The term "sale and lease back" explains a scenario in which a person, generally a corporation, owning organization residential or commercial property, either genuine or personal, sells their residential or commercial property with the understanding that the purchaser of the residential or commercial property will immediately reverse and lease the residential or commercial property back to the seller. The objective of this type of deal is to allow the seller to rid himself of a large non-liquid financial investment without depriving himself of the use (during the regard to the lease) of necessary or desirable buildings or equipment, while making the net cash profits available for other financial investments without turning to increased debt. A sale-leaseback transaction has the fringe benefit of increasing the taxpayers offered tax reductions, since the leasings paid are typically set at 100 per cent of the worth of the residential or commercial property plus interest over the regard to the payments, which results in a permissible reduction for the value of land as well as buildings over a period which might 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 permits an Investor to sell his existing residential or commercial property (given up residential or commercial property) and purchase more lucrative and/or productive residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and in most cases state, capital gain and devaluation regain earnings tax liabilities. This transaction is most typically described as a 1031 exchange however is likewise referred to 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 might defer all of their Federal, and in many cases state, capital gain and devaluation regain income tax liability on the sale of financial investment residential or commercial property so long as certain requirements are fulfilled. Typically, the Investor needs to (1) develop a legal plan with an entity referred to as a "Qualified Intermediary" to assist in the exchange and appoint 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 amounts to or higher in worth than the given up residential or commercial property (based upon net prices, not equity); (3) reinvest all of the net earnings (gross earnings minus certain appropriate closing expenses) or money 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 equal or higher quantity.

These requirements typically trigger Investor's to view the tax-deferred exchange procedure as more constrictive than it in fact is: while it is not permissible to either take money and/or settle debt in the tax deferred exchange process without sustaining tax liabilities on those funds, Investors may always put additional money into the deal. Also, where reinvesting all the net sales proceeds is simply not possible, or supplying outside cash does not lead to the best business choice, the Investor may elect to utilize a partial tax-deferred exchange. The partial exchange structure will allow the Investor to trade down in worth or pull squander of the deal, and pay the tax liabilities entirely associated with the amount not exchanged for qualified like-kind replacement residential or commercial property or "money boot" and/or "mortgage boot", while postponing their capital gain and depreciation regain liabilities on whatever part of the proceeds remain in truth consisted of in the exchange.

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

On its face, the concern 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 dealt with as gain from the sale of a capital property taxable at long-lasting capital gains rates, and/or any loss acknowledged on the sale will be dealt with as an ordinary loss, so that the loss deduction may be used to offset existing tax liability and/or a potential refund of taxes paid. The combined deal would permit a taxpayer to use the sale-leaseback structure to sell his given up residential or commercial property while maintaining beneficial use of the residential or commercial property, produce profits from the sale, and then reinvest those profits in a tax-deferred manner in a subsequent like-kind replacement residential or commercial property through using Section 1031 without recognizing any of his capital gain and/or devaluation recapture tax liabilities.

The very first issue can emerge when the Investor has no intent to participate in a tax-deferred exchange, but has actually participated in a sale-leaseback transaction where the worked out lease is for a regard to thirty years or more and the seller has actually losses meant to balance out any identifiable 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 ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for real estate, or exchanges enhanced realty for unaltered realty.

While this arrangement, which essentially allows the creation of 2 distinct residential or commercial property interests from one discrete piece of residential or commercial property, the fee interest and a leasehold interest, generally is deemed advantageous because it develops a number of planning alternatives in the context of a 1031 exchange, application of this arrangement on a sale-leaseback deal has the impact of avoiding the Investor from recognizing any appropriate loss on the sale of the residential or commercial property.

One of 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 deduction made by Crowley on their income tax return on the grounds that the sale-leaseback transaction they participated in constituted a like-kind exchange within the meaning of Section 1031. The IRS argued that application of area 1031 meant 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 thirty years or more, and accordingly the existing tax basis had rollovered into the leasehold interest.

There were a number of issues in the Crowley case: whether a tax-deferred exchange had in reality happened and whether the taxpayer was qualified for the instant loss deduction. The Tax Court, allowing the loss deduction, said that the deal did not make up a sale or exchange because the lease had no capital value, and promulgated the situations under which the IRS may take the position that such a lease performed in fact have capital value:

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

2. A lease may be considered 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 proof whatsoever that the list price or rental was less than fair market, considering that the deal was worked out at arm's length between independent celebrations. Further, the Court held that the sale was an independent transaction for tax functions, which suggested that the loss was correctly acknowledged by Crowley.

The IRS had other grounds on which to challenge the Crowley deal; the filing showing the instant loss reduction which the IRS argued remained in truth a premium paid by Crowley for the negotiated sale-leaseback transaction, and so appropriately should be amortized over the 30-year lease term rather than completely deductible in the present tax year. The Tax Court declined this argument also, and held that the excess expense was factor to consider for the lease, however appropriately reflected the expenses connected with completion of the structure as needed by the sales contract.

The lesson for taxpayers to draw from the holding in Crowley is essentially that sale-leaseback transactions might have unanticipated tax consequences, and the terms of the transaction need to be drafted with those effects in mind. When taxpayers are pondering this type of deal, they would be well served to think about thoroughly whether it is sensible to give the seller-tenant a choice to buy the residential or commercial property at the end of the lease, especially where the option rate will be below the fair market value at the end of the lease term. If their deal does include this repurchase option, not only does the IRS have the capability to potentially define the deal as a tax-deferred exchange, however they also have the capability to argue that the transaction is actually a mortgage, instead of a sale (in which the result is the very same as if a tax-free exchange occurs in that the seller is not eligible for the immediate loss reduction).

The concern is further made complex by the unclear treatment of lease extensions built into a sale-leaseback deal under typical law. When the leasehold is either prepared to be for thirty years or more or amounts to 30 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 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 best interests. Often the net outcome in these circumstances is the seller's recognition of any gain over the basis in the real residential or commercial property possession, balanced out only by the permissible long-lasting amortization.

Given the major tax consequences of having a sale-leaseback deal re-characterized as an involuntary tax-deferred exchange, taxpayers are well recommended to attempt to avoid the addition of the lease value as part of the seller's gain on sale. The most reliable way in which taxpayers can avoid this addition has been to take the lease prior to the sale of the residential or commercial property but drafting it in between the seller and a controlled entity, and after that participating in a sale made subject to 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 got a lease as a portion of the sale, so that any value attributable to the lease for that reason can not be taken into account in computing his gain.

It is necessary for taxpayers to note that this technique is not bulletproof: the IRS has a variety of prospective actions where this technique has been employed. The IRS may accept the seller's argument that the lease was not gotten as part of the sales deal, however then reject the portion of the basis assigned to the lease residential or commercial property and matching increase the capital gain tax liability. The IRS may likewise choose to utilize its time honored standby of "form over function", and break the transaction to its essential elements, 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 gets money in excess of their basis in the residential or commercial property, would acknowledge their complete tax liability on the gain.