Examine the Business and Tax Considerations of These Transactions.
While sale-leaseback transactions may be structured in a variety of ways, a basic sale-leaseback can benefit both the seller/lessee and the buyer/lessor. However, all parties must consider the business and tax advantages, disadvantages, and risks involved in this type of arrangement before moving forward.
In the typical sale-leaseback, a property owner sells real estate used in its business to an unrelated private investor or to an institutional investor. Simultaneously with the sale, the property is leased back to the seller for a mutually agreed-upon time period, usually 20 to 30 years.
The sale-leaseback may include either or both the land and the improvements. Lease payments typically are fixed to provide for amortization of the purchase price over the term of the lease plus a specified return rate on the buyer’s investment.
The typical transaction usually is a triple-net-lease arrangement. Sale-leasebacks often include an option for the seller to renew its lease, and on occasion, repurchase the property.
Seller Advantages
Raising funds through a sale-leaseback transaction offers property owners a number of important business advantages.
Converts Equity into Cash. With a sale-leaseback, the seller regains use of the capital that otherwise would be tied up in property ownership; at the same time, the seller retains possession and continued use of the property for the lease term.
The seller usually receives more cash with a sale-leaseback than through conventional mortgage financing. For example, if the transaction includes both land and improvements, the seller receives 100 percent of the property’s market value (minus any capital gains tax). In comparison, conventional mortgage financing normally funds no more than 70 percent to 80 percent of a property’s value.
Because capital gains tax reduces the cash from the sale, a sale-leaseback where the property is sold at a small gain or at a loss generally is most advantageous.
Alternative to Conventional Financing. The seller usually can structure the initial lease term for a period that meets its needs without the burden of balloon payments, call provisions, refinancing, or the other issues of conventional financing. Moreover, the seller avoids the substantial costs of conventional financing such as points, appraisal fees, and some legal fees.
A sale-leaseback also usually provides the seller with renewal options, while conventional mortgage financing has no guarantee for refinancing.
Possibility of Better Financing. Under a sale-leaseback arrangement, a buyer may be able to obtain better mortgage financing terms than the property owner. Even if the property owner defaults, the buyer is likely to continue payments to protect its equity. Thus, the lender might be willing to charge the buyer a lower interest rate, which could result in lower lease payments to the seller.
Improves Balance Sheet and Credit Standing. In a sale-leaseback, the seller replaces a fixed asset (the real estate) with a current asset (the cash proceeds from the sale). If the lease is classified as an operating lease, the seller’s rent obligation usually is disclosed in a footnote to the balance sheet rather than as a liability. This results in an increase in the seller’s current ratio, or the ratio of current assets to current liabilities – which often serves as an indicator of a borrower’s ability to service its short-term debt obligations. Thus, an increased current ratio improves the seller’s position for borrowing future additional funds.
However, if the lease is classified as a capital lease, the advantages of the sale-leaseback arrangement from an accounting perspective are altered considerably. Statement of Financial Accounting Standards No. 13 on accounting for leases requires that a capital lease be recorded as an asset and capitalized and requires the obligation to make future lease payments to be shown as a liability.
Avoid Debt Restrictions. Businesses restricted from incurring additional debt by prior loan or bond agreements may be able to circumvent these limits by using a sale-leaseback. Rent payments under a sale-leaseback usually are not considered indebtedness for such purposes, thus a business can meet its cash needs through the sale-leaseback without violating any previous agreements.
Deterrent to Corporate Takeovers. Undervalued real estate on a company’s books often serves as a target for corporate raiders. A timely liquidation through a sale-leaseback transaction may serve as a deterrent, providing management with funding to resist the takeover. In addition, a long-term lease is not as inviting to raiders as undervalued real estate.
Avoids Usury Limitations. Because a sale-leaseback is not considered a loan, state usury laws do not apply; a buyer in a sale-leaseback can earn a higher rate of return on its investment than if it had made a conventional mortgage loan to the property owner.
