Treas. Reg. Sec. 1.467-1(d)(2)(iii). 8 Treas. Reg. Sec. 1.467-1(c)(2)(ii).  See also, Stough v. Commissionner , 144 TC 306 (2015) (under Section 467, taxpayers were required in the year of receipt to include as gross income the entire lump-sum payment made pursuant to the terms of the lease because the lease did not specifically allocate fixed rent to any rental period). 9 Section 61;  John B. White, Inc. , 55 TC 729 (1965);  In re The Elder-Beerman Stores Inc. , 97-1 USTC 50,391 (Bankr SD Ohio 1997);  Price , 77 TCM 1928 (1999). 10   Id. 11   Id. 12 Section 451. 13 Treas. Reg. Sec. 1.110-1(b) and (c). 14 Treas. Reg. Sec. 1.263(a)-4(e)(1)(ii) and Treas. Reg. Sec. 1.263(a)-4(d)(6)(iii). 15 Treas. Reg. Sec. 1.263(a)-4(d)(7). 16 Section 162. 17 Letter Ruling 9607016. 18 FASB Staff Q&A – Topic 842 and Topic 840: Accounting for Lease Concessions Related to the Effects of the COVID-19 Pandemic. 19 Paragraph 842-20-25-5 of ASC 842. 20 Treas. Reg. Sec. 1.163(j)-1(b)(22)(i)(J). 21  See , for example, Section 7701(e) and a long list of cases including  Torres , 88 T.C. 702 (1987). 22 Paragraph 842-10-15-38 of ASC 842.

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This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “§,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.

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Tax Implications of the New Lease Accounting Standards: Part Two

In part one of this article, we discussed the changes under the new lease accounting standards, Topic 842, Leases (ASC 842), and began to examine the tax implication of such. In the final article of this two-part series, we cover each specific tax implication.

1. Accounting & Tracking Impacts

ASC 842 was a change in the accounting rules for leases. It was not a change in the Internal Revenue Code made by Congress to the tax rules applicable to leases. While the income tax treatment of the lease remains unchanged by ASC 842, a change in the book accounting for leases forces companies to also analyze what it is doing for tax purposes with leases. In analyzing the guidance with the new lease rules, lessors and lessees may discover that certain existing leases/sales/financing transactions may be misclassified for GAAP purposes and/or for federal income tax purposes. Thus, this may require a change in accounting methods to modify existing leases/sales/financing transactions or a change its tax treatment on a prospective basis.

A company implementing new processes or systems to track leases under ASC 842 will need not only to create processes for the post-implementation tracking of the lease, but will also need to track historical lease information for tax purposes.

The lease accounting structure needs to be revisited in tax accounting terms because of the potential change in:

• Characterization of leases
• Timing of the lease
• Timing of income
• Tenant allowances (general treatment)
• Valuation allowances
• Lease acquisition costs (general treatments and borrowing costs)

2. Deferred Taxes – DTA & DTLs

The tax expense recognized during the first year of an operating lease will likely not change under ASC 842 because (as noted above), the tax rules for leases are not changing with the transition to the new lease accounting standards. However, since operating leases are now required to be recorded as ROU assets and a corresponding lease liability on the company’s balance sheet, this will result in book-to-tax reconciliation items. This will specifically result in new deferred tax liabilities (DTL) and deferred tax assets (DTA). This is a temporary change and will reverse over the life of the lease.

There may also be some uncertainty with leases on partnership tax returns. Generally, a book or GAAP balance sheet is included with a partnership tax return. The liabilities on this balance sheet are then allocated to the various partners of the partnership. These liabilities are reported on the partner’s Schedule K-1 as recourse liabilities, nonrecourse liabilities or qualified nonrecourse financing. Under GAAP, the lease obligations are now reported on the balance sheet; however, since these might not be liabilities for tax purposes, they would not be reported on Schedule K-1 for the partners. This is another item to keep track of with leases for tax purposes.

3. State & Local Taxes

The new standards require lease-related ROU assets to be recorded, which may impact the property factor for apportionment if the ROU assets related to operating leases are to be recorded on the same line item as underlying assets. This may then affect state apportionment for companies that have activity in states that include property factors when calculating apportionment percentages. This will likely also affect state tax filings where a net worth-based tax applies.

4. Transfer Pricing

Companies may need to revise its related party leasing arrangements to reflect the arm’s length standards. The arm’s length standards rely on financial ratios and profit level indicators, which may change when companies begin to record all leases on their balance sheets and statements of financial position.

5. Foreign Taxes

Just as state and local income taxes depend on where company operations take place, the new standards’ requirement for ROU assets being recorded will likely have a similar impact on foreign country income tax filings. This depends on the tax regime of the country where a company, its branch or subsidiary is located (according to IFRS 16).

6. Property Taxes

Another potential impact on leases is the property tax treatment at the state, local and foreign levels that might be levied on leased assets. If ROU assets are considered “tangible personal property,” property taxes could be assessed on the assets. 

7. Sales-and-Use Taxes

Depending on whether local, state or foreign tax environments treat the lease transaction as a taxable purchase or not, companies may need to pay sales tax on these leases as well. This will have an impact on a company’s books.

Book vs. Tax Differences for ROU Lease Assets & Liabilities

ROU assets and related liability pertain to the lessee’s right to occupy, operate or hold a leased asset during the lease term. ROU is composed of different components, each with unique tax implications, thus the traditional change-in-balance approach to identifying book-tax differences may no longer apply. ROU assets under the new lease accounting standards are made up of several components, such as initial direct costs and lease incentives, and these are tracked differently for tax purposes. These components are now combined into one ROU asset. The ROU components are as follows:

• The initial amount of the lease liability
• Plus any lease payments made before the lease commencement date
• Plus any initial direct costs (IDC) incremental to the lease execution, such as commissions, payments to existing tenants to incentivize lease terminations, legal fees, etc.
• Less any lease incentives , such as tenant improvement allowances

There are several other issues to address with ASC 842 related to operating leases and finance leases.

Operating Lease Accounting under ASC 842. When accounting for an operating lease, the lessee must:

• Recognize a single lease cost allocated over the lease term, generally on a straight-line basis
• Classify all cash payments within operating activities on the statement of cash flows

Finance Lease Accounting under ASC 842. When accounting for finance leases, lessees must:

• Recognize interest on the lease liability and amortization of the ROU asset on separate line items of the lessee’s income statement
• Classify payments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows

ASC 842 presents significant changes regarding leases on a company’s financial statements. While the general tax rules related to leases have not changed, there may still be tax issues to address. Please contact your Sikich advisor for any assistance with leases. 

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References: The ASC 842 Standards, Lease Query

This publication contains general information only and Sikich is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or any other professional advice or services. This publication is not a substitute for such professional advice or services, nor should you use it as a basis for any decision, action or omission that may affect you or your business. Before making any decision, taking any action or omitting an action that may affect you or your business, you should consult a qualified professional advisor. In addition, this publication may contain certain content generated by an artificial intelligence (AI) language model. You acknowledge that Sikich shall not be responsible for any loss sustained by you or any person who relies on this publication.

About the Author

Monika Sondhi

Monika Sondhi, CPA, is a tax senior manager with over 15 years of experience in multi-facets of federal, state and local income taxation with particular emphasis on small business and individual income tax compliance and planning. Monika is responsible for all phases of client engagements, including primary client relationship maintenance, highly proactive management of tax compliance and tax advisory services.

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Travel expenses defined.

Members of the Armed Forces.

Main place of business or work.

No main place of business or work.

Factors used to determine tax home.

Tax Home Different From Family Home

Temporary assignment vs. indefinite assignment.

Exception for federal crime investigations or prosecutions.

Determining temporary or indefinite.

Going home on days off.

Probationary work period.

Separating costs.

Travel expenses for another individual.

Business associate.

Bona fide business purpose.

Lavish or extravagant.

50% limit on meals.

Actual Cost

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50% limit may apply.

Who can use the standard meal allowance.

Use of the standard meal allowance for other travel.

Amount of standard meal allowance.

Federal government's fiscal year.

Standard meal allowance for areas outside the continental United States.

Special rate for transportation workers.

Travel for days you depart and return.

Trip Primarily for Business

Trip primarily for personal reasons.

Public transportation.

Private car.

Travel entirely for business.

Travel considered entirely for business.

Exception 1—No substantial control.

Exception 2—Outside United States no more than a week.

Exception 3—Less than 25% of time on personal activities.

Exception 4—Vacation not a major consideration.

Travel allocation rules.

Counting business days.

Transportation day.

Presence required.

Day spent on business.

Certain weekends and holidays.

Nonbusiness activity on the way to or from your business destination.

Nonbusiness activity at, near, or beyond business destination.

Other methods.

Travel Primarily for Personal Reasons

Daily limit on luxury water travel.

Meals and entertainment.

Not separately stated.

Convention agenda.

North American area.

Reasonableness test.

Cruise Ships

Deduction may depend on your type of business.

Exceptions to the Rules

Entertainment events.

Entertainment facilities.

Club dues and membership fees.

Gift or entertainment.

Other rules for meals and entertainment expenses.

Costs to include or exclude.

Application of 50% limit.

When to apply the 50% limit.

Taking turns paying for meals.

1—Expenses treated as compensation.

2—Employee's reimbursed expenses.

3—Self-employed reimbursed expenses.

4—Recreational expenses for employees.

5—Advertising expenses.

6—Sale of meals.

Individuals subject to “hours of service” limits.

Incidental costs.

Exceptions.

• Illustration of transportation expenses.

Temporary work location.

No regular place of work.

Two places of work.

Armed Forces reservists.

Commuting expenses.

Parking fees.

Advertising display on car.

Hauling tools or instruments.

Union members' trips from a union hall.

Office in the home.

Examples of deductible transportation.

Choosing the standard mileage rate.

Standard mileage rate not allowed.

Five or more cars.

Personal property taxes.

Parking fees and tolls.

Sale, trade-in, or other disposition.

Business and personal use.

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Casualty and theft losses.

Depreciation and section 179 deductions.

Car defined.

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More information.

More than 50% business use requirement.

Limit on the amount of the section 179 deduction.

Limit for sport utility and certain other vehicles.

Limit on total section 179 deduction, special depreciation allowance, and depreciation deduction.

Cost of car.

Basis of car for depreciation.

When to elect.

How to elect.

Revoking an election.

Recapture of section 179 deduction.

Dispositions.

Combined depreciation.

Qualified car.

Election not to claim the special depreciation allowance.

Placed in service.

Car placed in service and disposed of in the same year.

Methods of depreciation.

More-than-50%-use test.

Qualified business use.

Use of your car by another person.

Business use changes.

Use for more than one purpose.

Change from personal to business use.

Unadjusted basis.

Improvements.

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Depreciation in future years.

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How to treat unrecovered basis.

• Table 4-1. 2023 MACRS Depreciation Chart      (Use To Figure Depreciation for 2023)

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Examples of Records

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Travel advance.

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Federal per diem rate method.

Information on use of cars.

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What Is TAS?

How can you learn about your taxpayer rights, what can tas do for you, how can you reach tas, how else does tas help taxpayers, low income taxpayer clinics (litcs), appendix a-1. inclusion amounts for passenger automobiles first leased in 2018, appendix a-2. inclusion amounts for passenger automobiles first leased in 2019, appendix a-3. inclusion amounts for passenger automobiles first leased in 2020, appendix a-4. inclusion amounts for passenger automobiles first leased in 2021, appendix a-5. inclusion amounts for passenger automobiles first leased in 2022, appendix a-6. inclusion amounts for passenger automobiles first leased in 2023, publication 463 - additional material, publication 463 (2023), travel, gift, and car expenses.

For use in preparing 2023 Returns

Publication 463 - Introductory Material

For the latest information about developments related to Pub. 463, such as legislation enacted after it was published, go to IRS.gov/Pub463 .

Standard mileage rate. For 2023, the standard mileage rate for the cost of operating your car for business use is 65.5 cents ($0.655) per mile. Car expenses and use of the standard mileage rate are explained in chapter 4.

Depreciation limits on cars, trucks, and vans. The first-year limit on the depreciation deduction, special depreciation allowance, and section 179 deduction for vehicles acquired before September 28, 2017, and placed in service during 2023, is $12,200. The first-year limit on depreciation, special depreciation allowance, and section 179 deduction for vehicles acquired after September 27, 2017, and placed in service during 2023 increases to $20,200. If you elect not to claim a special depreciation allowance for a vehicle placed in service in 2023, the amount increases to $12,200. Depreciation limits are explained in chapter 4.

Section 179 deduction. The maximum amount you can elect to deduct for section 179 property (including cars, trucks, and vans) you placed in service in tax years beginning in 2023 is $1,160,000. This limit is reduced by the amount by which the cost of section 179 property placed in service during the tax year exceeds $2,890,000. Section 179 deduction is explained in chapter 4.Also, the maximum section 179 expense deduction for sport utility vehicles placed in service in tax years beginning in 2023 is $28,900.

Temporary deduction of 100% business meals. The 100% deduction on certain business meals expenses as amended under the Taxpayer Certainty and Disaster Tax Relief Act of 2020, and enacted by the Consolidated Appropriations Act, 2021, has expired. Generally, the cost of business meals remains deductible, subject to the 50% limitation. See 50% Limit in chapter 2 for more information.

Photographs of missing children. The IRS is a proud partner with the National Center for Missing & Exploited Children® (NCMEC) . Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 800-THE-LOST (800-843-5678) if you recognize a child.

Per diem rates. Current and prior per diem rates may be found on the U.S. General Services Administration (GSA) website at GSA.gov/travel/plan-book/per-diem-rates .

Introduction

You may be able to deduct the ordinary and necessary business-related expenses you have for:

Non-entertainment-related meals,

Transportation.

This publication explains:

What expenses are deductible,

How to report them on your return,

What records you need to prove your expenses, and

How to treat any expense reimbursements you may receive.

You should read this publication if you are an employee or a sole proprietor who has business-related travel, non-entertainment-related meals, gift, or transportation expenses.

If an employer-provided vehicle was available for your use, you received a fringe benefit. Generally, your employer must include the value of the use or availability of the vehicle in your income. However, there are exceptions if the use of the vehicle qualifies as a working condition fringe benefit (such as the use of a qualified nonpersonal use vehicle).

A working condition fringe benefit is any property or service provided to you by your employer, the cost of which would be allowable as an employee business expense deduction if you had paid for it.

A qualified nonpersonal use vehicle is one that isn’t likely to be used more than minimally for personal purposes because of its design. See Qualified nonpersonal use vehicles under Actual Car Expenses in chapter 4.

For information on how to report your car expenses that your employer didn’t provide or reimburse you for (such as when you pay for gas and maintenance for a car your employer provides), see Vehicle Provided by Your Employer in chapter 6.

Partnerships, corporations, trusts, and employers who reimburse their employees for business expenses should refer to the instructions for their required tax forms, for information on deducting travel, meals, and entertainment expenses.

If you are an employee, you won’t need to read this publication if all of the following are true.

You fully accounted to your employer for your work-related expenses.

You received full reimbursement for your expenses.

Your employer required you to return any excess reimbursement and you did so.

There is no amount shown with a code L in box 12 of your Form W-2, Wage and Tax Statement.

If you perform services as a volunteer worker for a qualified charity, you may be able to deduct some of your costs as a charitable contribution. See Out-of-Pocket Expenses in Giving Services in Pub. 526, Charitable Contributions, for information on the expenses you can deduct.

We welcome your comments about this publication and suggestions for future editions.

You can send us comments through IRS.gov/FormComments . Or, you can write to the Internal Revenue Service, Tax Forms and Publications, 1111 Constitution Ave. NW, IR-6526, Washington, DC 20224.

Although we can’t respond individually to each comment received, we do appreciate your feedback and will consider your comments and suggestions as we revise our tax forms, instructions, and publications. Don’t send tax questions, tax returns, or payments to the above address.

If you have a tax question not answered by this publication or the How To Get Tax Help section at the end of this publication, go to the IRS Interactive Tax Assistant page at IRS.gov/Help/ITA where you can find topics by using the search feature or viewing the categories listed.

Go to IRS.gov/Forms to download current and prior-year forms, instructions, and publications.

Go to IRS.gov/OrderForms to order current forms, instructions, and publications; call 800-829-3676 to order prior-year forms and instructions. The IRS will process your order for forms and publications as soon as possible. Don’t resubmit requests you’ve already sent us. You can get forms and publications faster online.

Useful Items

Publication

946 How To Depreciate Property

Form (and Instructions)

Schedule A (Form 1040) Itemized Deductions

Schedule C (Form 1040) Profit or Loss From Business (Sole Proprietorship)

Schedule F (Form 1040) Profit or Loss From Farming

2106 Employee Business Expenses

4562 Depreciation and Amortization (Including Information on Listed Property)

See How To Get Tax Help for information about getting these publications and forms.

If you temporarily travel away from your tax home, you can use this chapter to determine if you have deductible travel expenses.

This chapter discusses:

Traveling away from home,

Temporary assignment or job, and

What travel expenses are deductible.

For tax purposes, travel expenses are the ordinary and necessary expenses of traveling away from home for your business, profession, or job.

An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your business. An expense doesn’t have to be required to be considered necessary.

You will find examples of deductible travel expenses in Table 1-1 .

Traveling Away From Home

You are traveling away from home if:

Your duties require you to be away from the general area of your tax home (defined later) substantially longer than an ordinary day's work, and

You need to sleep or rest to meet the demands of your work while away from home.

You are a railroad conductor. You leave your home terminal on a regularly scheduled round-trip run between two cities and return home 16 hours later. During the run, you have 6 hours off at your turnaround point where you eat two meals and rent a hotel room to get necessary sleep before starting the return trip. You are considered to be away from home.

You are a truck driver. You leave your terminal and return to it later the same day. You get an hour off at your turnaround point to eat. Because you aren’t off to get necessary sleep and the brief time off isn’t an adequate rest period, you aren’t traveling away from home.

If you are a member of the U.S. Armed Forces on a permanent duty assignment overseas, you aren’t traveling away from home. You can’t deduct your expenses for meals and lodging. You can’t deduct these expenses even if you have to maintain a home in the United States for your family members who aren’t allowed to accompany you overseas. If you are transferred from one permanent duty station to another, you may have deductible moving expenses, which are explained in Pub. 3, Armed Forces' Tax Guide.

A naval officer assigned to permanent duty aboard a ship that has regular eating and living facilities has a tax home (explained next) aboard the ship for travel expense purposes.

To determine whether you are traveling away from home, you must first determine the location of your tax home.

Generally, your tax home is your regular place of business or post of duty, regardless of where you maintain your family home. It includes the entire city or general area in which your business or work is located.

If you have more than one regular place of business, your tax home is your main place of business. See Main place of business or work , later.

If you don’t have a regular or a main place of business because of the nature of your work, then your tax home may be the place where you regularly live. See No main place of business or work , later.

If you don’t have a regular or main place of business or post of duty and there is no place where you regularly live, you are considered an itinerant (a transient) and your tax home is wherever you work. As an itinerant, you can’t claim a travel expense deduction because you are never considered to be traveling away from home.

If you have more than one place of work, consider the following when determining which one is your main place of business or work.

The total time you ordinarily spend in each place.

The level of your business activity in each place.

Whether your income from each place is significant or insignificant.

You live in Cincinnati where you have a seasonal job for 8 months each year and earn $40,000. You work the other 4 months in Miami, also at a seasonal job, and earn $15,000. Cincinnati is your main place of work because you spend most of your time there and earn most of your income there.

You may have a tax home even if you don’t have a regular or main place of work. Your tax home may be the home where you regularly live.

If you don’t have a regular or main place of business or work, use the following three factors to determine where your tax home is.

You perform part of your business in the area of your main home and use that home for lodging while doing business in the area.

You have living expenses at your main home that you duplicate because your business requires you to be away from that home.

You haven’t abandoned the area in which both your historical place of lodging and your claimed main home are located; you have a member or members of your family living at your main home; or you often use that home for lodging.

If you satisfy all three factors, your tax home is the home where you regularly live. If you satisfy only two factors, you may have a tax home depending on all the facts and circumstances. If you satisfy only one factor, you are an itinerant; your tax home is wherever you work and you can’t deduct travel expenses.

You are single and live in Boston in an apartment you rent. You have worked for your employer in Boston for a number of years. Your employer enrolls you in a 12-month executive training program. You don’t expect to return to work in Boston after you complete your training.

During your training, you don’t do any work in Boston. Instead, you receive classroom and on-the-job training throughout the United States. You keep your apartment in Boston and return to it frequently. You use your apartment to conduct your personal business. You also keep up your community contacts in Boston. When you complete your training, you are transferred to Los Angeles.

You don’t satisfy factor (1) because you didn’t work in Boston. You satisfy factor (2) because you had duplicate living expenses. You also satisfy factor (3) because you didn’t abandon your apartment in Boston as your main home, you kept your community contacts, and you frequently returned to live in your apartment. Therefore, you have a tax home in Boston.

You are an outside salesperson with a sales territory covering several states. Your employer's main office is in Newark, but you don’t conduct any business there. Your work assignments are temporary, and you have no way of knowing where your future assignments will be located. You have a room in your married sister's house in Dayton. You stay there for one or two weekends a year, but you do no work in the area. You don’t pay your sister for the use of the room.

You don’t satisfy any of the three factors listed earlier. You are an itinerant and have no tax home.

If you (and your family) don’t live at your tax home (defined earlier), you can’t deduct the cost of traveling between your tax home and your family home. You also can’t deduct the cost of meals and lodging while at your tax home. See Example 1 , later.

If you are working temporarily in the same city where you and your family live, you may be considered as traveling away from home. See Example 2 , later.

You are a truck driver and you and your family live in Tucson. You are employed by a trucking firm that has its terminal in Phoenix. At the end of your long runs, you return to your home terminal in Phoenix and spend one night there before returning home. You can’t deduct any expenses you have for meals and lodging in Phoenix or the cost of traveling from Phoenix to Tucson. This is because Phoenix is your tax home.

Your family home is in Pittsburgh, where you work 12 weeks a year. The rest of the year you work for the same employer in Baltimore. In Baltimore, you eat in restaurants and sleep in a rooming house. Your salary is the same whether you are in Pittsburgh or Baltimore.

Because you spend most of your working time and earn most of your salary in Baltimore, that city is your tax home. You can’t deduct any expenses you have for meals and lodging there. However, when you return to work in Pittsburgh, you are away from your tax home even though you stay at your family home. You can deduct the cost of your round trip between Baltimore and Pittsburgh. You can also deduct your part of your family's living expenses for non-entertainment-related meals and lodging while you are living and working in Pittsburgh.

Temporary Assignment or Job

You may regularly work at your tax home and also work at another location. It may not be practical to return to your tax home from this other location at the end of each workday.

If your assignment or job away from your main place of work is temporary, your tax home doesn’t change. You are considered to be away from home for the whole period you are away from your main place of work. You can deduct your travel expenses if they otherwise qualify for deduction. Generally, a temporary assignment in a single location is one that is realistically expected to last (and does in fact last) for 1 year or less.

However, if your assignment or job is indefinite, the location of the assignment or job becomes your new tax home and you can’t deduct your travel expenses while there. An assignment or job in a single location is considered indefinite if it is realistically expected to last for more than 1 year, whether or not it actually lasts for more than 1 year.

If your assignment is indefinite, you must include in your income any amounts you receive from your employer for living expenses, even if they are called “travel allowances” and you account to your employer for them. You may be able to deduct the cost of relocating to your new tax home as a moving expense. See Pub. 3 for more information.

If you are a federal employee participating in a federal crime investigation or prosecution, you aren’t subject to the 1-year rule. This means you may be able to deduct travel expenses even if you are away from your tax home for more than 1 year provided you meet the other requirements for deductibility.

For you to qualify, the Attorney General (or their designee) must certify that you are traveling:

For the federal government;

In a temporary duty status; and

To investigate, prosecute, or provide support services for the investigation or prosecution of a federal crime.

You must determine whether your assignment is temporary or indefinite when you start work. If you expect an assignment or job to last for 1 year or less, it is temporary unless there are facts and circumstances that indicate otherwise. An assignment or job that is initially temporary may become indefinite due to changed circumstances. A series of assignments to the same location, all for short periods but that together cover a long period, may be considered an indefinite assignment.

The following examples illustrate whether an assignment or job is temporary or indefinite.

You are a construction worker. You live and regularly work in Los Angeles. You are a member of a trade union in Los Angeles that helps you get work in the Los Angeles area. Your tax home is Los Angeles. Because of a shortage of work, you took a job on a construction project in Fresno. Your job was scheduled to end in 8 months. The job actually lasted 10 months.

You realistically expected the job in Fresno to last 8 months. The job actually did last less than 1 year. The job is temporary and your tax home is still in Los Angeles.

The facts are the same as in Example 1 , except that you realistically expected the work in Fresno to last 18 months. The job was actually completed in 10 months.

Your job in Fresno is indefinite because you realistically expected the work to last longer than 1 year, even though it actually lasted less than 1 year. You can’t deduct any travel expenses you had in Fresno because Fresno became your tax home.

The facts are the same as in Example 1 , except that you realistically expected the work in Fresno to last 9 months. After 8 months, however, you were asked to remain for 7 more months (for a total actual stay of 15 months).

Initially, you realistically expected the job in Fresno to last for only 9 months. However, due to changed circumstances occurring after 8 months, it was no longer realistic for you to expect that the job in Fresno would last for 1 year or less. You can deduct only your travel expenses for the first 8 months. You can’t deduct any travel expenses you had after that time because Fresno became your tax home when the job became indefinite.

If you go back to your tax home from a temporary assignment on your days off, you aren’t considered away from home while you are in your hometown. You can’t deduct the cost of your meals and lodging there. However, you can deduct your travel expenses, including meals and lodging, while traveling between your temporary place of work and your tax home. You can claim these expenses up to the amount it would have cost you to stay at your temporary place of work.

If you keep your hotel room during your visit home, you can deduct the cost of your hotel room. In addition, you can deduct your expenses of returning home up to the amount you would have spent for meals had you stayed at your temporary place of work.

