The term "sale and lease back" explains a scenario in which a person, normally 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 immediately reverse and lease the residential or commercial property back to the seller. The objective of this kind of deal is to allow the seller to rid himself of a large non-liquid financial investment without depriving himself of the use (during the term of the lease) of required or preferable buildings or devices, while making the net cash profits readily available for other investments without turning to increased debt. A sale-leaseback deal has the extra advantage of increasing the taxpayers offered tax reductions, since the leasings paid are usually set at 100 per cent of the worth of the residential or commercial property plus interest over the term of the payments, which leads to a permissible deduction for the value of land as well as buildings over a duration which may be much shorter than the life of the residential or commercial property and in specific 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 an Investor to offer his existing residential or commercial property (relinquished residential or commercial property) and acquire more rewarding and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while postponing Federal, and most of the times state, capital gain and devaluation recapture earnings tax liabilities. This transaction is most frequently referred to as a 1031 exchange however is likewise referred to as 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 may defer all of their Federal, and most of the times 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 satisfied. Typically, the Investor needs to (1) develop a legal plan with an entity described as a "Qualified Intermediary" to facilitate the exchange and designate into the sale and purchase agreements for the residential or commercial properties consisted of in the exchange; (2) acquire like-kind replacement residential or commercial property that is equivalent to or greater in value than the relinquished residential or commercial property (based on net sales rate, not equity); (3) reinvest all of the net earnings (gross proceeds minus certain appropriate closing costs) or cash from the sale of the given up residential or commercial property; and, (4) should change the quantity of secured debt that was settled at the closing of the given up residential or commercial property with new protected financial obligation on the replacement residential or commercial property of an equivalent or higher quantity.
These requirements normally cause Investor's to view the tax-deferred exchange process as more constrictive than it really is: while it is not allowable to either take money and/or pay off financial obligation in the tax deferred exchange process without sustaining tax liabilities on those funds, Investors may constantly put extra cash into the transaction. Also, where reinvesting all the net sales proceeds is simply not practical, or offering outdoors cash does not result in the very best company choice, the Investor might elect to use a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in value or pull money out of the deal, and pay the tax liabilities entirely related to the quantity not exchanged for qualified like-kind replacement residential or commercial property or "money boot" and/or "mortgage boot", while postponing their capital gain and depreciation regain liabilities on whatever part of the profits remain in fact consisted of in the exchange.
Problems including 1031 exchanges produced by the structure of the sale-leaseback.
On its face, the concern 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 treated as gain from the sale of a capital possession taxable at long-term capital gains rates, and/or any loss acknowledged on the sale will be dealt with as a common loss, so that the loss deduction may be used to offset current tax liability and/or a possible refund of taxes paid. The combined deal would enable a taxpayer to utilize the sale-leaseback structure to offer his given up residential or commercial property while maintaining useful use of the residential or commercial property, generate 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 recognizing any of his capital gain and/or depreciation recapture tax liabilities.
The very first complication 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 actually losses intended to balance out any identifiable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) supplies:
No gain or loss is recognized if ... (2) a taxpayer who is not a dealership in property exchanges city genuine estate for a ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for genuine estate, or exchanges enhanced property for unimproved genuine estate.
While this arrangement, which essentially enables the creation of two unique residential or commercial property interests from one discrete piece of residential or commercial property, the cost interest and a leasehold interest, typically is considered as useful in that it creates a variety 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 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 premises that the sale-leaseback deal they participated in constituted a like-kind exchange within the significance of Section 1031. The IRS argued that application of section 1031 suggested Crowley had in reality 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 several problems in the Crowley case: whether a tax-deferred exchange had in reality occurred and whether or not the taxpayer was qualified for the instant loss reduction. The Tax Court, allowing the loss reduction, said that the transaction 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 did in truth have capital value:
1. A lease may be considered to have capital value where there has actually been a "deal sale" or basically, the list prices is less than the residential or commercial property's fair market price; or
2. A lease may be considered 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 price or leasing was less than fair market, since the deal was negotiated at arm's length in between independent parties. Further, the Court held that the sale was an independent deal for tax purposes, which meant that the loss was effectively recognized by Crowley.
The IRS had other premises on which to challenge the Crowley transaction; the filing showing the instant loss deduction which the IRS argued was in truth a premium paid by Crowley for the negotiated sale-leaseback transaction, therefore accordingly should be amortized over the 30-year lease term rather than completely deductible in the existing tax year. The Tax Court rejected this argument also, and held that the excess cost was factor to consider for the lease, but properly reflected the costs connected with completion of the structure as required by the sales agreement.
The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback transactions may have unanticipated tax consequences, and the regards to the transaction must be prepared with those consequences in mind. When taxpayers are contemplating this kind of transaction, they would be well served to think about thoroughly whether or not it is sensible to provide the seller-tenant an option to redeem the residential or commercial property at the end of the lease, particularly where the choice cost will be below the fair market price at the end of the lease term. If their deal does include this repurchase choice, not just does the IRS have the capability to possibly define the deal as a tax-deferred exchange, but they likewise have the ability to argue that the deal is really a mortgage, instead of a sale (wherein the result is the exact same as if a tax-free exchange happens in that the seller is not eligible for the instant loss deduction).
The concern is even more complicated by the unclear treatment of lease extensions constructed into a sale-leaseback transaction under common law. When the leasehold is either drafted 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 cash received, 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 despite the fact that the seller had no intent to complete a tax-deferred exchange and though the outcome is contrary to the seller's benefits. Often the net outcome in these situations is the seller's recognition of any gain over the basis in the genuine residential or commercial property possession, balanced out just by the allowable long-term amortization.
Given the serious 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 value as part of the seller's gain on sale. The most reliable way in which taxpayers can avoid this addition has 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 participating in a sale made subject to the pre-existing lease. What this method enables the seller is a capability to argue that the seller is not the lessee under the pre-existing agreement, and for this reason never ever got a lease as a portion of the sale, so that any value attributable to the lease therefore can not be taken into consideration in calculating his gain.
It is very important for taxpayers to note that this technique is not bulletproof: the IRS has a variety of prospective responses where this method has actually been used. The IRS may accept the seller's argument that the lease was not gotten as part of the sales deal, however then deny the part of the basis designated to the lease residential or commercial property and matching increase the capital gain tax liability. The IRS might also choose to use its time honored standby of "type over function", and break the deal down to its essential components, wherein both money and a leasehold were gotten 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 complete tax liability on the gain.
