Federal Tax Implications of Sale-Leaseback Transactions   Tags: property, real_estate, tax  

With the current financial market crisis that has sprung from the massive devaluation of residential properties, mortgages, and mortgage-backed securities, many companies presently find it imperative to secure capital gains in order to offset the massive influx of losses these companies are now faced with. Another significant problem in the current market includes the lack of short-term credit which provides the necessary capital that allows many businesses to perform basic operating functions such as replenish inventory and make payroll.

One such way by which companies may increase their capital gains in order to offset capital losses is to sell their capital assets. Many companies, however, are not in a position to physically part with some of their capital assets, such as, for example, the headquarters in which the company runs its business. Additionally, with the current short-term lending crunch, some capital-intensive industries are having difficulties securing conventional financing and must find it elsewhere, lest their potential demise. One possible solution to these problems is through a financial arrangement known as a sale-leaseback transaction.

In a typical sale-leaseback transaction a seller sells property to a purchaser, yet retains long-term continued use through a leasehold. Essentially, the transaction is arranged so that the purchaser, as the lessor, relinquishes control over the property through a net lease (which gives the seller-lessee the same control and responsibility over the property); the seller retains a future interest in the property (generally through options to purchase), so that after a certain extensive time period, the seller-lessee may repurchase the property.

Generally the transaction is arranged so that the lease-term is long enough to secure the buyer-lessor's investment. The rental payments made by the seller-lessee over the course of the lease-term typically match the buyer-lessor's principal plus interest on the loan for the property and any initial investment made by him/her. The buyer-lessor retains a reversionary interest, subject to future options to purchase, or extensive lease renewal options, by the seller-lessee.

With such an arrangement, the seller-lessee secures capital, whilst retaining continued use over the property, and the buyer-lessor, as owner, may receive tax benefits such as deductions on depreciation and interest arising from loan indebtedness. The seller-lessee may also take deductions on rental payments; these deductions generally outweigh the depreciation deductions the seller-lessee foregoes in giving up ownership of the property.

More importantly, the seller-lessee can convert an illiquid fixed asset into cash and increase its store of working capital. This increase in capital not only provides the seller-lessee money to work with, but it enables the seller-lessee to increase its current ratio (of current assets to fixed assets), which makes the seller-lessee appear more credit-worthy to conventional short-term lenders. With the current tightening of short-term money markets, this attribute is extremely valuable. Furthermore, it provides an alternative financing arrangement for the seller-lessee if unable to secure conventional lending and offers a higher rate of return for the buyer-lessor than would be yielded in a conventional mortgage loan.

Structuring a genuine sale-leaseback transaction that will be honored for tax purposes requires careful planning and forethought. Historically, sale-leaseback transactions were deemed sham transactions. What essentially made these transactions void for tax purposes were the financial arrangements underlying them. Through crafty financial maneuvering, the financial arrangements were constructed in such a way to make risk for both parties nonexistent. In very general terms, the purchaser would take out a loan from a third party mortgagor and use the loan proceeds to pay for the purchase of the property. Those proceeds furnished the rent payments for the seller-lessee's use of the property and those rent payments paid back the purchaser's loan, rendering the financial arrangement almost entirely circular and off-setting.

Another aspect of these sale-leaseback transactions that prompted the IRS to invalidate many of them for tax purposes was the lack of true ownership possessed by the buyer-lessor. Generally the leasehold consisted of a "net lease", whereby the seller-lessee was obligated to pay for improvements on the property, property taxes, and insurance - responsibilities normally undertaken by a true owner. Thus, where the lessee acts as a genuine owner, courts and the IRS will raise an eyebrow as to which party is claiming depreciating deductions.

It was clear through certain sale-leaseback and LILO transactions that the only real benefits conferred to the buyer-lessor were the tax benefits received. It comes as no surprise then that the IRS paid little heed to the form of these transactions. As a result, many leveraged sale-leasebacks transactions have been invalidated in the last few decades.

What distinguishes genuine sale-leaseback transactions from those historically invalidated are the motivations and economic realities behind them. Where a sale-leaseback transaction is imbued with considerations beyond mere tax deductions, a sale-leaseback transaction has a greater chance of being respected for tax purposes. Some of the factors taken into consideration by Courts in finding sale-leaseback transactions valid for federal tax purposes include the need for capital and the existence of regulatory or practical business constraints that disallow or seriously hamper access to traditional financing.

With the current trend of the market, these factors could bring promise of a new era in which sale-leaseback transactions are viewed without disdain. There are many considerations that come into play; therefore familiarization with case law, IRS Rulings, and expert commentary are essential before one embarks on a transaction that historically had a sour reputation for its recurring stamps of invalidity by the government. With thorough research and prudent planning, sale-leaseback transactions may bring significant mutual benefits to the parties involved and offer some respite in today's downtrodden market.

The purpose of this research guide is to enable the user to identify the comprehensive outlay of legal sources devoted to the federal tax treatment of sale-leaseback and lease-in/lease-out (LILO) transactions. Sale-leaseback transactions are still widely used today and can present beneficial tax implications if planned wisely; effective planning cannot be had without knowledge of the array of legal sources that deal with the proper structuring of sale-leasebacks. Moreover, an extensive area of the law deals precisely with the sort of maneuvering in sale-leaseback or LILO arrangements that will be deemed ‘shams' for federal tax purposes. This bibliography should serve as a useful source of information for those interested in implementation of sale-leaseback transactions, or alternatively, for those who would simply like to inform themselves of the basic federal tax principles underlying the federal tax treatment of these transactions.

Eileen O'Neill is a 2009 J.D. Candidate at the Georgia State University College of Law in Atlanta, Georgia. During the course of her studies Eileen O'Neill has developed a strong interest in tax law, particularly federal income taxation. She received her undergraduate degree in political science and anthropology from the University of Georgia in Athens, Georgia, in August 2000. This bibliography was compiled for Advanced Legal Research, a class taught by Professor Nancy Johnson.

Send an email to njohnson@gsu.edu for more information about this bibliography.

This research guide is not comprehensive. It should not be understood to constitute legal advice and should not be relied upon for that purpose. Please consult the appropriate government agency or a qualified attorney for advice before relying on the materials contained herein. This guide was last updated in March, 2009.