May 13, 2014

NOTE: The information in this post was updated on October 13, 2015. Read the update.

Many owners of commercial or residential rental property in Washington are surprised to learn that they may owe business and occupation (B&O) tax to the state as a result of their rental activities.

While revenues generated directly from the non-transitory (i.e., long-term) lease or rental of real property are exempt from B&O tax, other ancillary revenue streams from the rental property rental may be subject to tax. By understanding the nature and limits of the rental income exemption, property owners can better evaluate the potential for assessment of B&O tax should they be selected for audit by the Washington Department of Revenue.

Washington law provides an exemption from B&O tax for the “gross proceeds derived from the sale of real estate.” Because “sale” is defined as “any transfer of the ownership of, title to, or possession of property,” the exemption has been held to apply to revenues derived from the rental or lease of real property, where the lessee enjoys exclusive possession and control of the property. However, property owners often mistakenly assume the exemption applies to any revenue related to the rental activity, rather than just to income directly derived from the right to exclusively possess and control property. To the contrary, revenues from related activities are often subject to tax.

For example, late payment fees imposed on lessees have been held not to be derived from the rental of real estate, but rather to compensate the property owner for losses incurred when rent is not paid timely. Because the revenue is not directly derived from the sale/rental of real estate, the income is subject to B&O tax. Similarly, non-refundable deposits, such as for post rental cleaning, are considered to be only indirectly related to the rental activity and therefore subject to B&O tax. Finally, revenue generated from the provision of products or services to lessees, such as coin-operated laundry facilities, will generally be subject to B&O tax based on the nature of the activity.

Commercial property leases often create further exposure for B&O tax. Commercial leases are commonly on a “triple-net” basis, calling for the tenants to reimburse the landlord for various expenses associated with the real property, such as utilities, property taxes, insurance and common area maintenance costs. While utility reimbursements are specifically exempted from B&O tax under Washington administrative rule, reimbursement of other expenses could potentially be considered to be related to, but not derived from, the rental of real estate and therefore subject to B&O tax. Many commercial lease agreements for Washington properties describe these charges as “additional rent,” but it is unclear whether this labeling is sufficient to exempt them from tax. Commercial lessors often also receive income from the sale of parking and garage services which may be subject to both B&O and retail sales taxes.

In our experience, there is significant variation within the Washington Department of Revenue’s Audit Division as to how carefully the ancillary revenue streams associated with real property rentals are scrutinized on audit, and in the resulting audit assessments. Thus, although some audits of property owners continue to go smoothly, lessors should recognize the potential risk in this area – particularly in light of the state’s ongoing budgetary issues.

Contact our SALT group for more information.

© Clark Nuber PS and Developing News, 2014. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Clark Nuber PS and Developing News with appropriate and specific direction to the original content.

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.