The term "sale and lease back" explains a circumstance in which an individual, normally a corporation, owning company residential or commercial property, either genuine or personal, offers their residential or commercial property with the understanding that the buyer of the residential or commercial property will right away turn around 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 big non-liquid financial investment without depriving himself of the use (throughout the regard to the lease) of essential or desirable structures or devices, while making the net money earnings offered for other investments without resorting to increased financial obligation. A sale-leaseback transaction has the extra benefit of increasing the taxpayers offered tax deductions, due to the fact that the leasings paid are usually set at 100 per cent of the value of the residential or commercial property plus interest over the regard to the payments, which leads to an allowable deduction for the worth of land as well as structures over a period which may be much 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 permits a Financier to sell his existing residential or commercial property (given up residential or commercial property) and buy more profitable and/or productive residential or commercial property (like-kind replacement residential or commercial property) while deferring 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 but is likewise called 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 postpone all of their Federal, and for the most part state, capital gain and devaluation regain income tax liability on the sale of investment residential or commercial property so long as specific requirements are satisfied. Typically, the Investor needs to (1) develop a contractual 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 included in the exchange; (2) acquire like-kind replacement residential or commercial property that is equal to or higher in worth than the relinquished residential or commercial property (based upon net list prices, not equity); (3) reinvest all of the net profits (gross proceeds minus specific appropriate closing expenses) or cash from the sale of the given up 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 new protected financial obligation on the replacement residential or commercial property of an equivalent or higher amount.

These requirements generally trigger Investor's to see the tax-deferred exchange process as more constrictive than it actually is: while it is not permissible to either take money and/or pay off debt in the tax deferred exchange process without incurring tax liabilities on those funds, Investors may always put additional money into the transaction. Also, where reinvesting all the net sales earnings is just not feasible, or providing outside cash does not lead to the best company choice, the Investor might choose to make use of 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 connected with the amount not exchanged for certified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while deferring their capital gain and depreciation recapture liabilities on whatever part of the earnings remain in truth 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 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 a regular loss, so that the loss reduction might be used to offset existing tax liability and/or a potential refund of taxes paid. The combined deal would allow a taxpayer to use the sale-leaseback structure to offer his relinquished residential or commercial property while retaining advantageous use of the residential or commercial property, create proceeds from the sale, and after that 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 very first issue can occur when the Investor has no intent to get in into a tax-deferred exchange, however has actually participated in a sale-leaseback transaction where the negotiated lease is for a regard to thirty years or more and the seller has actually losses intended to balance out any recognizable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) provides:

No gain or loss is acknowledged if ... (2) a taxpayer who is not a dealership in property exchanges city property for a cattle ranch or farm, or exchanges a leasehold of a fee with thirty years or more to run for property, or exchanges improved property for unimproved genuine estate.

While this provision, which basically permits the creation of two unique residential or commercial property interests from one discrete piece of residential or commercial property, the fee interest and a leasehold interest, typically is considered as useful because it develops a number 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 applicable 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 deduction made by Crowley on their tax return on the grounds 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 section 1031 implied Crowley had in truth exchanged their cost interest in their property for replacement residential or commercial property consisting of a leasehold interest in the same residential or commercial property for a regard to 30 years or more, and accordingly the existing tax basis had rollovered into the leasehold interest.

There were numerous issues in the Crowley case: whether a tax-deferred exchange had in truth took place and whether the taxpayer was eligible for the instant loss reduction. The Tax Court, permitting the loss deduction, said that the deal did not constitute a sale or exchange because the lease had no capital worth, and promoted the situations under which the IRS might take the position that such a lease performed in reality have capital worth:

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

2. A lease might be deemed to have capital worth where the rent 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 list price or rental was less than fair market, since the offer was negotiated at arm's length between independent parties. Further, the Court held that the sale was an independent transaction for tax purposes, which implied that the loss was correctly recognized by Crowley.

The IRS had other premises on which to challenge the Crowley deal; the filing reflecting the immediate loss reduction which the IRS argued was in truth a premium paid by Crowley for the negotiated sale-leaseback transaction, therefore appropriately must be amortized over the 30-year lease term rather than completely deductible in the existing tax year. The Tax Court declined this argument also, and held that the excess cost was factor to consider for the lease, but appropriately showed the expenses associated with conclusion of the structure as needed by the sales arrangement.

The lesson for taxpayers to draw from the holding in Crowley is basically that sale-leaseback deals might have unexpected tax consequences, and the regards to the transaction must be prepared with those repercussions in mind. When taxpayers are contemplating this type of transaction, they would be well served to think about carefully whether it is prudent to give the seller-tenant a choice to buy the residential or commercial property at the end of the lease, particularly where the choice price will be below the reasonable market price at the end of the lease term. If their transaction does include this repurchase alternative, not only does the IRS have the capability to potentially identify the deal as a tax-deferred exchange, but they also have the ability to argue that the deal is actually a mortgage, instead of a sale (where the effect is the exact same as if a tax-free exchange takes place in that the seller is not eligible for the instant loss reduction).

The issue is even more complicated by the unclear treatment of lease extensions developed into a sale-leaseback deal under typical law. When the leasehold is either drafted to be for 30 years or more or amounts to thirty years or more with consisted of 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 despite the fact that the seller had no intent to complete a tax-deferred exchange and though the outcome contrasts the seller's best interests. Often the net outcome in these scenarios is the seller's recognition of any gain over the basis in the genuine residential or commercial property possession, offset just by the permissible long-term amortization.

Given the serious tax repercussions of having a sale-leaseback transaction re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well encouraged to attempt to avoid the addition of the lease worth as part of the seller's gain on sale. The most reliable way in which taxpayers can avoid this addition has actually been to take the lease prior to the sale of the residential or commercial property however preparing it between the seller and a controlled entity, and then participating in a sale made subject to 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 contract, and thus never ever got a lease as a portion of the sale, so that any worth attributable to the lease therefore can not be considered in calculating his gain.

It is very important for taxpayers to note that this method is not bulletproof: the IRS has a number of prospective reactions where this strategy has actually been utilized. 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 assigned to the lease residential or commercial property and corresponding increase the capital gain tax liability. The IRS may also elect to use its time honored standby of "kind over function", and break the deal to its elemental parts, wherein both money and a leasehold were received upon the sale of the residential or commercial property; such a characterization would result in the application of Section 1031 and accordingly, if the taxpayer gets money in excess of their basis in the residential or commercial property, would recognize their full tax liability on the gain.