The term "sale and lease back" explains a situation in which an individual, generally a corporation, owning business residential or commercial property, either real or personal, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will immediately turn around and lease the residential or commercial property back to the seller. The aim of this kind of deal is to enable the seller to rid himself of a large non-liquid investment without depriving himself of the usage (during the regard to the lease) of required or desirable buildings or equipment, while making the net money profits offered for other financial investments without resorting to increased debt. A sale-leaseback deal has the fringe benefit of increasing the taxpayers offered tax deductions, since the rentals paid are normally set at 100 percent of the worth of the residential or commercial property plus interest over the term of the payments, which results in an acceptable deduction for the value of land as well as buildings over a period which may be shorter than the life of the residential or commercial property and in certain cases, a deduction of a common loss on the sale of the residential or commercial property.
What is a tax-deferred exchange?
A tax-deferred exchange permits a Financier to offer his existing residential or commercial property (given up residential or commercial property) and acquire more successful and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while delaying Federal, and in many cases state, capital gain and depreciation recapture income tax liabilities. This transaction is most typically described as a 1031 exchange but is likewise called 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 might delay all of their Federal, and for the most part state, capital gain and devaluation regain income tax liability on the sale of investment residential or commercial property so long as particular requirements are fulfilled. Typically, the Investor should (1) establish a legal arrangement with an entity referred to as a "Qualified Intermediary" to assist in the exchange and appoint into the sale and purchase contracts for the residential or commercial properties consisted of in the exchange; (2) get like-kind replacement residential or commercial property that is equivalent to or higher in value than the relinquished residential or commercial property (based on net list prices, not equity); (3) reinvest all of the net profits (gross profits minus certain appropriate closing expenses) or cash from the sale of the given up residential or commercial property; and, (4) need to replace the quantity of secured debt that was settled at the closing of the relinquished residential or commercial property with new secured debt on the replacement residential or commercial property of an equivalent or greater quantity.
These requirements usually trigger Investor's to view the tax-deferred exchange procedure as more constrictive than it actually is: while it is not allowable to either take money and/or settle financial obligation in the tax deferred exchange procedure without incurring tax liabilities on those funds, Investors may constantly put additional money into the transaction. Also, where reinvesting all the net sales proceeds is merely not possible, or supplying outside cash does not result in the very best company decision, the Investor might elect to use a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in value or pull squander of the transaction, and pay the tax liabilities entirely related to the amount not exchanged for qualified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while deferring their capital gain and devaluation recapture liabilities on whatever part of the earnings remain in truth included in the exchange.
Problems including 1031 exchanges created by the structure of the sale-leaseback.
On its face, the worry about integrating a sale-leaseback transaction and a tax-deferred exchange is not always 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 asset taxable at long-term capital gains rates, and/or any loss recognized on the sale will be dealt with as a regular loss, so that the loss reduction may be used to balance out existing tax liability and/or a possible refund of taxes paid. The combined deal would permit a taxpayer to utilize the sale-leaseback structure to offer his given up residential or commercial property while retaining helpful usage of the residential or commercial property, create profits from the sale, and then reinvest those earnings in a tax-deferred manner in a subsequent like-kind replacement residential or commercial property through the use of Section 1031 without acknowledging any of his capital gain and/or devaluation regain tax liabilities.
The very first complication can emerge when the Investor has no intent to participate in a tax-deferred exchange, however has gotten in into a sale-leaseback deal where the worked out lease is for a regard to thirty years or more and the seller has losses planned to offset any identifiable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) provides:
No gain or loss is recognized if ... (2) a taxpayer who is not a dealer in property exchanges city property for a cattle ranch or farm, or exchanges a leasehold of a cost with 30 years or more to run for realty, or exchanges improved real estate for unimproved property.
