The term "sale and lease back" describes a scenario in which a person, normally a corporation, owning business residential or commercial property, either genuine or personal, sells their residential or commercial property with the understanding that the purchaser of the residential or commercial property will immediately reverse and lease the residential or commercial property back to the seller. The aim of this type of transaction is to make it possible for the seller to rid himself of a big non-liquid financial investment without depriving himself of the use (throughout the term of the lease) of needed or desirable buildings or devices, while making the net cash proceeds available for other investments without turning to increased financial obligation. A sale-leaseback transaction has the extra benefit of increasing the taxpayers available tax deductions, since the rentals paid are usually set at 100 percent of the worth of the residential or commercial property plus interest over the regard to the payments, which leads to an allowable reduction for the worth of land as well as buildings over a duration which might be shorter than the life of the residential or commercial property and in specific cases, a reduction of a common loss on the sale of the residential or commercial property.
What is a tax-deferred exchange?
A tax-deferred exchange enables an Investor to sell his existing residential or commercial property (relinquished residential or commercial property) and purchase more lucrative and/or productive residential or commercial property (like-kind replacement residential or commercial property) while postponing Federal, and in a lot of cases state, capital gain and devaluation recapture earnings tax liabilities. This deal is most typically described as a 1031 exchange however is likewise referred to as a "delayed exchange", "tax-deferred exchange", "starker exchange", and/or a "like-kind exchange". Technically speaking, it is a tax-deferred, like-kind exchange pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Department of the Treasury Regulations.
Utilizing a tax-deferred exchange, Investors may defer all of their Federal, and most of the times state, capital gain and depreciation regain earnings tax liability on the sale of financial investment residential or commercial property so long as specific requirements are fulfilled. Typically, the Investor should (1) establish a contractual arrangement with an entity referred to as a "Qualified Intermediary" to help with the exchange and assign into the sale and purchase contracts for the residential or commercial properties included in the exchange; (2) obtain like-kind replacement residential or commercial property that is equivalent to or higher in worth than the given up residential or commercial property (based on net list prices, not equity); (3) reinvest all of the net earnings (gross earnings minus specific acceptable closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) must change the amount of protected debt that was paid off at the closing of the relinquished residential or commercial property with brand-new protected debt on the replacement residential or commercial property of an equivalent or greater quantity.
These requirements normally trigger Investor's to view the tax-deferred exchange procedure as more constrictive than it actually is: while it is not permissible to either take money and/or pay off debt in the tax deferred exchange procedure without incurring tax liabilities on those funds, Investors might always put extra cash into the deal. Also, where reinvesting all the net sales earnings is just not possible, or offering outside money does not result in the very best company decision, the Investor may choose to use a partial tax-deferred exchange. The partial exchange structure will allow the Investor to trade down in worth or pull squander of the deal, and pay the tax liabilities entirely associated with the amount not exchanged for certified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while postponing their capital gain and devaluation regain liabilities on whatever portion of the proceeds remain in reality included in the exchange.
Problems including 1031 exchanges produced by the structure of the sale-leaseback.
On its face, the worry about integrating a sale-leaseback deal and a tax-deferred exchange is not necessarily clear. Typically the gain on the sale of residential or commercial property held for more than a year in a sale-leaseback will be treated as gain from the sale of a capital possession taxable at long-term capital gains rates, and/or any loss recognized on the sale will be treated as a normal loss, so that the loss reduction might be utilized to offset existing tax liability and/or a potential refund of taxes paid. The combined transaction would permit a taxpayer to use the sale-leaseback structure to sell his given up residential or commercial property while retaining advantageous usage of the residential or commercial property, generate profits from the sale, and then reinvest those proceeds in a tax-deferred manner in a subsequent like-kind replacement residential or commercial property through making use of Section 1031 without acknowledging any of his capital gain and/or depreciation recapture tax liabilities.
The very first complication can occur when the Investor has no intent to enter into a tax-deferred exchange, but has entered into a sale-leaseback transaction where the negotiated lease is for a regard to thirty years or more and the seller has actually losses planned to offset any recognizable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) supplies:
No gain or loss is recognized if ... (2) a taxpayer who is not a dealership in realty exchanges city genuine estate for a cattle ranch or farm, or exchanges a leasehold of a cost with 30 years or more to run for property, or exchanges enhanced realty for unaltered genuine estate.
While this arrangement, which basically allows the development of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the fee interest and a leasehold interest, typically is considered as advantageous because it creates a number of preparing options in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the impact of avoiding the Investor from acknowledging any suitable loss on the sale of the residential or commercial property.
