Lease Agreements Between Landlords and Tenants – Part 6

In Part 5 of our Lease Agreements series we discussed the issue of specific clauses being required by some states.  In this article we’ll briefly discuss several issues regarding lease changes.

Modifications

There are a variety of circumstances when a lease agreement must be amended.  Reasons for amendments include the following:

• Renewal or extension of lease, with or without a rent increase or other changes.
• Adding a pet.
• Adding or deleting co-tenant occupants.
• Bringing in water-filled furniture.
• Replacing the original tenant by another to finish out the term of a lease.

Although it is legally acceptable to mark up the existing documents, with both parties initialing the changes, it usually best to not take this approach.  While some modifications can be made by using an amendment document (e.g., an extension of term without other changes), others should be accomplished by writing a new lease agreement (e.g., adding a co-tenant).  For a month-to-month tenancy, modifications can, in most jurisdictions, legally be done by providing proper notice to the tenant and the tenant’s signature is not required.

When replacing a lease agreement that hasn’t yet expired with a new one because of significant changes in terms, it is a good idea to write “Cancelled by mutual agreement and replaced with new document” on the front of the old one following execution of the new one by all parties, with both landlord and tenants (should be all adult occupants) signing and dating the statement.  You should also be sure that there is not an overlap or a gap between the cancellations date and the effective date of the new lease.

The subject of subleasing and assignment of leases should also be covered in lease clauses.  Unless prohibited by law, the lease agreement should require written consent of the landlord to a tenant’s request to sublet or assign the rental unit and require that the replacement tenants meet all screening criteria.

Sublease

An individual who rents all or part of a rental unit from a tenant and does not sign a lease with the landlord becomes a sub-tenant.  The individual rents or sublets the entire unit from a tenant who moves out temporarily or he rents or sublets a room or rooms from a tenant who continues to occupy the unit.  Oftentimes the original tenant moves out for the summer, semester, sabbatical leave, or temporary change in work location.  The arrangement is made by the tenant and the sub-tenant and is contingent upon the sub-tenant moving out when the original tenant returns.

Subleasing is usually prohibited by a lease agreement, although the agreement may provide for subleasing with permission of the landlord.  However, some states may not allow outright prohibition, requiring a legitmate business reason (e.g., bad rental history of the prospective subtenant).

Some states have statutes prohibiting subleasing without permission of the landlord even if not so stated in the lease agreement.  Other states do not address the issue and leave the decision to sublease to the landlord.  There are also limitations in some states regarding the type of lawsuits that may be filed by landlords against sub-tenants.  In some states the landlord and the sub-tenant may file suite against one another to correct behavior in violantion of the lease but they may not sue for money damages.  For example the sub-tenant could sue for violation of habitable premises,  but the landlord could not sue the sub-tenant for excessive property damage not covered by the security deposit.  In such a case, to recover his loss, the landlord would need to sue the original tenant.

The primary relationship between the landlord and tenant is retained with the tenant still having control over the rental unit either because he occupies part of the unit or he reserves the right to regain possession of the rental unit at a later date.

The original tenant becomes the sub-tenant’s landlord.  The sub-tenant pays rent to the tenant at whatever amount they mutually agreed to.  The original tenant is responsible to landlord for the rent per the master lease agreement.  The oral or written arrangement between the tenant and the sub-tenant is known as a sublease.

The landlord is cautioned to not accept rent from a sub-tenant.  If the landlord treats the sub-tenant as if he were a tenant by taking rent or acting in some manner towards the sub-tenant that would indicate his status as a tenant, the landlord by his actions might in effect relieve the tenant of his responsibility by creating a tenancy from a sub-tenancy.

There are situations where a sub-tenancy might be of benefit to the landlord.  If the original tenant was considered a model tenant with an excellent rental history with the landlord and the landlord is willing to take the risk that the original tenant will return to occupy the unit, the landlord probably does not risk a great deal.

Assignment

When the original tenant permanently turns over his lease to a new tenant, he has completed an assignment of the lease.  The original tenant, the assignor, moves out of the assignee moves in.  An assignee can sue or be sued by the landlord.

From several standpoints, the landlord should usually prefer an assignment of lease to allowing a sublease.  An assignment provides more landlord control over the tenant because the landlord has a direct legal relationship with the assignee.  Furthermore, it is usually possible to require that the assignor remain liable on the lease upon default of the assignee if the landlord so desires.  Assignors will usually agree to such liability because assignment is almost always due to financial difficulties and the assignors would likely have even  greater liabilities if they simply broke the lease.

Similar to subleasing, assignment is usually prohibited by a lease agreement,  although the agreement may provide for assignment with permission of the landlord.  However, some states may not allow outright prohibition, requiring a legitimate  business reason (e.g., bad screening reports regarding the prospective assignee).

