The term "sale and lease back" describes a situation in which an individual, typically a corporation, owning service residential or commercial property, either genuine or personal, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will instantly turn around and rent 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 large non-liquid financial investment without denying himself of the use (throughout the term of the lease) of necessary or desirable structures or devices, while making the net money profits offered for other investments without resorting to increased debt. A sale-leaseback deal has the additional benefit of increasing the taxpayers offered tax reductions, due to the fact that the leasings paid are typically set at 100 percent 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 value 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 particular 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 enables a Financier to offer his existing residential or commercial property (given up residential or commercial property) and purchase more lucrative 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 typically 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 might delay all of their Federal, and most of the times state, capital gain and depreciation recapture earnings tax liability on the sale of investment residential or commercial property so long as particular requirements are met. Typically, the Investor should (1) develop a legal arrangement with an entity referred to as a "Qualified Intermediary" to facilitate the exchange and appoint 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 equal to or greater in value than the given up residential or commercial property (based on net list prices, not equity); (3) reinvest all of the net profits (gross profits minus certain appropriate closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) should change the quantity of protected financial obligation that was settled at the closing of the given up residential or commercial property with brand-new protected financial obligation on the replacement residential or commercial property of an equal or greater quantity.

These requirements usually trigger Investor's to view the tax-deferred exchange procedure as more constrictive than it in fact is: while it is not acceptable to either take money and/or pay off debt in the tax deferred exchange process without sustaining 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 possible, or providing outdoors money does not lead to the very best business choice, the Investor might elect to make use of a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in worth or pull money out of the deal, and pay the tax liabilities entirely connected with the quantity not exchanged for qualified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while postponing their capital gain and devaluation recapture liabilities on whatever portion of the proceeds remain in reality included in the exchange.

Problems including 1031 exchanges developed by the structure of the sale-leaseback.

On its face, the interest in integrating 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 asset taxable at long-lasting capital gains rates, and/or any loss acknowledged on the sale will be treated as a regular loss, so that the loss deduction might be utilized to balance out present tax liability and/or a prospective refund of taxes paid. The combined transaction would allow a taxpayer to use the sale-leaseback structure to offer his given up residential or commercial property while maintaining helpful usage of the residential or commercial property, produce earnings from the sale, and then reinvest those proceeds 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 problem can emerge when the Investor has no intent to enter into a tax-deferred exchange, but 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 meant to offset any recognizable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) offers:

No gain or loss is acknowledged if ... (2) a taxpayer who is not a dealer in property exchanges city property for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for property, or exchanges enhanced realty for unimproved property.

While this arrangement, which essentially allows the development of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the charge interest and a leasehold interest, typically is seen as useful in that it creates a number of preparing options in the context of a 1031 exchange, application of this arrangement on a sale-leaseback deal has the result of avoiding the Investor from recognizing any applicable loss on the sale of the residential or commercial property.

Among the controlling cases in this area is Crowley, Milner & Co. v. Commissioner of Internal Revenue. In Crowley, the IRS prohibited the $300,000 taxable loss deduction made by Crowley on their income tax return on the premises that the sale-leaseback transaction they participated 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 real estate for replacement residential or commercial property including a leasehold interest in the exact same residential or commercial property for a term of 30 years or more, and accordingly the existing tax basis had actually carried over into the leasehold interest.

There were several problems in the Crowley case: whether a tax-deferred exchange had in fact occurred and whether or not the taxpayer was qualified for the instant loss deduction. The Tax Court, enabling the loss reduction, said that the deal did not make up a sale or exchange given that the lease had no capital worth, and promoted the circumstances under which the IRS might take the position that such a lease carried out in truth have capital value:

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

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

In the Crowley transaction, the Court held that there was no proof whatsoever that the price or leasing was less than fair market, because the offer was worked out at arm's length between independent parties. Further, the Court held that the sale was an independent transaction for tax functions, which implied that the loss was properly acknowledged by Crowley.

The IRS had other grounds on which to challenge the Crowley transaction; the filing showing the immediate loss deduction which the IRS argued remained in fact a premium paid by Crowley for the negotiated sale-leaseback deal, and so accordingly ought to be amortized over the 30-year lease term rather than totally deductible in the current tax year. The Tax Court rejected this argument too, and held that the excess cost was consideration for the lease, however appropriately showed the expenses connected with completion of the building as required by the sales agreement.

The lesson for taxpayers to take from the holding in Crowley is basically that sale-leaseback deals may have unanticipated tax effects, and the terms of the transaction should be drafted with those repercussions in mind. When taxpayers are considering this type of transaction, they would be well served to think about thoroughly whether or not it is prudent to provide the seller-tenant an option to redeem the residential or commercial property at the end of the lease, particularly where the alternative price will be below the fair market price at the end of the lease term. If their deal does include this repurchase alternative, not only 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 (where the effect is the exact same as if a tax-free exchange occurs in that the seller is not qualified for the immediate loss reduction).

The issue is further complicated by the uncertain treatment of lease extensions developed into a sale-leaseback transaction under typical law. When the leasehold is either drafted to be for thirty years or more or totals thirty 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 treated as an exchange of like-kind residential or commercial property and the money is treated as boot. This characterization holds although 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 lead to these scenarios is the seller's recognition of any gain over the basis in the genuine residential or commercial property asset, balanced out just by the allowable long-term amortization.

Given the serious tax repercussions of having a sale-leaseback deal re-characterized as an involuntary tax-deferred exchange, taxpayers are well encouraged to try to avoid the addition of the lease worth as part of the seller's gain on sale. The most effective manner in which taxpayers can prevent this addition has been to take the lease prior to the sale of the residential or commercial property however preparing it in between the seller and a controlled entity, and after that participating in a sale made subject to the pre-existing lease. What this technique permits the seller is a capability to argue that the seller is not the lessee under the pre-existing arrangement, and hence never ever 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 calculating his gain.

It is necessary for taxpayers to note that this technique is not bulletproof: the IRS has a number of potential reactions where this strategy has been employed. The IRS may accept the seller's argument that the lease was not received as part of the sales transaction, however then reject the part of the basis designated to the lease residential or commercial property and matching increase the capital gain tax liability. The IRS might likewise elect to use its time honored standby of "type over function", and break the transaction to its elemental components, where both money and a leasehold were received 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 gets cash in excess of their basis in the residential or commercial property, would recognize their full tax liability on the gain.