Understanding the Tax Impact of ASC 842 Lease Accounting

The ASC 842 lease accounting standard was issued by the FASB in early 2016. Many public companies have already adopted the standard and ASC 842 lease accounting software. And private companies soon to follow. However, adoption or initial compliance with ASC 842 is just the first step.

There are many other considerations that companies must plan for in “Day 2” and beyond.

Understanding the ASC 842 lease accounting tax impact is critical for finance and tax teams that need to maintain compliance while minimizing reporting friction. From classifying leases to tracking deferred rent and aligning ROU asset amortization with tax rules, ASC 842 introduces ongoing challenges - and new opportunities for automation and accuracy.

How ASC 842 changed right of use asset tax treatment

ASC 842 was issued to address concerns around “off balance sheet financing” associated with operating leases. The major change associated with ASC 842 is the addition of right of use (ROU) assets and lease liabilities to the balance sheet for operating leases. Tax accounting for leases hasn’t changed, but the introduction of ROU assets and lease liabilities to the balance sheet changes the tax accounting process.

Psst - want hours back in your day?

Cut the time you spend remeasuring ROU assets

Psst - want hours back in your day?

Classification of leases

For tax purposes a lease can be classified as a true lease or as a sale (financing) on financial statements. Tests are involved to determine which party carries the benefits and burdens of ownership. The tests for tax treatment are largely based on case law, depend on the substance of the transaction, and are similar but not identical to the finance vs operating tests in ASC 842 and IFRS 16.

Ultimately, for the lessee, the tests determine when and how expenses become deductible for tax purposes. Because the classifications can differ from financial reporting requirements, book-tax differences usually result.

Effects on book-tax differences

Classification determinations can certainly put GAAP books and tax books out of sync, but other items can also generate book-tax differences. For example: Tenant Improvement Allowances (TIA) received up front are recorded as an offset to the ROU Asset under ASC 842, which, for an operating lease, has the effect of reducing the level rent expense over the term of the lease.

However, for tax, TIA’s need to undergo a further test regarding which party owns and funds the improvement. Then, a determination can be made regarding the impact to the lessee’s income and deductible expenses, which may or may not correspond to the book treatment under ASC 842. 

Other examples of items that may generate rent book-tax differences include:

• Impairment scenarios
• Free rent periods
• Direct costs
• Asset retirement obligations
• Embedded leases

Hear from the smartest people in lease accounting

The Lease Alert podcast is live!

Hear from the smartest people in lease accounting

Deferred tax assets and liabilities

ROU asset and lease liability accounts are being added to the balance sheet for the first time for book purposes. The book and tax basis for the associated leases will need to be tracked going forward to calculate and record resulting deferred tax assets and liabilities.

Many accounting and tax teams are now implementing integrated lease management software to automate these calculations and ensure ongoing alignment between book and tax ledgers. This approach supports cleaner audits, consistent data across departments, and faster quarterly close cycles.

Key takeaways for managing the tax impacts of ASC 842 on lease accounting

Companies should involve tax resources early in the process of planning for lease accounting compliance. Ask your ASC 842 software provider to explain how other clients have addressed tax implications in their lease portfolios.

And be sure to partner with a lease accounting software provider that offers reporting features, experience and expert advice to help you manage ongoing industry changes and developments.