The term "sale and lease back" explains a circumstance in which a person, normally a corporation, owning organization residential or commercial property, either genuine or individual, sells their residential or commercial property with the understanding that the buyer of the residential or commercial property will instantly reverse and rent the residential or commercial property back to the seller. The objective of this type of deal is to make it possible for the seller to rid himself of a large non-liquid investment without depriving himself of the usage (during the term of the lease) of necessary or preferable buildings or devices, while making the net cash earnings offered for other financial investments without resorting to increased debt. A sale-leaseback transaction has the extra advantage of increasing the taxpayers offered tax reductions, because the leasings paid are generally set at 100 per cent of the value of the residential or commercial property plus interest over the term of the payments, which leads to an allowable reduction for the worth of land as well as structures over a period which might be shorter than the life of the residential or commercial property and in certain cases, a deduction of an ordinary loss on the sale of the residential or commercial property.
What is a tax-deferred exchange?
A tax-deferred exchange permits a Financier to sell his existing residential or commercial property (given up residential or commercial property) and purchase more profitable and/or productive residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and most of the times state, capital gain and devaluation regain earnings tax liabilities. This transaction is most frequently described as a 1031 exchange but is also known 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 devaluation recapture income tax liability on the sale of financial investment residential or commercial property so long as certain requirements are fulfilled. Typically, the Investor must (1) establish a legal arrangement with an entity referred to as a "Qualified Intermediary" to facilitate the exchange and appoint into the sale and purchase contracts for the residential or commercial properties consisted of in the exchange; (2) obtain like-kind replacement residential or commercial property that amounts to or greater in value than the relinquished residential or commercial property (based upon net sales rate, not equity); (3) reinvest all of the net profits (gross proceeds minus particular acceptable closing costs) or money from the sale of the given up residential or commercial property; and, (4) must change the amount of protected debt that was settled at the closing of the given up residential or commercial property with brand-new secured debt on the replacement residential or commercial property of an equivalent or higher amount.
These requirements normally trigger Investor's to view the tax-deferred exchange process as more constrictive than it in fact is: while it is not acceptable to either take cash and/or settle debt in the tax deferred exchange process without incurring tax liabilities on those funds, Investors may constantly put additional cash into the transaction. Also, where reinvesting all the net sales earnings is merely not practical, or supplying outside cash does not lead to the finest service decision, the Investor might choose to use a partial tax-deferred exchange. The partial exchange structure will enable the Investor to trade down in worth or pull squander of the deal, and pay the tax liabilities solely 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 portion of the earnings remain in fact consisted of in the exchange.
Problems involving 1031 exchanges created by the structure of the sale-leaseback.
On its face, the worry about combining 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 treated as gain from the sale of a capital asset taxable at long-lasting capital gains rates, and/or any loss recognized on the sale will be treated as an ordinary loss, so that the loss deduction might be utilized to offset current tax liability and/or a potential refund of taxes paid. The combined deal would permit a taxpayer to utilize the sale-leaseback structure to sell his relinquished residential or commercial property while retaining helpful use of the residential or commercial property, create profits from the sale, and then reinvest those earnings 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 recapture tax liabilities.
The very first problem can occur when the Investor has no intent to enter into a tax-deferred exchange, but has actually participated in a sale-leaseback transaction where the negotiated lease is for a regard to thirty years or more and the seller has losses meant 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 acknowledged if ... (2) a taxpayer who is not a dealer in property exchanges city genuine estate for a ranch or farm, or exchanges a leasehold of a charge with 30 years or more to run for property, or exchanges enhanced property for unaltered property.
While this provision, which basically permits the creation 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 in that it creates a variety of planning options in the context of a 1031 exchange, application of this provision on a sale-leaseback deal has the effect of avoiding the Investor from recognizing any relevant loss on the sale of the residential or commercial property.
One of the managing 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 premises 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 indicated Crowley had in truth exchanged their fee interest in their property for replacement residential or commercial property including a leasehold interest in the exact 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 issues in the Crowley case: whether a tax-deferred exchange had in truth occurred and whether or not the taxpayer was eligible for the immediate loss reduction. The Tax Court, permitting the loss reduction, stated that the deal did not constitute a sale or exchange because the lease had no capital value, and promulgated the scenarios under which the IRS might take the position that such a lease carried out in reality have capital worth:
1. A lease may be considered to have capital value where there has actually been a "bargain sale" or basically, the sales rate is less than the residential or commercial property's fair market price; or
2. A lease might be considered to have capital worth where the rent to be paid is less than the fair rental rate.
In the Crowley transaction, the Court held that there was no proof whatsoever that the list price or leasing was less than fair market, considering that the deal was worked out at arm's length in between independent parties. Further, the Court held that the sale was an independent transaction for tax purposes, which indicated that the loss was appropriately acknowledged by Crowley.
The IRS had other premises on which to challenge the Crowley deal; the filing showing the instant loss deduction which the IRS argued was in reality a premium paid by Crowley for the negotiated sale-leaseback deal, therefore accordingly must be amortized over the 30-year lease term rather than completely deductible in the current tax year. The Tax Court declined this argument too, and held that the excess expense was factor to consider for the lease, but appropriately showed the expenses related to conclusion 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 transactions may have unexpected tax repercussions, and the regards to the deal need to be prepared with those repercussions in mind. When taxpayers are contemplating this kind of deal, they would be well served to consider thoroughly whether or not it is sensible to give the seller-tenant an option to redeem the residential or commercial property at the end of the lease, particularly where the alternative price will be listed below the fair market worth at the end of the lease term. If their transaction does include this repurchase choice, not only does the IRS have the capability to possibly characterize the transaction as a tax-deferred exchange, but they likewise have the ability to argue that the deal is really a mortgage, rather than a sale (in which the impact is the same as if a tax-free exchange takes place in that the seller is not eligible for the immediate loss deduction).
The issue is further complicated by the unclear treatment of lease extensions built into a sale-leaseback transaction under common law. When the leasehold is either prepared to be for 30 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 received, 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 although the seller had no intent to finish a tax-deferred exchange and though the result is contrary to the seller's benefits. Often the net outcome in these circumstances is the seller's recognition of any gain over the basis in the genuine residential or commercial property asset, offset just by the allowable 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 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 inclusion has been to take the lease prior to the sale of the residential or commercial property however preparing it in between the seller and a controlled entity, and after that participating in a sale made based on the pre-existing lease. What this technique enables the seller is an ability to argue that the seller is not the lessee under the pre-existing arrangement, and thus never got a lease as a part of the sale, so that any value attributable to the lease for that reason can not be considered in calculating his gain.
It is necessary for taxpayers to note that this method is not bulletproof: the IRS has a variety of possible responses where this strategy has actually been used. The IRS might accept the seller's argument that the lease was not received as part of the sales transaction, but then reject the portion of the basis assigned to the lease residential or commercial property and matching 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 down to its elemental elements, wherein both money 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 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.
