Sales and Leasebacks in the context of the 1031 Exchange
What is a sale-leaseback transaction?
The term "sale and lease back" describes a situation in which a person, usually a corporation, owning business property, either real or personal, sells their property with the understanding that the buyer of the property will immediately turn around and lease the property back to the seller. The aim of this type of transaction is to enable the seller to rid himself of a large non-liquid investment without depriving himself of the use (during the term of the lease) of necessary or desirable buildings or equipment, while making the net cash proceeds available for other investments without resorting to increased debt. A sale-leaseback transaction has the additional benefit of increasing the taxpayers available tax deductions, because the rentals paid are usually set at 100 per cent of the value of the property plus interest over the term of the payments, which results in a permissible deduction for the value of land as well as buildings over a period which may be shorter than the life of the property and in certain cases, a deduction of an ordinary loss on the sale of the property.
What is a tax-deferred exchange?
A tax-deferred exchange allows an Investor to sell his existing property (relinquished property) and purchase more profitable and/or productive property (like-kind replacement property) while deferring Federal, and in most cases state, capital gain and depreciation recapture income tax liabilities. This transaction is most commonly referred to as a 1031 exchange but is also 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 tax-deferred exchange, Investors may defer all of their Federal, and in most cases state, capital gain and depreciation recapture income tax liability on the sale of investment property so long as certain requirements are met. Typically, the Investor must (1) establish a contractual arrangement with an entity referred to as a “Qualified Intermediary” to facilitate the exchange and assign into the sale and purchase contracts for the properties included in the exchange; (2) acquire like-kind replacement property that is equal to or greater in value than the relinquished property (based on net sales price, not equity); (3) reinvest all of the net proceeds (gross proceeds minus certain acceptable closing costs) or cash from the sale of the relinquished property; and, (4) must replace the amount of secured debt that was paid off at the closing of the relinquished property with new secured debt on the replacement property of an equal or greater amount.
These requirements typically cause Investor’s to view the tax-deferred exchange process as more constrictive than it actually is: while it is not permissible to either take cash and/or pay off debt in the tax deferred exchange process without incurring tax liabilities on those funds, Investors may always put additional cash into the transaction. Also, where reinvesting all the net sales proceeds is simply not feasible, or providing outside cash does not result in the best business decision, the Investor may elect to utilize a partial tax-deferred exchange. The partial exchange structure will allow the Investor to trade down in value or pull cash out of the transaction, and pay the tax liabilities solely associated with the amount not exchanged for qualified like-kind replacement property or “cash boot” and/or “mortgage boot”, while deferring their capital gain and depreciation recapture liabilities on whatever portion of the proceeds are in fact included in the exchange.
Problems involving 1031 exchanges created by the structure of the sale-leaseback.
On its face, the concern with combining a sale-leaseback transaction and a tax-deferred exchange is not necessarily clear. Typically the gain on the sale of 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-term capital gains rates, and/or any loss recognized on the sale will be treated as an ordinary loss, so that the loss deduction may be used to offset current tax liability and/or a potential refund of taxes paid. The combined transaction would allow a taxpayer to use the sale-leaseback structure to sell his relinquished property while retaining beneficial use of the property, generate proceeds from the sale, and then reinvest those proceeds in a tax-deferred manner in a subsequent like-kind replacement property through the use of Section 1031 without recognizing any of his capital gain and/or depreciation recapture tax liabilities.
The first complication can arise when the Investor has no intent to enter into a tax-deferred exchange, but has entered into a sale-leaseback transaction where the negotiated lease is for a term of thirty years or more and the seller has losses intended to offset any recognizable gain on the sale of the property. Treasury Regulations Section 1.1031(c) provides:
No gain or loss is recognized if ... (2) a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate.
While this provision, which essentially allows the creation of two distinct property interests from one discrete piece of property, the fee interest and a leasehold interest, typically is viewed as beneficial in that it creates a number of planning options in the context of a 1031 exchange, application of this provision on a sale-leaseback transaction has the effect of preventing the Investor from recognizing any applicable loss on the sale of the property.