As for subletting, some states may have statutes prohibiting assignment without permission of the landlord even if not so stated in the lease agreement.  In general, the landlord and the assignee are bound by the terms and conditions of the lease signed by the assignor except as modified by agreements of all parties.  The original security deposit is usually retained by the landlord, with adjustments made between assignor and assignee.  Accordingly, any refund of security deposit money will go to the assignee.

It is recommended that a formal document regarding assignment of lease be signed by all parties to the original lease and, if multiple assignees, by all of them.  In addition to other clauses in the assignment, unless the landlord agrees otherwise, the document should state that the assignor is still responsible for (1) the rent if the assignee fails to pay and (2) damages to property (other than normal wear and tear) if the assignee refuses or cannot pay.

Replacement Tenants

When a new tenant takes over from an existing tenant – whether as sub-tenant, assignee, a replacement co-tenant, or a tenant who is breaking his lease with permission of the landlord and being released from liability – the move-out checklist/walk-thru should be completed for the old tenant, with settlement of any unpaid rent or damages to that date being taken care of before completing the change.

Question

Recently, an applicant for one of the units in my 24-unit property asked whether my property provides for Section 42 housing. What is this about?

Answer

Section 42 housing is housing that was constructed under the Low Income Housing Tax Credit program. This is a cooperative effort between HUD and the IRS that provides tax credits to the owner. The purpose of the program is to provide more low income housing. The program sometimes is required when government financing is involved – e.g., via a state bond.

The program usually provides a tax credit of 10 percent of construction cost spread evenly over the first 10 years after completion. The project is subject to the rent requirements for at least 15 years, with significant tax penalties if discontinued early. Refinancing can result in restart of the 15-year period.

The rent that can be charged for a unit under Section 42 depends, among other things, on the location of the property. Tax credit properties must include units for low-income persons. At a minimum, at least 20% of the units
must be occupied by households whose income is at or below 50% of the County Median Income (CMI) or at least 40% of the units must be occupied by households whose income is at or below 60% of CMI.

Gross rent paid by tenants may not exceed 30% of the applicable qualifying income as adjusted for household size. If utilities are paid directly by the tenant, the maximum rent must be reduced by the amount of the utility allowance (determined according to program requirements).

Section 42 units are usually only found in projects much larger than yours because the program involves a lot of paperwork both in the beginning and throughout the required term.

Question

I recently moved into a new home and plan to rent my old house.  I’m wondering who is responsible for the landscaping.

Answer

Most states allow a landlord to make landscape maintenance the tenant’s responsibility for a single-family residence (even multi-unit rentals when units have individual private yard areas). When doing so, the landscaping-related
tasks and the penalties for failing to adequately do the work should be specified in the lease in great detail.

However, there are issues of concern when doing so. Does the tenant have the necessary tools and equipment (e.g., lawnmower)? Will he do the work as often as you wish and to the level of quality you expect?

Being a landlord includes a multitude of potential liabilities and letting a tenant perform work has the potential of adding yet more. In addition to the issues raised in the above paragraph that affect the owner’s property
physically, there are other risks.

For example, if you provide the lawn mower, the tenant allows his 10-year-old kid to do the mowing, and the kid cuts off his/her fingers or toes, you will likely be sued. As another example, if the tenant injures a visitor or
passerby while performing the work even using his own equipment, you will certainly be sued. I could easily think of dozens of different scenarios.

Depending on your lease and your insurance coverage, it may not cost you money, but it will cost you time and stress. If you allow a tenant to work on your property, be sure that your insurance covers you for all possible problems
and include a clause in your lease wherein the tenant indemnifies you.

Because of the uncertain quality of a tenant’s work (if you care) and potential enforcement hassles and the potential liability it is often best to charge more rent and pay a landscape maintenance vendor to do the work, being
sure that the vendor is properly licensed and insured (including providing workers’ compensation insurance for employees), or do it yourself. This usually assures both quality and minimum risk.

All the above being said, many landlords require tenants to maintain the landscaping either because they haven’t thought about the potential problems or are willing to accept the potential problems.

IRS Audits

Most landlords filed their 2012 income tax return months ago and have since forgotten about the matter. For some landlords, especially those who push the limit regarding their rental business, the 2012 return won’t be forgotten for at least many months because as everyone knows, the IRS can pursue issues for three years after the April 15^th filing date or, if filed during an extension period, for three years after the date the return was filed. Of course, if there is any fraud involved, there is no statute of limitations.

A letter from the Internal Revenue Service creates a lot of anxiety for most taxpayers, particularly prior to opening the mail and reading the notice. Many, perhaps the majority of letters are actually quite benign – you forgot to sign your return or two digits of your social security number were interchanged. Sometimes the letter is actually good news – the IRS recalculated your data and found you’d made a math error and will be receiving a refund.

Often, there is a simply a question regarding an issue that you must respond to. Perhaps the name used for an expense of your business is unusual and an explanation is required. Sometimes, however, the letter questions income,
deductions or both or an explanation regarding some other entry is required.

