The term "sale and lease back" describes a scenario in which an individual, normally a corporation, owning organization residential or commercial property, either real or personal, offers their residential or commercial property with the understanding that the buyer of the residential or commercial property will right away turn around and lease the residential or commercial property back to the seller. The objective of this type of transaction is to allow the seller to rid himself of a big non-liquid financial investment without denying himself of the use (throughout the term of the lease) of needed or desirable buildings or devices, while making the net money proceeds available for other investments without turning to increased financial obligation. A sale-leaseback deal has the fringe benefit of increasing the taxpayers available tax deductions, due to the fact that the rentals paid are typically 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 deduction for the value of land along with structures over a period which may be shorter than the life of the residential or commercial property and in particular 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 an Investor to sell his existing residential or commercial property (given up residential or commercial property) and buy more lucrative and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while postponing Federal, and most of the times state, capital gain and devaluation regain income tax liabilities. This deal is most commonly 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 defer all of their Federal, and most of the times state, capital gain and depreciation regain earnings tax liability on the sale of investment residential or commercial property so long as particular requirements are met. Typically, the Investor needs to (1) develop a contractual plan with an entity referred to as a "Qualified Intermediary" to assist in the exchange and designate into the sale and purchase contracts for the residential or commercial properties included in the exchange; (2) get like-kind replacement residential or commercial property that is equivalent to or greater in worth than the relinquished residential or commercial property (based on net list prices, not equity); (3) reinvest all of the net earnings (gross earnings minus specific appropriate closing costs) or money from the sale of the relinquished residential or commercial property; and, (4) need to replace the quantity of secured financial obligation that was paid off at the closing of the given up residential or commercial property with brand-new protected financial obligation on the replacement residential or commercial property of an equivalent or higher quantity.
These requirements usually cause Investor's to see the tax-deferred exchange procedure as more constrictive than it in fact is: while it is not allowable to either take cash and/or settle financial obligation in the tax deferred exchange procedure without incurring tax liabilities on those funds, Investors may always put additional cash into the transaction. Also, where reinvesting all the net sales earnings is merely not possible, or supplying outside cash does not lead to the very best organization decision, the Investor might elect to make use of a partial tax-deferred exchange. The partial exchange structure will enable the Investor to trade down in worth or pull money out of the deal, and pay the tax liabilities solely associated with the quantity not exchanged for certified like-kind replacement residential or commercial property or "money boot" and/or "mortgage boot", while deferring their capital gain and devaluation regain liabilities on whatever part of the profits are in truth consisted of in the exchange.
Problems involving 1031 exchanges developed by the structure of the sale-leaseback.
On its face, the interest in integrating a sale-leaseback deal 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 dealt with as gain from the sale of a capital asset taxable at long-lasting capital gains rates, and/or any loss acknowledged on the sale will be dealt with as a regular loss, so that the loss deduction might be utilized to balance out present tax liability and/or a possible refund of taxes paid. The combined deal would permit a taxpayer to use the sale-leaseback structure to offer his relinquished residential or commercial property while retaining helpful usage of the residential or commercial property, generate proceeds from the sale, and after that reinvest those profits in a tax-deferred way in a subsequent like-kind replacement residential or commercial property through making use of Section 1031 without recognizing any of his capital gain and/or depreciation regain tax liabilities.
The very first complication can arise when the Investor has no intent to participate in a tax-deferred exchange, however has participated in a sale-leaseback deal where the negotiated lease is for a term of thirty years or more and the seller has losses intended to offset any recognizable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) provides:
No gain or loss is acknowledged if ... (2) a taxpayer who is not a dealer in realty exchanges city property for a cattle ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for realty, or exchanges enhanced property for unimproved real estate.
While this provision, which basically enables the production of 2 distinct residential or commercial property interests from one discrete piece of residential or commercial property, the cost interest and a leasehold interest, typically is viewed as beneficial because it creates a number of preparing options in the context of a 1031 exchange, application of this arrangement on a sale-leaseback deal has the impact of avoiding the Investor from recognizing any suitable loss on the sale of the residential or commercial property.
