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The term "sale and lease back" explains a scenario in which a person, generally a corporation, owning service residential or commercial property, either real or personal, sells their residential or commercial property with the understanding that the purchaser of the residential or commercial property will immediately reverse and rent the residential or commercial property back to the seller. The goal of this kind of transaction is to make it possible for the seller to rid himself of a big non-liquid financial investment without denying himself of the usage (during the regard to the lease) of necessary or desirable structures or equipment, while making the net money profits offered for other investments without turning to increased financial obligation. A sale-leaseback deal has the extra advantage of increasing the taxpayers offered tax deductions, because the leasings paid are usually 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 reduction for the worth of land in addition to structures over a duration which may be much shorter than the life of the residential or commercial property and in specific cases, a deduction of a normal loss on the sale of the residential or commercial property.

What is a tax-deferred exchange?

A tax-deferred exchange permits an Investor to sell his existing residential or commercial property (relinquished residential or commercial property) and purchase more lucrative and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and most of the times state, capital gain and devaluation recapture earnings tax liabilities. This transaction is most typically referred to as a 1031 exchange but is likewise known 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 exchange, Investors may delay all of their Federal, and most of the times state, capital gain and depreciation regain income tax liability on the sale of financial investment residential or commercial property so long as specific requirements are met. Typically, the Investor must (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 included in the exchange; (2) get like-kind replacement residential or commercial property that amounts to or higher in worth than the given up residential or commercial property (based on net prices, not equity); (3) reinvest all of the net proceeds (gross earnings minus certain acceptable closing expenses) or cash from the sale of the relinquished residential or commercial property; and, (4) need to change the amount of secured financial obligation that was paid off 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 equivalent or greater quantity.
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These requirements usually trigger Investor's to view the tax-deferred exchange procedure as more constrictive than it really is: while it is not permissible to either take cash and/or settle financial obligation in the tax deferred exchange process without sustaining tax liabilities on those funds, Investors may always put additional money into the transaction. Also, where reinvesting all the net sales profits is just not possible, or providing outside money does not lead to the best company decision, the Investor might elect 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 solely connected with the quantity not exchanged for certified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while postponing their capital gain and depreciation regain liabilities on whatever portion of the profits are in reality included in the exchange.

Problems involving 1031 exchanges created by the structure of the sale-leaseback.

On its face, the worry about 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 recognized on the sale will be dealt with as an ordinary loss, so that the loss deduction might be used to offset present tax liability and/or a potential refund of taxes paid. The combined deal would enable a taxpayer to utilize the sale-leaseback structure to sell his given up residential or commercial property while maintaining advantageous use of the residential or commercial property, produce proceeds from the sale, and then reinvest those profits in a tax-deferred way in a subsequent like-kind replacement residential or commercial property through making use of Section 1031 without acknowledging any of his capital gain and/or devaluation recapture tax liabilities.

The first issue can emerge when the Investor has no intent to get in into a tax-deferred exchange, but has entered into a sale-leaseback deal where the negotiated lease is for a term of thirty years or more and the seller has losses intended to offset any identifiable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) provides:

No gain or loss is recognized if ... (2) a taxpayer who is not a dealership in real estate exchanges city real estate 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 property for unaltered genuine estate.

While this arrangement, which essentially enables the development of 2 distinct residential or commercial property interests from one discrete piece of residential or commercial property, the charge interest and a leasehold interest, usually is considered as helpful in that it creates a variety of preparing alternatives in the context of a 1031 exchange, application of this arrangement on a sale-leaseback deal has the impact of preventing the Investor from recognizing any appropriate loss on the sale of the residential or commercial property.

Among the managing 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 income tax return on the grounds that the sale-leaseback deal they engaged in made up a like-kind exchange within the meaning of Section 1031. The IRS argued that application of area 1031 suggested Crowley had in fact exchanged their cost interest in their property for replacement residential or commercial property consisting of 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 rollovered into the leasehold interest.

There were a number of concerns in the Crowley case: whether a tax-deferred exchange had in fact occurred and whether or not the taxpayer was eligible for the instant loss deduction. The Tax Court, permitting the loss deduction, said that the deal did not constitute a sale or exchange since the lease had no capital worth, and promulgated the situations under which the IRS may take the position that such a lease performed in reality have capital value:

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

2. A lease might be considered 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 proof whatsoever that the price or rental was less than reasonable market, given that the offer 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 properly recognized 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 was in truth a premium paid by Crowley for the negotiated sale-leaseback deal, therefore appropriately should be amortized over the 30-year lease term instead of completely deductible in the current tax year. The Tax Court declined this argument also, and held that the excess expense was consideration for the lease, but appropriately reflected the expenses related to conclusion of the structure as needed by the sales contract.

The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback deals might have unexpected tax consequences, and the terms of the transaction should be drafted with those consequences in mind. When taxpayers are contemplating this type of deal, they would be well served to consider carefully whether it is sensible to give the seller-tenant a choice to repurchase the residential or commercial property at the end of the lease, especially where the option price will be below the fair market price at the end of the lease term. If their deal does include this repurchase option, not just does the IRS have the ability to potentially define the deal as a tax-deferred exchange, but they also have the ability to argue that the transaction is really a mortgage, instead of a sale (where the effect is the very same as if a tax-free exchange happens because the seller is not qualified for the instant loss reduction).

The problem is even more complicated by the uncertain treatment of lease extensions built into a sale-leaseback deal under typical law. When the leasehold is either drafted to be for thirty years or more or totals 30 years or more with consisted of extensions, Treasury Regulations Section 1.1031(b)-1 categorizes 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 treated as boot. This characterization holds despite the fact that the seller had no intent to finish a tax-deferred exchange and though the outcome contrasts the seller's benefits. Often the net result in these scenarios is the seller's recognition of any gain over the basis in the real residential or commercial property asset, balanced out just by the permissible long-lasting amortization.

Given the major tax effects of having a sale-leaseback transaction re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well encouraged to try to prevent 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 sculpt out the lease prior to the sale of the residential or commercial property but drafting it in between the seller and a controlled entity, and then getting in into a sale made subject to the pre-existing lease. What this method permits the seller is an ability to argue that the seller is not the lessee under the pre-existing contract, and thus never got a lease as a portion of the sale, so that any worth attributable to the lease therefore can not be taken into account in calculating his gain.

It is essential for taxpayers to keep in mind that this method is not bulletproof: the IRS has a variety of possible responses where this strategy has been utilized. The IRS might accept the seller's argument that the lease was not gotten as part of the sales transaction, however then reject the portion of the basis designated to the lease residential or commercial property and matching increase the capital gain tax liability. The IRS might likewise choose to use its time honored standby of "kind over function", and break the deal down to its elemental parts, in which both cash 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 receives money in excess of their basis in the residential or commercial property, would recognize their complete tax liability on the gain.