One of the controlling cases in this area 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 tax return on the grounds that the sale-leaseback transaction they engaged in constituted a like-kind exchange within the meaning of Section 1031. The IRS argued that application of section 1031 meant Crowley had in fact exchanged their fee interest in their real estate for replacement property consisting of a leasehold interest in the same property for a term of 30 years or more, and accordingly the existing tax basis had carried over into the leasehold interest.
There were several issues in the Crowley case: whether a tax-deferred exchange had in fact occurred and whether or not the taxpayer was eligible for the immediate loss deduction. The Tax Court, allowing the loss deduction, said that the transaction did not constitute a sale or exchange since the lease had no capital value, 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 may be deemed to have capital value where there has been a "bargain sale" or essentially, the sales price is less than the property's fair market value; or
2. A lease may be deemed to have capital value where the rent to be paid is less than the fair rental rate.
In the Crowley transaction, the Court held that there was no evidence whatsoever that the sale price or rental was less than fair market, since the deal was negotiated at arm's length between independent parties. Further, the Court held that the sale was an independent transaction for tax purposes, which meant that the loss was properly recognized by Crowley.
The IRS had other grounds on which to challenge the Crowley transaction; the filing reflecting the immediate loss deduction which the IRS argued was in fact a premium paid by Crowley for the negotiated sale-leaseback transaction, and so accordingly should be amortized over the 30-year lease term rather than fully deductible in the current tax year. The Tax Court rejected this argument as well, and held that the excess cost was consideration for the lease, but appropriately reflected the costs associated with completion of the building as required by the sales agreement.
The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback transactions may have unanticipated tax consequences, and the terms of the transaction must be drafted with those consequences in mind. When taxpayers are contemplating this type of transaction, they would be well served to consider carefully whether or not it is prudent to give the seller-tenant an option to repurchase the property at the end of the lease, particularly where the option price will be below the fair market value at the end of the lease term. If their transaction does include this repurchase option, not only does the IRS have the ability to potentially characterize the transaction as a tax-deferred exchange, but they also have the ability to argue that the transaction is actually a mortgage, rather than a sale (wherein the effect is the same as if a tax-free exchange occurs in that the seller is not eligible for the immediate loss deduction).
The issue is further complicated by the unclear treatment of lease extensions built into a sale-leaseback transaction under common law. When the leasehold is either drafted to be for 30 years or more or totals 30 years or more with included extensions, Treasury Regulations Section 1.1031(b)-1 classifies the Investor’s gain as the cash received, so that the sale-leaseback is treated as an exchange of like-kind property and the cash is treated as boot. This characterization holds even though the seller had no intent to complete a tax-deferred exchange and though the result is contrary to the seller’s best interests. Often the net result in these situations is the seller’s recognition of any gain over the basis in the real property asset, offset only by the permissible long-term amortization.
Given the serious tax consequences of having a sale-leaseback transaction re-characterized as an involuntary tax-deferred exchange, taxpayers are well advised to try to avoid the inclusion of the lease value as part of the seller's gain on sale. The most effective manner in which taxpayers can avoid this inclusion has been to carve out the lease prior to the sale of the property but drafting it between the seller and a controlled entity, and then entering into a sale made subject to the pre-existing lease. What this strategy allows the seller is an ability to argue that the seller is not the lessee under the pre-existing agreement, and hence never received a lease as a portion of the sale, so that any value attributable to the lease therefore cannot be taken into account in computing his gain.
It is important for taxpayers to note that this strategy is not bulletproof: the IRS has a number of potential responses 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, but then deny the portion of the basis allocated to the lease property and corresponding increase the capital gain tax liability. The IRS may also elect to use its time honored standby of “form over function”, and break the transaction down to its elemental components, wherein both cash and a leasehold were received upon the sale of the property; such a characterization would result in the application of Section 1031 and accordingly, if the taxpayer receives cash in excess of their basis in the property, would recognize their full tax liability on the gain.
Given the complications inherent in sale-leaseback transactions, taxpayers would be well advised to consult their legal, tax and real estate professionals well in advance of drafting these transactions to get a sense for what the potential tax consequences may result from the terms of their particular proposed transaction.
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