One of 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 reduction made by Crowley on their tax return on the grounds that the sale-leaseback deal they took part in made up a like-kind exchange within the meaning of Section 1031. The IRS argued that application of area 1031 meant Crowley had in truth exchanged their fee interest in their genuine estate for replacement residential or commercial property including a leasehold interest in the same residential or commercial property for a term of 30 years or more, and accordingly the existing tax basis had rollovered into the leasehold interest.
There were a number of concerns in the Crowley case: whether a tax-deferred exchange had in truth happened and whether or not the taxpayer was eligible for the instant loss reduction. The Tax Court, permitting the loss deduction, stated that the transaction did not make up a sale or exchange since the lease had no capital worth, and promulgated the situations under which the IRS might take the position that such a lease did in fact have capital value:
1. A lease may be considered to have capital value where there has been a "deal sale" or essentially, the list prices is less than the residential or commercial property's reasonable market price; or
2. A lease might be deemed to have capital worth where the lease to be paid is less than the reasonable rental rate.
In the Crowley deal, the Court held that there was no proof whatsoever that the price or leasing was less than reasonable market, because the offer was negotiated at arm's length between independent parties. Further, the Court held that the sale was an independent transaction for tax functions, which indicated that the loss was correctly recognized by Crowley.
The IRS had other premises on which to challenge the Crowley deal; the filing reflecting the immediate loss reduction which the IRS argued remained in fact a premium paid by Crowley for the worked out sale-leaseback transaction, and so appropriately need to be amortized over the 30-year lease term rather than fully deductible in the existing tax year. The Tax Court declined this argument as well, and held that the excess expense was consideration for the lease, but properly reflected the expenses connected with completion of the building as required by the sales contract.
The lesson for taxpayers to take from the holding in Crowley is basically that sale-leaseback transactions may have unanticipated tax effects, and the regards to the transaction need to be drafted with those effects in mind. When taxpayers are contemplating 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 repurchase the residential or commercial property at the end of the lease, especially where the option price will be listed below the reasonable market worth at the end of the lease term. If their transaction does include this repurchase alternative, not only does the IRS have the ability to possibly characterize the deal as a tax-deferred exchange, but they likewise have the capability to argue that the transaction is actually a mortgage, rather than a sale (in which the result is the very same as if a tax-free exchange occurs because the seller is not qualified for the immediate loss deduction).
The problem is further made complex by the unclear treatment of lease extensions built into a sale-leaseback deal under common 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 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 dealt with as boot. This characterization holds although the seller had no intent to complete a tax-deferred exchange and though the result contrasts the seller's finest interests. Often the net lead to these circumstances is the seller's acknowledgment of any gain over the basis in the real residential or commercial property possession, balanced out just by the allowable long-term amortization.
Given the major tax effects of having a sale-leaseback deal re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well encouraged to try to prevent 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 inclusion has been to take the lease prior to the sale of the residential or commercial property but drafting it in between the seller and a controlled entity, and then participating in a sale made based on the pre-existing lease. What this method enables the seller is a capability to argue that the seller is not the lessee under the pre-existing arrangement, and thus never ever received a lease as a portion of the sale, so that any worth attributable to the lease therefore can not be taken into consideration in computing his gain.
It is essential for taxpayers to keep in mind that this strategy is not bulletproof: the IRS has a number of prospective actions where this method has been used. The IRS might accept the seller's argument that the lease was not received as part of the sales deal, but then reject the portion of the basis assigned to the lease residential or commercial property and corresponding increase the capital gain tax liability. The IRS may likewise elect to use its time honored standby of "kind over function", and break the deal down to its essential elements, in which both cash and a leasehold were received upon the sale of the residential or commercial property; such a characterization would result in the application of Section 1031 and appropriately, 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.