Seller Disadvantages
Owners should consider the following business disadvantages in deciding whether to raise funds through a sale-leaseback.
Loss of Residual Property Value. Perhaps the major disadvantage of the sale-leaseback is that the seller transfers title to the buyer. Owners can minimize this disadvantage by including a repurchase option in the leaseback. However, a repurchase option changes how the sale-leaseback arrangement is reported for accounting purposes. The lease will be recorded as an asset and capitalized, and the obligation to make the future lease payments will be shown as a liability.
Possible Relocation. At the end of a lease without any renewal options, the seller may have to negotiate an extension of the lease at current market rent or may be forced to relocate its business.
Loss of Flexibility. The seller loses the flexibility associated with property ownership, such as changing or discontinuing the use of the property or modifying a building. The sale-leaseback often restricts the seller’s right to transfer the leasehold interest, and even if possible, generally it is more difficult to dispose of a leasehold interest than a fee-ownership interest. Also, if a seller wants to improve the leased property, it may be difficult to obtain financing secured by a leasehold interest. Moreover, the leasehold may contain provisions that prohibit the seller from mortgaging the leasehold interest.
High Rental Payment. If the rental market softens, the seller may be locked into the higher rental rate negotiated at the time of the sale-leaseback. Rental payments under the lease cannot be adjusted without the consent of the buyer, which means that the seller is tied to the interest rate implicit in the leaseback for the full lease term.
Higher Cost of Financing. The interest rate in a sale-leaseback arrangement generally is higher than what the owner would pay through conventional mortgage financing. The buyer assumes additional risks by financing 100 percent of the property’s fair market value. In addition, the buyer’s investment in the leased property may be less liquid or marketable than a loan. Finally, the cost of negotiating may be higher, because substantial time and effort may be required to tailor the transaction to the seller’s needs.
Tax Considerations
A seller’s decision to raise funds through a sale-leaseback frequently is based on substantial income-tax advantages. These savings are an additional source of cash that the seller may use.
Deduction of Rental Payments. The main tax advantage of a valid sale-leaseback is that rental payments under the lease are fully deductible. With conventional mortgage financing, a borrower deducts interest and depreciation only. The rental deduction may exceed the depreciation in three cases: if the property consists primarily of a nondepreciable asset, such as land (although land is not depreciable, rental payments for the lease of land may be deducted); if the property has appreciated in value (while depreciation deductions are limited by the cost of the property, rental deductions may equal the fair market value of the property); or if the property has been fully depreciated.
Timing Gain and Loss Recognition. A seller can use a sale-leaseback to time the recognition of gains or losses while retaining the use of a property. A business may want to recognize gains to use business credits or net operating loss carryovers. If the business owns appreciated property, a sale of assets will produce a gain that could be offset by the credits or net operating loss carryovers. However, if the adjusted basis of the assets exceeds its fair market value, a recognized loss will reduce tax liability.
Capital Gain-Ordinary Loss Treatment. Because the property involved in a sale-leaseback generally is held for use in the seller’s trade or business, it qualifies for capital gain-ordinary loss treatment. Under Section 1231 of the Internal Revenue Code, if the property is held for the long-term holding period, gain on the sale, with some exceptions, will be taxable as long-term capital gain to the extent that the gain exceeds the losses in the same year from the sale of other Section 1231 property. However, the gain will be taxable as ordinary income to the extent of recapture income. But in the case that the sale results in a loss, it will be deductible in full as an ordinary loss to the extent the loss exceeds Section 1231 gains from the sale of other property in the same year. This can be a substantial advantage to the seller in a sale-leaseback transaction.
On the other hand, improper structuring of sale-leaseback transactions may result in adverse tax consequences to the seller.
Sale-Leaseback May Not Be Recognized. If the sale-leaseback transaction gives the seller an option to repurchase the property or if the seller retains substantial ownership rights, the Internal Revenue Service may view the transaction as a mortgage. In that case, the seller would not be allowed a deduction for rent but could deduct depreciation and a portion of the rent payments as interest.
