The term "sale and lease back" describes a situation in which an individual, 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 immediately reverse and lease the residential or commercial property back to the seller. The aim of this type of deal is to allow the seller to rid himself of a large non-liquid financial investment without depriving himself of the usage (throughout the term of the lease) of essential or preferable buildings or devices, while making the net money profits available for other investments without turning to increased financial obligation. A sale-leaseback transaction has the fringe benefit of increasing the taxpayers readily available tax deductions, since the leasings paid are normally set at 100 percent of the value of the residential or commercial property plus interest over the term of the payments, which results in a permissible deduction for the worth of land in addition to buildings over a duration which might 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 enables an Investor to sell his existing residential or commercial property (relinquished residential or commercial property) and buy more rewarding and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while delaying Federal, and in many cases state, capital gain and depreciation regain income tax liabilities. This deal is most frequently referred to as a 1031 exchange however is likewise 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 defer all of their Federal, and in many cases state, capital gain and depreciation regain earnings tax liability on the sale of investment residential or commercial property so long as specific requirements are met. Typically, the Investor should (1) develop a contractual arrangement with an entity described 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) acquire like-kind replacement residential or commercial property that amounts to or greater in worth than the relinquished residential or commercial property (based upon net sales rate, not equity); (3) reinvest all of the net profits (gross earnings minus certain appropriate closing costs) or cash from the sale of the given up residential or commercial property; and, (4) should replace the quantity of secured financial obligation that was paid off at the closing of the relinquished residential or commercial property with brand-new secured financial obligation on the replacement residential or commercial property of an equivalent or higher amount.
These requirements normally cause Investor's to see the tax-deferred exchange procedure as more constrictive than it actually is: while it is not allowable to either take money and/or settle debt in the tax deferred exchange procedure without incurring tax liabilities on those funds, Investors might constantly put additional money into the transaction. Also, where reinvesting all the net sales earnings is merely not feasible, or providing outdoors cash does not lead to the very best business decision, the Investor may choose to utilize a partial tax-deferred exchange. The partial exchange structure will enable the Investor to trade down in value or pull squander of the transaction, and pay the tax liabilities entirely 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 devaluation recapture liabilities on whatever portion of the profits remain in reality included in the exchange.
Problems involving 1031 exchanges developed 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 necessarily 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 property taxable at long-lasting capital gains rates, and/or any loss acknowledged on the sale will be treated as an ordinary loss, so that the loss deduction may be used to balance out existing tax liability and/or a prospective refund of taxes paid. The combined deal would allow a taxpayer to utilize the sale-leaseback structure to offer his relinquished residential or commercial property while retaining helpful usage of the residential or commercial property, generate profits from the sale, and after that reinvest those profits 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 regain tax liabilities.
The very first complication can arise when the Investor has no intent to get in into a tax-deferred exchange, however has gotten in into a sale-leaseback deal where the negotiated lease is for a term of thirty years or more and the seller has losses meant 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 real estate exchanges city property for a ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for real estate, or exchanges enhanced realty for unaltered genuine estate.
While this arrangement, which essentially permits the production of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the charge interest and a leasehold interest, usually is deemed helpful because it creates a number of preparing choices in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the impact of preventing the Investor from recognizing any suitable 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 disallowed the $300,000 taxable loss deduction made by Crowley on their 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 area 1031 implied Crowley had in fact exchanged their fee interest in their realty for replacement residential or commercial property consisting of a leasehold interest in the exact same residential or commercial property for a term of thirty 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 the taxpayer was eligible for the instant loss reduction. The Tax Court, allowing the loss reduction, stated that the transaction did not constitute a sale or exchange because the lease had no capital worth, and promoted the circumstances under which the IRS might take the position that such a lease performed in fact have capital worth:
1. A lease might be considered to have capital value where there has actually been a "bargain sale" or essentially, the prices is less than the residential or commercial property's reasonable market price; or
2. A lease might be considered to have capital worth where the lease to be paid is less than the fair rental rate.
In the Crowley deal, the Court held that there was no proof whatsoever that the list price or leasing was less than fair market, given 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 suggested that the loss was appropriately recognized by Crowley.
The IRS had other premises on which to challenge the Crowley deal; the filing reflecting the instant loss deduction which the IRS argued was in fact a premium paid by Crowley for the worked out sale-leaseback transaction, and so appropriately need to be amortized over the 30-year lease term instead of totally deductible in the present tax year. The Tax Court declined this argument as well, and held that the excess cost was factor to consider for the lease, but properly showed the costs connected with conclusion of the building as needed by the sales agreement.
The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback transactions may have unexpected tax repercussions, and the regards to the transaction must be prepared with those repercussions in mind. When taxpayers are contemplating this type of deal, they would be well served to consider thoroughly whether it is sensible to provide the seller-tenant an alternative to repurchase the residential or commercial property at the end of the lease, particularly where the option price will be listed below the fair 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 potentially characterize the deal as a tax-deferred exchange, but they likewise have the ability to argue that the transaction is really 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 eligible for the instant loss deduction).
The issue is even more complicated by the unclear treatment of lease extensions built into a sale-leaseback deal under typical law. When the leasehold is either prepared to be for 30 years or more or amounts to 30 years or more with included extensions, Treasury Regulations Section 1.1031(b)-1 classifies the Investor's gain as the money received, 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 although the seller had no intent to complete a tax-deferred exchange and though the result is contrary to the seller's benefits. Often the net outcome in these scenarios is the seller's recognition of any gain over the basis in the real residential or commercial property possession, balanced out just by the permissible long-term amortization.
Given the major tax effects of having a sale-leaseback deal re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well encouraged 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 prevent this addition has been to carve out the lease prior to the sale of the residential or commercial property however preparing it between the seller and a regulated entity, and after that entering into a sale made based on the pre-existing lease. What this strategy enables the seller is an ability to argue that the seller is not the lessee under the pre-existing agreement, and for this reason never received a lease as a part of the sale, so that any worth attributable to the lease therefore can not be taken into consideration in computing his gain.
It is very important for taxpayers to keep in mind that this method is not bulletproof: the IRS has a variety of possible actions where this method has 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 corresponding increase the capital gain tax liability. The IRS may likewise elect to utilize its time honored standby of "form 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 appropriately, if the taxpayer gets money in excess of their basis in the residential or commercial property, would acknowledge their complete tax liability on the gain.
