1031 Exchange Services

The term "sale and lease back" explains a circumstance in which a person, normally a corporation, owning organization residential or commercial property, either real or personal, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will right away turn around and rent 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 big non-liquid financial investment without depriving himself of the use (throughout the term of the lease) of necessary or desirable buildings or equipment, while making the net money earnings available for other investments without turning to increased debt. A sale-leaseback deal has the fringe benefit of increasing the taxpayers offered tax reductions, due to the fact that the leasings paid are usually set at 100 percent of the value 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 buildings over a duration which may be shorter than the life of the residential or commercial property and in certain cases, a reduction of a regular loss on the sale of the residential or commercial property.

What is a tax-deferred exchange?

A tax-deferred exchange allows an Investor to offer his existing residential or commercial property (given up residential or commercial property) and buy more rewarding and/or productive residential or commercial property (like-kind replacement residential or commercial property) while postponing Federal, and most of the times state, capital gain and devaluation regain earnings tax liabilities. This transaction is most typically described as a 1031 exchange however is likewise understood 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 for the most part state, capital gain and depreciation recapture earnings tax liability on the sale of financial investment residential or commercial property so long as specific requirements are fulfilled. Typically, the Investor must (1) develop a contractual plan with an entity described as a "Qualified Intermediary" to assist in 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 amounts to or higher in value than the given up residential or commercial property (based on net prices, not equity); (3) reinvest all of the net earnings (gross earnings minus particular appropriate closing expenses) or cash from the sale of the given up residential or commercial property; and, (4) should change the quantity of protected financial obligation that was paid off at the closing of the given up residential or commercial property with new protected financial obligation on the replacement residential or commercial property of an equal or higher quantity.

These requirements normally cause Investor's to see the tax-deferred exchange procedure as more constrictive than it in fact is: while it is not permissible to either take cash and/or settle debt in the tax deferred exchange procedure without sustaining tax liabilities on those funds, Investors may constantly put additional cash into the transaction. Also, where reinvesting all the net sales proceeds is simply not feasible, or offering outdoors money does not lead to the finest business decision, the Investor may elect to use a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in value or pull money out of the transaction, and pay the tax liabilities exclusively connected 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 regain liabilities on whatever part of the proceeds remain in truth consisted of in the exchange.

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

On its face, the worry about 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 acknowledged on the sale will be treated as a common loss, so that the loss reduction might be used to balance out current tax liability and/or a prospective refund of taxes paid. The combined transaction would enable a taxpayer to use the sale-leaseback structure to sell his given up residential or commercial property while keeping helpful use of the residential or commercial property, produce earnings from the sale, and after that reinvest those proceeds 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 depreciation recapture tax liabilities.

The very first problem can arise when the Investor has no intent to participate in a tax-deferred exchange, but has actually gotten in into a sale-leaseback transaction where the negotiated lease is for a term of thirty years or more and the seller has actually losses planned to balance out any recognizable gain on the sale of the residential or commercial property. Treasury Regulations Section 1.1031(c) offers:

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

While this provision, which basically allows 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, generally is considered as beneficial because it produces a variety of planning choices in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the impact of preventing the Investor from recognizing any appropriate 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 reduction made by Crowley on their tax return on the premises that the sale-leaseback transaction they participated in made up a like-kind exchange within the significance of Section 1031. The IRS argued that application of section 1031 meant Crowley had in reality exchanged their cost interest in their property 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 concerns in the Crowley case: whether a tax-deferred exchange had in truth happened and whether the taxpayer was eligible for the immediate loss reduction. The Tax Court, enabling the loss reduction, stated that the deal did not make up a sale or exchange since the lease had no capital worth, and promulgated the situations under which the IRS may take the position that such a lease carried out in truth have capital worth:

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

2. A lease might be deemed to have capital value where the rent to be paid is less than the reasonable rental rate.

In the Crowley deal, the Court held that there was no evidence whatsoever that the list price or leasing was less than fair market, considering that the offer was worked out at arm's length in between independent parties. Further, the Court held that the sale was an independent transaction for tax functions, which indicated that the loss was effectively acknowledged by Crowley.

The IRS had other premises on which to challenge the Crowley deal; the filing reflecting the instant loss deduction which the IRS argued remained in reality a premium paid by Crowley for the transaction, and so accordingly ought to be amortized over the 30-year lease term instead of totally deductible in the present tax year. The Tax Court rejected this argument too, and held that the excess cost was consideration for the lease, but appropriately showed the costs connected with conclusion of the building as required by the sales arrangement.

The lesson for taxpayers to take from the holding in Crowley is essentially that sale-leaseback transactions might have unexpected tax consequences, and the regards to the transaction should be prepared with those repercussions in mind. When taxpayers are considering this type of deal, they would be well served to consider thoroughly whether or not it is sensible to provide the seller-tenant an alternative to redeem the residential or commercial property at the end of the lease, particularly where the choice price will be listed below the fair market price at the end of the lease term. If their transaction does include this repurchase alternative, not only 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 really a mortgage, instead of a sale (in which the effect is the same as if a tax-free exchange happens because the seller is not qualified for the immediate loss reduction).

The problem is further complicated by the uncertain treatment of lease extensions constructed into a sale-leaseback deal under typical law. When the leasehold is either drafted to be for thirty years or more or amounts to 30 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 although the seller had no intent to complete 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 asset, balanced out just by the allowable long-lasting amortization.

Given the severe tax effects of having a sale-leaseback deal re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well encouraged to attempt to avoid the inclusion of the lease value as part of the seller's gain on sale. The most reliable way in which taxpayers can prevent this inclusion has 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 after that getting in into a sale made subject to the pre-existing lease. What this method allows the seller is an ability to argue that the seller is not the lessee under the pre-existing contract, and thus never ever received a lease as a part of the sale, so that any worth attributable to the lease therefore can not be considered in computing his gain.

It is crucial for taxpayers to keep in mind that this method is not bulletproof: the IRS has a number of prospective reactions 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 transaction, but then deny the part of the basis designated to the lease residential or commercial property and matching increase the capital gain tax liability. The IRS might also elect to utilize its time honored standby of "form over function", and break the deal 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 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 complete tax liability on the gain.