While this provision, which basically enables the production of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the fee interest and a leasehold interest, generally is seen as useful in that it develops a variety of planning choices in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the effect of preventing the Investor from acknowledging any appropriate 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 disallowed the $300,000 taxable loss reduction made by Crowley on their income tax return on the premises that the sale-leaseback deal they took part in constituted a like-kind exchange within the significance of Section 1031. The IRS argued that application of area 1031 meant Crowley had in reality exchanged their fee interest in their realty for replacement residential or commercial property including a leasehold interest in the very same residential or commercial property for a regard to 30 years or more, and appropriately the existing tax basis had rollovered into the leasehold interest.
There were several problems in the Crowley case: whether a tax-deferred exchange had in fact happened and whether the taxpayer was qualified for the instant loss deduction. The Tax Court, permitting the loss deduction, said that the transaction did not constitute a sale or exchange considering that the lease had no capital worth, and promulgated the situations under which the IRS might take the position that such a lease performed in reality have capital worth:
1. A lease might be considered to have capital value where there has actually been a "deal sale" or essentially, the list prices is less than the residential or commercial property's fair market value; or
2. A lease may be considered to have capital worth where the lease to be paid is less than the fair rental rate.
In the Crowley deal, the Court held that there was no proof whatsoever that the price or rental was less than reasonable 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 implied that the loss was correctly recognized by Crowley.
The IRS had other grounds on which to challenge the Crowley deal; the filing showing the instant loss reduction which the IRS argued was in reality a premium paid by Crowley for the worked out sale-leaseback deal, and so appropriately must be amortized over the 30-year lease term instead of completely deductible in the current tax year. The Tax Court rejected this argument also, and held that the excess cost was consideration for the lease, but appropriately reflected the expenses related to completion of the structure as needed by the sales agreement.
The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback deals might have unexpected tax repercussions, and the terms of the deal need to be prepared with those effects in mind. When taxpayers are pondering this kind of deal, they would be well served to think about thoroughly whether or not it is prudent to provide the seller-tenant an alternative to redeem the residential or commercial property at the end of the lease, especially where the choice cost will be below the reasonable market worth at the end of the lease term. If their deal does include this repurchase choice, not just does the IRS have the capability to possibly define the transaction as a tax-deferred exchange, however they likewise have the ability to argue that the deal is actually a mortgage, instead of a sale (in which the result is the very same as if a tax-free exchange takes place in that the seller is not qualified for the immediate loss reduction).
The issue is further made complex by the unclear treatment of lease extensions developed into a sale-leaseback deal under typical law. When the leasehold is either drafted to be for thirty years or more or amounts to thirty years or more with consisted of extensions, Treasury Regulations Section 1.1031(b)-1 categorizes the Investor's gain as the cash got, so that the sale-leaseback is dealt with as an exchange of like-kind residential or commercial property and the cash is dealt with as boot. This characterization holds although the seller had no intent to finish a tax-deferred exchange and though the result contrasts the seller's finest interests. Often the net outcome in these circumstances is the seller's acknowledgment of any gain over the basis in the genuine residential or commercial property possession, offset only by the acceptable long-term amortization.
Given the severe tax effects of having a sale-leaseback transaction re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well advised to try to prevent the addition of the lease worth as part of the seller's gain on sale. The most efficient way in which taxpayers can prevent this addition has been to take the lease prior to the sale of the residential or commercial property but preparing it between the seller and a regulated entity, and after that entering into a sale made based on the pre-existing lease. What this strategy permits the seller is an ability to argue that the seller is not the lessee under the pre-existing agreement, and hence never received a lease as a part of the sale, so that any value attributable to the lease therefore can not be considered in calculating his gain.
It is crucial for taxpayers to keep in mind that this strategy is not bulletproof: the IRS has a variety of prospective actions where this technique has been utilized. The IRS may accept the seller's argument that the lease was not received as part of the sales transaction, 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 likewise choose to use its time honored standby of "kind over function", and break the deal to its essential elements, in which both cash and a leasehold were gotten upon the sale of the residential or commercial property; such a characterization would result in the application of Section 1031 and accordingly, if the taxpayer receives money in excess of their basis in the residential or commercial property, would recognize their complete tax liability on the gain.
