1031 Exchange Services

The term "sale and lease back" describes a situation in which an individual, generally a corporation, owning service 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 rent the residential or commercial property back to the seller. The goal of this kind of deal is to make it possible for the seller to rid himself of a big non-liquid investment without depriving himself of the usage (throughout the term of the lease) of necessary or preferable structures or devices, while making the net money profits available for other investments without resorting to increased debt. A sale-leaseback transaction has the additional benefit of increasing the taxpayers offered tax deductions, because the leasings paid are typically set at 100 percent of the worth of the residential or commercial property plus interest over the regard to the payments, which leads to a permissible deduction for the worth of land in addition to structures over a period which may be much shorter than the life of the residential or commercial property and in particular cases, a deduction of a normal 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 purchase more profitable and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while postponing Federal, and for the most part state, capital gain and depreciation recapture income tax liabilities. This deal is most frequently described as a 1031 exchange but is likewise called 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 postpone all of their Federal, and in many cases state, capital gain and depreciation regain earnings tax liability on the sale of financial investment residential or commercial property so long as specific requirements are fulfilled. Typically, the Investor needs to (1) establish a legal arrangement with an entity referred to as a "Qualified Intermediary" to help with the exchange and designate into the sale and purchase agreements for the residential or commercial properties consisted of in the exchange; (2) obtain like-kind replacement residential or commercial property that is equal to or higher in value than the given up residential or commercial property (based upon net prices, not equity); (3) reinvest all of the net profits (gross earnings minus certain expenses) or money from the sale of the given up residential or commercial property; and, (4) must change the quantity of secured debt that was paid off at the closing of the relinquished residential or commercial property with new secured financial obligation on the replacement residential or commercial property of an equal or higher 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 money and/or pay off financial obligation in the tax deferred exchange process without sustaining tax liabilities on those funds, Investors might always put additional money into the transaction. Also, where reinvesting all the net sales profits is merely not possible, or providing outside cash does not lead to the very best organization decision, the Investor might elect to utilize a partial tax-deferred exchange. The partial exchange structure will enable the Investor to trade down in worth or pull cash out of the deal, and pay the tax liabilities exclusively associated with the quantity not exchanged for certified like-kind replacement residential or commercial property or "money boot" and/or "mortgage boot", while deferring their capital gain and devaluation recapture liabilities on whatever portion of the earnings remain in fact included in the exchange.

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

On its face, the worry about integrating a sale-leaseback transaction 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 possession taxable at long-term capital gains rates, and/or any loss acknowledged on the sale will be dealt with as a regular loss, so that the loss reduction might be utilized to balance out present tax liability and/or a prospective refund of taxes paid. The combined deal would allow a taxpayer to utilize the sale-leaseback structure to sell his relinquished residential or commercial property while retaining advantageous usage of the residential or commercial property, produce proceeds from the sale, and then reinvest those earnings in a tax-deferred manner in a subsequent like-kind replacement residential or commercial property through making use of Section 1031 without recognizing any of his capital gain and/or devaluation recapture tax liabilities.

The first issue can occur when the Investor has no intent to participate in a tax-deferred exchange, but has participated in a sale-leaseback deal where the negotiated 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 recognized if ... (2) a taxpayer who is not a dealership in realty exchanges city realty for a ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for property, or exchanges enhanced property for unaltered real estate.

While this arrangement, which essentially permits the production of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the charge interest and a leasehold interest, typically is considered as advantageous because it creates 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 recognizing any relevant loss on the sale of the residential or commercial property.

One of the managing 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 premises that the sale-leaseback deal they took part in constituted a like-kind exchange within the significance of Section 1031. The IRS argued that application of section 1031 implied Crowley had in fact exchanged their fee interest in their property for replacement residential or commercial property consisting of a leasehold interest in the exact same residential or commercial property for a term of 30 years or more, and accordingly the existing tax basis had actually carried over into the leasehold interest.

There were a number of concerns in the Crowley case: whether a tax-deferred exchange had in truth occurred and whether the taxpayer was eligible for the instant loss deduction. The Tax Court, allowing the loss reduction, said that the deal did not constitute a sale or exchange since the lease had no capital worth, and promoted the scenarios under which the IRS may take the position that such a lease did in truth have capital value:

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

2. A lease might be deemed to have capital value where the rent to be paid is less than the fair rental rate.
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In the Crowley deal, the Court held that there was no evidence whatsoever that the sale cost or leasing was less than fair market, given that the offer was worked out at arm's length between independent parties. Further, the Court held that the sale was an independent deal for tax functions, which suggested that the loss was appropriately acknowledged by Crowley.

The IRS had other premises on which to challenge the Crowley transaction; the filing showing the instant loss deduction which the IRS argued was in fact a premium paid by Crowley for the negotiated sale-leaseback deal, therefore appropriately must be amortized over the 30-year lease term instead of completely deductible in the current tax year. The Tax Court declined this argument also, and held that the excess expense was factor to consider for the lease, but appropriately reflected the expenses associated 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 may have unexpected tax effects, and the terms of the deal must be drafted with those consequences in mind. When taxpayers are considering this kind of transaction, they would be well served to consider carefully whether it is prudent to give the seller-tenant an alternative to redeem the residential or commercial property at the end of the lease, especially where the alternative rate will be listed below the reasonable market value at the end of the lease term. If their deal does include this repurchase alternative, not only does the IRS have the ability to potentially identify the transaction as a tax-deferred exchange, but they likewise have the ability to argue that the transaction is actually a mortgage, rather than a sale (where the effect is the same as if a tax-free exchange takes place because the seller is not eligible for the instant loss deduction).

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 30 years or more or totals thirty 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 residential or commercial property and the cash is dealt with as boot. This characterization holds even though the seller had no intent to finish a tax-deferred exchange and though the outcome contrasts the seller's finest interests. Often the net outcome in these circumstances is the seller's acknowledgment of any gain over the basis in the genuine residential or commercial property possession, balanced out just by the acceptable long-lasting amortization.

Given the severe 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 addition of the lease value as part of the seller's gain on sale. The most efficient way in which taxpayers can prevent this addition has actually been to take the lease prior to the sale of the residential or commercial property however drafting it between the seller and a controlled entity, and then getting in into a sale made subject to the pre-existing lease. What this strategy allows the seller is a capability to argue that the seller is not the lessee under the pre-existing agreement, 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 consideration in computing his gain.

It is necessary for taxpayers to note that this method is not bulletproof: the IRS has a variety of potential responses where this technique has been utilized. 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 allocated to the lease residential or commercial property and matching boost the capital gain tax liability. The IRS might also elect to utilize its time honored standby of "kind over function", and break the deal down to its essential parts, where both cash 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 appropriately, if the taxpayer gets money in excess of their basis in the residential or commercial property, would acknowledge their full tax liability on the gain.