If you take a job that requires you to move, with the understanding that you will keep the job if your work is satisfactory during a probationary period, the job is indefinite. You can’t deduct any of your expenses for meals and lodging during the probationary period.

What Travel Expenses Are Deductible?

Once you have determined that you are traveling away from your tax home, you can determine what travel expenses are deductible.

You can deduct ordinary and necessary expenses you have when you travel away from home on business. The type of expense you can deduct depends on the facts and your circumstances.

Table 1-1 summarizes travel expenses you may be able to deduct. You may have other deductible travel expenses that aren’t covered there, depending on the facts and your circumstances.

If you have one expense that includes the costs of non-entertainment-related meals, entertainment, and other services (such as lodging or transportation), you must allocate that expense between the cost of non-entertainment-related meals, and entertainment and the cost of other services. You must have a reasonable basis for making this allocation. For example, you must allocate your expenses if a hotel includes one or more meals in its room charge.

If a spouse, dependent, or other individual goes with you (or your employee) on a business trip or to a business convention, you generally can’t deduct their travel expenses.

You can deduct the travel expenses of someone who goes with you if that person:

Is your employee,

Has a bona fide business purpose for the travel, and

Would otherwise be allowed to deduct the travel expenses.

If a business associate travels with you and meets the conditions in (2) and (3) above, you can deduct the travel expenses you have for that person. A business associate is someone with whom you could reasonably expect to actively conduct business. A business associate can be a current or prospective (likely to become) customer, client, supplier, employee, agent, partner, or professional advisor.

Table 1-1. Travel Expenses You Can Deduct

A bona fide business purpose exists if you can prove a real business purpose for the individual's presence. Incidental services, such as typing notes or assisting in entertaining customers, aren’t enough to make the expenses deductible.

You drive to Chicago on business and take your spouse with you. Your spouse isn’t your employee. Your spouse occasionally types notes, performs similar services, and accompanies you to luncheons and dinners. The performance of these services doesn’t establish that your spouse’s presence on the trip is necessary to the conduct of your business. Your spouse’s expenses aren’t deductible.

You pay $199 a day for a double room. A single room costs $149 a day. You can deduct the total cost of driving your car to and from Chicago, but only $149 a day for your hotel room. If both you and your spouse use public transportation, you can only deduct your fare.

You can deduct a portion of the cost of meals if it is necessary for you to stop for substantial sleep or rest to properly perform your duties while traveling away from home on business. Meal and entertainment expenses are discussed in chapter 2 .

You can't deduct expenses for meals that are lavish or extravagant. An expense isn't considered lavish or extravagant if it is reasonable based on the facts and circumstances. Meal expenses won't be disallowed merely because they are more than a fixed dollar amount or because the meals take place at deluxe restaurants, hotels, or resorts.

You can figure your meal expenses using either of the following methods.

Actual cost.

If you are reimbursed for the cost of your meals, how you apply the 50% limit depends on whether your employer's reimbursement plan was accountable or nonaccountable. If you aren’t reimbursed, the 50% limit applies even if the unreimbursed meal expense is for business travel. Chapter 2 discusses the 50% Limit in more detail, and chapter 6 discusses accountable and nonaccountable plans.

You can use the actual cost of your meals to figure the amount of your expense before reimbursement and application of the 50% deduction limit. If you use this method, you must keep records of your actual cost.

Standard Meal Allowance

Generally, you can use the “standard meal allowance” method as an alternative to the actual cost method. It allows you to use a set amount for your daily meals and incidental expenses (M&IE), instead of keeping records of your actual costs. The set amount varies depending on where and when you travel. In this publication, “standard meal allowance” refers to the federal rate for M&IE, discussed later under Amount of standard meal allowance . If you use the standard meal allowance, you must still keep records to prove the time, place, and business purpose of your travel. See the recordkeeping rules for travel in chapter 5 .

The term “incidental expenses” means fees and tips given to porters, baggage carriers, hotel staff, and staff on ships.

Incidental expenses don’t include expenses for laundry, cleaning and pressing of clothing, lodging taxes, costs of telegrams or telephone calls, transportation between places of lodging or business and places where meals are taken, or the mailing cost of filing travel vouchers and paying employer-sponsored charge card billings.

You can use an optional method (instead of actual cost) for deducting incidental expenses only. The amount of the deduction is $5 a day. You can use this method only if you didn’t pay or incur any meal expenses. You can’t use this method on any day that you use the standard meal allowance. This method is subject to the proration rules for partial days. See Travel for days you depart and return , later, in this chapter.

The incidental-expenses-only method isn’t subject to the 50% limit discussed below.

If you use the standard meal allowance method for non-entertainment-related meal expenses and you aren’t reimbursed or you are reimbursed under a nonaccountable plan, you can generally deduct only 50% of the standard meal allowance. If you are reimbursed under an accountable plan and you are deducting amounts that are more than your reimbursements, you can deduct only 50% of the excess amount. The 50% Limit is discussed in more detail in chapter 2, and accountable and nonaccountable plans are discussed in chapter 6.

You can use the standard meal allowance whether you are an employee or self-employed, and whether or not you are reimbursed for your traveling expenses.

You can use the standard meal allowance to figure your meal expenses when you travel in connection with investment and other income-producing property. You can also use it to figure your meal expenses when you travel for qualifying educational purposes. You can’t use the standard meal allowance to figure the cost of your meals when you travel for medical or charitable purposes.

The standard meal allowance is the federal M&IE rate. For travel in 2023, the rate for most small localities in the United States is $59 per day.

Most major cities and many other localities in the United States are designated as high-cost areas, qualifying for higher standard meal allowances.

If you travel to more than one location in one day, use the rate in effect for the area where you stop for sleep or rest. If you work in the transportation industry, however, see Special rate for transportation workers , later.

Per diem rates are listed by the federal government's fiscal year, which runs from October 1 to September 30. You can choose to use the rates from the 2022 fiscal year per diem tables or the rates from the 2023 fiscal year tables, but you must consistently use the same tables for all travel you are reporting on your income tax return for the year. See Transition Rules , later.

The standard meal allowance rates above don’t apply to travel in Alaska, Hawaii, or any other location outside the continental United States. The Department of Defense establishes per diem rates for Alaska, Hawaii, Puerto Rico, American Samoa, Guam, Midway, the Northern Mariana Islands, the U.S. Virgin Islands, Wake Island, and other non-foreign areas outside the continental United States. The Department of State establishes per diem rates for all other foreign areas.

You can use a special standard meal allowance if you work in the transportation industry. You are in the transportation industry if your work:

Directly involves moving people or goods by airplane, barge, bus, ship, train, or truck; and

Regularly requires you to travel away from home and, during any single trip, usually involves travel to areas eligible for different standard meal allowance rates.

Using the special rate for transportation workers eliminates the need for you to determine the standard meal allowance for every area where you stop for sleep or rest. If you choose to use the special rate for any trip, you must use the special rate (and not use the regular standard meal allowance rates) for all trips you take that year.

For both the day you depart for and the day you return from a business trip, you must prorate the standard meal allowance (figure a reduced amount for each day). You can do so by one of two methods.

Method 1: You can claim 3 / 4 of the standard meal allowance.

Method 2: You can prorate using any method that you consistently apply and that is in accordance with reasonable business practice.

You are employed in New Orleans as a convention planner. In March, your employer sent you on a 3-day trip to Washington, DC, to attend a planning seminar. You left your home in New Orleans at 10 a.m. on Wednesday and arrived in Washington, DC, at 5:30 p.m. After spending 2 nights there, you flew back to New Orleans on Friday and arrived back home at 8 p.m. Your employer gave you a flat amount to cover your expenses and included it with your wages.

Under Method 1 , you can claim 2½ days of the standard meal allowance for Washington, DC: 3 / 4 of the daily rate for Wednesday and Friday (the days you departed and returned), and the full daily rate for Thursday.

Under Method 2 , you could also use any method that you apply consistently and that is in accordance with reasonable business practice. For example, you could claim 3 days of the standard meal allowance even though a federal employee would have to use Method 1 and be limited to only 2½ days.

Travel in the United States

The following discussion applies to travel in the United States. For this purpose, the United States includes the 50 states and the District of Columbia. The treatment of your travel expenses depends on how much of your trip was business related and on how much of your trip occurred within the United States. See Part of Trip Outside the United States , later.

You can deduct all of your travel expenses if your trip was entirely business related. If your trip was primarily for business and, while at your business destination, you extended your stay for a vacation, made a personal side trip, or had other personal activities, you can deduct only your business-related travel expenses. These expenses include the travel costs of getting to and from your business destination and any business-related expenses at your business destination.

You work in Atlanta and take a business trip to New Orleans in May. Your business travel totals 900 miles round trip. On your way home, you stop in Mobile to visit your parents. You spend $2,165 for the 9 days you are away from home for travel, non-entertainment-related meals, lodging, and other travel expenses. If you hadn’t stopped in Mobile, you would have been gone only 6 days, and your total cost would have been $1,633.50. You can deduct $1,633.50 for your trip, including the cost of round-trip transportation to and from New Orleans. The deduction for your non-entertainment-related meals is subject to the 50% limit on meals mentioned earlier.

If your trip was primarily for personal reasons, such as a vacation, the entire cost of the trip is a nondeductible personal expense. However, you can deduct any expenses you have while at your destination that are directly related to your business.

A trip to a resort or on a cruise ship may be a vacation even if the promoter advertises that it is primarily for business. The scheduling of incidental business activities during a trip, such as viewing videotapes or attending lectures dealing with general subjects, won’t change what is really a vacation into a business trip.

Part of Trip Outside the United States

If part of your trip is outside the United States, use the rules described later in this chapter under Travel Outside the United States for that part of the trip. For the part of your trip that is inside the United States, use the rules for travel in the United States. Travel outside the United States doesn’t include travel from one point in the United States to another point in the United States. The following discussion can help you determine whether your trip was entirely within the United States.

If you travel by public transportation, any place in the United States where that vehicle makes a scheduled stop is a point in the United States. Once the vehicle leaves the last scheduled stop in the United States on its way to a point outside the United States, you apply the rules under Travel Outside the United States , later.

You fly from New York to Puerto Rico with a scheduled stop in Miami. Puerto Rico isn’t considered part of the United States for purposes of travel. You return to New York nonstop. The flight from New York to Miami is in the United States, so only the flight from Miami to Puerto Rico is outside the United States. Because there are no scheduled stops between Puerto Rico and New York, all of the return trip is outside the United States.

Travel by private car in the United States is travel between points in the United States, even though you are on your way to a destination outside the United States.

You travel by car from Denver to Mexico City and return. Your travel from Denver to the border and from the border back to Denver is travel in the United States, and the rules in this section apply. The rules below under Travel Outside the United States apply to your trip from the border to Mexico City and back to the border.

Travel Outside the United States

If any part of your business travel is outside the United States, some of your deductions for the cost of getting to and from your destination may be limited. For this purpose, the United States includes the 50 states and the District of Columbia.

How much of your travel expenses you can deduct depends in part upon how much of your trip outside the United States was business related.

Travel Entirely for Business or Considered Entirely for Business

You can deduct all your travel expenses of getting to and from your business destination if your trip is entirely for business or considered entirely for business.

If you travel outside the United States and you spend the entire time on business activities, you can deduct all of your travel expenses.

Even if you didn’t spend your entire time on business activities, your trip is considered entirely for business if you meet at least one of the following four exceptions.

Your trip is considered entirely for business if you didn’t have substantial control over arranging the trip. The fact that you control the timing of your trip doesn’t, by itself, mean that you have substantial control over arranging your trip.

You don’t have substantial control over your trip if you:

Are an employee who was reimbursed or paid a travel expense allowance, and

Aren’t related to your employer, or

Aren’t a managing executive.

“Related to your employer” is defined later in chapter 6 under Per Diem and Car Allowances .

A “managing executive” is an employee who has the authority and responsibility, without being subject to the veto of another, to decide on the need for the business travel.

A self-employed person generally has substantial control over arranging business trips.

Your trip is considered entirely for business if you were outside the United States for a week or less, combining business and nonbusiness activities. One week means 7 consecutive days. In counting the days, don’t count the day you leave the United States, but do count the day you return to the United States.

You traveled to Brussels primarily for business. You left Denver on Tuesday and flew to New York. On Wednesday, you flew from New York to Brussels, arriving the next morning. On Thursday and Friday, you had business discussions, and from Saturday until Tuesday, you were sightseeing. You flew back to New York, arriving Wednesday afternoon. On Thursday, you flew back to Denver.

Although you were away from your home in Denver for more than a week, you weren’t outside the United States for more than a week. This is because the day you depart doesn’t count as a day outside the United States.

You can deduct your cost of the round-trip flight between Denver and Brussels. You can also deduct the cost of your stay in Brussels for Thursday and Friday while you conducted business. However, you can’t deduct the cost of your stay in Brussels from Saturday through Tuesday because those days were spent on nonbusiness activities.

Your trip is considered entirely for business if:

You were outside the United States for more than a week, and

You spent less than 25% of the total time you were outside the United States on nonbusiness activities.

You flew from Seattle to Tokyo, where you spent 14 days on business and 5 days on personal matters. You then flew back to Seattle. You spent 1 day flying in each direction.

Because only 5 / 21 (less than 25%) of your total time abroad was for nonbusiness activities, you can deduct as travel expenses what it would have cost you to make the trip if you hadn’t engaged in any nonbusiness activity. The amount you can deduct is the cost of the round-trip plane fare and 16 days of non-entertainment-related meals (subject to the 50% Limit ), lodging, and other related expenses.

Your trip is considered entirely for business if you can establish that a personal vacation wasn’t a major consideration, even if you have substantial control over arranging the trip.

Travel Primarily for Business

If you travel outside the United States primarily for business but spend some of your time on other activities, you generally can’t deduct all of your travel expenses. You can only deduct the business portion of your cost of getting to and from your destination. You must allocate the costs between your business and other activities to determine your deductible amount. See Travel allocation rules , later.

If your trip outside the United States was primarily for business, you must allocate your travel time on a day-to-day basis between business days and nonbusiness days. The days you depart from and return to the United States are both counted as days outside the United States.

To figure the deductible amount of your round-trip travel expenses, use the following fraction. The numerator (top number) is the total number of business days outside the United States. The denominator (bottom number) is the total number of business and nonbusiness days of travel.

Your business days include transportation days, days your presence was required, days you spent on business, and certain weekends and holidays.

Count as a business day any day you spend traveling to or from a business destination. However, if because of a nonbusiness activity you don’t travel by a direct route, your business days are the days it would take you to travel a reasonably direct route to your business destination. Extra days for side trips or nonbusiness activities can’t be counted as business days.

Count as a business day any day your presence is required at a particular place for a specific business purpose. Count it as a business day even if you spend most of the day on nonbusiness activities.

If your principal activity during working hours is the pursuit of your trade or business, count the day as a business day. Also, count as a business day any day you are prevented from working because of circumstances beyond your control.

Count weekends, holidays, and other necessary standby days as business days if they fall between business days. But if they follow your business meetings or activity and you remain at your business destination for nonbusiness or personal reasons, don’t count them as business days.

Your tax home is New York City. You travel to Quebec, where you have a business meeting on Friday. You have another meeting on the following Monday. Because your presence was required on both Friday and Monday, they are business days. Because the weekend is between business days, Saturday and Sunday are counted as business days. This is true even though you use the weekend for sightseeing, visiting friends, or other nonbusiness activity.

If, in Example 1 , you had no business in Quebec after Friday, but stayed until Monday before starting home, Saturday and Sunday would be nonbusiness days.

If you stopped for a vacation or other nonbusiness activity either on the way from the United States to your business destination, or on the way back to the United States from your business destination, you must allocate part of your travel expenses to the nonbusiness activity.

The part you must allocate is the amount it would have cost you to travel between the point where travel outside the United States begins and your nonbusiness destination and a return to the point where travel outside the United States ends.

You determine the nonbusiness portion of that expense by multiplying it by a fraction. The numerator (top number) of the fraction is the number of nonbusiness days during your travel outside the United States, and the denominator (bottom number) is the total number of days you spend outside the United States.

You live in New York. On May 4, you flew to Paris to attend a business conference that began on May 5. The conference ended at noon on May 14. That evening, you flew to Dublin where you visited with friends until the afternoon of May 21, when you flew directly home to New York. The primary purpose for the trip was to attend the conference.

If you hadn’t stopped in Dublin, you would have arrived home the evening of May 14. You don’t meet any of the exceptions that would allow you to consider your travel entirely for business. May 4 through May 14 (11 days) are business days and May 15 through May 21 (7 days) are nonbusiness days.

You can deduct the cost of your non-entertainment-related meals (subject to the 50% Limit ), lodging, and other business-related travel expenses while in Paris.

You can’t deduct your expenses while in Dublin. You also can’t deduct 7 / 18 of what it would have cost you to travel round trip between New York and Dublin.

You paid $750 to fly from New York to Paris, $400 to fly from Paris to Dublin, and $700 to fly from Dublin back to New York. Round-trip airfare from New York to Dublin would have been $1,250.

You figure the deductible part of your air travel expenses by subtracting 7 / 18 of the round-trip airfare and other expenses you would have had in traveling directly between New York and Dublin ($1,250 × 7 / 18 = $486) from your total expenses in traveling from New York to Paris to Dublin and back to New York ($750 + $400 + $700 = $1,850).

Your deductible air travel expense is $1,364 ($1,850 − $486).

If you had a vacation or other nonbusiness activity at, near, or beyond your business destination, you must allocate part of your travel expenses to the nonbusiness activity.

The part you must allocate is the amount it would have cost you to travel between the point where travel outside the United States begins and your business destination and a return to the point where travel outside the United States ends.

None of your travel expenses for nonbusiness activities at, near, or beyond your business destination are deductible.

Assume that the dates are the same as in the previous example but that instead of going to Dublin for your vacation, you fly to Venice, Italy, for a vacation.

You can’t deduct any part of the cost of your trip from Paris to Venice and return to Paris. In addition, you can’t deduct 7 / 18 of the airfare and other expenses from New York to Paris and back to New York.

You can deduct 11 / 18 of the round-trip plane fare and other travel expenses from New York to Paris, plus your non-entertainment-related meals (subject to the 50% Limit ), lodging, and any other business expenses you had in Paris. (Assume these expenses total $4,939.) If the round-trip plane fare and other travel-related expenses (such as food during the trip) are $1,750, you can deduct travel costs of $1,069 ( 11 / 18 × $1,750), plus the full $4,939 for the expenses you had in Paris.

You can use another method of counting business days if you establish that it more clearly reflects the time spent on other than business activities outside the United States.

If you travel outside the United States primarily for vacation or for investment purposes, the entire cost of the trip is a nondeductible personal expense. However, if you spend some time attending brief professional seminars or a continuing education program, you can deduct your registration fees and other expenses you have that are directly related to your business.

The university from which you graduated has a continuing education program for members of its alumni association. This program consists of trips to various foreign countries where academic exercises and conferences are set up to acquaint individuals in most occupations with selected facilities in several regions of the world. However, none of the conferences are directed toward specific occupations or professions. It is up to each participant to seek out specialists and organizational settings appropriate to their occupational interests.

Three-hour sessions are held each day over a 5-day period at each of the selected overseas facilities where participants can meet with individual practitioners. These sessions are composed of a variety of activities including workshops, mini-lectures, roleplaying, skill development, and exercises. Professional conference directors schedule and conduct the sessions. Participants can choose those sessions they wish to attend.

You can participate in this program because you are a member of the alumni association. You and your family take one of the trips. You spend about 2 hours at each of the planned sessions. The rest of the time you go touring and sightseeing with your family. The trip lasts less than 1 week.

Your travel expenses for the trip aren’t deductible since the trip was primarily a vacation. However, registration fees and any other incidental expenses you have for the five planned sessions you attended that are directly related and beneficial to your business are deductible business expenses. These expenses should be specifically stated in your records to ensure proper allocation of your deductible business expenses.

Luxury Water Travel

If you travel by ocean liner, cruise ship, or other form of luxury water transportation for business purposes, there is a daily limit on the amount you can deduct. The limit is twice the highest federal per diem rate allowable at the time of your travel. (Generally, the federal per diem is the amount paid to federal government employees for daily living expenses when they travel away from home within the United States for business purposes.)

The highest federal per diem rate allowed and the daily limit for luxury water travel in 2023 are shown in the following table.

You are a travel agent and traveled by ocean liner from New York to London, England, on business in May. Your expense for the 6-day cruise was $6,200. Your deduction for the cruise can’t exceed $4,776 (6 days × $796 daily limit).

If your expenses for luxury water travel include separately stated amounts for meals or entertainment, those amounts are subject to the 50% limit on non-entertainment-related meals and entertainment before you apply the daily limit. For a discussion of the 50% Limit , see chapter 2.

In the previous example, your luxury water travel had a total cost of $6,200. Of that amount, $3,700 was separately stated as non-entertainment-related meals and $1,000 was separately stated as entertainment. Considering that you are self-employed, you aren’t reimbursed for any of your travel expenses. You figure your deductible travel expenses as follows.

If your meal or entertainment charges aren’t separately stated or aren’t clearly identifiable, you don’t have to allocate any portion of the total charge to meals or entertainment.

The daily limit on luxury water travel (discussed earlier) doesn’t apply to expenses you have to attend a convention, seminar, or meeting on board a cruise ship. See Cruise Ships , later, under Conventions.

Conventions

You can deduct your travel expenses when you attend a convention if you can show that your attendance benefits your trade or business. You can’t deduct the travel expenses for your family.

If the convention is for investment, political, social, or other purposes unrelated to your trade or business, you can’t deduct the expenses.

The convention agenda or program generally shows the purpose of the convention. You can show your attendance at the convention benefits your trade or business by comparing the agenda with the official duties and responsibilities of your position. The agenda doesn’t have to deal specifically with your official duties and responsibilities; it will be enough if the agenda is so related to your position that it shows your attendance was for business purposes.

Conventions Held Outside the North American Area

You can’t deduct expenses for attending a convention, seminar, or similar meeting held outside the North American area unless:

The meeting is directly related to the active conduct of your trade or business, and

It is as reasonable to hold the meeting outside the North American area as within the North American area. See Reasonableness test , later.

The North American area includes the following locations.

The following factors are taken into account to determine if it was as reasonable to hold the meeting outside the North American area as within the North American area.

The purpose of the meeting and the activities taking place at the meeting.

The purposes and activities of the sponsoring organizations or groups.

The homes of the active members of the sponsoring organizations and the places at which other meetings of the sponsoring organizations or groups have been or will be held.

Other relevant factors you may present.

You can deduct up to $2,000 per year of your expenses of attending conventions, seminars, or similar meetings held on cruise ships. All ships that sail are considered cruise ships.

You can deduct these expenses only if all of the following requirements are met.

The convention, seminar, or meeting is directly related to the active conduct of your trade or business.

The cruise ship is a vessel registered in the United States.

All of the cruise ship's ports of call are in the United States or in territories of the United States.

You attach to your return a written statement signed by you that includes information about:

The total days of the trip (not including the days of transportation to and from the cruise ship port),

The number of hours each day that you devoted to scheduled business activities, and

A program of the scheduled business activities of the meeting.

You attach to your return a written statement signed by an officer of the organization or group sponsoring the meeting that includes:

A schedule of the business activities of each day of the meeting, and

The number of hours you attended the scheduled business activities.

2. Meals and Entertainment

You can no longer take a deduction for any expense related to activities generally considered entertainment, amusement, or recreation. You can continue to deduct 50% of the cost of business meals if you (or your employee) are present and the food or beverages aren't considered lavish or extravagant.

Entertainment

Entertainment—defined.

Entertainment includes any activity generally considered to provide entertainment, amusement, or recreation. Examples include entertaining guests at nightclubs; at social, athletic, and sporting clubs; at theaters; at sporting events; on yachts; or on hunting, fishing, vacation, and similar trips. Entertainment may also include meeting personal, living, or family needs of individuals, such as providing meals, a hotel suite, or a car to customers or their families.

Your kind of business may determine if a particular activity is considered entertainment. For example, if you are a dress designer and have a fashion show to introduce your new designs to store buyers, the show generally isn’t considered entertainment. This is because fashion shows are typical in your business. But, if you are an appliance distributor and hold a fashion show for the spouses of your retailers, the show is generally considered entertainment.

If you have one expense that includes the costs of entertainment and other services (such as lodging or transportation), you must allocate that expense between the cost of entertainment and the cost of other services. You must have a reasonable basis for making this allocation. For example, you must allocate your expenses if a hotel includes entertainment in its lounge on the same bill with your room charge.

In general, entertainment expenses are nondeductible. However, there are a few exceptions to the general rule, including:

Entertainment treated as compensation on your originally filed tax returns (and treated as wages to your employees);

Recreational expenses for employees such as a holiday party or a summer picnic;

Expenses related to attending business meetings or conventions of certain exempt organizations such as business leagues, chambers of commerce, professional associations, etc.; and

Entertainment sold to customers. For example, if you run a nightclub, your expenses for the entertainment you furnish to your customers, such as a floor show, aren’t subject to the nondeductible rules.

Examples of Nondeductible Entertainment

Generally, you can't deduct any expense for an entertainment event. This includes expenses for entertaining guests at nightclubs; at social, athletic, and sporting clubs; at theaters; at sporting events; on yachts; or on hunting, fishing, vacation, and similar trips.

Generally, you can’t deduct any expense for the use of an entertainment facility. This includes expenses for depreciation and operating costs such as rent, utilities, maintenance, and protection.

An entertainment facility is any property you own, rent, or use for entertainment. Examples include a yacht, hunting lodge, fishing camp, swimming pool, tennis court, bowling alley, car, airplane, apartment, hotel suite, or home in a vacation resort.

You can’t deduct dues (including initiation fees) for membership in any club organized for business, pleasure, recreation, or other social purposes.

This rule applies to any membership organization if one of its principal purposes is either:

To conduct entertainment activities for members or their guests; or

To provide members or their guests with access to entertainment facilities, discussed later.

