The term "sale and lease back" explains a situation in which a person, normally a corporation, owning business residential or commercial property, either genuine or personal, sells their residential or commercial property with the understanding that the buyer of the residential or commercial property will instantly reverse and lease the residential or commercial property back to the seller. The objective of this type of deal is to make it possible for the seller to rid himself of a big non-liquid investment without denying himself of the use (throughout the regard to the lease) of needed or desirable buildings or equipment, while making the net money profits readily available for other financial investments without turning to increased debt. A sale-leaseback transaction has the fringe benefit of increasing the taxpayers readily available tax reductions, because the rentals paid are typically set at 100 percent of the value of the residential or commercial property plus interest over the term of the payments, which results in a permissible deduction for the value of land in addition to structures over a duration which may be 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 sell his existing residential or commercial property (relinquished residential or commercial property) and acquire more successful and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and in many cases state, capital gain and devaluation recapture income tax liabilities. This deal is most frequently 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 may postpone all of their Federal, and in many cases state, capital gain and depreciation recapture earnings tax liability on the sale of investment residential or commercial property so long as certain requirements are met. Typically, the Investor needs to (1) establish 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) obtain like-kind replacement residential or commercial property that amounts to or higher in value than the relinquished residential or commercial property (based upon net sales cost, not equity); (3) reinvest all of the net profits (gross profits minus particular appropriate closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) need to replace the amount of protected debt that was paid off at the closing of the relinquished residential or commercial property with brand-new protected financial obligation on the replacement residential or commercial property of an equivalent or greater amount.

These requirements generally cause Investor's to view the tax-deferred exchange procedure as more constrictive than it really is: while it is not allowable to either take money and/or pay off financial obligation in the tax deferred exchange procedure without incurring tax liabilities on those funds, Investors may always put extra cash into the deal. Also, where reinvesting all the net sales earnings is merely not practical, or offering outside money does not lead to the finest organization decision, 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 money out of the deal, and pay the tax liabilities solely associated with the amount not exchanged for certified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while delaying their capital gain and devaluation regain liabilities on whatever portion of the proceeds remain in reality included in the exchange.

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

On its face, the issue with integrating 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 treated as gain from the sale of a capital possession taxable at long-lasting capital gains rates, and/or any loss recognized on the sale will be dealt with as a common loss, so that the loss reduction might be utilized to balance out existing tax liability and/or a possible refund of taxes paid. The combined transaction would allow a taxpayer to utilize the sale-leaseback structure to offer his relinquished residential or commercial property while maintaining beneficial usage of the residential or commercial property, generate profits from the sale, and then reinvest those proceeds 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 depreciation regain tax liabilities.

The very first complication can emerge when the Investor has no intent to participate in a tax-deferred exchange, but has actually entered into a sale-leaseback deal where the negotiated lease is for a regard to thirty years or more and the seller has actually losses meant 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 acknowledged if ... (2) a taxpayer who is not a dealer 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 realty, or exchanges improved property for unaltered genuine estate.

While this provision, which essentially enables the production of two unique residential or commercial property interests from one discrete piece of residential or commercial property, the fee interest and a leasehold interest, normally is seen as useful because it develops a variety of preparing alternatives in the context of a 1031 exchange, application of this arrangement on a sale-leaseback deal has the result of preventing the Investor from acknowledging any applicable 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 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 suggested Crowley had in truth exchanged their charge interest in their genuine estate for replacement residential or commercial property including a leasehold interest in the exact same residential or commercial property for a term of thirty years or more, and accordingly the existing tax basis had actually brought over into the leasehold interest.

There were numerous issues in the Crowley case: whether a tax-deferred exchange had in truth happened and whether the taxpayer was qualified for the instant loss deduction. The Tax Court, enabling the loss deduction, stated that the deal did not constitute a sale or exchange because the lease had no capital value, and promoted the circumstances under which the IRS might take the position that such a lease carried out in truth have capital worth:

1. A lease may be deemed to have capital worth where there has been a "bargain sale" or essentially, the sales cost 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 lease 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 list price or rental was less than reasonable market, given that the deal was worked out at arm's length in between independent celebrations. Further, the Court held that the sale was an independent deal for tax functions, which indicated that the loss was correctly recognized by Crowley.

The IRS had other premises on which to challenge the Crowley deal; the filing showing the immediate loss deduction which the IRS argued remained in reality a premium paid by Crowley for the negotiated sale-leaseback deal, therefore appropriately ought to be amortized over the 30-year lease term instead of fully deductible in the present tax year. The Tax Court declined this argument as well, and held that the excess cost was factor to consider for the lease, however appropriately reflected the costs associated with conclusion of the building as needed by the sales agreement.

The lesson for taxpayers to take from the holding in Crowley is basically that sale-leaseback deals might have unanticipated tax consequences, and the terms of the deal need to be drafted with those repercussions in mind. When taxpayers are pondering this kind of deal, they would be well served to consider carefully whether it is prudent to give the seller-tenant a choice to redeem the residential or commercial property at the end of the lease, especially 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 capability to potentially characterize the transaction as a tax-deferred exchange, however they likewise have the capability to argue that the transaction is actually a mortgage, rather than a sale (in which the effect is the same as if a tax-free exchange takes place in that the seller is not qualified for the instant loss deduction).

The concern is even more made complex by the unclear treatment of lease extensions built into a sale-leaseback deal under common law. When the leasehold is either prepared to be for thirty years or more or amounts to thirty years or more with included extensions, Treasury Regulations Section 1.1031(b)-1 categorizes the Investor's gain as the money got, so that the sale-leaseback is treated as an exchange of like-kind residential or commercial property and the cash is treated as boot. This characterization holds although the seller had no intent to finish a tax-deferred exchange and though the result contrasts the seller's finest interests. 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 possession, balanced out only by the acceptable long-term amortization.

Given the major tax consequences of having a sale-leaseback deal re-characterized as an involuntary tax-deferred exchange, taxpayers are well advised to attempt 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 avoid this inclusion has been to sculpt out the lease prior to the sale of the residential or commercial property however preparing it in between the seller and a controlled entity, and then participating in a sale made based on the pre-existing lease. What this technique allows the seller is a capability to argue that the seller is not the lessee under the pre-existing contract, and hence never received a lease as a portion of the sale, so that any worth attributable to the lease for that reason can not be taken into consideration in calculating his gain.

It is necessary for taxpayers to keep in mind that this strategy is not bulletproof: the IRS has a number of possible actions where this method has been employed. 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 assigned to the lease residential or commercial property and corresponding increase the capital gain tax liability. The IRS might also choose to use its time honored standby of "type over function", and break the transaction down to its essential components, in which 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 full tax liability on the gain.