The term "sale and lease back" describes a situation in which a person, generally a corporation, owning organization residential or commercial property, either genuine or personal, sells their residential or commercial property with the understanding that the purchaser 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 kind of transaction is to allow the seller to rid himself of a large non-liquid financial investment without denying himself of the use (during the term of the lease) of necessary or desirable buildings or devices, while making the net cash profits readily available for other financial investments without turning to increased financial obligation. A sale-leaseback transaction has the fringe benefit of increasing the taxpayers readily available tax reductions, due to the fact that 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 deduction for the worth of land as well as structures over a period which may be shorter than the life of the residential or commercial property and in specific 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 (given up residential or commercial property) and acquire more rewarding and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and in many cases state, capital gain and depreciation regain income tax liabilities. This deal is most typically described as a 1031 exchange however is likewise called a "postponed 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 many cases state, capital gain and devaluation recapture earnings tax liability on the sale of financial investment residential or commercial property so long as specific requirements are met. Typically, the Investor must (1) establish a contractual plan with an entity described as a "Qualified Intermediary" to help with the exchange and assign 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 value than the relinquished residential or commercial property (based on net prices, not equity); (3) reinvest all of the net proceeds (gross profits minus particular appropriate closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) must replace the quantity of secured financial obligation that was paid off at the closing of the relinquished residential or commercial property with new secured debt on the replacement residential or commercial property of an equal or greater quantity.
These requirements usually trigger Investor's to see the tax-deferred exchange process as more constrictive than it actually is: while it is not acceptable to either take cash and/or pay off debt in the tax deferred exchange process without incurring tax liabilities on those funds, Investors may constantly put extra money into the transaction. Also, where reinvesting all the net sales profits is merely not practical, or supplying outside cash does not result in the best organization choice, the Investor might choose to make use of a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in value or pull squander of the deal, and pay the tax liabilities exclusively associated with the amount not exchanged for certified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while delaying their capital gain and depreciation recapture liabilities on whatever portion 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 concern with 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 dealt with 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 common loss, so that the loss reduction might be used to offset current tax liability and/or a possible refund of taxes paid. The combined deal would allow a taxpayer to use the sale-leaseback structure to offer his given up residential or commercial property while keeping useful usage of the residential or commercial property, produce profits from the sale, and then reinvest those proceeds 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 first complication can arise when the Investor has no intent to participate in a tax-deferred exchange, but has actually entered into a sale-leaseback deal where the negotiated lease is for a term of thirty years or more and the seller has losses intended to balance out any identifiable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) offers:
No gain or loss is recognized if ... (2) a taxpayer who is not a dealer in realty exchanges city realty for a ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for property, or exchanges improved real estate for unimproved property.
While this arrangement, which basically allows the development of two unique residential or commercial property interests from one discrete piece of residential or commercial property, the cost interest and a leasehold interest, normally is deemed beneficial in that it develops a number of planning alternatives in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the result of preventing the Investor from acknowledging 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 disallowed the $300,000 taxable loss deduction made by Crowley on their tax return on the grounds that the sale-leaseback deal they engaged in made up a like-kind exchange within the significance of Section 1031. The IRS argued that application of area 1031 indicated Crowley had in fact exchanged their charge interest in their real estate for replacement residential or commercial property consisting of a leasehold interest in the 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 numerous concerns in the Crowley case: whether a tax-deferred exchange had in truth occurred and whether or not the taxpayer was eligible for the instant loss deduction. The Tax Court, allowing the loss deduction, said that the deal did not make up a sale or exchange because the lease had no capital value, and promulgated the circumstances under which the IRS may take the position that such a lease performed in reality have capital value:
1. A lease may be considered to have capital worth where there has been a "bargain sale" or essentially, the prices is less than the residential or commercial property's fair market worth; or
2. A lease might be considered to have capital worth where the lease to be paid is less than the reasonable rental rate.
In the Crowley transaction, the Court held that there was no proof whatsoever that the list price or rental was less than fair market, considering that the offer was worked out at arm's length between independent celebrations. Further, the Court held that the sale was an independent deal for tax functions, which suggested that the loss was correctly acknowledged by Crowley.
The IRS had other grounds on which to challenge the Crowley transaction; the filing showing the instant loss reduction which the IRS argued was in fact a premium paid by Crowley for the worked out sale-leaseback transaction, and so accordingly ought to be amortized over the 30-year lease term instead of completely deductible in the existing tax year. The Tax Court declined this argument also, and held that the excess expense was consideration for the lease, but appropriately showed 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 unexpected tax consequences, and the terms of the deal must be prepared with those consequences in mind. When taxpayers are pondering this type of transaction, they would be well served to think about carefully whether it is sensible to give the seller-tenant an option to buy the residential or commercial property at the end of the lease, particularly where the alternative price will be below the fair market value 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 transaction as a tax-deferred exchange, however they also have the ability to argue that the deal is actually a mortgage, instead of a sale (wherein the effect is the very same as if a tax-free exchange takes place in that the seller is not qualified for the immediate loss deduction).
The issue is further made complex by the unclear treatment of lease extensions developed into a sale-leaseback deal under common law. When the leasehold is either prepared to be for thirty years or more or totals 30 years or more with included 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 cash 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 lead to these scenarios is the seller's acknowledgment of any gain over the basis in the genuine residential or commercial property asset, balanced out just by the permissible long-term amortization.
Given the severe tax repercussions of having a sale-leaseback transaction re-characterized as an involuntary tax-deferred exchange, taxpayers are well encouraged to attempt 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 avoid this inclusion has been to carve out 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 subject to the pre-existing lease. What this technique enables the seller is a capability to argue that the seller is not the lessee under the pre-existing arrangement, and hence never received a lease as a part of the sale, so that any value attributable to the lease therefore can not be taken into consideration in computing his gain.
It is essential for taxpayers to note that this strategy is not bulletproof: the IRS has a number of potential responses where this strategy has been utilized. The IRS might accept the seller's argument that the lease was not gotten 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 may likewise choose to utilize its time honored standby of "type over function", and break the deal down to its essential parts, in which both money 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 gets money in excess of their basis in the residential or commercial property, would acknowledge their full tax liability on the gain.