The purposes and activities of a club, not its name, will determine whether or not you can deduct the dues. You can’t deduct dues paid to:

Country clubs,

Golf and athletic clubs,

Airline clubs,

Hotel clubs, and

Clubs operated to provide meals under circumstances generally considered to be conducive to business discussions.

Any item that might be considered either a gift or entertainment will generally be considered entertainment. However, if you give a customer packaged food or beverages that you intend the customer to use at a later date, treat it as a gift.

As discussed above, entertainment expenses are generally nondeductible. However, you may continue to deduct 50% of the cost of business meals if you (or an employee) is present and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant, or similar business contact.

Food and beverages that are provided during entertainment events are not considered entertainment if purchased separately from the entertainment, or if the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts. However, the entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.

Any allowed expense must be ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your business. An expense doesn't have to be required to be considered necessary. Expenses must not be lavish or extravagant. An expense isn't considered lavish or extravagant if it is reasonable based on the facts and circumstances.

For each example, assume that the food and beverage expenses are ordinary and necessary expenses under section 162(a) paid or incurred during the tax year in carrying on a trade or business and are not lavish or extravagant under the circumstances. Also assume that the taxpayer and the business contact are not engaged in a trade or business that has any relation to the entertainment activity.

Taxpayer A invites B, a business contact, to a baseball game. A purchases tickets for A and B to attend the game. While at the game, A buys hot dogs and drinks for A and B. The baseball game is entertainment as defined in Regulations section 1.274-11(b)(1)(i) and, thus, the cost of the game tickets is an entertainment expense and is not deductible by A. The cost of the hot dogs and drinks, which are purchased separately from the game tickets, is not an entertainment expense and is not subject to the section 274(a)(1) disallowance. Therefore, A may deduct 50% of the expenses associated with the hot dogs and drinks purchased at the game.

Taxpayer C invites D, a business contact, to a basketball game. C purchases tickets for C and D to attend the game in a suite, where they have access to food and beverages. The cost of the basketball game tickets, as stated on the invoice, includes the food and beverages. The basketball game is entertainment as defined in Regulations section 1.274-11(b)(1)(i) and, thus, the cost of the game tickets is an entertainment expense and is not deductible by C. The cost of the food and beverages, which are not purchased separately from the game tickets, is not stated separately on the invoice. Thus, the cost of the food and beverages is also an entertainment expense that is subject to the section 274(a)(1) disallowance. Therefore, C may not deduct any of the expenses associated with the basketball game.

Assume the same facts as in Example 2 , except that the invoice for the basketball game tickets separately states the cost of the food and beverages. As in Example 2 , the basketball game is entertainment as defined in Regulations section 1.274-2(b)(1)(i) and, thus, the cost of the game tickets, other than the cost of the food and beverages, is an entertainment expense and is not deductible by C. However, the cost of the food and beverages, which is stated separately on the invoice for the game tickets, is not an entertainment expense and is not subject to the section 274(a)(1) disallowance. Therefore, C may deduct 50% of the expenses associated with the food and beverages provided at the game.

In general, you can deduct only 50% of your business-related meal expenses, unless an exception applies. (If you are subject to the Department of Transportation's “hours of service” limits, you can deduct 80% of your business-related meal expenses. See Individuals subject to hours of service limits , later.)

The 50% limit applies to employees or their employers, and to self-employed persons (including independent contractors) or their clients, depending on whether the expenses are reimbursed.

Examples of meals might include:

Meals while traveling away from home (whether eating alone or with others) on business, or

Meal at a business convention or business league meeting.

Figure A. Does the 50% Limit Apply to Your Expenses?

There are exceptions to these rules. See Exceptions to the 50% Limit for Meals , later.

Figure A. Does the 50% limit apply to Your Expenses?TAs for Figure A are: Notice 87-23; Form 2106 instructions

Summary: This is a flowchart used to determine if employees and self-employed persons need to put a 50% limit on their business expense deductions.

This is the starting of the flowchart.

Decision (1)

Were your meal and entertainment expenses reimbursed? (Count only reimbursements your employer didn’t include in box 1 of your Form W-2. If self-employed, count only reimbursements from clients or customers that aren’t included on Form 1099-MISC, Miscellaneous Income.)

Decision (2)

If an employee, did you adequately account to your employer under an accountable plan? If self-employed, did you provide the payer with adequate records? (See Chapter 6.)

Decision (3)

Did your expenses exceed the reimbursement?

Decision (4)

Process (a)

Your meal and entertainment expenses are NOT subject to the limitations. However, since the reimbursement wasn’t treated as wages or as other taxable income, you can’t deduct the expenses.

Process (b)

Your nonentertainment meal expenses ARE subject to the 50% limit. Your entertainment expenses are nondeductible.

This is the ending of the flowchart.

Please click here for the text description of the image.

Taxes and tips relating to a business meal are included as a cost of the meal and are subject to the 50% limit. However, the cost of transportation to and from the meal is not treated as part of the cost and would not be subject to the limit.

The 50% limit on meal expenses applies if the expense is otherwise deductible and isn’t covered by one of the exceptions discussed later. Figure A can help you determine if the 50% limit applies to you.

The 50% limit also applies to certain meal expenses that aren’t business related. It applies to meal expenses you have for the production of income, including rental or royalty income. It also applies to the cost of meals included in deductible educational expenses.

The 50% limit will apply after determining the amount that would otherwise qualify for a deduction. You first have to determine the amount of meal expenses that would be deductible under the other rules discussed in this publication.

If a group of business acquaintances takes turns picking up each others' meal checks primarily for personal reasons, without regard to whether any business purposes are served, no member of the group can deduct any part of the expense.

You spend $200 (including tax and tip) for a business meal. If $110 of that amount isn’t allowable because it is lavish and extravagant, the remaining $90 is subject to the 50% limit. Your deduction can’t be more than $45 (50% (0.50) × $90).

You purchase two tickets to a concert for $200 for you and your client. Your deduction is zero because no deduction is allowed for entertainment expenses.

Exception to the 50% Limit for Meals

Your meal expense isn’t subject to the 50% limit if the expense meets one of the following exceptions.

In general, expenses for goods, services, and facilities, to the extent the expenses are treated by the taxpayer, with respect to entertainment, amusement, or recreation, as compensation to an employee and as wages to the employee for tax purposes.

If you are an employee, you aren’t subject to the 50% limit on expenses for which your employer reimburses you under an accountable plan. Accountable plans are discussed in chapter 6.

If you are self-employed, your deductible meal expenses aren’t subject to the 50% limit if all of the following requirements are met.

You have these expenses as an independent contractor.

Your customer or client reimburses you or gives you an allowance for these expenses in connection with services you perform.

You provide adequate records of these expenses to your customer or client. (See chapter 5 .)

In this case, your client or customer is subject to the 50% limit on the expenses.

You are a self-employed attorney who adequately accounts for meal expenses to a client who reimburses you for these expenses. You aren’t subject to the limitation on meal expenses. If the client can deduct the expenses, the client is subject to the 50% limit.

If you (as an independent contractor) have expenses for meals related to providing services for a client but don’t adequately account for and seek reimbursement from the client for those expenses, you are subject to the 50% limit on non-entertainment-related meals and the entertainment-related meal expenses are nondeductible to you.

You aren't subject to the 50% limit for expenses for recreational, social, or similar activities (including facilities) such as a holiday party or a summer picnic.

You aren’t subject to the 50% limit if you provide meals to the general public as a means of advertising or promoting goodwill in the community. For example, neither the expense of sponsoring a television or radio show nor the expense of distributing free food and beverages to the general public is subject to the 50% limit.

You aren’t subject to the 50% limit if you actually sell meals to the public. For example, if you run a restaurant, your expense for the food you furnish to your customers isn’t subject to the 50% limit.

You can deduct a higher percentage of your meal expenses while traveling away from your tax home if the meals take place during or incident to any period subject to the Department of Transportation's “hours of service” limits. The percentage is 80%.

Individuals subject to the Department of Transportation's “hours of service” limits include the following persons.

Certain air transportation workers (such as pilots, crew, dispatchers, mechanics, and control tower operators) who are under Federal Aviation Administration regulations.

Interstate truck operators and bus drivers who are under Department of Transportation regulations.

Certain railroad employees (such as engineers, conductors, train crews, dispatchers, and control operations personnel) who are under Federal Railroad Administration regulations.

Certain merchant mariners who are under Coast Guard regulations.

If you give gifts in the course of your trade or business, you may be able to deduct all or part of the cost. This chapter explains the limits and rules for deducting the costs of gifts.

You can deduct no more than $25 for business gifts you give directly or indirectly to each person during your tax year. A gift to a company that is intended for the eventual personal use or benefit of a particular person or a limited class of people will be considered an indirect gift to that particular person or to the individuals within that class of people who receive the gift.

If you give a gift to a member of a customer's family, the gift is generally considered to be an indirect gift to the customer. This rule doesn’t apply if you have a bona fide, independent business connection with that family member and the gift isn’t intended for the customer's eventual use.

If you and your spouse both give gifts, both of you are treated as one taxpayer. It doesn’t matter whether you have separate businesses, are separately employed, or whether each of you has an independent connection with the recipient. If a partnership gives gifts, the partnership and the partners are treated as one taxpayer.

You sell products to a local company. You and your spouse gave the local company three gourmet gift baskets to thank them for their business. You and your spouse paid $80 for each gift basket, or $240 total. Three of the local company's executives took the gift baskets home for their families' use. You and your spouse have no independent business relationship with any of the executives' other family members. You and your spouse can deduct a total of $75 ($25 limit × 3) for the gift baskets.

Incidental costs, such as engraving on jewelry, or packaging, insuring, and mailing, are generally not included in determining the cost of a gift for purposes of the $25 limit.

A cost is incidental only if it doesn’t add substantial value to the gift. For example, the cost of gift wrapping is an incidental cost. However, the purchase of an ornamental basket for packaging fruit isn’t an incidental cost if the value of the basket is substantial compared to the value of the fruit.

The following items aren’t considered gifts for purposes of the $25 limit.

An item that costs $4 or less and:

Has your name clearly and permanently imprinted on the gift, and

Is one of a number of identical items you widely distribute. Examples include pens, desk sets, and plastic bags and cases.

Signs, display racks, or other promotional material to be used on the business premises of the recipient.

Figure B. When Are Transportation Expenses Deductible?

Most employees and self-employed persons can use this chart. (Don’t use this chart if your home is your principal place of business. See Office in the home , later.)

Figure B. When Are Local Transportation Expenses Deductible?TAs for Figure B are: Reg 1.162-1(a); RR 55–109; RR 94–47

Summary: This illustration depicts the rules used to determine if transportation expenses are deductible.

The image then lists definitions for words used in the graphic:

Any item that might be considered either a gift or entertainment will generally be considered entertainment. However, if you give a customer packaged food or beverages you intend the customer to use at a later date, treat it as a gift.

4. Transportation

This chapter discusses expenses you can deduct for business transportation when you aren’t traveling away from home , as defined in chapter 1. These expenses include the cost of transportation by air, rail, bus, taxi, etc., and the cost of driving and maintaining your car.

Transportation expenses include the ordinary and necessary costs of all of the following.

Getting from one workplace to another in the course of your business or profession when you are traveling within the city or general area that is your tax home. Tax home is defined in chapter 1.

Visiting clients or customers.

Going to a business meeting away from your regular workplace.

Getting from your home to a temporary workplace when you have one or more regular places of work. These temporary workplaces can be either within the area of your tax home or outside that area.

Daily transportation expenses you incur while traveling from home to one or more regular places of business are generally nondeductible commuting expenses. However, there may be exceptions to this general rule. You can deduct daily transportation expenses incurred going between your residence and a temporary work station outside the metropolitan area where you live. Also, daily transportation expenses can be deducted if (1) you have one or more regular work locations away from your residence; or (2) your residence is your principal place of business and you incur expenses going between the residence and another work location in the same trade or business, regardless of whether the work is temporary or permanent and regardless of the distance.

Illustration of transportation expenses.

Figure B above illustrates the rules that apply for deducting transportation expenses when you have a regular or main job away from your home. You may want to refer to it when deciding whether you can deduct your transportation expenses.

If you have one or more regular work locations away from your home and you commute to a temporary work location in the same trade or business, you can deduct the expenses of the daily round-trip transportation between your home and the temporary location, regardless of distance.

If your employment at a work location is realistically expected to last (and does in fact last) for 1 year or less, the employment is temporary unless there are facts and circumstances that would indicate otherwise.

If your employment at a work location is realistically expected to last for more than 1 year or if there is no realistic expectation that the employment will last for 1 year or less, the employment isn’t temporary, regardless of whether it actually lasts for more than 1 year.

If employment at a work location initially is realistically expected to last for 1 year or less, but at some later date the employment is realistically expected to last more than 1 year, that employment will be treated as temporary (unless there are facts and circumstances that would indicate otherwise) until your expectation changes. It won’t be treated as temporary after the date you determine it will last more than 1 year.

If the temporary work location is beyond the general area of your regular place of work and you stay overnight, you are traveling away from home. You may have deductible travel expenses, as discussed in chapter 1 .

If you have no regular place of work but ordinarily work in the metropolitan area where you live, you can deduct daily transportation costs between home and a temporary work site outside that metropolitan area.

Generally, a metropolitan area includes the area within the city limits and the suburbs that are considered part of that metropolitan area.

You can’t deduct daily transportation costs between your home and temporary work sites within your metropolitan area. These are nondeductible commuting expenses.

If you work at two places in 1 day, whether or not for the same employer, you can deduct the expense of getting from one workplace to the other. However, if for some personal reason you don’t go directly from one location to the other, you can’t deduct more than the amount it would have cost you to go directly from the first location to the second.

Transportation expenses you have in going between home and a part-time job on a day off from your main job are commuting expenses. You can’t deduct them.

A meeting of an Armed Forces reserve unit is a second place of business if the meeting is held on a day on which you work at your regular job. You can deduct the expense of getting from one workplace to the other as just discussed under Two places of work .

You usually can’t deduct the expense if the reserve meeting is held on a day on which you don’t work at your regular job. In this case, your transportation is generally a nondeductible commuting expense. However, you can deduct your transportation expenses if the location of the meeting is temporary and you have one or more regular places of work.

If you ordinarily work in a particular metropolitan area but not at any specific location and the reserve meeting is held at a temporary location outside that metropolitan area, you can deduct your transportation expenses.

If you travel away from home overnight to attend a guard or reserve meeting, you can deduct your travel expenses. These expenses are discussed in chapter 1 .

If you travel more than 100 miles away from home in connection with your performance of services as a member of the reserves, you may be able to deduct some of your reserve-related travel costs as an adjustment to gross income rather than as an itemized deduction. For more information, see Armed Forces Reservists Traveling More Than 100 Miles From Home under Special Rules in chapter 6.

You can’t deduct the costs of taking a bus, trolley, subway, or taxi, or of driving a car between your home and your main or regular place of work. These costs are personal commuting expenses. You can’t deduct commuting expenses no matter how far your home is from your regular place of work. You can’t deduct commuting expenses even if you work during the commuting trip.

You sometimes use your cell phone to make business calls while commuting to and from work. Sometimes business associates ride with you to and from work, and you have a business discussion in the car. These activities don’t change the trip from personal to business. You can’t deduct your commuting expenses.

Fees you pay to park your car at your place of business are nondeductible commuting expenses. You can, however, deduct business-related parking fees when visiting a customer or client.

Putting display material that advertises your business on your car doesn’t change the use of your car from personal use to business use. If you use this car for commuting or other personal uses, you still can’t deduct your expenses for those uses.

You can’t deduct the cost of using your car in a nonprofit car pool. Don’t include payments you receive from the passengers in your income. These payments are considered reimbursements of your expenses. However, if you operate a car pool for a profit, you must include payments from passengers in your income. You can then deduct your car expenses (using the rules in this publication).

Hauling tools or instruments in your car while commuting to and from work doesn’t make your car expenses deductible. However, you can deduct any additional costs you have for hauling tools or instruments (such as for renting a trailer you tow with your car).

If you get your work assignments at a union hall and then go to your place of work, the costs of getting from the union hall to your place of work are nondeductible commuting expenses. Although you need the union to get your work assignments, you are employed where you work, not where the union hall is located.

If you have an office in your home that qualifies as a principal place of business, you can deduct your daily transportation costs between your home and another work location in the same trade or business. (See Pub. 587, Business Use of Your Home, for information on determining if your home office qualifies as a principal place of business.)

The following examples show when you can deduct transportation expenses based on the location of your work and your home.

You regularly work in an office in the city where you live. Your employer sends you to a 1-week training session at a different office in the same city. You travel directly from your home to the training location and return each day. You can deduct the cost of your daily round-trip transportation between your home and the training location.

Your principal place of business is in your home. You can deduct the cost of round-trip transportation between your qualifying home office and your client's or customer's place of business.

You have no regular office, and you don’t have an office in your home. In this case, the location of your first business contact inside the metropolitan area is considered your office. Transportation expenses between your home and this first contact are nondeductible commuting expenses. Transportation expenses between your last business contact and your home are also nondeductible commuting expenses. While you can’t deduct the costs of these trips, you can deduct the costs of going from one client or customer to another.

Car Expenses

If you use your car for business purposes, you may be able to deduct car expenses. You can generally use one of the two following methods to figure your deductible expenses.

Actual car expenses.

The cost of using your car as an employee, whether measured using actual expenses or the standard mileage rate, will no longer be allowed to be claimed as an unreimbursed employee travel expense as a miscellaneous itemized deduction due to the suspension of miscellaneous itemized deductions that are subject to the 2% floor under section 67(a). The suspension applies to tax years beginning after December 2017 and before January 2026. Deductions for expenses that are deductible in determining adjusted gross income are not suspended. For example, Armed Forces reservists, qualified performing artists, and fee-basis state or local government officials are allowed to deduct unreimbursed employee travel expenses as an adjustment to total income on Schedule 1 (Form 1040), line 12.

If you use actual expenses to figure your deduction for a car you lease, there are rules that affect the amount of your lease payments you can deduct. See Leasing a Car , later.

In this publication, “car” includes a van, pickup, or panel truck. For the definition of “car” for depreciation purposes, see Car defined under Actual Car Expenses , later.

Standard Mileage Rate

For 2023, the standard mileage rate for the cost of operating your car for business use is 65.5 cents ($0.655) per mile.

You can generally use the standard mileage rate whether or not you are reimbursed and whether or not any reimbursement is more or less than the amount figured using the standard mileage rate. See chapter 6 for more information on reimbursements .

If you want to use the standard mileage rate for a car you own, you must choose to use it in the first year the car is available for use in your business. Then, in later years, you can choose to use either the standard mileage rate or actual expenses.

If you want to use the standard mileage rate for a car you lease, you must use it for the entire lease period. For leases that began on or before December 31, 1997, the standard mileage rate must be used for the entire portion of the lease period (including renewals) that is after 1997.

You must make the choice to use the standard mileage rate by the due date (including extensions) of your return. You can’t revoke the choice. However, in later years, you can switch from the standard mileage rate to the actual expenses method. If you change to the actual expenses method in a later year, but before your car is fully depreciated, you have to estimate the remaining useful life of the car and use straight line depreciation for the car’s remaining estimated useful life, subject to depreciation limits (discussed later).

For more information about depreciation included in the standard mileage rate, see Exception under Methods of depreciation , later.

You can’t use the standard mileage rate if you:

Use five or more cars at the same time (such as in fleet operations);

Claimed a depreciation deduction for the car using any method other than straight line for the car’s estimated useful life;

Used the Modified Accelerated Cost Recovery System (MACRS) (as discussed later under Depreciation Deduction );

Claimed a section 179 deduction (discussed later) on the car;

Claimed the special depreciation allowance on the car; or

Claimed actual car expenses after 1997 for a car you leased.

You can elect to use the standard mileage rate if you used a car for hire (such as a taxi) unless the standard mileage rate is otherwise not allowed, as discussed above.

If you own or lease five or more cars that are used for business at the same time, you can’t use the standard mileage rate for the business use of any car. However, you may be able to deduct your actual expenses for operating each of the cars in your business. See Actual Car Expenses , later, for information on how to figure your deduction.

You aren’t using five or more cars for business at the same time if you alternate using (use at different times) the cars for business.

The following examples illustrate the rules for when you can and can’t use the standard mileage rate for five or more cars.

A salesperson owns three cars and two vans that they alternate using for calling on their customers. The salesperson can use the standard mileage rate for the business mileage of the three cars and the two vans because they don’t use them at the same time.

You and your employees use your four pickup trucks in your landscaping business. During the year, you traded in two of your old trucks for two newer ones. You can use the standard mileage rate for the business mileage of all six of the trucks you owned during the year.

You own a repair shop and an insurance business. You and your employees use your two pickup trucks and van for the repair shop. You alternate using your two cars for the insurance business. No one else uses the cars for business purposes. You can use the standard mileage rate for the business use of the pickup trucks, the van, and the cars because you never have more than four vehicles used for business at the same time.

You own a car and four vans that are used in your housecleaning business. Your employees use the vans, and you use the car to travel to various customers. You can’t use the standard mileage rate for the car or the vans. This is because all five vehicles are used in your business at the same time. You must use actual expenses for all vehicles.

If you are an employee, you can’t deduct any interest paid on a car loan. This applies even if you use the car 100% for business as an employee.

However, if you are self-employed and use your car in your business, you can deduct that part of the interest expense that represents your business use of the car. For example, if you use your car 60% for business, you can deduct 60% of the interest on Schedule C (Form 1040). You can’t deduct the part of the interest expense that represents your personal use of the car.

If you itemize your deductions on Schedule A (Form 1040), you can deduct on line 5c state and local personal property taxes on motor vehicles. You can take this deduction even if you use the standard mileage rate or if you don’t use the car for business.

If you are self-employed and use your car in your business, you can deduct the business part of state and local personal property taxes on motor vehicles on Schedule C (Form 1040), or Schedule F (Form 1040). If you itemize your deductions, you can include the remainder of your state and local personal property taxes on the car on Schedule A (Form 1040).

In addition to using the standard mileage rate, you can deduct any business-related parking fees and tolls. (Parking fees you pay to park your car at your place of work are nondeductible commuting expenses.)

If you sell, trade in, or otherwise dispose of your car, you may have a gain or loss on the transaction or an adjustment to the basis of your new car. See Disposition of a Car , later.

Actual Car Expenses

If you don’t use the standard mileage rate, you may be able to deduct your actual car expenses.

Actual car expenses include:

If you have fully depreciated a car that you still use in your business, you can continue to claim your other actual car expenses. Continue to keep records, as explained later in chapter 5 .

If you use your car for both business and personal purposes, you must divide your expenses between business and personal use. You can divide your expense based on the miles driven for each purpose.

You are a contractor and drive your car 20,000 miles during the year: 12,000 miles for business use and 8,000 miles for personal use. You can claim only 60% (12,000 ÷ 20,000) of the cost of operating your car as a business expense.

If you use a vehicle provided by your employer for business purposes, you can deduct your actual unreimbursed car expenses. You can’t use the standard mileage rate. See Vehicle Provided by Your Employer in chapter 6.

If you are an employee, you can’t deduct any interest paid on a car loan. This interest is treated as personal interest and isn’t deductible. If you are self-employed and use your car in that business, see Interest , earlier, under Standard Mileage Rate.

If you are an employee, you can deduct personal property taxes paid on your car if you itemize deductions. Enter the amount paid on Schedule A (Form 1040), line 5c.

Generally, sales taxes on your car are part of your car's basis and are recovered through depreciation, discussed later.

You can’t deduct fines you pay or collateral you forfeit for traffic violations.

If your car is damaged, destroyed, or stolen, you may be able to deduct part of the loss not covered by insurance. See Pub. 547, Casualties, Disasters, and Thefts, for information on deducting a loss on your car.

Generally, the cost of a car, plus sales tax and improvements, is a capital expense. Because the benefits last longer than 1 year, you generally can’t deduct a capital expense. However, you can recover this cost through the section 179 deduction (the deduction allowed by section 179 of the Internal Revenue Code), special depreciation allowance, and depreciation deductions. Depreciation allows you to recover the cost over more than 1 year by deducting part of it each year. The section 179 deduction , special depreciation allowance , and depreciation deductions are discussed later.

Generally, there are limits on these deductions. Special rules apply if you use your car 50% or less in your work or business.

You can claim a section 179 deduction and use a depreciation method other than straight line only if you don’t use the standard mileage rate to figure your business-related car expenses in the year you first place a car in service.

If, in the year you first place a car in service, you claim either a section 179 deduction or use a depreciation method other than straight line for its estimated useful life, you can’t use the standard mileage rate on that car in any future year.

For depreciation purposes, a car is any four-wheeled vehicle (including a truck or van) made primarily for use on public streets, roads, and highways. Its unloaded gross vehicle weight (for trucks and vans, gross vehicle weight) must not be more than 6,000 pounds. A car includes any part, component, or other item physically attached to it or usually included in the purchase price.

A car doesn’t include:

An ambulance, hearse, or combination ambulance-hearse used directly in a business;

A vehicle used directly in the business of transporting persons or property for pay or hire; or

A truck or van that is a qualified nonpersonal use vehicle.

These are vehicles that by their nature aren’t likely to be used more than a minimal amount for personal purposes. They include trucks and vans that have been specially modified so that they aren’t likely to be used more than a minimal amount for personal purposes, such as by installation of permanent shelving and painting the vehicle to display advertising or the company's name. Delivery trucks with seating only for the driver, or only for the driver plus a folding jump seat, are qualified nonpersonal use vehicles.

See Depreciation Deduction , later, for more information on how to depreciate your vehicle.

Section 179 Deduction

You can elect to recover all or part of the cost of a car that is qualifying section 179 property, up to a limit, by deducting it in the year you place the property in service. This is the section 179 deduction. If you elect the section 179 deduction, you must reduce your depreciable basis in the car by the amount of the section 179 deduction.

