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The term "sale and lease back" describes a scenario in which an individual, generally a corporation, owning organization residential or commercial property, either genuine or individual, offers their residential or commercial property with the understanding that the purchaser of the residential or commercial property will immediately turn around and lease the residential or commercial property back to the seller. The aim of this kind of transaction is to enable the seller to rid himself of a big non-liquid financial investment without depriving himself of the use (throughout the regard to the lease) of required or preferable structures or equipment, while making the net money proceeds offered for other investments without turning to increased debt. A sale-leaseback deal has the extra benefit of increasing the taxpayers offered tax reductions, because the leasings paid are typically set at 100 per cent of the value of the residential or commercial property plus interest over the term of the payments, which results in an allowable deduction for the worth of land in addition to buildings over a period which might be 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.
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What is a tax-deferred exchange?

A tax-deferred exchange enables an Investor to offer his existing residential or commercial property (given up residential or commercial property) and acquire more successful and/or efficient residential or commercial property (like-kind replacement residential or commercial property) while deferring Federal, and in many cases state, capital gain and devaluation regain income tax liabilities. This deal is most typically referred to as a 1031 exchange however is likewise known 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 delay all of their Federal, and most of the times state, capital gain and depreciation recapture earnings tax liability on the sale of investment residential or commercial property so long as certain requirements are met. 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 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 is equal to or greater in worth than the relinquished residential or commercial property (based upon net prices, not equity); (3) reinvest all of the net earnings (gross proceeds minus particular acceptable closing costs) or money from the sale of the relinquished residential or commercial property; and, (4) must change the quantity of secured financial obligation that was settled at the closing of the given up 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 view the tax-deferred exchange process as more constrictive than it actually is: while it is not permissible to either take money and/or pay off 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 earnings is simply not practical, or offering outdoors cash does not lead to the best organization choice, the Investor might elect to use a partial tax-deferred exchange. The partial exchange structure will enable the Investor to trade down in value or pull money out of the deal, and pay the tax liabilities solely connected with the quantity 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 profits remain in reality consisted of in the exchange.

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

On its face, the worry about combining 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 property taxable at long-term capital gains rates, and/or any loss recognized on the sale will be dealt with as a common loss, so that the loss reduction may be used to offset 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 beneficial use of the residential or commercial property, generate profits from the sale, and then 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 regain tax liabilities.

The first issue can arise when the Investor has no intent to participate in a tax-deferred exchange, however has entered into a sale-leaseback transaction where the worked out lease is for a term of thirty years or more and the seller has losses meant 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 recognized if ... (2) a taxpayer who is not a dealership in realty exchanges city realty for a cattle ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for property, or exchanges improved realty for unaltered realty.

While this arrangement, which essentially enables the development of two distinct residential or commercial property interests from one discrete piece of residential or commercial property, the fee interest and a leasehold interest, normally is deemed beneficial in that it develops a number of planning choices in the context of a 1031 exchange, application of this provision on a sale-leaseback transaction has the result of avoiding the Investor from acknowledging any applicable 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 reduction made by Crowley on their tax return on the premises that the sale-leaseback transaction they took part in constituted a like-kind exchange within the meaning of Section 1031. The IRS argued that application of area 1031 suggested Crowley had in reality exchanged their fee interest in their property for replacement residential or commercial property consisting of a leasehold interest in the same residential or commercial property for a term of 30 years or more, and accordingly the existing tax basis had brought over into the leasehold interest.

There were a number of concerns in the Crowley case: whether a tax-deferred exchange had in reality happened and whether the taxpayer was eligible for the immediate loss reduction. The Tax Court, permitting the loss deduction, said that the transaction did not constitute a sale or exchange because the lease had no capital value, and promoted the situations under which the IRS might take the position that such a lease carried out in truth have capital worth:

1. A lease might be considered to have capital worth where there has 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 deemed to have capital value where the rent to be paid is less than the reasonable rental rate.

In the Crowley transaction, the Court held that there was no evidence whatsoever that the price or rental was less than fair market, given that 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 effectively recognized by Crowley.

The IRS had other premises on which to challenge the Crowley deal; the filing showing the instant loss deduction which the IRS argued remained in reality a premium paid by Crowley for the negotiated sale-leaseback deal, and so accordingly must be amortized over the 30-year lease term instead of fully deductible in the current tax year. The Tax Court declined this argument also, and held that the excess cost was factor to consider for the lease, however properly reflected the expenses connected with completion of the building as needed by the sales arrangement.

The lesson for taxpayers to draw 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 consequences in mind. When taxpayers are pondering this kind of transaction, they would be well served to think about thoroughly 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 choice cost will be below the fair market worth at the end of the lease term. If their deal does include this repurchase option, not just does the IRS have the ability to potentially define the transaction as a tax-deferred exchange, but they also have the capability to argue that the transaction is in fact a mortgage, instead of a sale (in which the effect is the exact same as if a tax-free exchange happens in that the seller is not eligible for the immediate loss deduction).

The concern is even more complicated by the uncertain treatment of lease extensions built into a sale-leaseback transaction under typical law. When the leasehold is either prepared to be for 30 years or more or totals thirty years or more with consisted of 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 even though the seller had no intent to complete a tax-deferred exchange and though the result is contrary to the seller's benefits. Often the net result in these circumstances is the seller's recognition of any gain over the basis in the real residential or commercial property possession, offset only by the acceptable long-lasting amortization.

Given the severe tax consequences of having a sale-leaseback transaction re-characterized as an uncontrolled tax-deferred exchange, taxpayers are well recommended to try to avoid the inclusion of the lease value as part of the seller's gain on sale. The most effective 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 based on the pre-existing lease. What this strategy allows 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 worth attributable to the lease for that reason can not be taken into consideration in computing his gain.

It is essential for taxpayers to keep in mind that this strategy is not bulletproof: the IRS has a variety of potential actions where this strategy has been employed. The IRS might accept the seller's argument that the lease was not received as part of the sales deal, however then deny the part of the basis designated to the lease residential or commercial property and corresponding boost the capital gain tax liability. The IRS may also choose to use its time of "form over function", and break the transaction down to its essential components, in which both money and a leasehold were received 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 money in excess of their basis in the residential or commercial property, would recognize their complete tax liability on the gain.