IRC Code 467: Accrual Methods, Interest, and Recapture

IRC Section 467 requires landlords and tenants under certain commercial leases to report rental income and deductions on an accrual basis, on a schedule the statute dictates, regardless of when cash actually changes hands. The rule reaches rental agreements for tangible property (typically commercial real estate or equipment) where total payments exceed $250,000 and the rent is deferred, increasing, or decreasing. When Section 467 applies, it can either respect the lease’s own rent allocation, scale each period’s rent by a present-value fraction, or override the schedule entirely and level the rent into a single constant annual amount.

Which Leases Section 467 Covers

A rental agreement falls under Section 467 only if it meets two conditions. First, total payments received as consideration for using the property, plus the value of any other consideration exchanged, must exceed $250,000. Certain contingent rent is excluded from this count, so a lease with $200,000 in fixed rent plus variable percentage-of-sales payments may still fall below the threshold.¹

Second, the agreement must have at least one of two structural features. Deferred rent is any amount allocated to property use during a calendar year that isn’t due until after the close of the following calendar year; rent for property use in 2025 is deferred if payment isn’t required until 2027 or later.¹ Increasing or decreasing rent means the annualized fixed rent allocated to any rental period differs from the amount allocated to any other period.

A lease with equal monthly rent throughout the term that requires payment within the calendar year the rent relates to, or within the preceding or succeeding calendar year, is not a Section 467 rental agreement, even if total payments exceed $250,000.²

Rent Features That Do Not Trigger the Rule

Many commercial leases include variable payment features that look like increasing or decreasing rent but are specifically disregarded when determining whether Section 467 applies:²

Rent escalators tied to the CPI or a similar reasonable price index.
Qualified percentage rent provisions based on the tenant’s gross receipts.
Tenant reimbursement of property taxes, insurance, or common area maintenance.
Late payment charges.
Adjustments based on variable interest rates.

A rent holiday of three months or less at the beginning of the lease also does not create increasing or decreasing rent, even though the annualized rent during the free period is lower than the rest of the term.² Without these exclusions, nearly every long-term commercial lease would be swept in.

The Three Accrual Methods

Once a lease qualifies, the regulations sort it into one of three accrual regimes, each progressively more aggressive in overriding the lease’s stated payment schedule.

The lightest treatment applies when the lease is not a disqualified leaseback or long-term agreement and provides adequate interest on fixed rent. That happens either because the lease has no deferred or prepaid rent, or because it states interest at a single fixed rate meeting the threshold. In that case, the parties simply follow the lease’s stated rent allocation, and the interest on fixed rent is the amount the lease itself provides.²

When the lease lacks adequate interest but is not a disqualified leaseback or long-term agreement, the regulations require proportional rental accrual. This method respects the general shape of the rent schedule but adjusts each period’s rent using a present-value fraction.³

The heaviest treatment, constant rental accrual, is reserved for disqualified leaseback or long-term agreements. It overrides the lease’s payment schedule and levels the total rent into a single constant annual amount. Constant rental accrual is mandatory once the IRS classifies the agreement as disqualified.⁴

How Proportional Rental Accrual Is Calculated

Proportional rental accrual follows the lease’s stated allocation but scales each period’s rent by a fraction that accounts for the time value of money. The discount rate is 110% of the applicable federal rate, compounded semiannually, in effect when the lease is executed, using the AFR for debt instruments with a maturity matching the lease term.¹

The regulations walk through a worked example. A three-year lease allocates $800,000 to Year 1, $1,000,000 to Year 2, and $1,200,000 to Year 3, with a single $3,000,000 lump sum due on the last day. Assume 110% AFR is 8.5% compounded annually, the rate used in the regulatory example.³

Step one: compute the present value of the actual payments. The $3,000,000 discounted three years at 8.5% is $2,348,724. Step two: compute the present value of the allocated rent by discounting each year’s allocation from the end of that period. That comes to $2,526,272. Step three: divide the first by the second to get the proportional fraction, 0.9297.³

Multiply each year’s allocated rent by the fraction to get the Section 467 rent for each period: $743,776 in Year 1, $929,719 in Year 2, and $1,115,663 in Year 3. The landlord reports these amounts as income and the tenant deducts them, regardless of whether the $3,000,000 cash payment has occurred. The gap between accrued rent and actual cash payments is then accounted for as Section 467 interest.

Disqualified Leasebacks and Long-Term Agreements

A lease reaches the constant rental accrual regime only after clearing several hurdles, and the classification requires a determination by the IRS Commissioner rather than a taxpayer’s self-assessment.

A lease is a leaseback if the tenant, or a related person, held any interest in the property (other than a minimal one) at any time within two years before the lease began. Qualifying interests include ownership, purchase options, sub-lessor rights, and agreements to buy.¹ A lease is a long-term agreement if its term exceeds 75% of the property’s depreciation recovery period under Section 168.⁴ Nonresidential real property has a 39-year recovery period, so a lease exceeding roughly 29 years and 3 months qualifies as long-term.⁵

Being a leaseback or long-term agreement alone isn’t enough. The agreement becomes disqualified only if a principal purpose for the increasing or decreasing rent is federal income tax avoidance, and the Commissioner makes that determination.⁴ For leases entered into before July 19, 1999, total rents must also exceed $2,000,000.

The 10 Percent Safe Harbor

An agreement is not disqualified if the rent allocated to each calendar year doesn’t vary from the average annual rent over the entire lease term by more than 10%.⁶ Gentle escalators that stay within that band avoid disqualified status regardless of the parties’ marginal tax rates.

