The term "sale and lease back" describes a scenario in which an individual, typically a corporation, owning company residential or commercial property, either real or individual, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will instantly reverse and lease the residential or commercial property back to the seller. The aim of this kind of transaction is to enable the seller to rid himself of a big non-liquid investment without denying himself of the use (throughout the regard to the lease) of needed or desirable structures or devices, while making the net cash profits offered for other financial investments without turning to increased financial obligation. A sale-leaseback transaction has the extra advantage of increasing the taxpayers offered tax reductions, since the leasings paid are normally set at 100 per cent of the value of the residential or commercial property plus interest over the regard to the payments, which results in an allowable reduction for the worth of land in addition to buildings over a period which might be much shorter than the life of the residential or commercial property and in certain cases, a deduction of a regular 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 (relinquished residential or commercial property) and purchase more lucrative and/or productive residential or commercial property (like-kind replacement residential or commercial property) while delaying Federal, and most of the times state, capital gain and devaluation recapture earnings tax liabilities. This transaction is most commonly referred to as a 1031 exchange however is also 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 delay all of their Federal, and in many cases state, capital gain and devaluation regain income tax liability on the sale of financial investment residential or commercial property so long as certain requirements are fulfilled. Typically, the Investor needs to (1) establish a contractual plan with an entity described as a "Qualified Intermediary" to assist in the exchange and appoint 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 amounts to or greater in value than the given up residential or commercial property (based upon net prices, not equity); (3) reinvest all of the net earnings (gross earnings minus certain appropriate closing expenses) or cash from the sale of the given up residential or commercial property; and, (4) must replace the quantity of protected financial obligation that was settled at the closing of the given up residential or commercial property with brand-new secured financial obligation on the replacement residential or commercial property of an equivalent or higher quantity.
These requirements normally trigger Investor's to see the tax-deferred exchange process as more constrictive than it really is: while it is not allowable to either take cash and/or pay off financial obligation in the tax deferred exchange process without incurring tax liabilities on those funds, Investors may always put additional cash into the deal. Also, where reinvesting all the net sales profits is merely not practical, or offering outside money does not lead to the best organization choice, the Investor might choose to use a partial tax-deferred exchange. The partial exchange structure will allow the Investor to trade down in worth or pull squander of the transaction, and pay the tax liabilities entirely associated with the quantity not exchanged for certified 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 proceeds remain in fact included 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 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-term capital gains rates, and/or any loss recognized on the sale will be dealt with as a normal loss, so that the loss reduction may be utilized to balance out present tax liability and/or a possible refund of taxes paid. The combined deal would enable a taxpayer to use the sale-leaseback structure to offer his given up residential or commercial property while keeping helpful use of the residential or commercial property, create proceeds from the sale, and then reinvest those profits in a tax-deferred manner in a subsequent like-kind replacement residential or commercial property through the usage of Section 1031 without recognizing any of his capital gain and/or devaluation regain tax liabilities.
The very first problem can occur when the Investor has no intent to participate in a tax-deferred exchange, however has actually entered into 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 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 dealership in property exchanges city property for a cattle ranch or farm, or exchanges a leasehold of a charge with 30 years or more to run for property, or exchanges improved property for unaltered real estate.
While this provision, which basically enables the creation of 2 unique residential or commercial property interests from one discrete piece of residential or commercial property, the cost interest and a leasehold interest, normally is considered as advantageous in that it produces a variety of preparing options in the context of a 1031 exchange, application of this provision on a sale-leaseback deal has the impact of preventing the Investor from acknowledging any relevant 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 disallowed the $300,000 taxable loss deduction made by Crowley on their income tax return on the grounds 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 section 1031 indicated Crowley had in truth exchanged their fee interest in their real estate for replacement residential or commercial property including a leasehold interest in the exact same residential or commercial property for a regard to 30 years or more, and appropriately the existing tax basis had actually rollovered into the leasehold interest.
There were numerous problems in the Crowley case: whether a tax-deferred exchange had in fact took place and whether or not the taxpayer was qualified for the instant loss reduction. The Tax Court, enabling the loss deduction, stated that the deal did not make up a sale or exchange given that the lease had no capital value, and promulgated the situations under which the IRS might take the position that such a lease did in reality have capital value:
1. A lease might be considered to have capital value where there has been a "deal sale" or essentially, the sales price is less than the residential or commercial property's reasonable market value; or
2. A lease might be deemed to have capital value where the lease 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 sale cost or leasing was less than reasonable market, given that the offer was negotiated at arm's length 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 transaction; the filing reflecting the instant loss reduction which the IRS argued remained in fact a premium paid by Crowley for the negotiated sale-leaseback transaction, therefore appropriately should be amortized over the 30-year lease term rather than completely deductible in the current tax year. The Tax Court rejected this argument as well, and held that the excess expense was consideration for the lease, but appropriately showed the costs related to completion of the structure as required by the sales contract.
The lesson for taxpayers to draw from the holding in Crowley is basically that sale-leaseback transactions might have unanticipated tax effects, and the regards to the deal should be prepared with those effects in mind. When taxpayers are contemplating this type of transaction, they would be well served to think about thoroughly whether it is prudent to offer the seller-tenant an option to repurchase the residential or commercial property at the end of the lease, especially where the choice price will be listed below the reasonable market value at the end of the lease term. If their transaction does include this repurchase option, not just does the IRS have the capability to possibly characterize the deal as a tax-deferred exchange, however they also have the capability to argue that the deal is actually a mortgage, instead of a sale (in which the impact is the very same as if a tax-free exchange takes place because the seller is not qualified for the instant loss deduction).
The issue is even more complicated by the unclear treatment of lease extensions developed into a sale-leaseback transaction under common law. When the leasehold is either prepared to be for 30 years or more or totals thirty years or more with consisted of extensions, Treasury Regulations Section 1.1031(b)-1 categorizes 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 outcome contrasts the seller's benefits. Often the net outcome in these situations is the seller's acknowledgment of any gain over the basis in the real residential or commercial property possession, offset just by the acceptable long-term amortization.
Given the major tax repercussions of having a sale-leaseback transaction re-characterized as an involuntary tax-deferred exchange, taxpayers are well advised to try to avoid the inclusion of the lease worth as part of the seller's gain on sale. The most effective 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 preparing it in between the seller and a regulated entity, and after that participating in a sale made subject to 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 contract, and for this reason never got a lease as a part of the sale, so that any worth attributable to the lease for that reason can not be taken into account in calculating his gain.
It is very important for taxpayers to keep in mind that this strategy is not bulletproof: the IRS has a variety of potential reactions where this strategy has actually been employed. The IRS might accept the seller's argument that the lease was not gotten as part of the sales deal, however then deny the portion of the basis allocated to the lease residential or commercial property and matching increase the capital gain tax liability. The IRS might also elect to utilize its time honored standby of "form over function", and break the transaction down to its essential components, 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 cash in excess of their basis in the residential or commercial property, would recognize their full tax liability on the gain.
