When a tenant pays you to break a lease
A lease termination fee — sometimes called a lease buyout or early termination payment — is the amount a tenant pays the landlord in exchange for releasing the tenant from future lease obligations. When you receive this payment, it is ordinary income in the year received.
The IRS views this payment as a substitute for the rent you would have collected over the remaining lease term. It has the same character as rent: ordinary income, not capital gain. It is deductible for the tenant (generally) and taxable to you as the landlord in the year of receipt.
Report lease termination fees received on Schedule E as rental income. There is no special treatment or installment deferral available — you include the payment in income when you actually receive it.
When you pay a tenant to vacate
Sometimes landlords want a tenant out — to renovate, convert the property, or accommodate a new tenant — and offer a cash-for-keys payment or lease buyout to the existing tenant. The tax treatment of this outlay depends on why you are paying.
If you are paying the tenant to vacate so you can re-lease the unit at a higher rent to a new tenant, the buyout is generally a lease acquisition cost: a cost you incur to enter into a new lease. Under Revenue Ruling 2004-51 and related guidance, payments to cancel an existing lease so you can enter a new lease must be amortized over the term of the new lease, not deducted all at once.
If you are paying the tenant to vacate to demolish or extensively renovate the building, the payment may be a capital expenditure that is added to the basis of the building or new improvements.
The short-term lease exception
If the new lease you enter into after removing the tenant is a short-term lease (generally one year or less, with no option to renew), the lease termination payment to the departing tenant may be currently deductible rather than amortized. The theory is that a very short new lease does not create a significant intangible asset requiring capitalization.
The line between deductible and capitalizable can be uncertain, particularly where no specific IRS guidance covers the exact fact pattern. Document your intent and the circumstances in writing — including the reason for the buyout and the term of the replacement lease — and consult a tax professional for material amounts.
Frequently asked questions
Is a lease termination fee received from a tenant taxable income?
Yes. It is ordinary income in the year received, regardless of what portion of the lease term it covers.
Can I deduct cash-for-keys payments to tenants?
Generally, payments to remove a tenant so you can re-lease must be amortized over the new lease term, not deducted immediately. Exceptions apply for very short new leases.
How do tenants treat lease termination payments they make?
A tenant's lease termination payment is generally a deductible expense for a business tenant in the year paid, treated as a cost of ending a lease obligation.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.