You can claim the section 179 deduction only in the year you place the car in service. For this purpose, a car is placed in service when it is ready and available for a specifically assigned use in a trade or business. Even if you aren’t using the property, it is in service when it is ready and available for its specifically assigned use.

A car first used for personal purposes can’t qualify for the deduction in a later year when its use changes to business.

In 2022, you bought a new car and used it for personal purposes. In 2023, you began to use it for business. Changing its use to business use doesn’t qualify the cost of your car for a section 179 deduction in 2023. However, you can claim a depreciation deduction for the business use of the car starting in 2023. See Depreciation Deduction , later.

You must use the property more than 50% for business to claim any section 179 deduction. If you used the property more than 50% for business, multiply the cost of the property by the percentage of business use. The result is the cost of the property that can qualify for the section 179 deduction.

You purchased a new car in April 2023 for $24,500 and used it 60% for business. Based on your business usage, the total cost of your car that qualifies for the section 179 deduction is $14,700 ($24,500 cost × 60% (0.60) business use). But see Limit on total section 179, special depreciation allowance, and depreciation deduction , discussed later.

There are limits on:

The amount of the section 179 deduction;

The section 179 deduction for sport utility and certain other vehicles; and

The total amount of the section 179 deduction, special depreciation allowance, and depreciation deduction (discussed later ) you can claim for a qualified property.

For tax years beginning in 2023, the total amount you can elect to deduct under section 179 can’t be more than $1,160,000.

If the cost of your section 179 property placed in service in tax years beginning in 2023 is over $2,890,000, you must reduce the $1,160,000 dollar limit (but not below zero) by the amount of cost over $2,890,000. If the cost of your section 179 property placed in service during tax years beginning in 2023 is $4,050,000 or more, you can’t take a section 179 deduction.

The total amount you can deduct under section 179 each year after you apply the limits listed above cannot be more than the taxable income from the active conduct of any trade or business during the year.

If you are married and file a joint return, you and your spouse are treated as one taxpayer in determining any reduction to the dollar limit, regardless of which of you purchased the property or placed it in service.

If you and your spouse file separate returns, you are treated as one taxpayer for the dollar limit. You must allocate the dollar limit (after any reduction) between you.

For more information on the above section 179 deduction limits, see Pub. 946, How To Depreciate Property.

You cannot elect to deduct more than $28,900 of the cost of any heavy sport utility vehicle (SUV) and certain other vehicles placed in service during the tax years beginning in 2023. This rule applies to any four-wheeled vehicle primarily designed or used to carry passengers over public streets, roads, or highways that isn’t subject to any of the passenger automobile limits explained under Depreciation Limits , later, and that is rated at more than 6,000 pounds gross vehicle weight and not more than 14,000 pounds gross vehicle weight. However, the $28,900 limit doesn’t apply to any vehicle:

Designed to have a seating capacity of more than nine persons behind the driver's seat;

Equipped with a cargo area of at least 6 feet in interior length that is an open area or is designed for use as an open area but is enclosed by a cap and isn’t readily accessible directly from the passenger compartment; or

That has an integral enclosure, fully enclosing the driver compartment and load carrying device, doesn’t have seating rearward of the driver's seat, and has no body section protruding more than 30 inches ahead of the leading edge of the windshield.

The first-year limit on the depreciation deduction, special depreciation allowance, and section 179 deduction for vehicles acquired before September 28, 2017, and placed in service during 2023, is $12,200. The first-year limit on depreciation, special depreciation allowance, and section 179 deduction for vehicles acquired after September 27, 2017, and placed in service during 2023 increases to $20,200. If you elect not to claim a special depreciation allowance for a vehicle placed in service in 2023, the amount increases to $12,200. The limit is reduced if your business use of the vehicle is less than 100%. See Depreciation Limits , later, for more information.

In the earlier example under More than 50% business use requirement , you had a car with a cost (for purposes of the section 179 deduction) of $14,700. However, based on your business usage of the car, the total of your section 179 deduction, special depreciation allowance, and depreciation deductions is limited to $12,120 ($20,200 limit x 60% (0.60) business use) because the car was acquired after September 27, 2017, and placed in service during 2023.

For purposes of the section 179 deduction, the cost of the car doesn’t include any amount figured by reference to any other property held by you at any time. For example, if you buy a car as a replacement for a car that was stolen or that was destroyed in a casualty loss, and you use section 1033 to determine the basis in your replacement vehicle, your cost for purposes of the section 179 deduction doesn’t include your adjusted basis in the relinquished car. In that case, your cost includes only the cash you paid.

The amount of the section 179 deduction reduces your basis in your car. If you choose the section 179 deduction, you must subtract the amount of the deduction from the cost of your car. The resulting amount is the basis in your car you use to figure your depreciation deduction.

If you want to take the section 179 deduction, you must make the election in the tax year you place the car in service for business or work.

Employees use Form 2106, Employee Business Expenses, to make the election and report the section 179 deduction. All others use Form 4562, Depreciation and Amortization, to make an election.

File the appropriate form with either of the following.

Your original tax return filed for the year the property was placed in service (whether or not you file it timely).

An amended return filed within the time prescribed by law. An election made on an amended return must specify the item of section 179 property to which the election applies and the part of the cost of each such item to be taken into account. The amended return must also include any resulting adjustments to taxable income.

An election (or any specification made in the election) to take a section 179 deduction for 2023 can only be revoked with the Commissioner's approval.

To be eligible to claim the section 179 deduction, you must use your car more than 50% for business or work in the year you acquired it. If your business use of the car is 50% or less in a later tax year during the recovery period, you have to recapture (include in income) in that later year any excess depreciation. Any section 179 deduction claimed on the car is included in figuring the excess depreciation. For information on this calculation, see Excess depreciation , later in this chapter under Car Used 50% or Less for Business. For more information on recapture of a section 179 deduction, see Pub. 946.

If you dispose of a car on which you had claimed the section 179 deduction, the amount of that deduction is treated as a depreciation deduction for recapture purposes. You treat any gain on the disposition of the property as ordinary income up to the amount of the section 179 deduction and any allowable depreciation (unless you establish the amount actually allowed). For information on the disposition of a car, see Disposition of a Car , later. For more information on recapture of a section 179 deduction, see Pub. 946.

Special Depreciation Allowance

You may be able to claim the special depreciation allowance for your car, truck, or van if it is qualified property and was placed in service in 2023. The allowance for 2023 is an additional depreciation deduction for 100% of the car's depreciable basis (after any section 179 deduction, but before figuring your regular depreciation deduction under MACRS) if the vehicle was acquired after September 27, 2017, and placed in service during 2023. Further, while it applies to a new vehicle, it also applies to a used vehicle only if the vehicle meets the used property requirements. For more information on the used property requirements, see section 168(k)(2)(E)(ii). To qualify for the allowance, more than 50% of the use of the car must be in a qualified business use (as defined under Depreciation Deduction , later).

The first-year limit on the depreciation deduction, special depreciation allowance, and section 179 deduction for vehicles acquired before September 28, 2017, and placed in service during 2023, is $12,200. Your combined section 179 depreciation, special depreciation allowance, and regular MACRS depreciation deduction is limited to the maximum allowable depreciation deduction for vehicles acquired after September 27, 2017, and placed in service during 2023 is $20,200. If you elect not to claim a special depreciation allowance for a vehicle placed in service in 2023, the amount is $12,200. See Depreciation Limits , later in this chapter.

To be qualified property, the car (including the truck or van) must meet all of the following tests.

You acquired the car after September 27, 2017, but only if no written binding contract to acquire the car existed before September 28, 2017.

You acquired the car new or used.

You placed the car in service in your trade or business before January 1, 2027.

You used the car more than 50% in a qualified business use during the tax year.

You can elect not to claim the special depreciation allowance for your car, truck, or van that is qualified property. If you make this election, it applies to all 5-year property placed in service during the year.

To make this election, attach a statement to your timely filed return (including extensions) indicating the class of property (5-year for cars) for which you are making the election and that you are electing not to claim the special depreciation allowance for qualified property in that class of property.

Depreciation Deduction

If you use actual car expenses to figure your deduction for a car you own and use in your business, you can claim a depreciation deduction. This means you can deduct a certain amount each year as a recovery of your cost or other basis in your car.

You generally need to know the following things about the car you intend to depreciate.

Your basis in the car.

The date you place the car in service.

The method of depreciation and recovery period you will use.

Your basis in a car for figuring depreciation is generally its cost. This includes any amount you borrow or pay in cash, other property, or services.

Generally, you figure depreciation on your car, truck, or van using your unadjusted basis (see Unadjusted basis , later). However, in some situations, you will use your adjusted basis (your basis reduced by depreciation allowed or allowable in earlier years). For one of these situations, see Exception under Methods of depreciation , later.

If you change the use of a car from personal to business, your basis for depreciation is the lesser of the fair market value or your adjusted basis in the car on the date of conversion. Additional rules concerning basis are discussed later in this chapter under Unadjusted basis .

You generally place a car in service when it is available for use in your work or business, in an income-producing activity, or in a personal activity. Depreciation begins when the car is placed in service for use in your work or business or for the production of income.

For purposes of figuring depreciation, if you first start using the car only for personal use and later convert it to business use, you place the car in service on the date of conversion.

If you place a car in service and dispose of it in the same tax year, you can’t claim any depreciation deduction for that car.

Generally, you figure depreciation on cars using the Modified Accelerated Cost Recovery (MACRS) discussed later in this chapter.

If you used the standard mileage rate in the first year of business use and change to the actual expenses method in a later year, you can’t depreciate your car under the MACRS rules. You must use straight line depreciation over the estimated remaining useful life of the car. The amount you depreciate can’t be more than the depreciation limit that applies for that year. See Depreciation Limits , later.

To figure depreciation under the straight line method, you must reduce your basis in the car (but not below zero) by a set rate per mile for all miles for which you used the standard mileage rate. The rate per mile varies depending on the year(s) you used the standard mileage rate. For the rate(s) to use, see Depreciation adjustment when you used the standard mileage rate under Disposition of a Car , later.

This reduction of basis is in addition to those basis adjustments described later under Unadjusted basis . You must use your adjusted basis in your car to figure your depreciation deduction. For additional information on the straight line method of depreciation, see Pub. 946.

Generally, you must use your car more than 50% for qualified business use (defined next) during the year to use MACRS. You must meet this more-than-50%-use test each year of the recovery period (6 years under MACRS) for your car.

If your business use is 50% or less, you must use the straight line method to depreciate your car. This is explained later under Car Used 50% or Less for Business .

A qualified business use is any use in your trade or business. It doesn’t include use for the production of income (investment use), or use provided under lease to, or as compensation to, a 5% owner or related person. However, you do combine your business and investment use to figure your depreciation deduction for the tax year.

Don’t treat any use of your car by another person as use in your trade or business unless that use meets one of the following conditions.

It is directly connected with your business.

It is properly reported by you as income to the other person (and, if you have to, you withhold tax on the income).

It results in a payment of fair market rent. This includes any payment to you for the use of your car.

If you used your car more than 50% in qualified business use in the year you placed it in service, but 50% or less in a later year (including the year of disposition), you have to change to the straight line method of depreciation. See Qualified business use 50% or less in a later year under Car Used 50% or Less for Business , later.

If you use your car for more than one purpose during the tax year, you must allocate the use to the various purposes. You do this on the basis of mileage. Figure the percentage of qualified business use by dividing the number of miles you drive your car for business purposes during the year by the total number of miles you drive the car during the year for any purpose.

If you change the use of a car from 100% personal use to business use during the tax year, you may not have mileage records for the time before the change to business use. In this case, you figure the percentage of business use for the year as follows.

Determine the percentage of business use for the period following the change. Do this by dividing business miles by total miles driven during that period.

Multiply the percentage in (1) by a fraction. The numerator (top number) is the number of months the car is used for business, and the denominator (bottom number) is 12.

You use a car only for personal purposes during the first 6 months of the year. During the last 6 months of the year, you drive the car a total of 15,000 miles of which 12,000 miles are for business. This gives you a business use percentage of 80% (12,000 ÷ 15,000) for that period. Your business use for the year is 40% (80% (0.80) × 6 / 12 ).

The amount you can claim for section 179, special depreciation allowance, and depreciation deductions may be limited. The maximum amount you can claim depends on the year in which you placed your car in service. You have to reduce the maximum amount if you did not use the car exclusively for business. See Depreciation Limits , later.

You use your unadjusted basis (often referred to as your basis or your basis for depreciation) to figure your depreciation using the MACRS depreciation chart, explained later under Modified Accelerated Cost Recovery System (MACRS) . Your unadjusted basis for figuring depreciation is your original basis increased or decreased by certain amounts.

To figure your unadjusted basis, begin with your car's original basis, which is generally its cost. Cost includes sales taxes (see Sales taxes , earlier), destination charges, and dealer preparation. Increase your basis by any substantial improvements you make to your car, such as adding air conditioning or a new engine. Decrease your basis by any section 179 deduction, special depreciation allowance, gas guzzler tax, and vehicle credits claimed. See Pub. 551, Basis of Assets, for further details.

If you acquired the car by gift or inheritance, see Pub. 551, Basis of Assets, for information on your basis in the car.

A major improvement to a car is treated as a new item of 5-year recovery property. It is treated as placed in service in the year the improvement is made. It doesn’t matter how old the car is when the improvement is added. Follow the same steps for depreciating the improvement as you would for depreciating the original cost of the car. However, you must treat the improvement and the car as a whole when applying the limits on the depreciation deductions. Your car's depreciation deduction for the year (plus any section 179 deduction, special depreciation allowance, and depreciation on any improvements) can’t be more than the depreciation limit that applies for that year. See Depreciation Limits , later.

If you traded one car (the “old car”) for another car (the “new car”) in 2023, you must treat the transaction as a disposition of the old car and the purchase of the new car. You must treat the old car as disposed of at the time of the trade-in. The depreciable basis of the new car is the adjusted basis of the old car (figured as if 100% of the car’s use had been for business purposes) plus any additional amount you paid for the new car. You then figure your depreciation deduction for the new car beginning with the date you placed it in service. You must also complete Form 2106, Part II, Section D. This method is explained later, beginning at Effect of trade-in on basis .

The discussion that follows applies to trade-ins of cars in 2023, where the election was made to treat the transaction as a disposition of the old car and the purchase of the new car. For information on how to figure depreciation for cars involved in a like-kind exchange (trade-in) in 2023, for which the election wasn’t made, see Pub. 946 and Regulations section 1.168(i)-6(d)(3).

Like‐kind exchanges completed after December 31, 2017, are generally limited to exchanges of real property not held primarily for sale. Regulations section 1.168(i)-6 doesn't reflect this change in law.

If you trade in a car you used only in your business for another car that will be used only in your business, your original basis in the new car is your adjusted basis in the old car, plus any additional amount you pay for the new car.

You trade in a car that has an adjusted basis of $5,000 for a new car. In addition, you pay cash of $20,000 for the new car. Your original basis of the new car is $25,000 (your $5,000 adjusted basis in the old car plus the $20,000 cash paid). Your unadjusted basis is $25,000 unless you claim the section 179 deduction, special depreciation allowance, or have other increases or decreases to your original basis, discussed under Unadjusted basis , earlier.

If you trade in a car you used partly in your business for a new car you will use in your business, you must make a “trade-in” adjustment for the personal use of the old car. This adjustment has the effect of reducing your basis in your old car, but not below zero, for purposes of figuring your depreciation deduction for the new car. (This adjustment isn’t used, however, when you determine the gain or loss on the later disposition of the new car. See Pub. 544, Sales and Other Dispositions of Assets, for information on how to report the disposition of your car.)

To figure the unadjusted basis of your new car for depreciation, first add to your adjusted basis in the old car any additional amount you pay for the new car. Then subtract from that total the excess, if any, of:

The total of the amounts that would have been allowable as depreciation during the tax years before the trade if 100% of the use of the car had been business and investment use, over

The total of the amounts actually allowed as depreciation during those years.

MACRS is the name given to the tax rules for getting back (recovering) through depreciation deductions the cost of property used in a trade or business or to produce income.

The maximum amount you can deduct is limited, depending on the year you placed your car in service. See Depreciation Limits , later.

Under MACRS, cars are classified as 5-year property. You actually depreciate the cost of a car, truck, or van over a period of 6 calendar years. This is because your car is generally treated as placed in service in the middle of the year, and you claim depreciation for one-half of both the first year and the sixth year.

For more information on the qualifications for this shorter recovery period and the percentages to use in figuring the depreciation deduction, see chapter 4 of Pub. 946.

You can use one of the following methods to depreciate your car.

The 200% declining balance method (200% DB) over a 5-year recovery period that switches to the straight line method when that method provides an equal or greater deduction.

The 150% declining balance method (150% DB) over a 5-year recovery period that switches to the straight line method when that method provides an equal or greater deduction.

The straight line method (SL) over a 5-year recovery period.

Before choosing a method, you may wish to consider the following facts.

Using the straight line method provides equal yearly deductions throughout the recovery period.

Using the declining balance methods provides greater deductions during the earlier recovery years with the deductions generally getting smaller each year.

A 2023 MACRS Depreciation Chart and instructions are included in this chapter as Table 4-1 . Using this table will make it easy for you to figure the 2023 depreciation deduction for your car. A similar chart appears in the Instructions for Form 2106.

You must use the Depreciation Tables in Pub. 946 rather than the 2023 MACRS Depreciation Chart in this publication if any one of the following three conditions applies to you.

You file your return on a fiscal year basis.

You file your return for a short tax year (less than 12 months).

During the year, all of the following conditions apply.

You placed some property in service from January through September.

You placed some property in service from October through December.

Your basis in the property you placed in service from October through December (excluding nonresidential real property, residential rental property, and property placed in service and disposed of in the same year) was more than 40% of your total bases in all property you placed in service during the year.

If you use the percentages from the chart, you generally must continue to use them for the entire recovery period of your car. However, you can’t continue to use the chart if your basis in your car is adjusted because of a casualty. In that case, for the year of the adjustment and the remaining recovery period, figure the depreciation without the chart using your adjusted basis in the car at the end of the year of the adjustment and over the remaining recovery period. See Figuring the Deduction Without Using the Tables in chapter 4 of Pub. 946.

If you dispose of the car before the last year of the recovery period, you are generally allowed a half-year of depreciation in the year of disposition. This rule applies unless the mid-quarter convention applies to the vehicle being disposed of. See Depreciation deduction for the year of disposition under Disposition of a Car , later, for information on how to figure the depreciation allowed in the year of disposition.

To figure your depreciation deduction for 2023, find the percentage in the column of Table 4-1 based on the date that you first placed the car in service and the depreciation method that you are using. Multiply the unadjusted basis of your car (defined earlier) by that percentage to determine the amount of your depreciation deduction. If you prefer to figure your depreciation deduction without the help of the chart, see Pub. 946.

You bought a used truck in February 2022 to use exclusively in your landscape business. You paid $9,200 for the truck with no trade-in. You didn’t claim any section 179 deduction, the truck didn’t qualify for the special depreciation allowance, and you chose to use the 200% DB method to get the largest depreciation deduction in the early years.

You used the MACRS Depreciation Chart in 2022 to find your percentage. The unadjusted basis of the truck equals its cost because you used it exclusively for business. You multiplied the unadjusted basis of the truck, $9,200, by the percentage that applied, 20%, to figure your 2022 depreciation deduction of $1,840.

In 2023, you used the truck for personal purposes when you repaired your parent’s cabin. Your records show that the business use of the truck was 90% in 2023. You used Table 4-1 to find your percentage. Reading down the first column for the date placed in service and across to the 200% DB column, you locate your percentage, 32%. You multiply the unadjusted basis of the truck, $8,280 ($9,200 cost × 90% (0.90) business use), by 32% (0.32) to figure your 2023 depreciation deduction of $2,650.

Depreciation Limits

There are limits on the amount you can deduct for depreciation of your car, truck, or van. The section 179 deduction and special depreciation allowance are treated as depreciation for purposes of the limits. The maximum amount you can deduct each year depends on the date you acquired the passenger automobile and the year you place the passenger automobile in service. These limits are shown in the following tables for 2023.

Maximum Depreciation Deduction for Passenger Automobiles (Including Trucks and Vans) Acquired Before September 28, 2017, and Placed in Service During 2018–2023

Maximum Depreciation Deduction for Passenger Automobiles (Including Trucks and Vans) Acquired After September 27, 2017, and Placed in Service During 2018 or Later

The maximum amount you can deduct each year depends on the year you place the car in service. These limits are shown in the following tables for prior years.

Maximum Depreciation Deduction for Cars Placed in Service Prior to 2018

For tax years prior to 2018, the maximum depreciation deductions for trucks and vans are generally higher than those for cars. A truck or van is a passenger automobile that is classified by the manufacturer as a truck or van and rated at 6,000 pounds gross vehicle weight or less.

Maximum Depreciation Deduction for Trucks and Vans Placed in Service Prior to 2018

The depreciation limits aren’t reduced if you use a car for less than a full year. This means that you don’t reduce the limit when you either place a car in service or dispose of a car during the year. However, the depreciation limits are reduced if you don’t use the car exclusively for business and investment purposes. See Reduction for personal use next.

The depreciation limits are reduced based on your percentage of personal use. If you use a car less than 100% in your business or work, you must determine the depreciation deduction limit by multiplying the limit amount by the percentage of business and investment use during the tax year.

The section 179 deduction is treated as a depreciation deduction. If you acquired a passenger automobile (including trucks and vans) after September 27, 2017, and placed it in service in 2023, use it only for business, and choose the section 179 deduction, the special depreciation allowance and depreciation deduction for that vehicle for 2023 is limited to $20,200.

On September 4, 2023, you bought and placed in service a used car for $15,000. You used it 80% for your business, and you choose to take a section 179 deduction for the car. The car isn’t qualified property for purposes of the special depreciation allowance.

Before applying the limit, you figure your maximum section 179 deduction to be $12,000. This is the cost of your qualifying property (up to the maximum $1,160,000 amount) multiplied by your business use ($15,000 × 80% (0.80)).

You then figure that your section 179 deduction for 2023 is limited to $9,760 (80% of $12,200). You then figure your unadjusted basis of $2,440 (($15,000 × 80% (0.80)) − $9,760) for determining your depreciation deduction. You have reached your maximum depreciation deduction for 2023. For 2024, you will use your unadjusted basis of $2,440 to figure your depreciation deduction.

If the depreciation deductions for your car are reduced under the passenger automobile limits (discussed earlier), you will have unrecovered basis in your car at the end of the recovery period. If you continue to use your car for business, you can deduct that unrecovered basis (subject to depreciation limits) after the recovery period ends.

This is your cost or other basis in the car reduced by any clean-fuel vehicle deduction (for vehicles placed in service before January 1, 2006), alternative motor vehicle credit, electric vehicle credit, gas guzzler tax, and depreciation (including any special depreciation allowance , discussed earlier, unless you elect not to claim it) and section 179 deductions that would have been allowable if you had used the car 100% for business and investment use.

For 5-year property, your recovery period is 6 calendar years. A part year's depreciation is allowed in the first calendar year, a full year's depreciation is allowed in each of the next 4 calendar years, and a part year's depreciation is allowed in the 6th calendar year.

Under MACRS, your recovery period is the same whether you use declining balance or straight line depreciation. You determine your unrecovered basis in the 7th year after you placed the car in service.

If you continue to use your car for business after the recovery period, you can claim a depreciation deduction in each succeeding tax year until you recover your basis in the car. The maximum amount you can deduct each year is determined by the date you placed the car in service and your business-use percentage. For example, no deduction is allowed for a year you use your car 100% for personal purposes.

In April 2017, you bought and placed in service a car you used exclusively in your business. The car cost $31,500. You didn’t claim a section 179 deduction or the special depreciation allowance for the car. You continued to use the car 100% in your business throughout the recovery period (2017 through 2022). For those years, you used the MACRS Depreciation Chart (200% DB method), the Maximum Depreciation Deduction for Cars Placed in Service Prior to 2018 table and Maximum Depreciation Deduction for Passenger Automobiles (Including Trucks and Vans) Acquired Before September 28, 2017, and Placed in Service During 2018–2023 table, earlier, for the applicable tax year to figure your depreciation deductions during the recovery period. Your depreciation deductions were subject to the depreciation limits, so you will have unrecovered basis at the end of the recovery period as shown in the following table.

At the end of 2022, you had an unrecovered basis in the car of $14,626 ($31,500 – $16,874). If you continued to use the car 100% for business in 2023 and later years, you can claim a depreciation deduction equal to the lesser of $1,875 or your remaining unrecovered basis.

If your business use of the car was less than 100% during any year, your depreciation deduction would be less than the maximum amount allowable for that year. However, in determining your unrecovered basis in the car, you would still reduce your original basis by the maximum amount allowable as if the business use had been 100%. For example, if you had used your car 60% for business instead of 100%, your allowable depreciation deductions would have been $10,124 ($16,874 × 60% (0.60)), but you still would have to reduce your basis by $16,874 to determine your unrecovered basis.

Table 4-1. 2023 MACRS Depreciation Chart (Use To Figure Depreciation for 2023)

Car Used 50% or Less for Business

If you use your car 50% or less for qualified business use (defined earlier under Depreciation Deduction ) either in the year the car is placed in service or in a later year, special rules apply. The rules that apply in these two situations are explained in the following paragraphs. (For this purpose, “car” was defined earlier under Actual Car Expenses and includes certain trucks and vans.)

If you use your car 50% or less for qualified business use, the following rules apply.

You can’t take the section 179 deduction.

You can’t take the special depreciation allowance.

You must figure depreciation using the straight line method over a 5-year recovery period. You must continue to use the straight line method even if your percentage of business use increases to more than 50% in a later year.

Instead of making the computation yourself, you can use column (c) of Table 4-1 to find the percentage to use.

In May 2023, you bought and placed in service a car for $17,500. You used it 40% for your consulting business. Because you didn’t use the car more than 50% for business, you can’t take any section 179 deduction or special depreciation allowance, and you must use the straight line method over a 5-year recovery period to recover the cost of your car.