The IRS defines an audit as “a review-examination” of a return “to verify the amount of tax reported is accurate.” If you are selected for one, the agency has on its website a video guide to the process.

In 2011, the IRS audited nearly 1.6 million individual returns, slightly more than 1 percent of the total filed. About three-quarters were done by correspondence, the rest through field examinations done in person by an IRS agent. Only 1 percent of people with incomes under $200,000 had their returns audited; the audit rate for those with incomes of $1 million and higher was about 12.5 percent.

The IRS says that the vast majority of taxpayers fills out their returns accurately and has nothing to worry about. However, they also remind us that they have a variety of screening processes to make sure they catch the people who are cutting corners.

There’s no magic equation for knowing which returns the IRS will select for a major audit – i.e., your chances of getting the scary letter. Some returns are selected for audit through computer screening. The IRS is looking for unreported income.  Accordingly, the IRS often focuses on taxpayers with cash earnings.

An IRS computer simply compares data from your return to average numbers for that data from people in similar types of business or at income levels. Your return could be flagged for further action if your numbers are significantly different than “normal.”

The computer may also compare your most recent return with your returns for previous years, looking for different types of entries compared to other years and/or for large variances from other years. Things that are reviewed include charitable contributions, interest income, and whether there are variations from averages in your income bracket or zip code. The computer will flag each significant variance.

The computer will also compare various types of reported income items – e.g., interest, dividends, wages, and self-employment – with W-2s and 1099s that were submitted to the government by those making payments to you. It’s important that you think through those items reported by third parties and make sure those are going to match up. This means that you have reported at least as much income within each category as will be reported by the payers. Reporting less than
that reported by payers is certain to trigger questions. Reporting more than will have been reported to the government may actually be of benefit in avoiding audits.

Assuming that you can forget about income for which you received no W-2 or 1099 is both dishonest and risky. It’s risky because there might be some reason why you didn’t receive a copy rather than the payer didn’t follow the rules in submitting the proper reports to the government – perhaps your copy was lost by the Post Office.

There’s yet another category of things that can trigger an audit of your return called “related examinations” by the IRS. Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit for some reason.

Some potential issues are of similar risk for a large percentage of taxpayers. Others are more of a problem for self-employed individuals, including landlords.

The IRS is well aware that landlords might be tempted to forget about some of the rents received in cash and/or to write off personal expenditures as rental expenses.  In order to avoid additional scrutiny rents, including cash, should be
deposited into a bank account other than other business or employment receipts and expenditures not made by check from that account should be via a credit card or other business credit lines dedicated to the rental business.

Many landlords claim deductions for a home office and this expense often attracts IRS scrutiny. However, if you qualify for the deduction, don’t be afraid to claim it. To qualify to claim expenses for business use of your home you must use part of your home:

(1) exclusively and regularly as your principal place of business (as defined by the IRS),

(2) exclusively and regularly as a place where you meet or deal with patients, clients, or customers in the normal course of your trade or business,

(3) in the case of a separate structure which is not attached to your home, used in connection with your trade or business, or

(4-6) three other uses that are not usually of concern to landlords.

All landlords utilize one or more motor vehicles in managing their income properties. However, many small business owners, including landlords, do not fully comply with the IRS requirements regarding the deductibility of vehicle use and many do not even come close. Claiming significant business auto expenses may result in a request that you furnish a copy of the mileage log that you were supposed to maintain contemporaneously with the business driving.

There’s no particular amount for charitable contributions guaranteed to catch the IRS’ attention, but inordinate amounts relative to income might do so. However, you shouldn’t shortchange yourself. As for most issues, it’s all in the
documentation. Find out what donated items sell for, at a thrift store, for example, or check valuation tools on the Internet.

The IRS will notify taxpayers of an impending audit by telephone or mail. E-mail is not used.  Just because your return has been selected for an audit doesn’t suggest you made an error or you’re dishonest. Audits can result in acceptance of the tax return without change or even result in an unexpected refund.

The IRS has a Declaration of Taxpayer Rights that sets forth what you can expect from an audit, ranging from privacy and confidentiality to professional and courteous service. Taxpayers have the right to be accompanied at an audit by anyone of their choosing or to have someone else represent them rather than even appear at the audit. Taxpayers or their representative also have the right to make an audio recording of the session.

They may appeal the judgment, either to the Appeals Office or to a court, and can request that penalties and interest be waived.

Being accurate and having the records to confirm the accuracy is the best defense in an audit. Using tax preparation software gives significant protection against mistakes in tax code interpretation if you prepare your own returns rather than have a licensed professional do so.

Again, don’t increase the odds of being audited by making careless mistakes..

Summary

The bottom line is that the most important thing in an IRS audit will be paper. Maintain good records. Keep your receipts. If you maintain good records and have receipts, you should win.