Among the controlling cases in this location is Crowley, Milner & Co. v. Commissioner of Internal Revenue. In Crowley, the IRS prohibited the $300,000 taxable loss deduction made by Crowley on their tax return on the grounds that the sale-leaseback transaction they took part in made up a like-kind exchange within the meaning of Section 1031. The IRS argued that application of area 1031 implied Crowley had in truth exchanged their fee interest in their real estate for replacement residential or commercial property consisting of a leasehold interest in the same residential or commercial property for a term of thirty years or more, and accordingly the existing tax basis had actually brought over into the leasehold interest.
There were numerous concerns in the Crowley case: whether a tax-deferred exchange had in truth happened and whether the taxpayer was eligible for the instant loss reduction. The Tax Court, allowing the loss deduction, said that the deal did not make up a sale or exchange since the lease had no capital worth, and promoted the scenarios under which the IRS might take the position that such a lease carried out in truth have capital worth:
1. A lease may be deemed to have capital value where there has actually been a "deal sale" or basically, the sales rate is less than the residential or commercial property's fair market value; or
2. A lease may be deemed to have capital worth where the rent to be paid is less than the reasonable rental rate.
In the Crowley transaction, the Court held that there was no proof whatsoever that the sale price or rental was less than fair market, given that the offer was negotiated at arm's length in between independent celebrations. Further, the Court held that the sale was an independent deal for tax purposes, which suggested that the loss was effectively recognized by Crowley.
The IRS had other grounds on which to challenge the Crowley transaction; the filing reflecting the instant loss deduction which the IRS argued was in reality a premium paid by Crowley for the worked out sale-leaseback deal, therefore appropriately ought to be amortized over the 30-year lease term rather than totally deductible in the existing tax year. The Tax Court rejected this argument as well, and held that the excess expense was factor to consider for the lease, but appropriately showed the expenses connected with completion of the building as needed by the sales agreement.
The lesson for taxpayers to take from the holding in Crowley is basically that sale-leaseback deals may have unanticipated tax consequences, and the regards to the deal must be drafted with those repercussions in mind. When taxpayers are pondering this type of deal, they would be well served to consider carefully whether or not it is prudent to give the seller-tenant an alternative to redeem the residential or commercial property at the end of the lease, particularly where the option cost will be listed below the reasonable market price at the end of the lease term. If their transaction does include this repurchase choice, not just does the IRS have the ability to possibly characterize the transaction as a tax-deferred exchange, but they likewise have the ability to argue that the transaction is actually a mortgage, instead of a sale (wherein the result is the same as if a tax-free exchange takes place in that the seller is not eligible for the instant loss deduction).
The problem is even more made complex by the uncertain treatment of lease extensions developed into a sale-leaseback transaction under typical law. When the leasehold is either prepared to be for thirty years or more or totals 30 years or more with consisted of extensions, Treasury Regulations Section 1.1031(b)-1 classifies the Investor's gain as the money got, so that the sale-leaseback is treated as an exchange of like-kind residential or commercial property and the cash is treated as boot. This characterization holds although the seller had no intent to complete a tax-deferred exchange and though the outcome contrasts the seller's benefits. Often the net outcome in these situations is the seller's acknowledgment of any gain over the basis in the real residential or commercial property possession, offset only by the acceptable long-term amortization.
Given the serious tax repercussions of having a sale-leaseback deal re-characterized as an involuntary tax-deferred exchange, taxpayers are well advised to attempt to avoid the addition of the lease value as part of the seller's gain on sale. The most effective manner in which taxpayers can prevent this addition has been to sculpt out the lease prior to the sale of the residential or commercial property but preparing it between the seller and a controlled entity, and then participating in a sale made based on the pre-existing lease. What this method allows the seller is a capability to argue that the seller is not the lessee under the pre-existing contract, and hence never received a lease as a part of the sale, so that any value attributable to the lease therefore can not be taken into account in computing his gain.
It is essential for taxpayers to note that this method is not bulletproof: the IRS has a number of potential reactions where this technique has been employed. The IRS may accept the seller's argument that the lease was not gotten as part of the sales deal, however then deny the portion of the basis designated to the lease residential or commercial property and corresponding increase the capital gain tax liability. The IRS might also elect to use its time honored standby of "form over function", and break the transaction to its essential elements, wherein both money and a leasehold were gotten upon the sale of the residential or commercial property; such a characterization would lead to the application of Section 1031 and appropriately, if the taxpayer gets money in excess of their basis in the residential or commercial property, would acknowledge their complete tax liability on the gain.
