The term "sale and lease back" explains a situation in which an individual, normally a corporation, owning company 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 right away turn around and rent the residential or commercial property back to the seller. The objective of this kind of transaction is to enable the seller to rid himself of a big non-liquid financial investment without denying himself of the usage (during the regard to the lease) of required or preferable structures or equipment, while making the net money earnings available for other financial investments without resorting to increased financial obligation. A sale-leaseback deal has the fringe benefit of increasing the taxpayers available tax reductions, since the leasings paid are generally set at 100 percent of the value of the residential or commercial property plus interest over the regard to the payments, which leads to a permissible reduction for the worth of land along with structures over a duration 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 allows an Investor to offer his existing residential or commercial property (relinquished 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 most of the times state, capital gain and depreciation recapture income tax liabilities. This transaction is most commonly described as a 1031 exchange however is also 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 may delay all of their Federal, and for the most part state, capital gain and devaluation recapture income tax liability on the sale of investment residential or commercial property so long as particular requirements are fulfilled. Typically, the Investor should (1) develop a contractual arrangement with an entity described as a "Qualified Intermediary" to assist in the exchange and assign into the sale and purchase contracts for the residential or commercial properties consisted of in the exchange; (2) acquire like-kind replacement residential or commercial property that is equal to or greater in value than the relinquished residential or commercial property (based on net sales cost, not equity); (3) reinvest all of the net profits (gross profits minus specific appropriate closing expenses) or cash from the sale of the relinquished residential or commercial property; and, (4) need to replace the amount of protected financial obligation 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 higher quantity.
These requirements typically cause Investor's to view the tax-deferred exchange procedure as more constrictive than it actually is: while it is not allowable to either take cash and/or pay off debt in the tax deferred exchange procedure without sustaining tax liabilities on those funds, Investors might constantly put additional cash into the deal. Also, where reinvesting all the net sales profits is just not practical, or offering outside cash does not result in the best business choice, the Investor may choose to utilize a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in value or pull money out of the transaction, and pay the tax liabilities entirely connected with the amount 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 portion of the profits remain in truth included in the exchange.
Problems involving 1031 exchanges produced by the structure of the sale-leaseback.
On its face, the issue with combining 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 dealt with as gain from the sale of a capital possession taxable at long-lasting capital gains rates, and/or any loss acknowledged on the sale will be dealt with as a common loss, so that the loss reduction may be used to balance out current tax liability and/or a possible refund of taxes paid. The combined deal would allow a taxpayer to utilize the sale-leaseback structure to sell his relinquished residential or commercial property while keeping beneficial use of the residential or commercial property, produce profits 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 recognizing any of his capital gain and/or devaluation recapture tax liabilities.
The very first problem can arise when the Investor has no intent to get in into a tax-deferred exchange, however has participated in a sale-leaseback deal where the worked out lease is for a term of thirty years or more and the seller has losses meant to offset any identifiable 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 cattle ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges enhanced real estate for unaltered property.
While this provision, which basically permits the creation 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 deemed useful in that it develops a number of planning options in the context of a 1031 exchange, application of this provision on a sale-leaseback transaction has the result of preventing the Investor from recognizing any applicable loss on the sale of the residential or commercial property.
Among the managing cases in this area 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 grounds that the sale-leaseback deal they engaged in constituted a like-kind exchange within the significance of Section 1031. The IRS argued that application of section 1031 implied Crowley had in reality exchanged their cost interest in their realty for replacement residential or commercial property including a leasehold interest in the same residential or commercial property for a regard to thirty years or more, and appropriately the existing tax basis had brought over into the leasehold interest.
There were a number of concerns in the Crowley case: whether a tax-deferred exchange had in truth occurred and whether the taxpayer was eligible for the immediate loss deduction. The Tax Court, enabling the loss deduction, said that the transaction did not constitute a sale or exchange because the lease had no capital worth, and promoted the scenarios under which the IRS may take the position that such a lease performed in reality have capital worth:
1. A lease may be considered to have capital worth where there has been a "bargain sale" or essentially, 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 price or rental was less than reasonable market, since the deal was negotiated at arm's length between independent celebrations. Further, the Court held that the sale was an independent transaction for tax functions, which meant that the loss was correctly recognized by Crowley.
The IRS had other premises on which to challenge the Crowley transaction; the filing showing the immediate loss deduction which the IRS argued remained in reality a premium paid by Crowley for the negotiated sale-leaseback deal, and so appropriately should be amortized over the 30-year lease term instead of completely 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 appropriately reflected the costs related to completion of the building as needed by the sales arrangement.
The lesson for taxpayers to draw from the holding in Crowley is basically that sale-leaseback transactions may have unanticipated tax repercussions, and the regards to the deal need to be prepared with those effects in mind. When taxpayers are pondering this type of transaction, they would be well served to consider carefully whether it is sensible to give the seller-tenant a choice to buy the residential or commercial property at the end of the lease, especially where the option price will be listed below the reasonable market price 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 define the transaction as a tax-deferred exchange, however they also have the ability to argue that the deal is in fact a mortgage, rather than a sale (wherein the result is the very same as if a tax-free exchange happens in that the seller is not eligible for the immediate loss reduction).
The concern is further made complex by the unclear treatment of lease extensions built into a sale-leaseback transaction under common law. When the leasehold is either drafted to be for 30 years or more or totals thirty years or more with included extensions, Treasury Regulations Section 1.1031(b)-1 categorizes the Investor's gain as the cash got, so that the sale-leaseback is treated as an exchange of like-kind residential or commercial property and the money 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 benefits. Often the net lead to these circumstances is the seller's acknowledgment of any gain over the basis in the genuine residential or commercial property asset, balanced out only by the allowable long-term amortization.
Given the major tax consequences of having a sale-leaseback transaction re-characterized as an involuntary tax-deferred exchange, taxpayers are well recommended to try to prevent the inclusion of the lease worth as part of the seller's gain on sale. The most reliable way in which taxpayers can avoid this inclusion has actually been to take the lease prior to the sale of the residential or commercial property but drafting it in between the seller and a regulated entity, and after that entering into a sale made subject to the pre-existing lease. What this strategy permits the seller is a capability to argue that the seller is not the lessee under the pre-existing contract, and thus never got a lease as a portion of the sale, so that any worth attributable to the lease for that reason can not be taken into consideration in calculating his gain.
It is necessary for taxpayers to note that this method is not bulletproof: the IRS has a variety of potential actions where this method has 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 portion of the basis assigned to the lease residential or commercial property and matching boost the capital gain tax liability. The IRS may also choose to utilize its time honored standby of "form over function", and break the deal down to its essential elements, where both cash and a leasehold were received 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 receives money in excess of their basis in the residential or commercial property, would recognize their full tax liability on the gain.