You deduct $700 in 2023. This is the lesser of:

$700 (($17,500 cost × 40% (0.40) business use) × 10% (0.10) recovery percentage (from column (c) of Table 4-1 )), or

$4,880 ($12,200 maximum limit × 40% (0.40) business use).

If you use your car more than 50% in qualified business use in the tax year it is placed in service but the business use drops to 50% or less in a later year, you can no longer use an accelerated depreciation method for that car.

For the year the business use drops to 50% or less and all later years in the recovery period, you must use the straight line depreciation method over a 5-year recovery period. In addition, for the year your business use drops to 50% or less, you must recapture (include in your gross income) any excess depreciation (discussed later). You also increase the adjusted basis of your car by the same amount.

In June 2020, you purchased a car for exclusive use in your business. You met the more-than-50%-use test for the first 3 years of the recovery period (2020 through 2022) but failed to meet it in the fourth year (2023). You determine your depreciation for 2023 using 20% (from column (c) of Table 4-1 ). You will also have to determine and include in your gross income any excess depreciation, discussed next.

You must include any excess depreciation in your gross income and add it to your car's adjusted basis for the first tax year in which you don’t use the car more than 50% in qualified business use. Use Form 4797, Sales of Business Property, to figure and report the excess depreciation in your gross income.

Excess depreciation is:

The amount of the depreciation deductions allowable for the car (including any section 179 deduction claimed and any special depreciation allowance claimed) for tax years in which you used the car more than 50% in qualified business use, minus

The amount of the depreciation deductions that would have been allowable for those years if you hadn’t used the car more than 50% in qualified business use for the year you placed it in service. This means the amount of depreciation figured using the straight line method.

In September 2019, you bought a car for $20,500 and placed it in service. You didn’t claim the section 179 deduction or the special depreciation allowance. You used the car exclusively in qualified business use for 2019, 2020, 2021, and 2022. For those years, you used the appropriate MACRS Depreciation Chart to figure depreciation deductions totaling $13,185 ($3,160 for 2019, $5,100 for 2020, $3,050 for 2021, and $1,875 for 2022) under the 200% DB method.

During 2023, you used the car 30% for business and 70% for personal purposes. Since you didn’t meet the more-than-50%-use test, you must switch from the 200% DB depreciation method to the straight line depreciation method for 2023, and include in gross income for 2023 your excess depreciation determined as follows.

In 2023, using Form 4797, you figure and report the $2,110 excess depreciation you must include in your gross income. Your adjusted basis in the car is also increased by $2,110. Your 2023 depreciation is $1,230 ($20,500 (unadjusted basis) × 30% (0.30) (business-use percentage) × 20% (0.20) (from column (c) of Table 4-1 on the line for Jan. 1–Sept. 30, 2019)). However, your depreciation deduction is limited to $563 ($1,875 x 30% (0.30) business use).

Leasing a Car

If you lease a car, truck, or van that you use in your business, you can use the standard mileage rate or actual expenses to figure your deductible expense. This section explains how to figure actual expenses for a leased car, truck, or van.

If you choose to use actual expenses, you can deduct the part of each lease payment that is for the use of the vehicle in your business. You can’t deduct any part of a lease payment that is for personal use of the vehicle, such as commuting.

You must spread any advance payments over the entire lease period. You can’t deduct any payments you make to buy a car, truck, or van even if the payments are called “lease payments.”

If you lease a car, truck, or van for 30 days or more, you may have to reduce your lease payment deduction by an “inclusion amount,” explained next.

Inclusion Amounts

If you lease a car, truck, or van that you use in your business for a lease term of 30 days or more, you may have to include an inclusion amount in your income for each tax year you lease the vehicle. To do this, you don’t add an amount to income. Instead, you reduce your deduction for your lease payment. (This reduction has an effect similar to the limit on the depreciation deduction you would have on the vehicle if you owned it.)

The inclusion amount is a percentage of part of the fair market value of the leased vehicle multiplied by the percentage of business and investment use of the vehicle for the tax year. It is prorated for the number of days of the lease term in the tax year.

The inclusion amount applies to each tax year that you lease the vehicle if the fair market value (defined next) when the lease began was more than the amounts shown in the following tables.

All vehicles are subject to a single inclusion amount threshold for passenger automobiles leased and put into service in 2023. You may have an inclusion amount for a passenger automobile if:

Passenger Automobiles (Including Trucks and Vans)

For years prior to 2018, see the inclusion tables below. You may have an inclusion amount for a passenger automobile if:

Cars (Except for Trucks and Vans)

Trucks and Vans

Fair market value is the price at which the property would change hands between a willing buyer and seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts. Sales of similar property around the same date may be helpful in figuring the fair market value of the property.

Figure the fair market value on the first day of the lease term. If the capitalized cost of a car is specified in the lease agreement, use that amount as the fair market value.

Inclusion amounts for tax years 2018–2023 are listed in Appendices A-1 through A-6 for passenger vehicles (including trucks and vans). If the fair market value of the vehicle is $100,000 or less, use the appropriate appendix (depending on the year you first placed the vehicle in service) to determine the inclusion amount. If the fair market value is more than $100,000, see the revenue procedure(s) identified in the footnote of that year’s appendix for the inclusion amount.

For each tax year during which you lease the car for business, determine your inclusion amount by following these three steps.

Locate the appendix that applies to you. To find the inclusion amount, do the following.

Find the line that includes the fair market value of the car on the first day of the lease term.

Go across the line to the column for the tax year in which the car is used under the lease to find the dollar amount. For the last tax year of the lease, use the dollar amount for the preceding year.

Prorate the dollar amount from (1b) for the number of days of the lease term included in the tax year.

Multiply the prorated amount from (2) by the percentage of business and investment use for the tax year. This is your inclusion amount.

On January 17, 2023, you leased a car for 3 years and placed it in service for use in your business. The car had a fair market value of $62,500 on the first day of the lease term. You use the car 75% for business and 25% for personal purposes during each year of the lease. Assuming you continue to use the car 75% for business, you use Appendix A-6 to arrive at the following inclusion amounts for each year of the lease. For the last tax year of the lease, 2026, you use the amount for the preceding year.

2024 is a leap year and includes an extra calendar day, February 29, 2024.

For each year of the lease that you deduct lease payments, you must reduce your deduction by the inclusion amount figured for that year.

If you lease a car for business use and, in a later year, change it to personal use, follow the rules explained earlier under Figuring the inclusion amount . For the tax year in which you stop using the car for business, use the dollar amount for the previous tax year. Prorate the dollar amount for the number of days in the lease term that fall within the tax year.

On August 16, 2022, you leased a car with a fair market value of $64,500 for 3 years. You used the car exclusively in your data processing business. On November 6, 2023, you closed your business and went to work for a company where you aren’t required to use a car for business. Using Appendix A-5 , you figured your inclusion amount for 2022 and 2023 as shown in the following table and reduced your deductions for lease payments by those amounts.

If you lease a car for personal use and, in a later year, change it to business use, you must determine the car's fair market value on the date of conversion. Then figure the inclusion amount using the rules explained earlier under Figuring the inclusion amount . Use the fair market value on the date of conversion.

In March 2021, you leased a truck for 4 years for personal use. On June 1, 2023, you started working as a self-employed advertising consultant and started using the leased truck for business purposes. Your records show that your business use for June 1 through December 31 was 60%. To figure your inclusion amount for 2023, you obtained an appraisal from an independent car leasing company that showed the fair market value of your 2021 truck on June 1, 2023, was $62,650. Using Appendix A-6 , you figured your inclusion amount for 2023 as shown in the following table.

For information on reporting inclusion amounts, employees should see Car rentals under Completing Forms 2106 in chapter 6. Sole proprietors should see the Instructions for Schedule C (Form 1040), and farmers should see the Instructions for Schedule F (Form 1040).

Disposition of a Car

If you dispose of your car, you may have a taxable gain or a deductible loss. The portion of any gain that is due to depreciation (including any section 179 deduction, clean-fuel vehicle deduction (for vehicles placed in service before January 1, 2006), and special depreciation allowance) that you claimed on the car will be treated as ordinary income. However, you may not have to recognize a gain or loss if you dispose of the car because of a casualty or theft.

This section gives some general information about dispositions of cars. For information on how to report the disposition of your car, see Pub. 544.

Like‐kind exchanges completed after December 31, 2017, are generally limited to exchanges of real property not held primarily for sale.

For a casualty or theft, a gain results when you receive insurance or other reimbursement that is more than your adjusted basis in your car. If you then spend all of the proceeds to acquire replacement property (a new car or repairs to the old car) within a specified period of time, you don’t recognize any gain. Your basis in the replacement property is its cost minus any gain that isn’t recognized. See Pub. 547 for more information.

When you trade in an old car for a new one, the transaction is considered a like-kind exchange. Generally, no gain or loss is recognized. (For exceptions, see chapter 1 of Pub. 544.) In a trade-in situation, your basis in the new property is generally your adjusted basis in the old property plus any additional amount you pay. (See Unadjusted basis , earlier.)

If you used the standard mileage rate for the business use of your car, depreciation was included in that rate. The rate of depreciation that was allowed in the standard mileage rate is shown in the Rate of Depreciation Allowed in Standard Mileage Rate table, later. You must reduce your basis in your car (but not below zero) by the amount of this depreciation.

If your basis is reduced to zero (but not below zero) through the use of the standard mileage rate, and you continue to use your car for business, no adjustment (reduction) to the standard mileage rate is necessary. Use the full standard mileage rate (65.5 cents ($0.655) per mile from January 1–December 31 for 2023) for business miles driven.

Rate of Depreciation Allowed in Standard Mileage Rate

In 2018, you bought and placed in service a car for exclusive use in your business. The car cost $25,500. From 2018 through 2023, you used the standard mileage rate to figure your car expense deduction. You drove your car 14,100 miles in 2018, 16,300 miles in 2019, 15,600 miles in 2020, 16,700 miles in 2021, 15,100 miles in 2022, and 14,900 miles in 2023. The depreciation portion of your car expense deduction is figured as follows.

If you deduct actual car expenses and you dispose of your car before the end of the recovery period (years 2 through 5), you are allowed a reduced depreciation deduction in the year of disposition.

Use the depreciation tables in Pub. 946 to figure the reduced depreciation deduction for a car disposed of in 2023.

The depreciation amounts computed using the depreciation tables in Pub. 946 for years 2 through 5 that you own your car are for a full year’s depreciation. Years 1 and 6 apply the half-year or mid-quarter convention to the computation for you. If you dispose of the vehicle in years 2 through 5 and the half-year convention applies, then the full year’s depreciation amount must be divided by 2. If the mid-quarter convention applies, multiply the full year’s depreciation by the percentage from the following table for the quarter that you disposed of the car.

If the car is subject to the Depreciation Limits , discussed earlier, reduce (but do not increase) the computed depreciation to this amount. See Sale or Other Disposition Before the Recovery Period Ends in chapter 4 of Pub. 946 for more information.

5. Recordkeeping

If you deduct travel, gift, or transportation expenses, you must be able to prove (substantiate) certain elements of expense. This chapter discusses the records you need to keep to prove these expenses.

How To Prove Expenses

Table 5-1 is a summary of records you need to prove each expense discussed in this publication. You must be able to prove the elements listed across the top portion of the chart. You prove them by having the information and receipts (where needed) for the expenses listed in the first column.

You should keep adequate records to prove your expenses or have sufficient evidence that will support your own statement. You must generally prepare a written record for it to be considered adequate. This is because written evidence is more reliable than oral evidence alone. However, if you prepare a record on a computer, it is considered an adequate record.

What Are Adequate Records?

You should keep the proof you need in an account book, diary, log, statement of expense, trip sheets, or similar record. You should also keep documentary evidence that, together with your record, will support each element of an expense.

You must generally have documentary evidence such as receipts, canceled checks, or bills, to support your expenses.

Documentary evidence isn’t needed if any of the following conditions apply.

You have meals or lodging expenses while traveling away from home for which you account to your employer under an accountable plan, and you use a per diem allowance method that includes meals and/or lodging. ( Accountable plans and per diem allowances are discussed in chapter 6.)

Your expense, other than lodging, is less than $75.

You have a transportation expense for which a receipt isn’t readily available.

Documentary evidence will ordinarily be considered adequate if it shows the amount, date, place, and essential character of the expense.

For example, a hotel receipt is enough to support expenses for business travel if it has all of the following information.

The name and location of the hotel.

The dates you stayed there.

Separate amounts for charges such as lodging, meals, and telephone calls.

A restaurant receipt is enough to prove an expense for a business meal if it has all of the following information.

The name and location of the restaurant.

The number of people served.

The date and amount of the expense.

A canceled check, together with a bill from the payee, ordinarily establishes the cost. However, a canceled check by itself doesn’t prove a business expense without other evidence to show that it was for a business purpose.

You don‘t have to record information in your account book or other record that duplicates information shown on a receipt as long as your records and receipts complement each other in an orderly manner.

You don’t have to record amounts your employer pays directly for any ticket or other travel item. However, if you charge these items to your employer, through a credit card or otherwise, you must keep a record of the amounts you spend.

You should record the elements of an expense or of a business use at or near the time of the expense or use and support it with sufficient documentary evidence. A timely kept record has more value than a statement prepared later when there is generally a lack of accurate recall.

You don’t need to write down the elements of every expense on the day of the expense. If you maintain a log on a weekly basis that accounts for use during the week, the log is considered a timely kept record.

If you give your employer, client, or customer an expense account statement, it can also be considered a timely kept record. This is true if you copy it from your account book, diary, log, statement of expense, trip sheets, or similar record.

You must generally provide a written statement of the business purpose of an expense. However, the degree of proof varies according to the circumstances in each case. If the business purpose of an expense is clear from the surrounding circumstances, then you don’t need to give a written explanation.

If you are a sales representative who calls on customers on an established sales route, you don’t have to give a written explanation of the business purpose for traveling that route. You can satisfy the requirements by recording the length of the delivery route once, the date of each trip at or near the time of the trips, and the total miles you drove the car during the tax year. You could also establish the date of each trip with a receipt, record of delivery, or other documentary evidence.

You don’t need to put confidential information relating to an element of a deductible expense (such as the place, business purpose, or business relationship) in your account book, diary, or other record. However, you do have to record the information elsewhere at or near the time of the expense and have it available to fully prove that element of the expense.

What if I Have Incomplete Records?

If you don’t have complete records to prove an element of an expense, then you must prove the element with:

Your own written or oral statement containing specific information about the element, and

Other supporting evidence that is sufficient to establish the element.

If the element is the description of a gift, or the cost, time, place, or date of an expense, the supporting evidence must be either direct evidence or documentary evidence. Direct evidence can be written statements or the oral testimony of your guests or other witnesses setting forth detailed information about the element. Documentary evidence can be receipts, paid bills, or similar evidence.

If the element is either the business relationship of your guests or the business purpose of the amount spent, the supporting evidence can be circumstantial rather than direct. For example, the nature of your work, such as making deliveries, provides circumstantial evidence of the use of your car for business purposes. Invoices of deliveries establish when you used the car for business.

Table 5-1. How To Prove Certain Business Expenses

You can keep an adequate record for parts of a tax year and use that record to prove the amount of business or investment use for the entire year. You must demonstrate by other evidence that the periods for which an adequate record is kept are representative of the use throughout the tax year.

You use your car to visit the offices of clients, meet with suppliers and other subcontractors, and pick up and deliver items to clients. There is no other business use of the car, but you and your family use the car for personal purposes. You keep adequate records during the first week of each month that show that 75% of the use of the car is for business. Invoices and bills show that your business use continues at the same rate during the later weeks of each month. Your weekly records are representative of the use of the car each month and are sufficient evidence to support the percentage of business use for the year.

You can satisfy the substantiation requirements with other evidence if, because of the nature of the situation in which an expense is made, you can’t get a receipt. This applies if all the following are true.

You were unable to obtain evidence for an element of the expense or use that completely satisfies the requirements explained earlier under What Are Adequate Records .

You are unable to obtain evidence for an element that completely satisfies the two rules listed earlier under What if I Have Incomplete Records .

You have presented other evidence for the element that is the best proof possible under the circumstances.

If you can’t produce a receipt because of reasons beyond your control, you can prove a deduction by reconstructing your records or expenses. Reasons beyond your control include fire, flood, and other casualties.

Separating and Combining Expenses

This section explains when expenses must be kept separate and when expenses can be combined.

Each separate payment is generally considered a separate expense. For example, if you entertain a customer or client at dinner and then go to the theater, the dinner expense and the cost of the theater tickets are two separate expenses. You must record them separately in your records.

You can make one daily entry in your record for reasonable categories of expenses. Examples are taxi fares, telephone calls, or other incidental travel costs. Nonentertainment meals should be in a separate category. You can include tips for meal-related services with the costs of the meals.

Expenses of a similar nature occurring during the course of a single event are considered a single expense.

You can account for several uses of your car that can be considered part of a single use, such as a round trip or uninterrupted business use, with a single record. Minimal personal use, such as a stop for lunch on the way between two business stops, isn’t an interruption of business use.

You make deliveries at several different locations on a route that begins and ends at your employer's business premises and that includes a stop at the business premises between two deliveries. You can account for these using a single record of miles driven.

You don’t always have to record the name of each recipient of a gift. A general listing will be enough if it is evident that you aren’t trying to avoid the $25 annual limit on the amount you can deduct for gifts to any one person. For example, if you buy a large number of tickets to local high school basketball games and give one or two tickets to each of many customers, it is usually enough to record a general description of the recipients.

If you can prove the total cost of travel or entertainment but you can’t prove how much it costs for each person who participated in the event, you may have to allocate the total cost among you and your guests on a pro rata basis. To do so, you must establish the number of persons who participated in the event.

If your return is examined, you may have to provide additional information to the IRS. This information could be needed to clarify or to establish the accuracy or reliability of information contained in your records, statements, testimony, or documentary evidence before a deduction is allowed.

How Long To Keep Records and Receipts

You must keep records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support your deduction (or an item of income) for 3 years from the date you file the income tax return on which the deduction is claimed. A return filed early is considered filed on the due date. For a more complete explanation of how long to keep records, see Pub. 583, Starting a Business and Keeping Records.

You must keep records of the business use of your car for each year of the recovery period. See More-than-50%-use test in chapter 4 under Depreciation Deduction.

Employees who give their records and documentation to their employers and are reimbursed for their expenses generally don’t have to keep copies of this information. However, you may have to prove your expenses if any of the following conditions apply.

You claim deductions for expenses that are more than reimbursements.

Your expenses are reimbursed under a nonaccountable plan.

Your employer doesn’t use adequate accounting procedures to verify expense accounts.

You are related to your employer as defined under Per Diem and Car Allowances in chapter 6.

Table 5-2 and Table 5-3 are examples of worksheets that can be used for tracking business expenses.

Table 5-2. Daily Business Mileage and Expense Log

Table 5-3. Weekly Traveling Expense Record

6. How To Report

This chapter explains where and how to report the expenses discussed in this publication. It discusses reimbursements and how to treat them under accountable and nonaccountable plans. It also explains rules for independent contractors and clients, fee-basis officials, certain performing artists, Armed Forces reservists, and certain disabled employees. The chapter ends with illustrations of how to report travel, gift, and car expenses on Forms 2106.

Where To Report

This section provides general information on where to report the expenses discussed in this publication.

You must report your income and expenses on Schedule C (Form 1040) if you are a sole proprietor, or on Schedule F (Form 1040) if you are a farmer. You don’t use Form 2106.

If you claim car or truck expenses, you must provide certain information on the use of your vehicle. You provide this information on Schedule C (Form 1040) or Form 4562.

If you file Schedule C (Form 1040):

Report your travel expenses, except meals, on line 24a;

Report your deductible non-entertainment-related meals (actual cost or standard meal allowance) on line 24b;

Report your gift expenses and transportation expenses, other than car expenses, on line 27a; and

Report your car expenses on line 9. Complete Part IV of the form unless you have to file Form 4562 for depreciation or amortization.

If you file Schedule F (Form 1040), do the following.

Report your car expenses on line 10. Attach Form 4562 and provide information on the use of your car in Part V of Form 4562.

Report all other business expenses discussed in this publication on line 32. You can only include 50% of your non-entertainment-related meals on that line.

If you are both self-employed and an employee, you must keep separate records for each business activity. Report your business expenses for self-employment on Schedule C (Form 1040), or Schedule F (Form 1040), as discussed earlier. Report your business expenses for your work as an employee on Form 2106, as discussed next.

If you are an employee, you must generally complete Form 2106 to deduct your travel and transportation expenses.

You are an employee deducting expenses attributable to your job.

You weren’t reimbursed by your employer for your expenses (amounts included in box 1 of your Form W-2 aren’t considered reimbursements).

If you claim car expenses, you use the standard mileage rate.

For more information on how to report your expenses on Form 2106, see Completing Form 2106 , later.

If you didn’t receive any reimbursements (or the reimbursements were all included in box 1 of your Form W-2), the only business expense you are claiming is for gifts, and the special rules discussed later don’t apply to you, don’t complete Form 2106.

If you received a Form W-2 and the “Statutory employee” box in box 13 was checked, report your income and expenses related to that income on Schedule C (Form 1040). Don’t complete Form 2106.

Statutory employees include full-time life insurance salespersons, certain agent or commission drivers, traveling salespersons, and certain homeworkers.

If your employer reimburses you for nondeductible personal expenses, such as for vacation trips, your employer must report the reimbursement as wage income in box 1 of your Form W-2. You can’t deduct personal expenses.

If you have travel or transportation expenses related to income-producing property, report your deductible expenses on the form appropriate for that activity.

For example, if you have rental real estate income and expenses, report your expenses on Schedule E (Form 1040), Supplemental Income and Loss. See Pub. 527, Residential Rental Property, for more information on the rental of real estate.

Vehicle Provided by Your Employer

If your employer provides you with a car, you may be able to deduct the actual expenses of operating that car for business purposes. The amount you can deduct depends on the amount that your employer included in your income and the business and personal miles you drove during the year. You can’t use the standard mileage rate.

Your employer can figure and report either the actual value of your personal use of the car or the value of the car as if you used it only for personal purposes (100% income inclusion). Your employer must separately state the amount if 100% of the annual lease value was included in your income. If you are unsure of the amount included on your Form W-2, ask your employer.

You may be able to deduct the value of the business use of an employer-provided car if your employer reported 100% of the value of the car in your income. On your 2023 Form W-2, the amount of the value will be included in box 1, Wages, tips, other compensation; and box 14, Other.

To claim your expenses, complete Form 2106, Part II, Sections A and C. Enter your actual expenses on line 23 of Section C and include the entire value of the employer-provided car on line 25. Complete the rest of the form.

If less than the full annual lease value of the car was included on your Form W-2, this means that your Form W-2 only includes the value of your personal use of the car. Don’t enter this value on your Form 2106 because it isn’t deductible.

If you paid any actual costs (that your employer didn’t provide or reimburse you for) to operate the car, you can deduct the business portion of those costs. Examples of costs that you may have are gas, oil, and repairs. Complete Form 2106, Part II, Sections A and C. Enter your actual costs on line 23 of Section C and leave line 25 blank. Complete the rest of the form.

Reimbursements

This section explains what to do when you receive an advance or are reimbursed for any of the employee business expenses discussed in this publication.

If you received an advance, allowance, or reimbursement for your expenses, how you report this amount and your expenses depends on whether your employer reimbursed you under an accountable plan or a nonaccountable plan.

This section explains the two types of plans, how per diem and car allowances simplify proving the amount of your expenses, and the tax treatment of your reimbursements and expenses. It also covers rules for independent contractors.

You aren’t reimbursed or given an allowance for your expenses if you are paid a salary or commission with the understanding that you will pay your own expenses. In this situation, you have no reimbursement or allowance arrangement, and you don’t have to read this section on reimbursements. Instead, see Completing Form 2106 , later, for information on completing your tax return.

A reimbursement or other expense allowance arrangement is a system or plan that an employer uses to pay, substantiate, and recover the expenses, advances, reimbursements, and amounts charged to the employer for employee business expenses. Arrangements include per diem and car allowances.

A per diem allowance is a fixed amount of daily reimbursement your employer gives you for your lodging and M&IE when you are away from home on business. (The term “incidental expenses” is defined in chapter 1 under Standard Meal Allowance. ) A car allowance is an amount your employer gives you for the business use of your car.

Your employer should tell you what method of reimbursement is used and what records you must provide.

If you are an employer and you reimburse employee business expenses, how you treat this reimbursement on your employee's Form W-2 depends in part on whether you have an accountable plan. Reimbursements treated as paid under an accountable plan, as explained next, aren’t reported as pay. Reimbursements treated as paid under nonaccountable plans , as explained later, are reported as pay. See Pub. 15 (Circular E), Employer's Tax Guide, for information on employee pay.

Accountable Plans

To be an accountable plan, your employer's reimbursement or allowance arrangement must include all of the following rules.

Your expenses must have a business connection—that is, you must have paid or incurred deductible expenses while performing services as an employee of your employer.

You must adequately account to your employer for these expenses within a reasonable period of time.

You must return any excess reimbursement or allowance within a reasonable period of time.

Adequate accounting and returning excess reimbursements are discussed later.

An excess reimbursement or allowance is any amount you are paid that is more than the business-related expenses that you adequately accounted for to your employer.

The definition of reasonable period of time depends on the facts and circumstances of your situation. However, regardless of the facts and circumstances of your situation, actions that take place within the times specified in the following list will be treated as taking place within a reasonable period of time.

You receive an advance within 30 days of the time you have an expense.

You adequately account for your expenses within 60 days after they were paid or incurred.

You return any excess reimbursement within 120 days after the expense was paid or incurred.

You are given a periodic statement (at least quarterly) that asks you to either return or adequately account for outstanding advances and you comply within 120 days of the statement.

If you meet the three rules for accountable plans, your employer shouldn’t include any reimbursements in your income in box 1 of your Form W-2. If your expenses equal your reimbursements, you don’t complete Form 2106. You have no deduction since your expenses and reimbursements are equal.

