By Ryan Paul, CPA

ASC 842 changes how businesses and nonprofits report leases on financial statements, requiring nearly all leases to be recognized as Right-of-Use (ROU) assets and lease liabilities. However, these changes do not affect how leases are taxed. This creates key differences between book and tax treatment, particularly in how lease expenses, depreciation, and interest deductions are recorded.

Organizations will want to carefully track these differences to ensure accurate tax reporting, compliance with IRS rules, and proper financial planning.

Background

Before ASC 842, many leases were kept off the balance sheet. This made it difficult for financial statement users to assess a company’s total lease commitments. Without visibility into long-term lease obligations, lenders, investors, grant providers, and other stakeholders had an incomplete picture of an organization’s financial position.

To address this issue, the Financial Accounting Standards Board (FASB) issued ASC 842 in 2016, requiring businesses to recognize nearly all leases as Right-of-Use (ROU) assets with corresponding lease liabilities. Since ASC 842 is part of Generally Accepted Accounting Principles (GAAP), any organization that follows GAAP will need to comply.

ASC 842 was implemented in phases. Public companies were required to adopt the standard beginning January 1, 2019. Private companies and nonprofits were given additional time but were ultimately required to comply for fiscal years beginning after December 15, 2021. While these changes improve financial transparency, tax laws did not change, creating new challenges in lease-related tax reporting.

Tax Treatment of Leases

True Lease vs. Non-Tax Lease 

A true lease, often aligned with an operating lease for tax purposes, means that the lessee does not assume ownership of the asset and therefore deducts rental payments as ordinary expenses. By contrast, a non-tax lease is closer to what many describe as a finance lease for tax reasons; in this scenario, the lessee is effectively considered the owner and would be allowed to claim depreciation and interest expense deductions.

On the surface, it may seem straightforward: new GAAP rules, same tax rules. But ASC 842 adds a step by requiring businesses to reconcile differences in lease expense recognition, depreciation timing, and interest deductions.

Deferred Rent

Traditionally, leases accounted for under GAAP featured deferred rent or prepaid rent accounts to reconcile the difference between the actual cash paid and the straight-line expense recognized. However, under ASC 842, the right-of-use asset and corresponding liability are measured at the start of the lease, reducing the reliance on deferred or prepaid rent balances as separate line items. For tax purposes, many companies continue deducting lease payments based on the actual payment schedule. This ongoing mismatch means organizations will still track timing differences over the life of the lease; the main difference is that the mechanisms for doing so (like a “deferred rent” account) may be absent in the new GAAP framework.

Lease Incentives

Another area under scrutiny is lease incentives. For instance, if a landlord contributes cash or breaks on rent that help improve the tenant’s space, those amounts may potentially be excluded from certain taxable income under IRC Section 110, so long as the improvements are effectively the landlord’s property at the outset. Under the new accounting rules, however, many of these incentives become part of the right-of-use asset for GAAP. This can create an issue when it comes to tracking what is included in income for tax versus what gets capitalized for financial statement purposes. Without this careful attention, a business could mistakenly overstate or understate its taxable income and run into reconciliation headaches down the road.

Deferred Taxes

A lessee may not always capitalize a lease for income tax purposes (true/operating leases). Such companies will not have any tax basis in the right-of-use asset and lease liability under GAAP. An entity must recognize either a “deferred tax asset” or a “deferred tax liability” as a result. For example, if there is a recorded GAAP basis for the right-of-use asset, then a deferred tax liability is recorded. If there is GAAP basis in the related lease liability, then a deferred tax asset would need to be recorded. For GAAP, the right-of-use asset is initially computed using the same method for both finance and operating leases. These book-to-tax differences will reverse over time and the manner of reversal will depend on whether it was a financing or operating lease. Impairments, if any, will need to be reversed for tax purposes as well.

Interest Expenses

Before ASC 842, operating leases generally did not generate interest expense entries at the GAAP level. Now, finance leases and certain features of operating leases can create what appears to be “interest” on the income statement. For a true lease under tax rules, though, there is no corresponding interest expense deduction; the company still just deducts the rental payments. This misalignment means finance departments must stay vigilant. If the financial statements show interest for leases that are “true” leases from the tax viewpoint, that interest may have to be reversed on the tax return or otherwise separated in the records to prevent any unintended reporting errors.

Exemptions & Other Considerations 

Certain leases remain exempt from ASC 842, including short-term leases (12 months or less), intangible assets, and leases related to natural resource extraction. While these leases do not require balance sheet recognition, they still require proper classification for tax purposes.

State and local tax implications may also arise, as some states calculate franchise or net worth taxes using GAAP-based net worth figures. Businesses must evaluate whether ASC 842 affects their state tax obligations.

There are many considerations for the tax treatment of leases under ASC 842, and the facts and circumstances may differ from one lease to the next. For many companies, transitioning to lease management software may be necessary.

Practical Steps to Manage Tax Impacts

  • Identify All Leases: Pull together a comprehensive lease inventory. This should include obvious long-term real estate leases and any equipment or vehicle leases that run beyond 12 months.
  • Review and Classify for Tax Purposes: Distinguish leases that qualify as true leases from those that count as non-tax (or finance) leases. This classification dictates whether the lease produces rental deductions or depreciation and interest.
  • Implement a Tracking System: Investing in lease management software can streamline how you capture key data points—from initial entries to ongoing payments—and automatically generate reconciliations between book and tax treatments.
  • Monitor and Reconcile Book-to-Tax Differences: Maintain detailed schedules for changes in right-of-use assets, lease liabilities, deferred rent eliminations, and interest expense permutations. These schedules will feed into deferred tax calculations and assist in year-end (or interim) reviews.
  • Stay Current with Rules: Tax law is fluid. Keep an eye on potential federal or state changes that could alter how various leases are treated. Also, remain alert to international standard changes if you have global footprints under IFRS 16.

Looking Ahead

Implementing ASC 842 has changed how organizations record lease obligations on the balance sheet. Businesses that maintain a proactive approach, working closely with advisors to fine-tune compliance and strategy, will be better positioned to avoid pitfalls and capitalize on any benefits that arise from these new reporting realities. For more information on the tax implications of the new lease accounting rules, contact Ryan Paul, Partner on PBMares’ Construction & Real Estate team.