Understanding the Options (and Opportunities)
When it comes to facilities, every nonprofit has to answer the question at one time or another: “Should we lease or buy?” Certainly, if a nonprofit has enough cash for the standard 30-35 percent down payment, buying facilities can make sense.
But leasing is a better option for many organizations today, especially newly minted nonprofits that may want more flexibility in the short-term. Leasing also requires very little in the way of up-front costs. Depending on the landlord, concession packages that include allowances and a period of free rent may reduce out-of-pocket costs to virtually zero.
Understand the Cycle
Depending on the area, the typical lease cycle could be a 10-year term followed by a five-year renewal. In each lease “event,” the costs typically increase. Yet, even in the middle of a long-term lease, there are opportunities to renegotiate the term and reduce costs or “right size” the space. Under a conventional lease, nonprofits are treated no differently than any other applicant. In fact, 501(c)3 organizations typically pay a portion of a leased building’s real estate taxes just like anyone else. The only exemption is for a building that is actually purchased by the nonprofit. That said, there are some alternatives to a conventional lease that can help make leasing work for your nonprofit:
- Seek out a sub-market lease. Some property managers look for a tax write-off by offering space to a nonprofit at a steep discount. In these situations, the landlord or property manager can often take a tax deduction for what that space would have earned in rent, allowing them to save on taxes. Municipalities also work out such deals, offering nonprofits space in return for a token amount, such as $1 a year. Others offer free space in exchange for the nonprofit taking care of building maintenance and utilities. When entering into such agreements, though, nonprofits need to carefully analyze their responsibilities as far as building maintenance, damages and other potential issues.
- Consider co-location. Faced with tight budgets, some nonprofits are sharing space (and costs) with other nonprofits. While the benefits can be considerable, these arrangements can result in complex managerial and legal relationships. It’s best to build the necessary flexibility into the lease at the outset.
- Look for grants. Some funders will specifically assist nonprofits in securing appropriate office space. Grants may be available to partially or fully fund a lease, while other funders may help with office equipment, supplies and overhead (such as utilities, phone service and an Internet connection).
Many nonprofits like the idea of owning a building. Yet leasing makes sense in a number of cases. Regardless, make sure all tax, legal and financial considerations are evaluated by an attorney and tax professional.
Be Aware of Proposed Lease Accounting Rules
Under the current approach to lease accounting, leases are required to be classified as either operating leases (i.e., off-balance sheet) or capital leases (i.e., on-balance sheet). Frequently, leases of office equipment are capital leases, while office space and vehicle leases are operating leases. However, each lease must be analyzed individually.
Under an operating lease, the total lease rent obligation is not recorded on a nonprofit’s books and only appears as a footnote disclosure in a set of financial statements. Under capital leases, a nonprofit records the lease obligation as debt and a related lease asset.
With new regulations in the works, nonprofits may soon be facing changes in the way that debt is recorded. The Financial Accounting Standards Board (FASB) has proposed rules that would treat all leases similar to capital leases, meaning that nonprofits would be required to record debt on their books for all leases.
The proposed regulations have been hotly debated over the past several years, and FASB and the International Accounting Standards Board (IASB) continue working jointly toward a resolution. In the meantime, nonprofits can take some actions now while waiting for the final standards:
- Stay abreast of developments related to lease accounting.
- Develop an inventory of all of your organization’s lease agreements and key provisions.
- Make note of any debt covenants or contracts based on financial metrics, and consider the potential impact from the proposed changes on them. For example, debt-to-equity covenants, as well as compensation agreements based on EBITDA or other metrics, may need to be renegotiated since the calculations could be significantly impacted by the proposed changes.
Contact our office today for more information on lease accounting rules.