IRC Code 467: Accrual Methods, Interest, and Recapture

IRC Section 467 rental agreements are commercial leases that the tax code pulls out of ordinary cash-method reporting and forces onto a specific accrual schedule. The rule applies to leases of tangible property with total payments above $250,000 that also feature deferred, increasing, or decreasing rent. If your lease hits both tests, how much rent you report each year, and how much your counterparty deducts, is set by the Section 467 rules rather than by when the check clears.

Which Leases Section 467 Covers

Two conditions have to be met. The lease must be for tangible property, most often commercial real estate or equipment, and total payments plus any other consideration must exceed $250,000. Certain contingent rent is excluded from that total, so a lease with $200,000 in fixed rent plus percentage-of-sales payments can sit under the threshold.¹

The second condition is a structural one. The lease has to have either deferred rent or increasing/decreasing rent. Rent is deferred when an amount allocated to a calendar year isn’t due until after the close of the following calendar year, so rent for 2025 use that isn’t payable until 2027 counts.¹ Rent is increasing or decreasing when the annualized fixed rent allocated to one rental period differs from the amount allocated to another period in the lease.

A lease with level monthly rent that is paid within the calendar year the rent relates to, or in the year immediately before or after, is not a Section 467 rental agreement no matter how large the total.²

Rent Features That Look Triggering But Aren’t

Several common escalators are specifically disregarded when you test whether a lease has increasing or decreasing rent:²

Rent adjustments tied to the CPI or a similar reasonable price index.
Qualified percentage rent based on the tenant’s gross receipts.
Tenant reimbursements of property taxes, insurance, and common area maintenance.
Late-payment charges.
Rent adjustments driven by variable interest rate provisions.

A rent holiday of three months or less at the beginning of the lease is also ignored, even though the free period obviously carries a lower annualized rent than the rest of the term.² Without these carve-outs, nearly every long-term commercial lease would be swept in.

The Three Accrual Methods

Once a lease qualifies, one of three methods governs how both sides report rent.

Follow the lease. If the agreement is not a disqualified leaseback or long-term agreement and it provides adequate interest on fixed rent, both parties use the rent allocation stated in the lease. Adequate interest exists when there is no deferred or prepaid rent, or when the lease states interest at a single fixed rate that meets the regulatory threshold.² This is the lightest treatment and the one most parties prefer.

Proportional rental accrual. When a lease lacks adequate interest but isn’t disqualified, the regulations require proportional rental accrual. The method respects the general shape of the lease’s rent schedule but scales each period down with a present-value fraction.³

Constant rental accrual. Reserved for disqualified leasebacks and long-term agreements, this method ignores the lease’s payment schedule entirely and levels the total rent into a single annual amount. There is no election; once an agreement is disqualified, constant accrual is mandatory.⁴

How Proportional Rental Accrual Is Calculated

Proportional accrual uses a discount rate of 110% of the applicable federal rate, compounded semiannually, in effect when the lease is signed, matched to the lease term.¹

The regulations work through an 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 payment due on the last day of the lease. At the 8.5% rate used in the example, the $3,000,000 payment discounted back three years is $2,348,724. The present value of the allocated rent, discounting each year’s amount from the end of its period, is $2,526,272. The proportional fraction is $2,348,724 divided by $2,526,272, or 0.9297.³

Multiply each year’s allocated rent by that fraction. Year 1 becomes $743,776, Year 2 becomes $929,719, and Year 3 becomes $1,115,663. The landlord reports those amounts as income and the tenant deducts them, with no regard for the fact that the $3,000,000 cash payment hasn’t been made yet. The gap between accrued rent and actual cash movement is handled through Section 467 interest.

Disqualified Leasebacks and Long-Term Agreements

Getting labeled “disqualified” is what triggers the harshest treatment, and the label requires several things.