Even though you are reimbursed under an accountable plan, some of your expenses may not meet all three rules. All reimbursements that fail to meet all three rules for accountable plans are generally treated as having been reimbursed under a nonaccountable plan (discussed later).

If you are reimbursed under an accountable plan, but you fail to return, within a reasonable time, any amounts in excess of the substantiated amounts, the amounts paid in excess of the substantiated expenses are treated as paid under a nonaccountable plan. See Reasonable period of time , earlier, and Returning Excess Reimbursements , later.

You may be reimbursed under your employer's accountable plan for expenses related to that employer's business, some of which would be allowable as employee business expense deductions and some of which would not. The reimbursements you receive for the nondeductible expenses don’t meet rule (1) for accountable plans, and they are treated as paid under a nonaccountable plan.

Your employer's plan reimburses you for travel expenses while away from home on business and also for meals when you work late at the office, even though you aren’t away from home. The part of the arrangement that reimburses you for the nondeductible meals when you work late at the office is treated as paid under a nonaccountable plan.

One of the rules for an accountable plan is that you must adequately account to your employer for your expenses. You adequately account by giving your employer a statement of expense, an account book, a diary, or a similar record in which you entered each expense at or near the time you had it, along with documentary evidence (such as receipts) of your travel, mileage, and other employee business expenses. (See Table 5-1 in chapter 5 for details you need to enter in your record and documents you need to prove certain expenses.) A per diem or car allowance satisfies the adequate accounting requirement under certain conditions. See Per Diem and Car Allowances , later.

You must account for all amounts you received from your employer during the year as advances, reimbursements, or allowances. This includes amounts you charged to your employer by credit card or other method. You must give your employer the same type of records and supporting information that you would have to give to the IRS if the IRS questioned a deduction on your return. You must pay back the amount of any reimbursement or other expense allowance for which you don’t adequately account or that is more than the amount for which you accounted.

Per Diem and Car Allowances

If your employer reimburses you for your expenses using a per diem or a car allowance, you can generally use the allowance as proof for the amount of your expenses. A per diem or car allowance satisfies the adequate accounting requirements for the amount of your expenses only if all the following conditions apply.

Your employer reasonably limits payments of your expenses to those that are ordinary and necessary in the conduct of the trade or business.

The allowance is similar in form to and not more than the federal rate (defined later).

You prove the time (dates), place, and business purpose of your expenses to your employer (as explained in Table 5-1 ) within a reasonable period of time.

You aren’t related to your employer (as defined next). If you are related to your employer, you must be able to prove your expenses to the IRS even if you have already adequately accounted to your employer and returned any excess reimbursement.

You are related to your employer if:

Your employer is your brother or sister, half brother or half sister, spouse, ancestor, or lineal descendant;

Your employer is a corporation in which you own, directly or indirectly, more than 10% in value of the outstanding stock; or

Certain relationships (such as grantor, fiduciary, or beneficiary) exist between you, a trust, and your employer.

The federal rate can be figured using any one of the following methods.

For per diem amounts:

The regular federal per diem rate.

The high-low rate.

For car expenses:

A fixed and variable rate (FAVR).

The regular federal per diem rate is the highest amount that the federal government will pay to its employees for lodging and M&IE (or M&IE only) while they are traveling away from home in a particular area. The rates are different for different localities. Your employer should have these rates available. You can also find federal per diem rates at GSA.gov/travel/plan-book/per-diem-rates .

The standard meal allowance is the federal M&IE rate. For travel in 2023, the rate for most small localities in the United States is $59 per day. Most major cities and many other localities qualify for higher rates. You can find this information at GSA.gov/travel/plan-book/per-diem-rates .

You receive an allowance only for M&IE when your employer does one of the following.

Provides you with lodging (furnishes it in kind).

Reimburses you, based on your receipts, for the actual cost of your lodging.

Pays the hotel, motel, etc., directly for your lodging.

Doesn’t have a reasonable belief that you had (or will have) lodging expenses, such as when you stay with friends or relatives or sleep in the cab of your truck.

Figures the allowance on a basis similar to that used in figuring your compensation, such as number of hours worked or miles traveled.

This is a simplified method of figuring the federal per diem rate for travel within the continental United States. It eliminates the need to keep a current list of the per diem rates for each city.

Under the high-low method, the per diem amount for travel during January through September of 2023 is $297 (which includes $74 for M&IE) for certain high-cost locations. All other areas have a per diem amount of $204 (which includes $64 for M&IE). For more information, see Notice 2022-44, which can be found at IRS.gov/irb/2022-41_IRB#NOT-2022-44 .

Effective October 1, 2023, the per diem rate for certain high-cost locations increased to $309 (which includes $74 for M&IE). The rate for all other locations increased to $214 (which includes $64 for M&IE). For more information, see Notice 2023-68, which can be found at IRS.gov/irb/2023-41_IRB#NOT-2023-68 , and Revenue Procedure 2019-48 at IRS.gov/irb/2019-51_IRB#REV-PROC-2019-48 .

The standard meal allowance is for a full 24-hour day of travel. If you travel for part of a day, such as on the days you depart and return, you must prorate the full-day M&IE rate. This rule also applies if your employer uses the regular federal per diem rate or the high-low rate.

You can use either of the following methods to figure the federal M&IE for that day.

For the day you depart, add 3 / 4 of the standard meal allowance amount for that day.

For the day you return, add 3 / 4 of the standard meal allowance amount for the preceding day.

Method 2: Prorate the standard meal allowance using any method you consistently apply in accordance with reasonable business practice. For example, an employer can treat 2 full days of per diem (that includes M&IE) paid for travel away from home from 9 a.m. of one day to 5 p.m. of the next day as being no more than the federal rate. This is true even though a federal employee would be limited to a reimbursement of M&IE for only 1½ days of the federal M&IE rate.

This is a set rate per mile that you can use to figure your deductible car expenses. For 2023, the standard mileage rate for the cost of operating your car for business use is 65.5 cents ($0.655) per mile.

This is an allowance your employer may use to reimburse your car expenses. Under this method, your employer pays an allowance that includes a combination of payments covering fixed and variable costs, such as a cents-per-mile rate to cover your variable operating costs (such as gas, oil, etc.) plus a flat amount to cover your fixed costs (such as depreciation (or lease payments), insurance, etc.). If your employer chooses to use this method, your employer will request the necessary records from you.

If your reimbursement is in the form of an allowance received under an accountable plan, the following facts affect your reporting.

Whether the allowance or your actual expenses were more than the federal rate.

If your allowance is less than or equal to the federal rate, the allowance won’t be included in box 1 of your Form W-2. You don’t need to report the related expenses or the allowance on your return if your expenses are equal to or less than the allowance.

However, if your actual expenses are more than your allowance, you can complete Form 2106. If you are using actual expenses, you must be able to prove to the IRS the total amount of your expenses and reimbursements for the entire year. If you are using the standard meal allowance or the standard mileage rate, you don’t have to prove that amount.

In April, a member of a reserve component of the Armed Forces takes a 2-day business trip to Denver. The federal rate for Denver is $278 ($199 lodging + $79 M&IE) per day. As required by their employer's accountable plan, they account for the time (dates), place, and business purpose of the trip. Their employer reimburses them $278 a day ($556 total) for living expenses. Their living expenses in Denver aren’t more than $278 a day.

Their employer doesn’t include any of the reimbursement on their Form W-2 and they don’t deduct the expenses on their return.

In June, a fee-basis local government official takes a 2-day business trip to Boston. Their employer uses the high-low method to reimburse employees. Because Boston is a high-cost area, they are given an advance of $297 (which includes $74 for M&IE) a day ($594 total) for their lodging and M&IE. Their actual expenses totaled $700.

Since their $700 of expenses are more than their $594 advance, they include the excess expenses when they itemize their deductions. They complete Form 2106 (showing all of their expenses and reimbursements). They must also allocate their reimbursement between their meals and other expenses as discussed later under Completing Form 2106 .

A fee-basis state government official drives 10,000 miles during 2023 for business. Under their employer's accountable plan, they account for the time (dates), place, and business purpose of each trip. Their employer pays them a mileage allowance of 40 cents ($0.40) a mile.

Because their $6,550 expense figured under the standard mileage rate (10,000 miles x 65.5 cents ($0.655) per mile) is more than their $4,000 reimbursement (10,000 miles × 40 cents ($0.40)), they itemize their deductions to claim the excess expense. They complete Form 2106 (showing all their expenses and reimbursements) and enter $2,550 ($6,550 − $4,000) as an itemized deduction.

If your allowance is more than the federal rate, your employer must include the allowance amount up to the federal rate under code L in box 12 of your Form W-2. This amount isn’t taxable. However, the excess allowance will be included in box 1 of your Form W-2. You must report this part of your allowance as if it were wage income.

If your actual expenses are less than or equal to the federal rate, you don’t complete Form 2106 or claim any of your expenses on your return.

However, if your actual expenses are more than the federal rate, you can complete Form 2106 and deduct those excess expenses. You must report on Form 2106 your reimbursements up to the federal rate (as shown under code L in box 12 of your Form W-2) and all your expenses. You should be able to prove these amounts to the IRS.

Sasha, a performing artist, lives and works in Austin. In July, the employer sent Sasha to Albuquerque for 4 days on business. The employer paid the hotel directly for Sasha’s lodging and reimbursed $80 a day ($320 total) for M&IE. Sasha’s actual meal expenses weren’t more than the federal rate for Albuquerque, which is $69 per day.

The employer included the $44 that was more than the federal rate (($80 − $69) × 4) in box 1 of Sasha’s Form W-2. The employer shows $276 ($69 a day × 4) under code L in box 12 of Form W-2. This amount isn’t included in income. Sasha doesn’t have to complete Form 2106; however, Sasha must include the $44 in gross income as wages (by reporting the total amount shown in box 1 of their Form W-2).

Another performing artist, Ari, also lives in Austin and works for the same employer as in Example 1 . In May, the employer sent Ari to San Diego for 4 days and paid the hotel directly for the hotel bill. The employer reimbursed Ari $75 a day for M&IE. The federal rate for San Diego is $74 a day.

Ari can prove that actual non-entertainment-related meal expenses totaled $380. The employer's accountable plan won’t pay more than $75 a day for travel to San Diego, so Ari doesn’t give the employer the records that prove that the amount actually spent was $380. However, Ari does account for the time (dates), place, and business purpose of the trip. This is Ari’s only business trip this year.

Ari was reimbursed $300 ($75 × 4 days), which is $4 more than the federal rate of $296 ($74 × 4 days). The employer includes the $4 as income on the employee’s Form W-2 in box 1. The employer also enters $296 under code L in box 12 of the employee’s Form W-2.

Ari completes Form 2106 to figure deductible expenses and enters the total of actual expenses for the year ($380) on Form 2106. Ari also enters the reimbursements that weren’t included in income ($296). Ari’s total deductible meals and beverages expense, before the 50% limit, is $96. Ari will include $48 as an itemized deduction.

Palmer, a fee-basis state government official, drives 10,000 miles during 2023 for business. Under the employer's accountable plan, Palmer gets reimbursed 70 cents ($0.70) a mile, which is more than the standard mileage rate. The total reimbursement is $7,000.

The employer must include the reimbursement amount up to the standard mileage rate, $6,550 (10,000 miles x 65.5 cents ($0.655) per mile), under code L in box 12 of the employee’s Form W-2. That amount isn’t taxable. The employer must also include $450 ($7,000 − $6,550) in box 1 of the employee's Form W-2. This is the reimbursement that is more than the standard mileage rate.

If the expenses are equal to or less than the standard mileage rate, Palmer wouldn’t complete Form 2106. If the expenses are more than the standard mileage rate, Palmer would complete Form 2106 and report total expenses and reimbursement (shown under code L in box 12 of their Form W-2). Palmer would then claim the excess expenses as an itemized deduction.

Returning Excess Reimbursements

Under an accountable plan, you are required to return any excess reimbursement or other expense allowances for your business expenses to the person paying the reimbursement or allowance. Excess reimbursement means any amount for which you didn’t adequately account within a reasonable period of time. For example, if you received a travel advance and you didn’t spend all the money on business-related expenses or you don’t have proof of all your expenses, you have an excess reimbursement.

Adequate accounting and reasonable period of time were discussed earlier in this chapter.

You receive a travel advance if your employer provides you with an expense allowance before you actually have the expense, and the allowance is reasonably expected to be no more than your expense. Under an accountable plan, you are required to adequately account to your employer for this advance and to return any excess within a reasonable period of time.

If you don’t adequately account for or don't return any excess advance within a reasonable period of time, the amount you don’t account for or return will be treated as having been paid under a nonaccountable plan (discussed later).

If you don’t prove that you actually traveled on each day for which you received a per diem or car allowance (proving the elements described in Table 5-1 ), you must return this unproven amount of the travel advance within a reasonable period of time. If you don’t do this, the unproven amount will be considered paid under a nonaccountable plan (discussed later).

If your employer's accountable plan pays you an allowance that is higher than the federal rate, you don’t have to return the difference between the two rates for the period you can prove business-related travel expenses. However, the difference will be reported as wages on your Form W-2. This excess amount is considered paid under a nonaccountable plan (discussed later).

Your employer sends you on a 5-day business trip to Phoenix in March 2023 and gives you a $400 ($80 × 5 days) advance to cover your M&IE. The federal per diem for M&IE for Phoenix is $69. Your trip lasts only 3 days. Under your employer's accountable plan, you must return the $160 ($80 × 2 days) advance for the 2 days you didn’t travel. For the 3 days you did travel, you don’t have to return the $33 difference between the allowance you received and the federal rate for Phoenix (($80 − $69) × 3 days). However, the $33 will be reported on your Form W-2 as wages.

Nonaccountable Plans

A nonaccountable plan is a reimbursement or expense allowance arrangement that doesn’t meet one or more of the three rules listed earlier under Accountable Plans .

In addition, even if your employer has an accountable plan, the following payments will be treated as being paid under a nonaccountable plan.

Excess reimbursements you fail to return to your employer.

Reimbursement of nondeductible expenses related to your employer's business. See Reimbursement of nondeductible expenses , earlier, under Accountable Plans.

If you aren’t sure if the reimbursement or expense allowance arrangement is an accountable or nonaccountable plan, ask your employer.

Your employer will combine the amount of any reimbursement or other expense allowance paid to you under a nonaccountable plan with your wages, salary, or other pay. Your employer will report the total in box 1 of your Form W-2.

You must complete Form 2106 and itemize your deductions to deduct your expenses for travel, transportation, or non-entertainment-related meals. Your meal and entertainment expenses will be subject to the 50% Limit discussed in chapter 2.

Your employer gives you $1,000 a month ($12,000 total for the year) for your business expenses. You don’t have to provide any proof of your expenses to your employer, and you can keep any funds that you don’t spend.

You are a performing artist and are being reimbursed under a nonaccountable plan. Your employer will include the $12,000 on your Form W-2 as if it were wages. If you want to deduct your business expenses, you must complete Form 2106 and itemize your deductions.

You are paid $2,000 a month by your employer. On days that you travel away from home on business, your employer designates $50 a day of your salary as paid to reimburse your travel expenses. Because your employer would pay your monthly salary whether or not you were traveling away from home, the arrangement is a nonaccountable plan. No part of the $50 a day designated by your employer is treated as paid under an accountable plan.

Rules for Independent Contractors and Clients

This section provides rules for independent contractors who incur expenses on behalf of a client or customer. The rules cover the reporting and substantiation of certain expenses discussed in this publication, and they affect both independent contractors and their clients or customers.

You are considered an independent contractor if you are self-employed and you perform services for a customer or client.

Accounting to Your Client

If you received a reimbursement or an allowance for travel, or gift expenses that you incurred on behalf of a client, you should provide an adequate accounting of these expenses to your client. If you don’t account to your client for these expenses, you must include any reimbursements or allowances in income. You must keep adequate records of these expenses whether or not you account to your client for these expenses.

If you don’t separately account for and seek reimbursement for meal and entertainment expenses in connection with providing services for a client, you are subject to the 50% limit on those expenses. See 50% Limit in chapter 2.

As a self-employed person, you adequately account by reporting your actual expenses. You should follow the recordkeeping rules in chapter 5 .

For information on how to report expenses on your tax return, see Self-employed at the beginning of this chapter.

Required Records for Clients or Customers

If you are a client or customer, you generally don’t have to keep records to prove the reimbursements or allowances you give, in the course of your business, to an independent contractor for travel or gift expenses incurred on your behalf. However, you must keep records if:

You reimburse the contractor for entertainment expenses incurred on your behalf, and

The contractor adequately accounts to you for these expenses.

If the contractor adequately accounts to you for non-entertainment-related meal expenses, you (the client or customer) must keep records documenting each element of the expense, as explained in chapter 5 . Use your records as proof for a deduction on your tax return. If non-entertainment-related meal expenses are accounted for separately, you are subject to the 50% limit on meals. If the contractor adequately accounts to you for reimbursed amounts, you don’t have to report the amounts on an information return.

If the contractor doesn’t adequately account to you for allowances or reimbursements of non-entertainment-related meal expenses, you don’t have to keep records of these items. You aren’t subject to the 50% limit on meals in this case. You can deduct the reimbursements or allowances as payment for services if they are ordinary and necessary business expenses. However, you must file Form 1099-MISC to report amounts paid to the independent contractor if the total of the reimbursements and any other fees is $600 or more during the calendar year.

How To Use Per Diem Rate Tables

This section contains information about the per diem rate substantiation methods available and the choice of rates you must make for the last 3 months of the year.

The Two Substantiation Methods

IRS Notices list the localities that are treated under the high-low substantiation method as high-cost localities for all or part of the year. Notice 2022-44, available at IRS.gov/irb/2022-41_IRB#NOT-2022-44 , lists the high-cost localities that are eligible for $297 (which includes $74 for meals and incidental expenses (M&IE)) per diem, effective October 1, 2022. For travel on or after October 1, 2022, all other localities within the continental United States (CONUS) are eligible for $204 (which includes $64 for M&IE) per diem under the high-low method.

Notice 2023-68, available at IRS.gov/irb/2023-41_IRB#NOT-2023-68 , lists the high-cost localities that are eligible for $309 (which includes $74 for M&IE) per diem, effective October 1, 2023. For travel on or after October 1, 2023, the per diem for all other localities increased to $214 (which includes $64 for M&IE).

Regular federal per diem rates are published by the General Services Administration (GSA). Both tables include the separate rate for M&IE for each locality. The rates listed for FY2023 at GSA.gov/travel/plan-book/per-diem-rates are effective October 1, 2022, and those listed for FY2024 are effective October 1, 2023. The standard rate for all locations within CONUS not specifically listed for FY2023 is $157 ($98 for lodging and $59 for M&IE). For FY2024, this rate increases to $166 ($107 for lodging and $59 for M&IE).

Transition Rules

The transition period covers the last 3 months of the calendar year, from the time that new rates are effective (generally, October 1) through December 31. During this period, you may generally change to the new rates or finish out the year with the rates you had been using.

If you use the high-low substantiation method, when new rates become effective (generally, October 1), you can either continue with the rates you used for the first part of the year or change to the new rates. However, you must continue using the high-low method for the rest of the calendar year (through December 31). If you are an employer, you must use the same rates for all employees reimbursed under the high-low method during that calendar year.

The new rates and localities for the high-low method are included each year in a notice that is generally published in mid to late September. You can find the notice in the weekly Internal Revenue Bulletin (IRB) at IRS.gov/IRB , or visit IRS.gov and enter “Special Per Diem Rates” in the search box.

New CONUS per diem rates become effective on October 1 of each year and remain in effect through September 30 of the following year. Employees being reimbursed under the per diem rate method during the first 9 months of a year (January 1–September 30) must continue under the same method through the end of that calendar year (December 31). However, for travel by these employees from October 1 through December 31, you can choose to continue using the same per diem rates or use the new rates.

The new federal CONUS per diem rates are published each year, generally early in September. Go to GSA.gov/travel/plan-book/per-diem-rates .

Completing Form 2106

For tax years beginning after 2017, the Form 2106 will be used by Armed Forces reservists, qualified performing artists, fee-basis state or local government officials, and employees with impairment-related work expenses. Due to the suspension of miscellaneous itemized deductions subject to the 2% floor under section 67(a), employees who do not fit into one of the listed categories may not use Form 2106.

This section briefly describes how employees complete Forms 2106. Table 6-1 explains what the employer reports on Form W-2 and what the employee reports on Form 2106. The instructions for the forms have more information on completing them.

Table 6-1. Reporting Travel, Nonentertainment Meal, Gift, and Car Expenses and Reimbursements

If you used a car to perform your job as an employee, you may be able to deduct certain car expenses. These are generally figured on Form 2106, Part II, and then claimed on Form 2106, Part I, line 1, column A.

If you claim any deduction for the business use of a car, you must answer certain questions and provide information about the use of the car. The information relates to the following items.

Date placed in service.

Mileage (total, business, commuting, and other personal mileage).

Percentage of business use.

After-work use.

Use of other vehicles.

Whether you have evidence to support the deduction.

Whether or not the evidence is written.

If you claim a deduction based on the standard mileage rate instead of your actual expenses, you must complete Form 2106, Part II, Section B. The amount on line 22 (Section B) is carried to Form 2106, Part I, line 1. In addition, on Part I, line 2, you can deduct parking fees and tolls that apply to the business use of the car. See Standard Mileage Rate in chapter 4 for information on using this rate.

If you claim a deduction based on actual car expenses, you must complete Form 2106, Part II, Section C. In addition, unless you lease your car, you must complete Section D to show your depreciation deduction and any section 179 deduction you claim.

If you are still using a car that is fully depreciated, continue to complete Section C. Since you have no depreciation deduction, enter zero on line 28. In this case, don’t complete Section D.

If you claim car rental expenses on Form 2106, line 24a, you may have to reduce that expense by an inclusion amount , as described in chapter 4. If so, you can show your car expenses and any inclusion amount as follows.

Figure the inclusion amount without taking into account your business-use percentage for the tax year.

Report the inclusion amount from (1) on Form 2106, Part II, line 24b.

Report on line 24c the net amount of car rental expenses (total car rental expenses minus the inclusion amount figured in (1)).

Show your transportation expenses that didn’t involve overnight travel on Form 2106, line 2, column A. Also include on this line business expenses you have for parking fees and tolls. Don’t include expenses of operating your car or expenses of commuting between your home and work.

Show your other employee business expenses on Form 2106, lines 3 and 4, column A. Don’t include expenses for nonentertainment meals on those lines. Line 4 is for expenses such as gifts, educational expenses (tuition and books), office-in-the-home expenses, and trade and professional publications.

Show the full amount of your expenses for nonentertainment business-related meals on Form 2106, line 5, column B. Include meals while away from your tax home overnight and other business meals. Enter 50% of the line 8, column B, meal expenses on line 9, column B.

If you are subject to the Department of Transportation's “hours of service” limits (as explained earlier under Individuals subject to hours of service limits in chapter 2), use 80% instead of 50% for meals while away from your tax home.

Enter on Form 2106, line 7, the amounts your employer (or third party) reimbursed you that weren’t reported to you in box 1 of your Form W-2. This includes any amount reported under code L in box 12 of Form W-2.

If you were reimbursed under an accountable plan and want to deduct excess expenses that weren’t reimbursed, you may have to allocate your reimbursement. This is necessary when your employer pays your reimbursement in the following manner.

Pays you a single amount that covers non-entertainment-related meals and/or entertainment, as well as other business expenses.

Doesn’t clearly identify how much is for deductible non-entertainment-related meals.

Your employer paid you an expense allowance of $12,000 this year under an accountable plan. The $12,000 payment consisted of $5,000 for airfare and $7,000 for non-entertainment-related meals, and car expenses. Your employer didn’t clearly show how much of the $7,000 was for the cost of deductible non-entertainment-related meals. You actually spent $14,000 during the year ($5,500 for airfare, $4,500 for non-entertainment-related meals, and $4,000 for car expenses).

Since the airfare allowance was clearly identified, you know that $5,000 of the payment goes in column A, line 7, of Form 2106. To allocate the remaining $7,000, you use the worksheet from the Instructions for Form 2106. Your completed worksheet follows.

Reimbursement Allocation Worksheet (Keep for your records.)

If you are a government official paid on a fee basis, a performing artist, an Armed Forces reservist, or a disabled employee with impairment-related work expenses, see Special Rules , later.

Your employee business expenses may be subject to either of the limits described next. They are figured in the following order on the specified form.

Certain non-entertainment-related meal expenses are subject to a 50% limit. Generally, entertainment expenses are nondeductible if paid or incurred after December 2017. If you are an employee, you figure this limit on line 9 of Form 2106. (See 50% Limit in chapter 2.)

Limitations on itemized deductions are suspended for tax years beginning after 2017 and before tax year January 2026, per section 68(g).

Special Rules

This section discusses special rules that apply only to Armed Forces reservists, government officials who are paid on a fee basis, performing artists, and disabled employees with impairment-related work expenses. For tax years beginning after 2017, they are the only taxpayers who can use Form 2106.

Armed Forces Reservists Traveling More Than 100 Miles From Home

If you are a member of a reserve component of the Armed Forces of the United States and you travel more than 100 miles away from home in connection with your performance of services as a member of the reserves, you can deduct your travel expenses as an adjustment to gross income rather than as a miscellaneous itemized deduction. The amount of expenses you can deduct as an adjustment to gross income is limited to the regular federal per diem rate (for lodging and M&IE) and the standard mileage rate (for car expenses) plus any parking fees, ferry fees, and tolls. See Per Diem and Car Allowances , earlier, for more information.

You are a member of a reserve component of the Armed Forces of the United States if you are in the Army, Navy, Marine Corps, Air Force, or Coast Guard Reserve; the Army National Guard of the United States; the Air National Guard of the United States; or the Reserve Corps of the Public Health Service.

If you have reserve-related travel that takes you more than 100 miles from home, you should first complete Form 2106. Then include your expenses for reserve travel over 100 miles from home, up to the federal rate, from Form 2106, line 10, in the total on Schedule 1 (Form 1040), line 12.

