The term "sale and lease back" describes a situation in which an individual, usually a corporation, owning organization residential or commercial property, either genuine or personal, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will instantly turn around and lease the residential or commercial property back to the seller. The objective of this type of deal is to enable the seller to rid himself of a large non-liquid investment without depriving himself of the use (throughout the term of the lease) of necessary or preferable buildings or devices, while making the net money earnings readily available for other financial investments without turning to increased financial obligation. A sale-leaseback transaction has the extra benefit of increasing the taxpayers readily available tax deductions, since the leasings paid are generally set at 100 per cent of the worth of the residential or commercial property plus interest over the regard to the payments, which results in a permissible reduction for the value of land along with buildings over a duration 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 enables a Financier to offer his existing residential or commercial property (relinquished residential or commercial property) and buy more successful and/or productive residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and in many cases state, capital gain and depreciation recapture income tax liabilities. This deal is most commonly referred to as a 1031 exchange but 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 might defer all of their Federal, and in the majority of cases state, capital gain and devaluation regain earnings tax liability on the sale of investment residential or commercial property so long as certain requirements are satisfied. Typically, the Investor needs to (1) develop a legal arrangement with an entity described as a "Qualified Intermediary" to facilitate the exchange and appoint into the sale and purchase agreements for the residential or commercial properties included in the exchange; (2) get like-kind replacement residential or commercial property that amounts 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 profits (gross proceeds minus particular acceptable closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) must replace the amount of protected 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 amount.
These requirements typically trigger Investor's to see the tax-deferred exchange process as more constrictive than it actually is: while it is not permissible to either take money and/or pay off financial obligation in the tax deferred exchange process without sustaining tax liabilities on those funds, Investors might constantly put extra cash into the deal. Also, where reinvesting all the net sales proceeds is just not practical, or providing outside cash does not lead to the finest company decision, the Investor may 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 squander of the transaction, and pay the tax liabilities solely associated with the quantity not exchanged for qualified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while postponing their capital gain and depreciation recapture liabilities on whatever part of the earnings remain in truth consisted of in the exchange.
Problems involving 1031 exchanges developed 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 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 asset taxable at long-term capital gains rates, and/or any loss acknowledged on the sale will be dealt with as an ordinary loss, so that the loss reduction might be used to balance out current tax liability and/or a potential refund of taxes paid. The combined deal would permit a taxpayer to use the sale-leaseback structure to offer his given up residential or commercial property while keeping beneficial use of the residential or commercial property, produce earnings from the sale, and after that reinvest those earnings 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 regain tax liabilities.
The very first problem can develop when the Investor has no intent to participate in a tax-deferred exchange, however has participated in a sale-leaseback transaction where the worked out lease is for a regard to thirty years or more and the seller has losses intended to offset any identifiable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) offers:
No gain or loss is acknowledged if ... (2) a taxpayer who is not a dealership in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for realty, or exchanges improved property for unimproved property.
While this arrangement, which essentially permits the creation of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the charge interest and a leasehold interest, generally is seen as useful because it produces a variety of preparing alternatives in the context of a 1031 exchange, application of this provision on a sale-leaseback deal has the effect of preventing the Investor from recognizing 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 prohibited the $300,000 taxable loss reduction made by Crowley on their income tax return on the grounds that the sale-leaseback transaction they participated in made up a like-kind exchange within the significance of Section 1031. The IRS argued that application of area 1031 implied Crowley had in truth exchanged their cost interest in their realty for replacement residential or commercial property consisting of a leasehold interest in the exact same residential or commercial property for a term of thirty years or more, and accordingly the existing tax basis had actually carried over into the leasehold interest.
There were numerous problems in the Crowley case: whether a tax-deferred exchange had in truth occurred and whether the taxpayer was qualified for the immediate loss deduction. The Tax Court, enabling the loss deduction, said that the deal did not constitute a sale or exchange considering that the lease had no capital worth, and promulgated the situations under which the IRS may take the position that such a lease did in reality have capital worth:
1. A lease might be deemed to have capital worth where there has been a "deal sale" or essentially, the sales cost is less than the residential or commercial property's fair market price; or
2. A lease might be considered to have capital value where the rent to be paid is less than the fair rental rate.
In the Crowley deal, the Court held that there was no evidence whatsoever that the list price or rental was less than reasonable market, because the deal was negotiated at arm's length in between independent parties. Further, the Court held that the sale was an independent transaction for tax functions, which implied that the loss was correctly acknowledged by Crowley.
The IRS had other premises on which to challenge the Crowley transaction; the filing showing the instant loss reduction which the IRS argued was in truth a premium paid by Crowley for the worked out sale-leaseback transaction, and so appropriately ought to be amortized over the 30-year lease term instead of fully deductible in the current tax year. The Tax Court declined this argument also, and held that the excess cost was consideration for the lease, however appropriately showed the costs related to completion of the structure as needed by the sales contract.
The lesson for taxpayers to take from the holding in Crowley is basically that sale-leaseback deals might have unexpected tax effects, and the terms of the deal should be prepared with those repercussions in mind. When taxpayers are considering this type of deal, they would be well served to consider carefully whether it is prudent to give the seller-tenant an alternative to buy the residential or commercial property at the end of the lease, especially where the option cost will be listed below the fair market price at the end of the lease term. If their transaction does include this repurchase choice, not only does the IRS have the ability to potentially define the deal as a tax-deferred exchange, but they also have the capability to argue that the transaction is actually a mortgage, rather than a sale (wherein the result is the same as if a tax-free exchange happens in that the seller is not qualified for the instant loss deduction).
The concern is even more made complex by the uncertain treatment of lease extensions developed into a sale-leaseback deal under common law. When the leasehold is either prepared to be for 30 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 dealt with as an exchange of like-kind residential or commercial property and the money is treated as boot. This characterization holds despite the fact that the seller had no intent to complete a tax-deferred exchange and though the result contrasts the seller's benefits. Often the net outcome in these circumstances is the seller's recognition of any gain over the basis in the real residential or commercial property asset, balanced out only by the allowable long-term amortization.
Given the severe tax repercussions of having a sale-leaseback transaction re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well advised to try to prevent the inclusion of the lease worth as part of the seller's gain on sale. The most efficient manner in which taxpayers can avoid this inclusion has been to take 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 an ability to argue that the seller is not the lessee under the pre-existing agreement, and hence never ever got a lease as a part of the sale, so that any value attributable to the lease therefore can not be considered in computing his gain.
It is necessary for taxpayers to note that this strategy is not bulletproof: the IRS has a variety of potential responses where this method has actually been utilized. The IRS might accept the seller's argument that the lease was not received as part of the sales deal, but then deny the part of the basis assigned to the lease residential or commercial property and matching boost the capital gain tax liability. The IRS might also choose to utilize its time honored standby of "form over function", and break the deal to its elemental components, where 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 appropriately, if the taxpayer receives cash in excess of their basis in the residential or commercial property, would recognize their full tax liability on the gain.
