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The term "sale and lease back" explains a situation in which an individual, usually a corporation, owning business residential or commercial property, either real or individual, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will instantly turn around and lease the residential or commercial property back to the seller. The aim of this kind of deal is to enable the seller to rid himself of a big non-liquid investment without depriving himself of the usage (throughout the term of the lease) of essential or desirable structures or devices, while making the net money earnings readily available for other financial investments without turning to increased financial obligation. A sale-leaseback deal has the additional advantage of increasing the taxpayers available tax reductions, due to the fact that the leasings paid are typically set at 100 percent 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 value of land as well as structures over a period 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.
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What is a tax-deferred exchange?
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A tax-deferred exchange permits a Financier to offer his existing residential or commercial property (given up residential or commercial property) and purchase more successful and/or productive residential or commercial property (like-kind replacement residential or commercial property) while delaying Federal, and most of the times state, capital gain and devaluation regain income tax liabilities. This transaction is most typically referred to as a 1031 exchange but is also 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 most of the times state, capital gain and devaluation regain income tax liability on the sale of financial investment residential or commercial property so long as particular requirements are fulfilled. Typically, the Investor needs to (1) establish a legal plan with an entity described as a "Qualified Intermediary" to help with the exchange and designate into the sale and purchase contracts for the residential or commercial properties included in the exchange; (2) acquire like-kind replacement residential or commercial property that is equal to or greater in value than the relinquished residential or commercial property (based on net list prices, not equity); (3) reinvest all of the net profits (gross profits minus specific acceptable closing expenses) or money from the sale of the given up residential or commercial property; and, (4) must replace the quantity of protected financial obligation that was settled at the closing of the given up residential or commercial property with brand-new protected debt on the replacement residential or commercial property of an equal or greater amount.

These requirements usually trigger Investor's to see the tax-deferred exchange process as more constrictive than it in fact is: while it is not permissible to either take money and/or settle financial obligation in the tax deferred exchange procedure without sustaining tax liabilities on those funds, Investors might always put extra cash into the deal. Also, where reinvesting all the net sales proceeds is merely not possible, or offering outside cash does not lead to the finest organization choice, the Investor may choose to use a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in value or pull squander of the deal, and pay the tax liabilities entirely associated with the quantity not exchanged for qualified like-kind replacement residential or commercial property or "cash boot" and/or "mortgage boot", while deferring their capital gain and devaluation recapture liabilities on whatever part 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 interest in combining a sale-leaseback deal 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 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 reduction might be utilized to offset present tax liability and/or a potential refund of taxes paid. The combined deal would enable a taxpayer to utilize the sale-leaseback structure to sell his given up residential or commercial property while maintaining useful use of the residential or commercial property, create proceeds from the sale, and then reinvest those proceeds in a tax-deferred way in a subsequent like-kind replacement residential or commercial property through the use of Section 1031 without acknowledging any of his capital gain and/or devaluation regain tax liabilities.

The first complication can develop when the Investor has no intent to enter into a tax-deferred exchange, but has actually gotten in into a sale-leaseback deal where the worked out lease is for a term of 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) supplies:

No gain or loss is acknowledged if ... (2) a taxpayer who is not a dealership in real estate exchanges city real estate for a cattle ranch or farm, or exchanges a leasehold of a charge with 30 years or more to run for genuine estate, or exchanges improved property for unaltered genuine estate.

While this provision, which essentially permits the creation of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the charge interest and a leasehold interest, usually is considered as advantageous in that it creates a number of planning choices in the context of a 1031 exchange, application of this provision on a sale-leaseback transaction has the impact of preventing the Investor from acknowledging any appropriate 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 tax return on the grounds that the sale-leaseback deal they participated in made up a like-kind exchange within the significance of Section 1031. The IRS argued that application of area 1031 indicated Crowley had in reality exchanged their cost interest in their genuine estate for replacement residential or commercial property consisting of a leasehold interest in the very same residential or commercial property for a regard to thirty years or more, and appropriately the existing tax basis had rollovered into the leasehold interest.

There were a number of problems in the Crowley case: whether a tax-deferred exchange had in truth took place and whether or not the taxpayer was qualified for the instant loss deduction. The Tax Court, enabling the loss reduction, stated that the transaction did not constitute a sale or exchange considering that the lease had no capital worth, and promoted the situations under which the IRS might take the position that such a lease did in reality have capital worth:

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

2. A lease may be deemed to have capital value where the lease to be paid is less than the fair rental rate.

In the Crowley deal, the Court held that there was no proof whatsoever that the price or leasing was less than reasonable market, because the offer was negotiated at arm's length in between independent parties. Further, the Court held that the sale was an independent transaction for tax purposes, which meant that the loss was correctly recognized by Crowley.

The IRS had other premises on which to challenge the Crowley transaction; the filing reflecting the immediate loss deduction which the IRS argued remained in truth a premium paid by Crowley for the worked out sale-leaseback deal, and so appropriately should be amortized over the 30-year lease term rather than fully deductible in the existing tax year. The Tax Court declined this argument as well, and held that the excess cost was consideration for the lease, but properly reflected the expenses connected with conclusion of the structure as required by the sales agreement.

The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback deals might have unexpected tax effects, and the regards to the deal should be prepared with those repercussions in mind. When taxpayers are pondering this kind of transaction, they would be well served to consider carefully whether it is prudent to provide the seller-tenant an option to repurchase the residential or commercial property at the end of the lease, especially where the alternative cost will be below the fair market price at the end of the lease term. If their deal does include this repurchase option, not just does the IRS have the ability to possibly identify the transaction as a tax-deferred exchange, however they likewise have the capability to argue that the transaction is really a mortgage, instead of a sale (in which 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 deduction).

The problem 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 30 years or more or amounts to thirty years or more with included 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 cash is dealt with as boot. This characterization holds despite the fact that the seller had no intent to complete a tax-deferred exchange and though the result contrasts the seller's benefits. Often the net lead to these situations is the seller's recognition of any gain over the basis in the genuine residential or commercial property possession, balanced out just by the allowable long-term amortization.

Given the major tax effects of having a sale-leaseback deal re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well encouraged to attempt to prevent the inclusion of the lease value as part of the seller's gain on sale. The most efficient manner in which taxpayers can avoid this inclusion has actually been to take the lease prior to the sale of the residential or commercial property however drafting it in between the seller and a regulated entity, and after that participating in a sale made based on the pre-existing lease. What this method enables the seller is a capability to argue that the seller is not the lessee under the pre-existing contract, and for this reason never ever received a lease as a part of the sale, so that any worth attributable to the lease therefore can not be taken into consideration in computing his gain.

It is important for taxpayers to keep in mind that this strategy is not bulletproof: the IRS has a variety of potential responses where this technique has actually been utilized. The IRS may accept the seller's argument that the lease was not gotten as part of the sales deal, however then deny 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 choose to utilize its time honored standby of "kind over function", and break the transaction down to its elemental parts, wherein both money and a leasehold were gotten 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 receives cash in excess of their basis in the residential or commercial property, would recognize their full on the gain.