The term "sale and lease back" explains a scenario in which an individual, usually a corporation, owning organization residential or commercial property, either real or personal, offers 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 aim of this type of transaction is to enable the seller to rid himself of a big non-liquid financial investment without denying himself of the use (throughout the regard to the lease) of necessary or preferable structures or equipment, while making the net cash earnings available for other investments without turning to increased financial obligation. A sale-leaseback deal has the extra advantage of increasing the taxpayers offered tax reductions, since the rentals 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 leads to an acceptable deduction for the worth of land as well as buildings over a duration which may be shorter than the life of the residential or commercial property and in particular 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 allows a Financier to sell his existing residential or commercial property (given up 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 for the most part state, capital gain and devaluation recapture income tax liabilities. This deal is most typically referred to as a 1031 exchange but 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 might delay all of their Federal, and in many cases state, capital gain and devaluation recapture earnings tax liability on the sale of investment residential or commercial property so long as specific requirements are fulfilled. Typically, the Investor must (1) establish a legal arrangement with an entity described as a "Qualified Intermediary" to help with the exchange and designate into the sale and purchase contracts for the residential or commercial properties included in the exchange; (2) acquire like-kind replacement residential or commercial property that is equivalent 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 proceeds (gross profits minus specific acceptable closing expenses) or cash from the sale of the relinquished residential or commercial property; and, (4) need to change the amount of protected 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 higher quantity.

These requirements typically trigger Investor's to view the tax-deferred exchange procedure as more constrictive than it in fact is: while it is not allowable to either take cash and/or settle financial obligation in the tax deferred exchange process without incurring tax liabilities on those funds, Investors might always put extra cash into the deal. Also, where reinvesting all the net sales proceeds is simply not practical, or providing outdoors money does not result in the very best organization choice, the Investor might elect to make use of a partial tax-deferred exchange. The partial exchange structure will allow the Investor to trade down in worth or pull squander of the deal, and pay the tax liabilities solely connected with the quantity not exchanged for qualified like-kind replacement residential or commercial property or "money boot" and/or "mortgage boot", while delaying their capital gain and devaluation recapture liabilities on whatever part of the profits are in reality consisted of 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 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 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 an ordinary loss, so that the loss reduction might be used to balance out current tax liability and/or a potential refund of taxes paid. The combined transaction would enable a taxpayer to use the sale-leaseback structure to sell his relinquished residential or commercial property while keeping advantageous usage of the residential or commercial property, create proceeds from the sale, and after that reinvest those earnings in a tax-deferred way in a subsequent like-kind replacement residential or commercial property through using Section 1031 without recognizing any of his capital gain and/or devaluation recapture tax liabilities.

The very first issue can arise when the Investor has no intent to participate in a tax-deferred exchange, however has actually entered into a sale-leaseback transaction where the negotiated lease is for a regard to thirty years or more and the seller has losses planned 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 acknowledged if ... (2) a taxpayer who is not a dealership in real estate exchanges city genuine estate for a ranch or farm, or exchanges a leasehold of a fee with thirty years or more to run for property, or exchanges enhanced real estate for unaltered realty.

While this arrangement, 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, typically is considered as advantageous because it creates a variety of preparing choices in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the impact of avoiding the Investor from recognizing any suitable 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 prohibited the $300,000 taxable loss reduction made by Crowley on their tax return on the grounds that the sale-leaseback deal they took part in made up a like-kind exchange within the meaning of Section 1031. The IRS argued that application of section 1031 meant Crowley had in truth exchanged their charge 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 regard to thirty years or more, and accordingly 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 reality happened and whether the taxpayer was eligible for the immediate loss reduction. 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 did in truth have capital value:

1. A lease might be deemed to have capital value where there has been a "deal sale" or essentially, the list prices is less than the residential or commercial property's reasonable market price; or

2. A lease may be deemed to have capital worth where the rent to be paid is less than the reasonable rental rate.

In the Crowley transaction, the Court held that there was no evidence whatsoever that the sale price or rental was less than reasonable market, since the deal was worked out at arm's length in between independent parties. Further, the Court held that the sale was an independent deal for tax purposes, which indicated that the loss was correctly recognized by Crowley.

The IRS had other premises on which to challenge the Crowley transaction; the filing reflecting the immediate loss deduction which the IRS argued remained in fact a premium paid by Crowley for the worked out sale-leaseback deal, therefore appropriately need to be amortized over the 30-year lease term rather than totally deductible in the present tax year. The Tax Court rejected this argument as well, and held that the excess expense was consideration for the lease, however appropriately showed the expenses related to conclusion of the building as required by the sales arrangement.

The lesson for taxpayers to draw from the holding in Crowley is essentially that sale-leaseback deals may have unanticipated tax repercussions, and the terms of the deal need to be drafted with those consequences in mind. When taxpayers are considering this type of transaction, they would be well served to think about thoroughly whether it is sensible to offer the seller-tenant an option to repurchase the residential or commercial property at the end of the lease, especially where the option rate will be listed below the fair market price 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 define the transaction as a tax-deferred exchange, but they likewise have the ability to argue that the deal is in fact a mortgage, instead of a sale (in which the impact is the same as if a tax-free exchange happens because the seller is not qualified for the immediate loss deduction).

The problem is even more complicated by the unclear treatment of lease extensions constructed into a sale-leaseback deal under typical law. When the leasehold is either prepared to be for thirty 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 dealt with as an exchange of like-kind residential or commercial property and the cash is treated as boot. This characterization holds even though the seller had no intent to complete a tax-deferred exchange and though the outcome 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, offset just by the allowable long-lasting amortization.

Given the major tax repercussions of having a sale-leaseback deal re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well recommended to try to avoid the inclusion of the lease worth as part of the seller's gain on sale. The most reliable manner in which taxpayers can avoid this addition has actually been to sculpt out the lease prior to the sale of the residential or commercial property but drafting it between the seller and a controlled entity, and after that getting in into a sale made based on the pre-existing lease. What this technique allows the seller is an ability to argue that the seller is not the lessee under the pre-existing agreement, and hence never ever received a lease as a portion of the sale, so that any value attributable to the lease therefore can not be taken into account in computing his gain.

It is essential for taxpayers to keep in mind that this technique is not bulletproof: the IRS has a number of prospective actions where this technique has actually been employed. The IRS might accept the seller's argument that the lease was not gotten as part of the sales transaction, but then reject the part of the basis designated to the lease residential or commercial property and corresponding boost the capital gain tax liability. The IRS may also choose to utilize its time honored standby of "type over function", and break the transaction down to its elemental elements, where both cash 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 accordingly, 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.