The tax-avoidance analysis also considers the marginal tax rates of the parties. A difference exceeding 10 percentage points during the rental periods where allocated rent is below the lease average (for increasing rent) or above it (for decreasing rent) is a red flag.⁶ The classic problem case is a tax-exempt landlord leasing to a taxable tenant on a steeply increasing schedule, which front-loads deductions to the tenant while the landlord faces no tax on the deferred income.

How Constant Rental Accrual Works

When a lease is disqualified, constant rental accrual completely overrides the payment schedule. The goal is a single, level annual rent the landlord reports as income and the tenant deducts every year of the lease, regardless of what the lease says or when cash actually moves.¹

The constant rental amount is the annual figure that, when discounted back to the lease start date at 110% of the AFR compounded semiannually, produces a present value equal to the present value of all actual payments due under the lease. It answers the question: what level annual payment would carry the same present value as the actual payment stream?

For a 10-year lease calling for $100,000 per year in years one through five and $200,000 per year in years six through ten, constant rental accrual would produce a single leveled amount, somewhere around $140,000 to $150,000 depending on the AFR, replacing the stepped schedule for tax purposes. The landlord cannot defer income into the higher-payment years, and the tenant cannot accelerate deductions into them.

Section 467 Interest

Whenever the Section 467 rent accrued for a period differs from the cash actually paid, a notional loan arises between the landlord and tenant. The cumulative gap is the outstanding balance, and Section 467 interest is charged on that balance.

If the interest for a rental period is positive, the landlord has interest income and the tenant has an interest expense. If it’s negative, which can happen when the tenant prepays relative to the accrual schedule, the positions flip. The statute treats Section 467 interest as interest for all purposes of the Internal Revenue Code, so the usual rules governing interest income and deductions, including the limitations under Section 163, apply.²

The interest rate is 110% of the AFR in effect when the agreement is executed, matching the discount rate used for the rent accrual calculations.¹ Both parties track the running loan balance throughout the lease, adding each year’s accrued rent, subtracting each year’s cash payment, and computing interest on the net figure.

Recapture When the Landlord Sells

A landlord who sells property subject to a Section 467 rental agreement can face a recapture rule that converts part of the gain from capital gain to ordinary income. This applies even if the lease was not subject to constant rental accrual during the holding period.⁷

The recapture amount is the lesser of two figures. The first is the “prior understated inclusion,” the excess of the aggregate Section 467 rent and interest computed as though the lease were a disqualified leaseback or long-term agreement over the aggregate rent and interest the landlord actually reported.⁷ The second is the Section 467 gain on the disposition, generally the gain realized on the sale. The smaller of the two is ordinary income.

This is the backstop that prevents a landlord from structuring a deferred-rent lease, benefiting from lower early-year income, and then selling the property at capital gains rates before the higher payments come due. Even for a lease that qualified for proportional accrual, the recapture computation retroactively measures what constant accrual would have produced and claws back the difference as ordinary income.

Modifications Can Trigger a Full Retest

Amending a Section 467 lease can require the parties to run the analysis again from scratch. If a modification is substantial, the post-modification agreement is treated as an entirely new lease, with the modification date becoming the new agreement date. A new AFR is locked in, the $250,000 threshold is reapplied, and the accrual method is redetermined.²

Whether a modification is substantial depends on all facts and circumstances, specifically whether the altered legal rights or obligations are economically significant. The regulations provide safe harbors for changes that are never treated as substantial modifications:

Adjustments that flow through from the landlord refinancing secured debt on the property, provided the new debt terms are essentially the same and the parties aren’t related.
Modifications to CPI adjustments, expense pass-throughs, or other types of contingent rent that are already disregarded under the Section 467 rules.

A renegotiated rent schedule that seems commercially reasonable can push a previously compliant lease into disqualified territory, particularly if the parties have developed a tax-rate differential the new schedule exploits.

Fixing a Wrong Section 467 Method

Taxpayers who discover they’ve been reporting rent under the wrong method, or ignoring Section 467 entirely, file Form 3115, Application for Change in Accounting Method, with the IRS. The form is used to request changes to an overall accounting method or the treatment of a specific item.⁸ The procedures are governed by revenue procedures the IRS updates periodically, including Rev. Proc. 2025-23 for the current list of automatic method changes.

Getting this wrong isn’t a minor issue. Underpaying Section 467 rent in early years creates a cumulative understatement that compounds and can trigger the recapture rules on sale. The Form 3115 filing captures the entire cumulative difference as a Section 481(a) adjustment, typically spread over four tax years for positive adjustments but taken entirely in the year of change for negative ones. On a long-term lease where the error has compounded, that catch-up amount can be substantial.

1
Office of the Law Revision Counsel. 26 U.S. Code 467 – Certain Payments for the Use of Property or Services
2
eCFR. 26 CFR 1.467-1 – Treatment of Lessors and Lessees Generally
3
eCFR. 26 CFR 1.467-2 – Rent Accrual for Section 467 Rental Agreements Without Adequate Interest
4
eCFR. 26 CFR 1.467-3 – Disqualified Leasebacks and Long-Term Agreements
5
Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System
6
Internal Revenue Service. TD 8820 – Section 467 Rental Agreements
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eCFR. 26 CFR 1.467-7 – Section 467 Recapture and Other Rules Relating to Dispositions and Modifications
8
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method