Loss May Not Be Recognized. If the lease term is for 30 years or more, any ordinary loss deduction that otherwise would be allowable on a sale-leaseback transaction might be barred on the theory that it is a nontaxable exchange of like-kind property under IRC Section 1031. However, the seller would be entitled to depreciation on its basis for the leasehold over the lease term.
Deductions May Be Recaptured. The effect of any recapture on the sale-leaseback transaction must be taken into account, since the sale of the property under a sale-leaseback may trigger depreciation, investment tax credit, and other types of recapture.
Buyer Advantages
The viability of a sale-leaseback often depends on the potential effects of the transaction on the buyer. A properly structured sale-leaseback transaction provides the buyer with a number of advantages and benefits.
Higher Return Rate. The buyer usually receives a higher rate of return in a sale-leaseback than in a conventional loan arrangement. Also, the buyer may be able to circumvent state usury laws that limit the rate of interest charged with conventional financing. In addition, at the end of the lease term, the buyer receives the benefit of any appreciation in the value of the property. Finally, the buyer can leverage the purchase with mortgage financing; this may further magnify the return rate on the cash invested.
Predictable and Secure Return Rate. The long-term net lease enables the buyer to estimate accurately the expected future rate of return. Also, the extended term of the lease provides the buyer with protection from downturns in the real estate market and an inflation hedge, assuming that the property value appreciates over time.
Greater Ease in Handling a Seller Default. In the event that the seller defaults under the lease, the buyer can simply terminate the lease and have the seller evicted. The risk here is that the buyer may have trouble finding another tenant after the eviction process is completed.
Avoids Usury Problems. In a sale-leaseback arrangement, the buyer can avoid the state usury problems encountered by lenders when money is tight. The buyer and the seller can establish any mutually agreed upon rent level.
Ownership of the Reversion. The buyer owns the reversionary interest in the property. If the seller has an option to purchase or an option to renew the lease, this may limit or postpone the time that the buyer actually realizes the profit potential. The buyer also bears the risk that the property value actually might decline over the lease term.
Built-in Tenant. Finally, in purchasing the property, the buyer has a built-in tenant, namely the seller.
Buyer Disadvantages
Even though there are significant advantages to the buyer in a sale-leaseback transaction, disadvantages also must be considered.
Possibility of Seller Default. Perhaps the biggest risk that the buyer faces is that the seller will default on the lease, which would leave the buyer without a tenant. If the seller files for bankruptcy, the buyer is considered a general creditor. If the arrangement were a conventional mortgage, the buyer would be considered a secured creditor. If the seller files bankruptcy in a soft real estate market, the buyer may have a difficult time finding a new tenant.
Higher Administrative Costs. Because the typical sale-leaseback usually must be structured to meet the specific needs and requirements of both parties, it may require more time and increased administrative costs than a conventional loan transaction.
Required Property Management. In most cases, the seller assumes the responsibility and expense of day-to-day property management during the lease term. However, the buyer must make sure that the seller pays the property taxes on time and that tax assessments are reviewed and challenged when appropriate. The buyer also must periodically review the insurance coverage on the property and inspect it for proper maintenance.
Tax Considerations
The basic income tax considerations from the buyer’s perspective are straightforward.
Rental Payments Are Taxed in Full. The buyer in a sale-leaseback reports rental payments as ordinary income as they are received over the lease term. In a loan transaction, the lender is taxed only on the interest portion of the payment and not on the amount that represents the repayment of principal.
Availability of Deductions and Tax Credits. The buyer can offset, in part, the rental income with available deductions and credits. The buyer may claim depreciation deductions, assuming the property is eligible. Interest on mortgage debt also would be deductible, subject to certain limitations. The buyer may be able to claim certain tax credits to the extent that they still are available. However, passive loss limitations and at-risk rules may limit the deductions available for certain taxpayers.
By Donald J. Valachi, CCIM, CPA
