Gross Lease

Filed reports define gross, modified gross and net leases by who pays operating expenses.

A government-leased office REIT's Form 10-K for 2006 puts it plainly: net leases require the tenant to pay all operating expenses, gross leases require the landlord to pay all operating expenses, and modified gross leases require the landlord and tenant each to pay a portion. The same filer said its federal government leases were generally modified gross.

That filer treated gross and modified gross leases as the higher-risk category and said it tried to offset that risk through strict underwriting, due diligence and intensive property management. Among its acquisition criteria it listed whether the lease adjusts rent for increases in operating expenses and taxes, which is how many owners claw back part of that risk.

Residential rentals sit at the gross end. IRS Publication 527 treats the owner's ordinary and necessary costs of managing, conserving and maintaining the property as deductible rental expenses, and it says that if a tenant pays one of your expenses, the payment is rental income to you.

In a worked example, the owner absorbs the expense increase.

Hypothetical: an office building leased on gross terms brings in $240,000 of rent, and operating expenses are $90,000, leaving $150,000. Next year taxes and insurance push expenses up 10% to $99,000 while rent is fixed, so net income falls to $141,000. Under a triple net lease with the same base rent, the tenant would have paid the $9,000 increase. Run your own numbers with your CPA.

The reverse also holds: if expenses fall, a gross-lease owner keeps the saving. That two-way exposure is why gross-leased income should be underwritten on expenses as well as rent, and why net operating income is the figure to compare rather than gross rent.

It bites when you choose between a managed property, a net lease and a DST.

Rev. Proc. 2019-38 excludes triple net leased real estate from its section 199A rental safe harbor. A gross-leased property is not excluded on that ground, but it still has to meet the procedure's other conditions, including 250 or more hours of rental services.

In a DST, Rev. Rul. 2004-86 bars the trustee from entering new leases or renegotiating the existing one except on the tenant's bankruptcy or insolvency. Filed DST programs therefore describe properties leased either to a single tenant on a long-term lease or to a sponsor affiliate under a master lease, as in a non-traded real estate partnership's 2025 annual report; the occupants' leases, gross or net, sit beneath that master lease. See DST master lease risk.

If you are leaving a gross-leased office or apartment building because of expense and management load, compare the options in exchanging an office building and double net leases.