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 point within two years before the lease began.¹ Qualifying interests include ownership, sub-lessor rights, purchase options, and agreements to buy. A lease is long-term if its term exceeds 75% of the property’s Section 168 depreciation recovery period.⁴ Nonresidential real property has a 39-year recovery period, so leases longer than roughly 29 years and 3 months qualify.⁵

Even then, being a leaseback or long-term agreement isn’t enough on its own. The agreement becomes disqualified only if a principal purpose of the increasing or decreasing rent is federal income tax avoidance, and the IRS Commissioner has to make that determination.⁴

Safe Harbors From Disqualification

An agreement is not disqualified if the rent allocated to any calendar year varies from the average annual rent over the whole term by no more than 10%.⁶ A rent schedule that stays within that band isn’t treated as tax-motivated.

The tax-avoidance analysis also weighs the gap between the parties’ marginal rates. A difference of more than 10 percentage points during periods where allocated rent is below the lease average (for increasing rent) or above it (for decreasing rent) is a warning sign.⁶ The textbook abuse pattern is a tax-exempt landlord leasing to a taxable tenant with steeply increasing rent, front-loading deductions to the tenant while the landlord faces no tax on the deferred income.

Constant Rental Accrual

For a disqualified lease, constant accrual replaces the actual payment schedule with a single level annual rent. That amount is the figure that, when discounted back to the lease’s start at 110% of the AFR compounded semiannually, matches the present value of all actual payments owed under the lease.¹ The landlord recognizes that constant amount each year and the tenant deducts it, regardless of what the lease calls for in cash.

A 10-year lease that pays $100,000 per year for five years and then $200,000 per year for five more would collapse to a single leveled figure for tax purposes. Deferral into the back half is eliminated, and so is any attempt to accelerate deductions into it.

Section 467 Interest

Whenever accrued rent for a period differs from the cash actually paid, the regulations treat the gap as a notional loan between the parties. The cumulative difference is the outstanding balance, and Section 467 interest accrues on it at 110% of the AFR in effect when the lease was signed, matching the discount rate used for accrual.¹

When Section 467 interest for a period is positive, the landlord has interest income and the tenant has an interest expense. The statute treats this interest as interest for every other purpose in the Code, so limitations like Section 163 apply the same way they would on any other debt.² Both sides have to track the running balance year by year.

Recapture When the Property Is Sold

A landlord who sells property that is subject to a Section 467 lease can be forced to convert part of the gain from capital gain to ordinary income, even if the lease was never on 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 rent and interest the landlord would have reported under constant rental accrual over what the landlord actually reported.⁷ The second is the gain on the sale. The smaller number is recognized as ordinary income. The rule prevents a landlord from running a deferred-rent lease, enjoying the low early-year income, and then selling at capital gains rates before the big payments arrive.

Modifications That Reset the Lease

Amending a Section 467 lease can trigger a full retest. If the change is “substantial,” the post-modification lease is treated as a brand-new agreement for Section 467 purposes, with a new agreement date, a new AFR, a fresh look at the $250,000 threshold, and a fresh determination of the accrual method.²

Whether a modification is substantial turns on all facts and circumstances, judged by whether the altered legal rights are economically significant. Two kinds of changes are never treated as substantial:

Rent 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.
Changes to CPI adjustments, expense pass-throughs, or other contingent rent that was already disregarded under Section 467.

A renegotiated rent schedule that looks commercially reasonable can push a previously compliant lease into disqualified territory, especially if the tax-rate differential between the parties has shifted since signing.

Fixing a Wrong Section 467 Method

Taxpayers who have been reporting rent under the wrong method, or ignoring Section 467 entirely, file Form 3115, Application for Change in Accounting Method, to correct it.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.

The cumulative correction flows through as a Section 481(a) adjustment, spread across four tax years for positive adjustments and taken entirely in the year of change for negative ones. On long-term leases where the error has compounded, that catch-up can be large, and leaving it alone only makes it larger: understated early-year rent compounds through the Section 467 interest mechanism and can be clawed back as ordinary income under the recapture rule when the property is eventually sold.

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