You can’t deduct expenses of travel that doesn’t take you more than 100 miles from home as an adjustment to gross income.

Certain fee-basis officials can claim their employee business expenses on Form 2106.

Fee-basis officials are persons who are employed by a state or local government and who are paid in whole or in part on a fee basis. They can deduct their business expenses in performing services in that job as an adjustment to gross income rather than as a miscellaneous itemized deduction.

If you are a fee-basis official, include your employee business expenses from Form 2106, line 10, in the total on Schedule 1 (Form 1040), line 12.

Expenses of Certain Performing Artists

If you are a performing artist, you may qualify to deduct your employee business expenses as an adjustment to gross income. To qualify, you must meet all of the following requirements.

During the tax year, you perform services in the performing arts as an employee for at least two employers.

You receive at least $200 each from any two of these employers.

Your related performing-arts business expenses are more than 10% of your gross income from the performance of those services.

Your adjusted gross income isn’t more than $16,000 before deducting these business expenses.

If you are married, you must file a joint return unless you lived apart from your spouse at all times during the tax year. If you file a joint return, you must figure requirements (1), (2), and (3) separately for both you and your spouse. However, requirement (4) applies to your and your spouse's combined adjusted gross income.

If you meet all of the above requirements, you should first complete Form 2106. Then you include your performing-arts-related expenses from Form 2106, line 10, in the total on Schedule 1 (Form 1040), line 12.

If you don’t meet all of the above requirements, you don’t qualify to deduct your expenses as an adjustment to gross income.

If you are an employee with a physical or mental disability, your impairment-related work expenses aren’t subject to the 2%-of-adjusted-gross-income limit that applies to most other employee business expenses. After you complete Form 2106, enter your impairment-related work expenses from Form 2106, line 10, on Schedule A (Form 1040), line 16, and identify the type and amount of this expense on the line next to line 16.

Impairment-related work expenses are your allowable expenses for attendant care at your workplace and other expenses in connection with your workplace that are necessary for you to be able to work.

You are disabled if you have:

A physical or mental disability (for example, blindness or deafness) that functionally limits your being employed; or

A physical or mental impairment (for example, a sight or hearing impairment) that substantially limits one or more of your major life activities, such as performing manual tasks, walking, speaking, breathing, learning, or working.

You can deduct impairment-related expenses as business expenses if they are:

Necessary for you to do your work satisfactorily;

For goods and services not required or used, other than incidentally, in your personal activities; and

Not specifically covered under other income tax laws.

You are blind. You must use a reader to do your work. You use the reader both during your regular working hours at your place of work and outside your regular working hours away from your place of work. The reader's services are only for your work. You can deduct your expenses for the reader as business expenses.

You are deaf. You must use a sign language interpreter during meetings while you are at work. The interpreter's services are used only for your work. You can deduct your expenses for the interpreter as business expenses.

How To Get Tax Help

If you have questions about a tax issue; need help preparing your tax return; or want to download free publications, forms, or instructions, go to IRS.gov to find resources that can help you right away.

After receiving all your wage and earnings statements (Forms W-2, W-2G, 1099-R, 1099-MISC, 1099-NEC, etc.); unemployment compensation statements (by mail or in a digital format) or other government payment statements (Form 1099-G); and interest, dividend, and retirement statements from banks and investment firms (Forms 1099), you have several options to choose from to prepare and file your tax return. You can prepare the tax return yourself, see if you qualify for free tax preparation, or hire a tax professional to prepare your return.

Your options for preparing and filing your return online or in your local community, if you qualify, include the following.

Free File. This program lets you prepare and file your federal individual income tax return for free using software or Free File Fillable Forms. However, state tax preparation may not be available through Free File. Go to IRS.gov/FreeFile to see if you qualify for free online federal tax preparation, e-filing, and direct deposit or payment options.

VITA. The Volunteer Income Tax Assistance (VITA) program offers free tax help to people with low-to-moderate incomes, persons with disabilities, and limited-English-speaking taxpayers who need help preparing their own tax returns. Go to IRS.gov/VITA , download the free IRS2Go app, or call 800-906-9887 for information on free tax return preparation.

TCE. The Tax Counseling for the Elderly (TCE) program offers free tax help for all taxpayers, particularly those who are 60 years of age and older. TCE volunteers specialize in answering questions about pensions and retirement-related issues unique to seniors. Go to IRS.gov/TCE or download the free IRS2Go app for information on free tax return preparation.

MilTax. Members of the U.S. Armed Forces and qualified veterans may use MilTax, a free tax service offered by the Department of Defense through Military OneSource. For more information, go to MilitaryOneSource ( MilitaryOneSource.mil/MilTax ).

Also, the IRS offers Free Fillable Forms, which can be completed online and then e-filed regardless of income.

Go to IRS.gov/Tools for the following.

The Earned Income Tax Credit Assistant ( IRS.gov/EITCAssistant ) determines if you’re eligible for the earned income credit (EIC).

The Online EIN Application ( IRS.gov/EIN ) helps you get an employer identification number (EIN) at no cost.

The Tax Withholding Estimator ( IRS.gov/W4App ) makes it easier for you to estimate the federal income tax you want your employer to withhold from your paycheck. This is tax withholding. See how your withholding affects your refund, take-home pay, or tax due.

The First Time Homebuyer Credit Account Look-up ( IRS.gov/HomeBuyer ) tool provides information on your repayments and account balance.

The Sales Tax Deduction Calculator ( IRS.gov/SalesTax ) figures the amount you can claim if you itemize deductions on Schedule A (Form 1040).

Go to IRS.gov/Help : A variety of tools to help you get answers to some of the most common tax questions.

Go to IRS.gov/ITA : The Interactive Tax Assistant, a tool that will ask you questions and, based on your input, provide answers on a number of tax topics.

Go to IRS.gov/Forms : Find forms, instructions, and publications. You will find details on the most recent tax changes and interactive links to help you find answers to your questions.

You may also be able to access tax information in your e-filing software.

There are various types of tax return preparers, including enrolled agents, certified public accountants (CPAs), accountants, and many others who don’t have professional credentials. If you choose to have someone prepare your tax return, choose that preparer wisely. A paid tax preparer is:

Primarily responsible for the overall substantive accuracy of your return,

Required to sign the return, and

Required to include their preparer tax identification number (PTIN).

The Social Security Administration (SSA) offers online service at SSA.gov/employer for fast, free, and secure W-2 filing options to CPAs, accountants, enrolled agents, and individuals who process Form W-2, Wage and Tax Statement, and Form W-2c, Corrected Wage and Tax Statement.

Go to IRS.gov/SocialMedia to see the various social media tools the IRS uses to share the latest information on tax changes, scam alerts, initiatives, products, and services. At the IRS, privacy and security are our highest priority. We use these tools to share public information with you. Don’t post your social security number (SSN) or other confidential information on social media sites. Always protect your identity when using any social networking site.

The following IRS YouTube channels provide short, informative videos on various tax-related topics in English, Spanish, and ASL.

Youtube.com/irsvideos .

Youtube.com/irsvideosmultilingua .

Youtube.com/irsvideosASL .

The IRS Video portal (IRSVideos.gov) contains video and audio presentations for individuals, small businesses, and tax professionals.

You can find information on IRS.gov/MyLanguage if English isn’t your native language.

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With an online account, you can access a variety of information to help you during the filing season. You can get a transcript, review your most recently filed tax return, and get your adjusted gross income. Create or access your online account at IRS.gov/Account .

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The safest and easiest way to receive a tax refund is to e-file and choose direct deposit, which securely and electronically transfers your refund directly into your financial account. Direct deposit also avoids the possibility that your check could be lost, stolen, destroyed, or returned undeliverable to the IRS. Eight in 10 taxpayers use direct deposit to receive their refunds. If you don’t have a bank account, go to IRS.gov/DirectDeposit for more information on where to find a bank or credit union that can open an account online.

Tax-related identity theft happens when someone steals your personal information to commit tax fraud. Your taxes can be affected if your SSN is used to file a fraudulent return or to claim a refund or credit.

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Go to IRS.gov/IdentityTheft , the IRS Identity Theft Central webpage, for information on identity theft and data security protection for taxpayers, tax professionals, and businesses. If your SSN has been lost or stolen or you suspect you’re a victim of tax-related identity theft, you can learn what steps you should take.

Get an Identity Protection PIN (IP PIN). IP PINs are six-digit numbers assigned to taxpayers to help prevent the misuse of their SSNs on fraudulent federal income tax returns. When you have an IP PIN, it prevents someone else from filing a tax return with your SSN. To learn more, go to IRS.gov/IPPIN .

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Download the official IRS2Go app to your mobile device to check your refund status.

Call the automated refund hotline at 800-829-1954.

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Keep in mind, many questions can be answered on IRS.gov without visiting a TAC. Go to IRS.gov/LetUsHelp for the topics people ask about most. If you still need help, TACs provide tax help when a tax issue can’t be handled online or by phone. All TACs now provide service by appointment, so you’ll know in advance that you can get the service you need without long wait times. Before you visit, go to IRS.gov/TACLocator to find the nearest TAC and to check hours, available services, and appointment options. Or, on the IRS2Go app, under the Stay Connected tab, choose the Contact Us option and click on “Local Offices.”

The Taxpayer Advocate Service (TAS) Is Here To Help You

TAS is an independent organization within the IRS that helps taxpayers and protects taxpayer rights. TAS strives to ensure that every taxpayer is treated fairly and that you know and understand your rights under the Taxpayer Bill of Rights .

The Taxpayer Bill of Rights describes 10 basic rights that all taxpayers have when dealing with the IRS. Go to TaxpayerAdvocate.IRS.gov to help you understand what these rights mean to you and how they apply. These are your rights. Know them. Use them.

TAS can help you resolve problems that you can’t resolve with the IRS. And their service is free. If you qualify for their assistance, you will be assigned to one advocate who will work with you throughout the process and will do everything possible to resolve your issue. TAS can help you if:

Your problem is causing financial difficulty for you, your family, or your business;

You face (or your business is facing) an immediate threat of adverse action; or

You’ve tried repeatedly to contact the IRS but no one has responded, or the IRS hasn’t responded by the date promised.

TAS has offices in every state, the District of Columbia, and Puerto Rico . To find your advocate’s number:

Go to TaxpayerAdvocate.IRS.gov/Contact-Us ;

Download Pub. 1546, The Taxpayer Advocate Service Is Your Voice at the IRS, available at IRS.gov/pub/irs-pdf/p1546.pdf ;

Call the IRS toll free at 800-TAX-FORM (800-829-3676) to order a copy of Pub. 1546;

Check your local directory; or

Call TAS toll free at 877-777-4778.

TAS works to resolve large-scale problems that affect many taxpayers. If you know of one of these broad issues, report it to TAS at IRS.gov/SAMS . Be sure to not include any personal taxpayer information.

LITCs are independent from the IRS and TAS. LITCs represent individuals whose income is below a certain level and who need to resolve tax problems with the IRS. LITCs can represent taxpayers in audits, appeals, and tax collection disputes before the IRS and in court. In addition, LITCs can provide information about taxpayer rights and responsibilities in different languages for individuals who speak English as a second language. Services are offered for free or a small fee. For more information or to find an LITC near you, go to the LITC page at TaxpayerAdvocate.IRS.gov/LITC or see IRS Pub. 4134, Low Income Taxpayer Clinic List , at IRS.gov/pub/irs-pdf/p4134.pdf .

Appendices A-1 through A-6 show the lease inclusion amounts that you may need to report if you first leased a passenger automobile (including a truck and van) in 2018 through 2023 for 30 days or more.

If any of these apply to you, use the appendix for the year you first leased the car. (See Leasing a Car in chapter 4.)

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• REAL ESTATE

Lease Payments Are Not Always Rent

• IRS Practice & Procedure

Landlords and tenants should know the tax treatment of items associated with the language built into a lease and all ancillary agreements, as well as items that are not included in any written agreement. Three areas that present tax opportunities are tenant improvement allowances, lease inducement payments, and lease termination payments. This item addresses the tax consequences for the lessor and lessee in these areas.

Tenant Allowances

A lessor pays a tenant allowance to provide a lessee with funds to prepare the space for its intended business use. Generally, the tenant treats a tenant allowance received from the landlord as ordinary income. The tenant would recognize income and depreciate assets over their useful life, resulting in a mismatch of income and expenses. However, if the parties structure a tenant allowance correctly, Sec. 110 provides a safe harbor so that the tenant is not required to recognize income for the allowance.

Sec. 110(a) allows a lessee to exclude from income the amount of a qualified construction allowance received from a landlord to the extent the allowance does not exceed the actual costs incurred to improve the leased space. For tenant allowance payments from a landlord to a lessee to be considered a qualified lessee construction allowance, the lease must be short - term and for retail space. Regs. Sec. 1. 110 - 1 (b)(2)(ii) defines a short - term lease as any agreement for the occupancy or use of a retail space for a term of 15 years or less. The lease term is determined by taking the initial lease term in the lease agreement and including any lease extension options unless the rent is to be renewed at fair market value determined at the time of the renewal (Sec. 168(i)(3)). Regs. Sec. 1. 110 - 1 (b)(2)(iii) defines retail space as space "that is leased, occupied, or otherwise used by the lessee in its trade or business of selling tangible personal property or services to the general public . . . [and includes] space where activities supporting the retail activity are performed." Regs. Sec. 1. 110 - 1 (b)(3) also contains a purpose requirement, which requires that the tenant allowance be expressly provided for in the lease agreement (or an ancillary agreement) and be for the purpose of constructing or improving qualified long - term real property for use in the lessee's trade or business at the retail space. Personal property, even if it is used in the retail space, will not qualify under the safe harbor.

Sec. 110 provides that improvements related to a qualified leasehold improvement allowance are determined to be owned by the landlord. For purposes of retail space, qualified property generally meets the following requirements: It has a recovery period of 20 years or less; is acquired prior to Jan. 1, 2020; and is deemed qualified improvement property (Sec. 168(k)(2)(A)(i)). Once these guidelines are met, the improvements are then eligible to be treated as 15 - year recovery qualified leasehold improvement property eligible for special depreciation, which includes 50% bonus depreciation for tax year 2016.

When developing language within the lease agreement concerning the tenant allowance, the landlord should consider including a restriction on the use of funds to ensure the allowance is eligible to be treated as qualified leasehold improvement property and for special depreciation allowance treatment under Sec. 168(k). Qualified leasehold improvement property is carved out of the general definition for qualified property, as it applies specifically to improvements made to the interior of nonresidential real property. The property must be placed in service more than three years after the building was first placed in service, and the space must be occupied solely by the lessee (Sec. 168(e)(6)(A)).

When a qualified lessee construction allowance is paid pursuant to a lease agreement, both parties are required to make disclosures with their federal tax returns under Sec. 110. The lessor and lessee must attach a statement to their returns that includes the location of the retail space and the full amount of the tenant allowance provided. The lessor is also required to disclose what portion of the allowance is being treated as nonresidential real property owned by the lessor. The lessee should include the portion of the construction allowance that is deemed to be a qualified lessee construction allowance under Regs. Sec. 1. 110 - 1 (b) (Regs. Sec. 1. 110 - 1 (c)(3)). Parties that fail to make the required tax return disclosures associated with a construction allowance may be subject to penalties under Sec. 6721.

Lease Inducement Payments

Another common arrangement between landlords and tenants (which the parties may or may not provide for in the lease agreement) is a lease inducement payment. Lease inducement payments are those made by or on behalf of the landlord to entice a tenant to sign a lease agreement. Lease inducement payments may be in the form of cash but may also include a transfer of ownership of a building or land, payment of costs by the lessor on the lessee's behalf, a lessor's assumption of the lessee's prior lease obligation with a different landlord, moving expenses, or payment of termination fees to the lessee's previous landlord. When the landlord makes a lease inducement payment, the tenant recognizes income in the year in which the payment is received or earned, depending on the tenant's accounting method. If the tenant uses the amount received for real property improvements, the tenant can capitalize and depreciate the improvements under Sec. 168.

The consideration paid by the landlord to induce a tenant to enter into a lease is considered a cost of obtaining a lease, and therefore it must be amortized by the landlord over the term of the lease under Sec. 178. The lease inducement payment is considered an expense related to acquiring the lease. If the lessor constructs the improvements and owns the property pursuant to the lease agreement, the lessor treats the improvements as a trade or business asset and depreciates them over the appropriate recovery period. At the end of the lease, the landlord may be able to treat the improvements as abandoned property and write them off under Sec. 168(i)(8)(B). To qualify as an abandonment loss under Sec. 168, the improvement must have been paid for by the lessor and related to leased property and be disposed of or abandoned subsequent to a lease termination. To be considered abandoned, it should be more than just vacated by the tenant. For example, if the improvement is unique to the tenant and unable to be used by another tenant, this may qualify as abandonment. Another potential abandonment would be if the improvement is no longer functional or legally allowed to be used by a future tenant.

Lease Termination Payments

The third area of consideration relates to lease termination payments. The parties should draft an additional lease termination agreement at the time of termination if the original lease agreement does not outline any conditions surrounding the termination payment in order to specify the terms for payment. There are two types of lease termination payments: (1) payments made by the landlord to the tenant and (2) payments made by the tenant to the landlord.

Payments made by the landlord to the tenant: Generally, the tax treatment by the lessor depends on the reason the landlord makes the lease termination payment. If a landlord pays a tenant to vacate a space before the end of the lease term, the landlord cannot take a deduction in the year in which the lease termination payment is made. The landlord generally recovers a lease termination payment made to the lessee over the remaining term of the terminated lease ( Miller ,10 B.T.A. 383 (1928)). When a lessor terminates a lease to make the space available for a new tenant, the lessor should amortize the payment over the life of the new tenant's lease ( Wells Fargo Bank & Union Trust Co. , 163 F.2d 521 (9th Cir. 1947); Latter , T.C. Memo. 1961 - 67 ). If the landlord is terminating the lease early in anticipation of selling the building, the landlord should add the termination payment to the cost of the building ( Shirley Hill Coal Co. , 6 B.T.A. 935 (1927)). If the tenant is required to vacate the space due to construction or a buildout, the lessor should add the termination payment to the capitalized cost of the improvements ( Keiler , 285 F. Supp. 520 (W.D. Ky. 1967)).

Sec. 1241 governs the tenant's treatment of a lease termination payment. Sec. 1241 states that amounts received by a lessee for the cancellation of a lease shall be considered as amounts received in exchange for such lease or agreement. Therefore, if the lease is a Sec. 1231 asset, the tenant can potentially recognize the income as capital gain. Sec. 1241 does not determine whether the lease is a capital asset (Regs. Sec. 1. 1241 - 1 (a)). The taxpayer should look to Sec. 1231 to determine whether it can treat the lease as a capital asset. Also, the entire lease termination payment could potentially be deferred under Sec. 1031; the payment must be made to a qualified intermediary and used to acquire a replacement lease (that qualifies under Sec. 1031) or even a fee simple interest in real estate. One should review the remaining lease term (including extension options) to determine whether this would qualify. A leasehold interest in real estate with 30 years or more left on the lease can be considered a fee simple interest in real estate under Sec. 1031.

Payments made by the tenant to the landlord: Lease termination payments received by the landlord are taxable income to the landlord as a substitute for rental payments under Regs. Sec. 1. 61 - 8 (b). If a tenant is required to pay a fee to terminate a lease early, the landlord should be careful to not require such a payment in excess of the actual and reasonable loss incurred as a result of the early lease termination. It is possible that the lessor could recognize capital gain treatment on the receipt of a lease termination payment if Sec. 1234A applies. Sec. 1234A states:

gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation . . . with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer . . . shall be treated as gain or loss from the sale of a capital asset.

For the payment to qualify under Sec. 1234A, the property must be a capital asset and not an asset used in a trade or business, which would be considered Sec. 1231 property and would not qualify as a capital asset under Sec. 1221. For the property to be qualified as a capital asset, the activities of the landlord should be minimal with respect to it, and the landlord should hold the property for investment purposes. This provision under Sec. 1234A would not apply to a real estate professional.

Whether the tenant's lease termination payment is deductible depends on the reason for early termination. If the lease was terminated because the lease agreement has become unprofitable, the payment is fully deductible under Sec. 162 ( Cassatt ,137 F.2d 745 (3d Cir. 1943)). However, if the tenant is terminating to acquire new property, the tenant capitalizes and amortizes the payment as outlined in Letter Ruling 9607016.

Several areas must be considered when entering into a lease agreement. The prospective landlord, tenant, and each party's tax representative and legal counsel should examine the language built into an agreement to occupy space. Frequently, the lease agreement does not list the areas of opportunity addressed in this item, so a separate agreement may be warranted. The scenarios that may have a tax effect for either party can be addressed through the appropriate analysis of the lease language. Such an analysis leads to tax planning and a smoother tenant - landlord relationship.

Editor Notes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or [email protected] .

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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The 2022 act affected a wide array of retirement fund and pension plan provisions. This article highlights many of the most noteworthy ones, along with relevant IRS guidance and congressional plans for technical corrections.

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Real Estate Transfer Taxes (RETT) on Leases

• News and Insights Real Estate Transfer Taxes (RETT) on Leases

Real estate transfer taxes (RETT) are a one-time tax or fee imposed by a state or local jurisdiction on the transfer of real property. Currently 17 states impose the tax under a variety of names (i.e., Recordation Tax, Stamp Tax, etc.)  

The tax is typically levied when recording a deed or other legal document from buyer to seller but can also be imposed on a variety of other structured transactions, including leases. The party responsible for paying the tax differs by each jurisdiction.

Other names for Real Estate Transfer Taxes include:  

• Deed transfer tax
• Real property transfer tax
• Realty transfer tax
• Recordation tax
• Documentary transfer tax
• Conveyance tax

Transfer Taxes on Leaseholds and Subleases

Transfer taxes contain many nuances that impact their applicability, tax base and computations. Many states and municipalities apply a RETT on the creation, surrender, and assignment of a lease. Some common triggers include:  

• Length of lease
• Options for renewal and purchase
• Capital improvements to the property
• Sale of a controlling interest in entities that hold leasehold interests

Taxable Consideration  

Taxable consideration is generally defined as the entire compensation paid or to be paid for the transfer of real property and can be determined in a variety of ways. As an example, New York consideration can be computed using the present value of the right to receive rental payments or other payments attributable to the use and occupancy of the real property, plus the present value of rental or other payments attributable to any renewal term.  

Operating costs and expenses to 3 rd parties, including heat, gas, electricity, furnishings, insurance, maintenance, management, and real estate taxes can be taken into account when:  

Surrender of lease  

Generally, the consideration for the surrender of a leasehold interest is the amount paid for the surrender by the lessor to the lessee. Consideration does not include the value of the remaining rental payments that are required in accordance with the terms of the lease.  

No tax will be imposed on the surrender of a leasehold interest if the lessee pays consideration to the lessor to accept the surrender.  

Assignment of lease    

The consideration for the assignment of a lease is the amount paid for the assignment by the assignee to the assignor. Meaning, the lessee under the lease or the person who is assigning his or her rights to purchase the property under the option or contract. Consideration does not include the value of the remaining rental payments that are required pursuant to the terms of the lease.  

Need Assistance Understanding Transfer Taxes on Leases?

Contact a Tax Specialist Today

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Determining the tax treatment of a lease transaction, including worked examples

A property lease is basically a right to use an asset. A lease is a contract by which one party (lessor) gives the use and possession of land and building to another party (lessee) for a specific period of time, usually in return for a specific rent.

This contrasts with a licence, which entitles a person (licensee) to the use of the property, but which is subject to termination at the will of the owner of the property (licensor).

Leases usually run for many years, while licences cover a relatively short period of time (up to two years).

The key point in determining the tax treatment of a lease transaction is to establish whether there is an assignment of a lease or a grant of a lease. An assignment of a lease is the legal term used for the sale of a lease. On assignment, the owner relinquishes rights over the property.

A grant of a lease is the creation of a new asset. The person who owns the property grants a lease to a tenant for a specific period of time; however, the rights in the property will eventually revert back to the freehold landlord.

Assignment of a lease

The tax treatment on the assignment of a lease depends on whether the taxpayer is selling a long or short lease.

A long lease is a lease that has more than 50 years to run at the date it was sold; a lease with less than 50 years to run is a short lease.

Assignment of a long lease

The capital gains tax (CGT) computation on the assignment of a long lease is quite straightforward; the original cost is deducted from the proceeds and the resulting gain is then subject to CGT (after the annual exemption).

Assignment of a short lease

The CGT computation on the assignment of a short lease is slightly more complex.

A lease with a useful life of less than 50 years is called a ‘wasting asset’. As wasting assets depreciate over time, the allowable base cost for CGT purposes is calculated using the lease depreciation tables ( Schedule 8 Paragraph 1, TCGA 1992 ).

The allowable base cost is the original acquisition cost multiplied by the fraction S/P, where: 

• ‘S’ is the percentage from the lease depreciation table for the years of the lease remaining at the date of assignment
• ‘P’ is the percentage from the lease depreciation table for years of the lease remaining at the date of purchase. 

Sarah purchased a 42-year lease for £100,000 in January 2000. In January 2012, she sells the lease for £150,000.

As 12 years have passed since original acquisition, Sarah is selling a lease with 30 years left to run.

From the proceeds of £150,000, we deduct the allowable base cost (which is the original acquisition cost multiplied by the fraction S/P).

From the lease depreciation table, the relevant percentage for a 42-year lease is 96.593 and for a 30-year lease the relevant percentage is 87.33.

The capital gain is therefore:

Proceeds: £150,000

Allowable cost: 100,000 x 87.33/96.593 (90,410)

Gain: £59,590

A long lease will become a short lease once less than 50 years are remaining.

Louise bought a 60-year lease on 1 January 1990 for £90,000. She sells the lease on 1 January 2010 for £120,000.

As 20 years have passed since original acquisition, Louise is selling a lease with 40 years left to run.

Accordingly, Louise is selling a short lease and we need to refer to the lease depreciation tables.

The percentage for 50 years or more is always 100, and the percentage for a 40-year lease is 95.457.

