The term "sale and lease back" describes a situation in which a person, normally a corporation, owning organization 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 right away turn around and lease the residential or commercial property back to the seller. The goal of this kind of transaction is to enable the seller to rid himself of a big non-liquid financial investment without depriving himself of the usage (during the term of the lease) of essential or preferable structures or equipment, while making the net money proceeds readily available for other investments without turning to increased financial obligation. A sale-leaseback transaction has the fringe benefit of increasing the taxpayers available tax deductions, because the rentals paid are normally 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 acceptable reduction for the worth of land as well as buildings over a period which may be much shorter than the life of the residential or commercial property and in particular cases, a reduction of a normal loss on the sale of the residential or commercial property.

What is a tax-deferred exchange?

A tax-deferred exchange allows an Investor to sell his existing residential or commercial property (relinquished residential or commercial property) and buy more successful and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and for the most part state, capital gain and devaluation recapture earnings tax liabilities. This transaction is most commonly described as a 1031 exchange however 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 delay all of their Federal, and in many cases state, capital gain and depreciation recapture income tax liability on the sale of investment residential or commercial property so long as certain requirements are satisfied. Typically, the Investor must (1) establish a contractual arrangement with an entity described as a "Qualified Intermediary" to assist in the exchange and appoint into the sale and purchase contracts for the residential or commercial properties consisted of in the exchange; (2) get like-kind replacement residential or commercial property that amounts to or greater in worth than the given up residential or commercial property (based upon net list prices, not equity); (3) reinvest all of the net proceeds (gross proceeds minus specific appropriate closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) need to replace the quantity of secured financial obligation that was settled at the closing of the given up residential or commercial property with brand-new secured financial obligation on the replacement residential or commercial property of an equal or greater amount.

These requirements generally cause Investor's to see the tax-deferred exchange process as more constrictive than it actually is: while it is not acceptable to either take cash and/or settle financial obligation in the tax deferred exchange procedure without incurring tax liabilities on those funds, Investors might always put extra money into the transaction. Also, where reinvesting all the net sales profits is just not possible, or offering outdoors money does not result in the very best company choice, the Investor might choose to make use of a partial tax-deferred exchange. The partial exchange structure will enable the Investor to trade down in value or pull squander of the deal, and pay the tax liabilities exclusively related to the quantity not exchanged for certified like-kind replacement residential or commercial property or "money boot" and/or "mortgage boot", while postponing their capital gain and devaluation recapture liabilities on whatever portion of the profits remain in reality included in the exchange.

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

On its face, the issue with integrating a sale-leaseback transaction 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 recognized on the sale will be treated as a regular loss, so that the loss deduction might be used to offset present tax liability and/or a possible refund of taxes paid. The combined deal would permit a taxpayer to use the sale-leaseback structure to offer his relinquished residential or commercial property while retaining beneficial usage of the residential or commercial property, produce profits 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 the use of Section 1031 without recognizing any of his capital gain and/or devaluation regain tax liabilities.

The first complication can emerge when the Investor has no intent to participate in a tax-deferred exchange, however has participated in a sale-leaseback deal where the worked out lease is for a regard to thirty years or more and the seller has losses meant to balance out any recognizable 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 genuine estate exchanges city property for a cattle ranch or farm, or exchanges a leasehold of a cost with 30 years or more to run for genuine estate, or exchanges improved realty for unimproved realty.

While this arrangement, which essentially allows the development 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 deemed beneficial in that it develops a number of planning alternatives in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the result of avoiding the Investor from acknowledging any relevant loss on the sale of the residential or commercial property.

One of the controlling cases in this location is Crowley, Milner & Co. v. Commissioner of Internal Revenue. In Crowley, the IRS disallowed the $300,000 taxable loss reduction made by Crowley on their income tax return on the premises that the sale-leaseback deal they engaged in constituted a like-kind exchange within the meaning of Section 1031. The IRS argued that application of area 1031 indicated Crowley had in truth exchanged their cost interest in their realty for replacement residential or commercial property including a leasehold interest in the same residential or commercial property for a term of 30 years or more, and appropriately 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 took place and whether or not the taxpayer was qualified for the instant loss deduction. The Tax Court, enabling the loss deduction, said that the transaction did not constitute a sale or exchange considering that the lease had no capital worth, and promulgated the circumstances under which the IRS may take the position that such a lease did in fact have capital value:

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

2. A lease might 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, considering that the offer was negotiated at arm's length in between independent parties. Further, the Court held that the sale was an independent deal for tax purposes, which implied that the loss was correctly recognized by Crowley.

The IRS had other grounds on which to challenge the Crowley deal; the filing showing the immediate loss deduction which the IRS argued was in reality a premium paid by Crowley for the negotiated sale-leaseback deal, and so accordingly must be amortized over the 30-year lease term instead of fully deductible in the current tax year. The Tax Court declined this argument too, and held that the excess cost was consideration for the lease, but properly reflected the costs connected with completion of the structure as required by the sales contract.

The lesson for taxpayers to take from the holding in Crowley is basically that sale-leaseback transactions may have unexpected tax effects, and the regards to the deal must be prepared with those repercussions in mind. When taxpayers are contemplating this kind of transaction, they would be well served to think about carefully whether or not it is prudent to offer the seller-tenant an option to redeem the residential or commercial property at the end of the lease, particularly where the option price will be listed below the reasonable market value at the end of the lease term. If their transaction does include this repurchase option, not just does the IRS have the ability to potentially characterize the transaction as a tax-deferred exchange, however they likewise have the ability to argue that the deal is in fact a mortgage, rather than a sale (in which the impact is the same as if a tax-free exchange takes place in that the seller is not qualified for the instant loss reduction).

The issue is even more complicated by the uncertain treatment of lease extensions developed into a sale-leaseback deal under common 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 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 even though the seller had no intent to complete a tax-deferred exchange and though the outcome is contrary to the seller's finest interests. Often the net result in these scenarios is the seller's recognition of any gain over the basis in the genuine residential or commercial property possession, offset only by the permissible long-term amortization.

Given the major tax effects of having a sale-leaseback transaction re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well recommended to try to prevent the inclusion of the lease worth as part of the seller's gain on sale. The most effective manner in which taxpayers can avoid this addition has been to carve out the lease prior to the sale of the residential or commercial property but drafting it between the seller and a regulated entity, and then participating in a sale made subject to the pre-existing lease. What this method allows 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 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 necessary for taxpayers to note that this strategy is not bulletproof: the IRS has a variety of possible reactions where this method has actually been used. The IRS might accept the seller's argument that the lease was not gotten as part of the sales deal, however then deny the portion of the basis designated 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 transaction to its elemental parts, in which both money 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 appropriately, if the taxpayer gets cash in excess of their basis in the residential or commercial property, would acknowledge their full tax liability on the gain.