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1031 Exchange Services

The term “sale and lease back” describes a scenario in which a person, usually a corporation, owning organization residential or commercial property, either genuine or individual, sells their residential or commercial property with the understanding that the purchaser of the residential or commercial property will right away turn around and lease 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 (during the regard to the lease) of needed or preferable structures or equipment, while making the net money proceeds readily available for other investments without resorting 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 generally set at 100 percent of the worth of the residential or commercial property plus interest over the regard to the payments, which results in an acceptable reduction for the worth of land along with buildings over a duration which might be shorter than the life of the residential or commercial property and in specific cases, a reduction of a normal loss on the sale of the residential or commercial property.

What is a tax-deferred exchange?

A tax-deferred exchange allows an Investor to sell his existing residential or commercial property (relinquished residential or commercial property) and buy more successful 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 recapture income tax liabilities. This deal is most commonly described as a 1031 exchange but is also 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 might defer all of their Federal, and most of the times state, capital gain and devaluation regain income tax liability on the sale of investment residential or commercial property so long as certain requirements are fulfilled. Typically, the Investor must (1) develop a legal plan with an entity described as a “Qualified Intermediary” to help with the exchange and assign into the sale and purchase contracts for the residential or commercial properties consisted of in the exchange; (2) obtain like-kind replacement residential or commercial property that amounts to or greater in worth than the relinquished residential or commercial property (based upon net prices, not equity); (3) reinvest all of the net proceeds (gross profits minus certain acceptable closing expenses) or money from the sale of the relinquished residential or commercial property; and, (4) should replace the amount of secured debt that was paid off at the closing of the given up residential or commercial property with brand-new secured debt on the replacement residential or commercial property of an equal or higher amount.

These requirements typically trigger Investor’s to view the tax-deferred exchange process as more constrictive than it really is: while it is not acceptable to either take money 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 just not possible, or providing outside money does not lead to the finest service choice, the Investor may elect to make use of a partial tax-deferred exchange. The partial exchange structure will permit the Investor to trade down in worth or pull money out of the transaction, and pay the tax liabilities solely associated with the quantity not exchanged for certified like-kind replacement residential or commercial 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 including 1031 exchanges produced 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 dealt with as gain from the sale of a capital asset taxable at long-lasting capital gains rates, and/or any loss recognized on the sale will be treated as a common loss, so that the loss deduction might be used to balance out present tax liability and/or a prospective refund of taxes paid. The combined deal would permit a taxpayer to utilize the sale-leaseback structure to sell his given up residential or commercial property while maintaining helpful use of the residential or commercial property, generate proceeds from the sale, and after that reinvest those earnings 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 problem can arise when the Investor has no intent to participate in a tax-deferred exchange, but has participated in a sale-leaseback transaction where the negotiated lease is for a term of thirty years or more and the seller has 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 dealer in real estate exchanges city real estate for a cattle ranch or farm, or exchanges a leasehold of a charge with thirty years or more to run for property, or exchanges improved real estate for unaltered real estate.

While this provision, which essentially enables the creation of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the cost interest and a leasehold interest, typically is deemed advantageous in that it creates a variety of planning choices in the context of a 1031 exchange, application of this arrangement on a sale-leaseback transaction has the effect of preventing the Investor from acknowledging any appropriate loss on the sale of the residential or commercial property.

Among 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 deduction made by Crowley on their income tax return on the grounds that the sale-leaseback transaction they took part in made up a like-kind exchange within the meaning 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 consisting of a leasehold interest in the exact same residential or commercial property for a regard to 30 years or more, and appropriately the existing tax basis had brought over into the leasehold interest.

There were several problems in the Crowley case: whether a tax-deferred exchange had in reality happened and whether the taxpayer was eligible for the instant loss deduction. The Tax Court, allowing the loss deduction, stated that the deal did not constitute a sale or exchange since the lease had no capital worth, and promoted the situations under which the IRS might take the position that such a lease performed in truth have capital worth:

1. A lease may 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 price; or

2. A lease may be considered to have capital worth 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 sale cost or leasing was less than fair market, since the deal 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 appropriately recognized by Crowley.

The IRS had other grounds on which to challenge the Crowley transaction; the filing showing the immediate loss deduction which the IRS argued was in fact a premium paid by Crowley for the negotiated sale-leaseback transaction, therefore accordingly should be amortized over the 30-year lease term rather than totally deductible in the present tax year. The Tax Court declined this argument also, and held that the excess cost was factor to consider for the lease, but properly showed the costs associated with conclusion of the structure as required by the sales agreement.

The lesson for taxpayers to draw from the holding in Crowley is essentially that sale-leaseback deals may have unanticipated tax effects, and the regards to the deal should be prepared with those consequences in mind. When taxpayers are contemplating this type of deal, they would be well served to consider thoroughly whether or not it is prudent to offer the seller-tenant a choice to repurchase the residential or commercial property at the end of the lease, especially where the choice price will be listed below the fair market price at the end of the lease term. If their deal does include this repurchase choice, not only does the IRS have the capability to potentially define the deal as a tax-deferred exchange, but they likewise have the capability to argue that the transaction is actually a mortgage, rather than a sale (where the result is the same as if a tax-free exchange takes place in that the seller is not qualified for the immediate loss reduction).

The problem is further complicated by the uncertain treatment of lease extensions developed into a sale-leaseback deal under common law. When the leasehold is either prepared to be for thirty years or more or totals thirty years or more with consisted of extensions, Treasury Regulations Section 1.1031(b)-1 classifies the Investor’s gain as the cash received, so that the sale-leaseback is dealt with 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 finish a tax-deferred exchange and though the outcome contrasts the seller’s benefits. Often the net outcome in these circumstances is the seller’s acknowledgment of any gain over the basis in the real residential or commercial property asset, offset just by the allowable long-lasting amortization.

Given the major tax effects 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 worth as part of the seller’s gain on sale. The most reliable way in which taxpayers can avoid this inclusion has actually been to take the lease prior to the sale of the residential or commercial property but drafting it between the seller and a controlled entity, and then getting in into a sale made based on the pre-existing lease. What this technique permits the seller is an ability to argue that the seller is not the lessee under the pre-existing arrangement, and for this reason never received a lease as a part of the sale, so that any value attributable to the lease therefore can not be taken into account in calculating his gain.

It is necessary for taxpayers to keep in mind that this technique is not bulletproof: the IRS has a number of potential responses where this technique has been used. The IRS may accept the seller’s argument that the lease was not gotten as part of the sales transaction, however then reject the part of the basis designated 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 “type 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 appropriately, if the taxpayer gets cash in excess of their basis in the residential or commercial property, would recognize their complete on the gain.