Proceeds: £120,000

Allowable cost:

90,000 x 95.457/100 (85,911)

Gain: £34,089

Grant of a lease

As with the assignment of a lease the tax implication on the grant of a lease depends on the length of the lease granted.

Grant of a long lease

Where a freeholder grants a long lease to a tenant, CGT is calculated by using the part-disposal formula:

The allowable cost is the acquisition cost multiplied by the fraction A/(A+B), where:

• ‘A’ is the gross amount of the premium paid
• ‘B’ is the value of the remainder or the reversionary interest. 

Rose grants a 55-year lease on a freehold property which she purchased in 2000 for £100,000.

She receives a premium of £150,000 from the leaseholder. The value of the freehold reversion is £200,000.

Premium: £150,000 

100,000 x 150,000/(150,000+200,000) (42,857)

Gain: £107,143

Grant of a short lease

The premium received from the grant of a short lease must be split between the amount chargeable to income tax (under property income rule ITTOIA 2005 S 277 (4)) and the amount chargeable to CGT.

The capital element chargeable to CGT is 2 per cent x (N-1) x P, where:

• ‘N’ is the number of years of the lease
• ‘P’ is the premium received. 

The grant of a lease out of a freehold is treated as a part-disposal; accordingly, allowable cost is calculated as the acquisition cost multiplied by the fraction a/(A+B), where:

• ‘A’ is the gross premium paid
• ‘B’ is the reversionary interest
• ‘a’ is the part of the premium that is chargeable to CGT. 

Elizabeth bought a freehold property 20 years ago for £50,000. In 2010, she granted a 40-year lease for a premium of £100,000, the reversionary interest being £200,000.

We first need to split the premium of £100,000 into the amount subject to income tax and the amount subject to CGT:

The capital element is 2% x (40-1) x £100,000 = £78,000.

The amount chargeable to income tax (as property income) is the difference between the premium received and the amount charged to CGT (£100,000-£78,000 = £22,000).

The capital gain is as follows:

Capital element of the premium: £78,000

Less allowable cost:

50,000 x 78,000/(100,000+200,000) (13,000)

Gain: £65,000

The above only looks at tax implications on assigning or granting of a lease; however, there might be legal implications if the taxpayer wishes to get out of a lease agreement before the end of the term.

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The Importance of Lease Assignment Agreements

Understanding Lease Assignment Agreements: A Vital Guide for Franchisees

Running a franchise is no small feat, especially when you’re managing multiple locations. Amidst the hustle of daily operations, financial reporting, marketing strategies, and employee management, the importance of lease agreements can often be overlooked. However, understanding and managing lease assignment agreements is crucial for the long-term success and stability of your franchise business.

Lease assignment agreements are crucial in real estate transactions as they facilitate the transfer of lease rights and obligations from one party to another. For tenants, they offer flexibility by allowing them to exit leases before expiration without penalties, while for landlords, they ensure continuity of rental income and compliance with lease terms.

This article will dive deeper into lease assignment agreements, how they can impact your business, and why you should keep an eye on them.

What is a Lease Assignment Agreement?

A lease assignment agreement is more than just a piece of paper; it is a vital legal document that can significantly impact your business operations and financial health. This agreement comes into play when you need to transfer the lease of one of your locations to another party, perhaps when selling a location or restructuring your business. It ensures that the new tenant assumes all rights and responsibilities associated with the lease, protecting both the franchisee and the landlord from potential legal disputes and financial losses.

For franchisees, particularly those with multiple locations, keeping a close eye on lease assignment agreements is essential. These agreements ensure smooth transitions, whether you are expanding, downsizing, or selling parts of your business. They help maintain operational continuity and safeguard your investments, allowing you to focus on growth and profitability without the looming threat of legal complications or unexpected financial burdens.

A lease assignment agreement is a legal document that transfers the rights and responsibilities of an existing lease from one party (the assignor) to another party (the assignee). This is common in business scenarios where a franchisee, who operates multiple locations, wants to transfer the lease of one of their locations to another party.

Why is a Lease Assignment Agreement Important to Franchisees?

For a franchisee with multiple locations, a lease assignment agreement is crucial for several reasons:

Transferring Responsibilities : When a franchisee decides to sell or transfer ownership of one of their locations, they often need to transfer the lease agreement along with it. The lease assignment agreement outlines the terms of this transfer, including the new tenant’s responsibilities for rent, maintenance, and compliance with lease terms.

Avoiding Breach of Contract : Without a proper lease assignment agreement, attempting to transfer a lease to a new tenant could be a breach of contract with the landlord. This could lead to legal issues, including eviction or financial penalties. The agreement ensures that the transfer is done in accordance with the terms of the original lease.

Protecting Investment : For a franchisee, each location represents a significant investment of time and money. Properly managing lease agreements ensures that this investment is protected, even if the franchisee decides to sell or exit a particular location.

Maintaining Brand Reputation : Franchise businesses rely on maintaining a consistent brand image across all locations. Ensuring that lease agreements are transferred smoothly helps maintain this consistency and avoids disruptions in operations that could harm the franchise’s reputation.

Facilitating Growth or Restructuring : Having clear processes for lease assignments makes it easier for franchisees to expand their business by acquiring new locations or reorganizing their existing portfolio. It provides flexibility for future growth or strategic changes.

These agreements mitigate financial risks for both parties and serve as negotiation tools, enabling tenants to find suitable replacements and landlords to vet new occupants. By formalizing the transfer of lease interests, lease assignment agreements provide legal clarity, documentation, and record-keeping, thereby minimizing disputes and ensuring smooth transitions in tenancy arrangements.

Kal Gullapalli, CEO of MPZ Holdings, explains the importance of lease assignment agreements in our latest webinar .

“We spend a lot of time and money on the assignment language. In one scenario, when I first sold a portion of my European Wax Center franchise in early 2020, we were going through a lease assignment. It was 7 stores that I was taking private equity capital on that we were rolling into the new holding company. I offered the landlord everything. So I said, ‘Hey, I’m going to be CEO of the new company. I’m gonna keep my personal guarantee on in the new holding company, you have nothing to worry about’.

6 months later, he held out. There was a time where I even said to the landlord, ‘Here’s $50,000, sign the assignment’. He wouldn’t respond.

I finally got him to sign on March 11th, 2020, just before Covid shut everything down. If this had gone on to mid or late March, my deal with private equity would not have been consummated, which was in the 8 figures. 

It’s really important as you think about these leases that you focus and spend extra money on these assignments and try to make the assignment as liquid as humanly possible”.

The Benefits of Lease Assignments:

Lease assignment agreements play a crucial role in real estate transactions, particularly in the context of commercial leases. Here are some key points highlighting their importance:

Transfer of Lease Obligations :

A lease assignment agreement allows a tenant (assignor) to transfer their rights and obligations under a lease to another party (assignee). This transfer typically includes responsibilities such as paying rent, maintaining the property, and complying with lease terms.

Flexibility for Tenants :

For tenants, lease assignment agreements provide flexibility. They allow tenants to exit a lease before its expiration without incurring penalties or breaking lease terms. This can be beneficial if a business needs to relocate or downsize.

Opportunities for Landlords :

Lease assignment agreements also offer benefits for landlords. They provide landlords with the assurance that the lease obligations will continue to be met even if the original tenant decides to assign the lease to another party. This helps landlords maintain a steady stream of rental income and minimizes vacancies.

Risk Management :

Lease assignment agreements help manage risks associated with leasing property. For tenants, it can mitigate financial risks by transferring lease obligations to a new party. For landlords, it ensures that the property remains occupied and lease terms are honored, reducing the risk of income loss.

Legal Compliance :

By formalizing the transfer of lease rights and obligations through a lease assignment agreement, both parties ensure legal compliance. The agreement outlines the terms of the assignment, including any conditions or restrictions, protecting the interests of both the assignor and the assignee.

Negotiation Tool :

Lease assignment agreements can serve as negotiation tools for both tenants and landlords. Tenants may negotiate favorable terms with prospective assignees to facilitate the transfer, while landlords may negotiate additional guarantees or concessions to mitigate potential risks associated with the new tenant.

Documentation and Record-Keeping :

Having a lease assignment agreement in place provides clear documentation of the transfer of lease rights and obligations. This documentation is essential for record-keeping purposes and can help resolve disputes or misunderstandings that may arise in the future.

What Happens if Lease Assignments Aren’t Handled Correctly?

If lease assignments are not handled properly, it can have significant implications for the franchisee’s business down the road:

Legal Issues : Improperly executed lease assignments can lead to legal disputes with landlords or new tenants, resulting in financial losses or even the loss of the location.

Financial Impact : If a lease assignment is not structured favorably, it could result in increased costs for the franchisee or limit their ability to negotiate favorable terms with the landlord.

Operational Disruptions : Without clear agreements in place, transferring a lease could disrupt operations at the location, affecting revenue and customer relationships.

Impact on Sale Value : When selling a location, having unclear or unfavorable lease terms can reduce the attractiveness of the business to potential buyers, impacting its sale value.

In conclusion , lease assignment agreements are vital components of real estate transactions, offering flexibility, risk management, legal compliance, and negotiation opportunities for both tenants and landlords. They provide a structured framework for the transfer of lease interests while safeguarding the interests of all parties involved.

Leasecake is used by multi-unit operators and franchisees to manage their lease and location data, so they never have to risk losing a location again. To learn more about  Leasecake’s lease management platform  and how we can help you grow your business, manage multiple locations, save money by understanding exactly what’s in your documents, and minimize the risk of overpaying or missing a lease renewal,  schedule a demo .

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Why Lease Accounting Matters—Even if You’re Not Concerned About ASC 842 or IFRS 16

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Tax impacts of the new lease accounting standard asc 842.

The Financial Accounting Standards Board (FASB) recently proposed a delay in the implementation of Accounting Standards Update on Topic 842, Leases , originally enacted on February 25, 2016. Although the delay will give most private companies until fiscal years beginning after December 15, 2020, to comply, it is important for companies to be proactive in considering the tax as well as the GAAP impact of ASC 842.

The changes in the accounting guidance will not impact how leases are treated for federal income tax purposes, as there were no direct changes in tax law with respect to the treatment of leases. However, as companies transition to the new leasing standard, the new GAAP accounting standards may impact several areas within the tax function.

Prior Lessee Accounting Model

Leasing guidance before the issuance of ASC 842 required lessees to classify leases as either capital or operating leases. Capital leases required lessees to recognize an asset and a corresponding liability equal to the present value of the future lease payments. Expenses associated with capital leases were recognized by amortizing the leased asset and recognizing interest expense on the lease obligation. Many lease arrangements were classified as operating leases. Lessees would not recognize lease assets or liabilities on their balance sheets, but would recognize lease payments as rent expense on a straight line basis over the lease term.

Leasing guidance prior to the issuance of ASC 842 was often criticized for not providing users of financial statements the information necessary to understand a reporting entity’s leasing activities, primarily because it did not provide a comprehensive understanding of the costs of property essential to a reporting entity’s operations and how those costs were funded. Most leasing activity was reported as off balance sheet items in the footnotes to the financial statements.

New Lessee Accounting Model

Under the new accounting model under ASC 842, virtually all leases that were previously expensed only on the income statement now must be recorded on the balance sheet. Lessees will now need to recognize a right-of-use asset and a lease liability upon the inception of a lease. The liability will be equal to the present value of the future lease payments, discounted using the rate implicit in the lease. The right-of-use asset will be based on the amount of the initial measurement of the lease liability plus any lease payments made to the lessor at or before the commencement date of the lease, minus any lease incentives received and any initial direct costs incurred by the lessee.

For income statement purposes, ASC 842 retains a dual model requiring leases to be classified as either operating or finance. Operating leases will result in straight-line rental expense similar to current operating leases. Finance leases will result in interest expense determined under the effective interest method. Amortization expense is recorded on the right-of-use asset, usually on a straight line basis.

Under ASC 842 lessors will classify leases as sales-type — direct financing or operating. The distinction between a sales-type and direct financing lease is that in a sales-type lease, the lessee obtains control of the underlying asset, and the lessor recognizes selling profit and sales revenue upon lease commencement. No sales transaction is recognized for tax purposes at the time of lease commencement. For sales-type and direct financing leases, the underlying asset is derecognized, and the net investment in the lease (the sum of the present value of the future lease payments and unguaranteed residual value) is recorded. The net investment is increased by interest income and decreased by payments collected. For operating leases, the underlying asset remains on the balance sheet, net of depreciation expense over its useful life. The lessor will depreciate the property on a straight line basis for GAAP and over the applicable recovery period for tax.

Tax Impacts

ASC 842 does not impact how leases are treated for federal income tax purposes. Leases will either be treated as a true tax lease or a non-tax lease. Under a true tax lease, the lessor maintains ownership of the asset and the related deductions such as depreciation, while the lessee would deduct rental payments. A non-tax lease assumes that the risks and rewards of ownership are with the lessee. Tax deductions such as depreciation and interest expense are booked by the lessee, while the lessor recognizes interest income.

Deferred Tax Accounting

Since ASC 842 does not change the treatment of leases for income tax purposes, companies will have to consider the deferred tax implications in the implementation of the new standard. A lessee that is otherwise not required to capitalize the lease for income tax purposes will not have any tax basis in the right-of-use asset and related lease liability recorded for GAAP purposes. Since the differences between the GAAP and tax basis of the right-of-use asset and related lease liability will result in taxable income or deductions upon their reversal, such differences are temporary in nature. Accordingly, a company must recognize a deferred tax liability for the excess GAAP basis in the right-of-use asset and a deferred tax asset for the excess GAAP basis in the related lease liability. Whether the lease is classified as a finance or operating lease under the new guidance, the right=of=use asset and related lease liability are initially measured in the same manner. Accordingly, the initial measurement of the temporary differences will generally be the same, regardless of the classification of the lease.

The manner in which the initial temporary differences reverse, however, is dependent on whether the lease is classified as a finance or operating lease under the new standard. Even though the income statement effect of leases under ASC 842 is largely unchanged from previous guidance, the difference in the reversal pattern between a finance and operating lease will affect the subsequent adjustments to the original deferred tax asset and liability. For finance leases, the new lease standard will generally result in an accelerated expense recognition for financial statement purposes. This outcome is due to the subsequent accretion in the lease liability being based on an effective interest rate calculation, similar to a mortgage with higher interest expense being incurred in the earlier years and less interest expense incurred in later years, as the mortgage liability is reduced by payments made.

For operating leases, the new lease standard will generally result in a constant annual cost similar to the expense pattern under current operating lease accounting. While the subsequent accretion in the lease liability is also based on an effective interest rate calculation, the right-of-use asset is amortized at a rate to ensure that the cost of the lease is allocated over the lease term on a generally straight line basis.

Also, if any impairment is created for a right-of-use asset for book purposes, it will need to be reversed for tax purposes.

State Taxes

Certain states levy franchise taxes for companies doing business within particular jurisdictions. Franchise taxes are generally based upon the net worth (stockholder’s equity) of a corporation; however, various adjustments may be required (e.g., treasury stock, liabilities, reserves, etc.) to arrive at the taxable base. Implementation of the new leasing standard may impact the computation of a company’s franchise tax base, due to the requirement to record essentially all leasing transactions on the balance sheet for financial accounting purposes. Moreover, the property factor utilized in the computation of many state apportionment factors (for both income and franchise tax purposes) is determined through the use of an average owned property (generally, valued at its original cost) and eight times the net annual rent. After the adoption of ASC 842, companies may need to change the process used to gather information for property factor computations, particularly if the right-of-use asset is recorded in the same balance sheet account or line item as other owned property.

Other Tax considerations

Companies should consider whether the adoption of the new lease accounting standard will impact any other non-income based taxes. For example, a company should consider whether its property tax liability (if based on its financial accounting balance sheet) will change as a result of the proposed standard. Companies should also consider if there will be any sales and use tax impact resulting from the adoption of the new lease accounting standard. For example, companies should assess whether a state would consider a lease transaction as a purchase, since companies will have lease transactions on the balance sheet after adopting the new standard. Companies with off shore leases may also need to evaluate the effect that ASC 842 may have in each foreign jurisdiction in which they operate. ASC 842 could also impact transfer pricing arrangements.

As companies prepare to adopt the new lease accounting standard, tax implications and opportunities should be considered at each step of the implementation process.

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Sales (assignments) of leases

Assignment is the disposal of an existing lease. The assignment of a lease represents a disposal for capital gains purposes of an interest in property. There is no deemed rental income to calculate on the disposal because the assignment is not the grant of a new lease.

The chargeable gain on assignment of a 'long' lease, that is a lease with at least 50 years to run, is computed as a standard capital gains disposal. This is dealt with further below.

Where the lease has less than 50 years to run at the point at which it is assigned then it will be regarded as a wasting asset. This means that only a proportion of the original expenditure will be an allowable deduction against the disposal value. The amount of the original cost of a short-term lease allowable as a deduction on disposal reduces in accordance with a statutory formula given in TCGA 1992, Sch 8 (also known as a curvilinear

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Tax Director at Crane Dale Tax , Corporate Tax, OMB, Personal Tax

Rob is a cross-tax advisor with a particular focus on property tax planning, and business structure planning for OMB’s. He provides tax advice to other accounting firms, balancing commerciality, ethics, and understanding complexity. His 30+ years of experience start at the Inland Revenue in Hull. After completing his ATT and CTA by 1999 with PKF, he subsequently worked at KPMG and UHY prior to managing the business tax team as a director at Garbutt + Elliott. Rob is now Tax Director at the independent tax consultancy, Crane Dale Tax. He is a regular author for Taxation magazine with many articles and Readers Forum contributions since 2005, and he contributes as a virtual member to the CIOT Property Tax technical committee. Rob works remotely from Vancouver in Canada.

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Andrew Symons examines the CGT implications of assignment and grant of land leases

What is the issue?

The capital gains tax implications of the assignment and grant of land leases can be complex.

What does it mean to me?

Transactions concerning land often involve significant numbers and so correctly assessing the facts of a case is important to avoid potentially costly errors.

What can I take away?

By working through the facts of a case methodically the correct tax analysis should not, in many cases, be unduly difficult to reach. Particular care must be taken in establishing restrictions on or reductions to allowable costs.

Where an individual makes an outright disposal (assignment) of, or grants an interest in, a lease relating to land, they are disposing of a chargeable asset.

Where a lease is granted, this represents a part disposal of the asset from which the grant is made.

The proceeds of disposal, after the deduction of allowable costs, are subject to capital gains tax (CGT), assuming a gain arises. This article focuses on some of the main provisions which apply to such a disposal when calculating the chargeable gain, or loss.

Statutory references are to Schedule 8 of the Taxation of Chargeable Gains Act 1992, unless otherwise specified.

Meaning of ‘lease’

It is important to first consider some definitions. For CGT purposes a lease of land is given an extended definition at paragraph 10(1) as including an underlease, sublease or any tenancy or licence, and any agreement for such and, in the case of land outside the UK, any interest corresponding to a lease as so defined.

Lease duration

Where the duration of a lease does not exceed 50 years it is considered a wasting asset (a ‘short’ lease); a fact which significantly impacts the gain computation, hence its identification is of great importance.

Often, the duration of a lease will simply be its length as determined by the lease agreement. However, it may be treated differently in some circumstances. Reference only to the facts known or ascertainable at the time when the lease was acquired or created need be made.

When determining the length of a lease:

• Where it is terminable by way of notice given by the landlord, it is taken to expire on the date it could first be terminated under such notice;
• Where its terms (or other circumstances) render it unlikely to continue beyond a given date (before its natural expiry), it is taken to expire on that earlier date. This applies in particular where rent is due to substantially increase or some other onerous obligation crystallises and the lease may be terminated by notice given by the tenant;
• Where the tenant can extend the lease unilaterally by notice, it is assumed to be so extended subject to the right of the landlord, by notice, to determine the lease.

Assignment of a long lease (>50 years)

Where the duration of an assigned lease exceeds 50 years, the normal gain computational rules apply. Namely, cost (including enhancement expenditure) is deducted from disposal proceeds to arrive at the chargeable gain, or loss. 

Assignment of a short lease

Where a short lease (determined as at the date of assignment) is disposed there is a restriction on the amount of expenditure which is allowable (the lease being a wasting asset).

A curved line reduction in the allowable cost is made with reference to the depreciation table, containing percentages, in paragraph 1, which also provides the fraction with which to calculate the restriction: (P(1)-P(3)) / P(1).

P(1) represents the percentage for the unexpired lease term at acquisition of the lease and P(3), the percentage derived from the table for the length of unexpired lease at the date of disposal.

Enhancement expenditure is similarly restricted using the fraction: (P(2)-P(3)) / P(2), where P(3) is defined as above and P(2) is the relevant percentage for the length of unexpired lease term at the time of enhancement.

An exception to this treatment includes where a lease is acquired subject to a sublease otherwise than at a rack-rent and the lease’s anticipated value at the time of expiry of the sublease exceeds the allowable expenditure on disposal. Here, the lease is not treated as a wasting asset until the end of the duration of the sublease.

Another exception arises where the property subject to the lease has, during the period of ownership, been used solely or partly for the purpose of a trade, profession or vocation and capital allowances have or could have been claimed in respect of the lease or related enhancement expenditure.

The lease percentages in paragraph 1 are stated in whole years; where the duration of the disposed lease is not a whole number of years, a monthly apportionment should be applied. For this purpose, 14 days or more counts as one month.

Where, at acquisition or enhancement, the lease is not a wasting asset (but it is when sold), P(1) and P(3) are taken to be 100 when wasting each element of cost. See example 2 .

Meaning of ‘premium’

Before discussing the grant of leases, the meaning of premium must be understood. Premium is defined in paragraph 10(2) as including any like sum (other than rent), whether payable to the intermediate or a superior landlord, on or in connection with the granting of a tenancy. It is presumed that such a sum paid represents a premium except in so far as other sufficient consideration can be shown to have been given.

A premium may be paid in cash or in money’s worth.

Other capital sums may be treated as premiums. For example, where the landlord is a freeholder or leaseholder (with more than 50 years to expiry) and a payment is made by their tenant under the terms of the lease for the commutation of rent, as consideration for the surrender of the lease, or as consideration for the variation or waiver of terms of the lease, that sum is often treated as if it were a premium.

The occurrence of such a deemed premium does not require revision of a previous disposal computation; it is considered a separate transaction and hence a further part disposal. There are a number of more specific provisions in this area which are not discussed further here.

A deemed premium may also arise where a lease is granted between connected persons or persons otherwise not acting at arm’s length.

Grant of a long lease

Unsurprisingly, the premium paid on the grant of a lease is taxed after a deduction for allowable costs. 

Being a part disposal, the well known apportionment of costs in s.42 of ‘A/A+B’ is applied, where ‘A’ represents the value of the premium and ‘B’, the value of the reversionary interest, including the right to receive rents under the lease.

A part disposal will still arise even where no premium is paid by the lessee. Where the landlord has incidental expenditure allowable under s.38(1)(c) a capital loss equal thereto arises. See example 1 .

Grant of a short lease from a freehold or long lease

Where a short lease is granted from a freehold or long lease, part of the premium received is assessed to income tax on the landlord (the calculation of which is outside the scope of this article); this must be excluded from the CGT computation (i.e. only the ‘capital’ element of the premium is assessed to CGT, again, after a deduction for allowable costs).

Reflecting a part disposal, the allowable cost is restricted using the now subtly changed s.42 apportionment of a/A+B, where ‘a’ is the capital element of the premium. ‘A’ and ‘B’ retain the definitions as for the grant of a long lease.

Grant of a lease from a short lease

The A/A+B part disposal apportionment does not apply where a sublease is granted out of a short lease. Initially, the full premium (capital and income elements) is included in the computation, from which a proportion of base cost is deducted – a number of restrictions to this cost can apply.

Firstly, a reduction in the allowable expenditure is required where the sublease covers only part of the land subject to the original lease.

Being a part disposal of a wasting asset the allowable cost is restricted using the lease depreciation table, and fraction: (C-D)/P(1) [or (C-D)/P(2) in the case of enhancement expenditure], where ‘C’ is the relevant percentage in respect of the unexpired lease term at the time of grant of the sublease and ‘D’, is the relevant percentage in respect of the unexpired lease term at the time when the sublease expires. The definitions of P(1) and P(2) remain as before.

Before applying ‘(C-D)/P(1)’, allowable cost is reduced for the grantor, where their interest in the asset was itself acquired by way of grant (of a short lease) to the extent that they have received a deduction for the purpose of calculating the profits of a trade, profession or vocation in respect of the income element of the premium previously paid by them.

Additionally, where the actual value of the premium paid on the grant of the sublease is less than that which would have been paid (the ‘notional premium’) had the rent payable under the sublease been the same as that payable on the head-lease then the allowable cost on the grant of the sublease is reduced in the proportion: actual premium/notional premium. This seeks to prevent tax manipulation arising by charging higher rents in lieu of a lower premium, thus avoiding CGT.

Finally, to arrive at the chargeable gain, a deduction is made for the element of the premium which is assessed to income tax. This deduction cannot convert a gain into a loss, or increase a loss.

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Business Income Manual

Bim46265 - specific deductions: premiums: assignment of lease.

S61 Income Tax (Trading and Other Income) Act 2005, S63 Corporation Tax Act 2009

Where a taxed lease is assigned (or sold - see PIM1204 ) and the new tenant occupies or uses the land subject to the lease for the purposes of a trade, the new tenant inherits the old tenant’s entitlement to a deduction in respect of the premium.

The facts are the same as the example in BIM46255 , except that B Limited vacates the property after ten years and sells its lease to C Limited. The consideration for the sale is £100,000.

C Limited inherits B Limited’s entitlement to a trading deduction of £8,572 per annum for eleven years (21 less 10) or for such lesser period as C Limited occupies the property for trade purposes. If the rules dealing with the assignment of a lease at undervalue (see PIM1222 ) do not apply, the sum of £100,000 paid by C Limited to B Limited as consideration for the assignment of the lease is a capital payment which is not a premium taxable on B Limited and does not rank as a trading deduction allowable to C Limited.

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