This Insights was contributed by Richard Pasquantonio, CPA/CFF, CFE, CDFA (N.C. License Number 33577), an associate at Adam Shay CPA, PLLC.
It’s not uncommon for a business owner to decide on purchasing real property instead of renting to diversify their holdings, recognize tax benefits, and exchange rent payments for equity. To maximize the benefits of ownership, business people need to be aware of the tools that are available for extracting the cash value of their real estate investment. One of those ways is the sale-leaseback.
The function of sale-leasebacks is a pretty dynamic issue. This article attempts to define the transaction, list some advantages and disadvantages, and highlight some pitfalls when using this strategy.
The 2008 financial crisis leading to the Great Recession resulted in an increased demand for financing for middle market businesses. Although the federal government enacted the Emergency Economic Stabilization Act of 2008 which created the TARP Program to provide some relief, companies continue to struggle in many cases to borrow money. Because of this difficulty, the popularity of sale-leaseback transactions is increasing.
The typical sale-leaseback includes two concurrent transactions. The first transaction is the sale of property. The second simultaneous transaction is a lease executed by the buyer to the seller. The result of the two transactions is that the seller is now the lessee and the purchaser is the landlord.
While sale-leasebacks can be an effective way to raise capital for growth, restructuring, and exit planning, the substance of the transaction is subject to a higher level of scrutiny for tax and financial reporting. One concern when executing a sale-leaseback is if the transaction will be respected or be re-characterized as a financing transaction.
A sale-leaseback can be used to convert real property into cash to expand a business through acquisition or to acquire additional technology or equipment. Sale-leasebacks can be used to provide a seller the opportunity to turn an illiquid, non-income producing asset into growth capital. The company then can reserve bank financing for future acquisitions and growth opportunities. Since sale-leasebacks lack the covenants placed on businesses that traditional financing places, the sale-leaseback proceeds could also be used for other corporate dealings, such as the buyout of a shareholder or a special cash distribution to all shareholders.
If a business lacks the liquidity to pay creditors, or worse, if it is considering bankruptcy, then it might look to a sale-leaseback to raise capital. Depending on the real estate's value, a sale-leaseback can provide the necessary liquidity and expedite the reorganization process.
Sale-leaseback investors may be better positioned to meet sensitive time restrictions. If a prospective seller is able to provide accurate historical financial statements, a business plan, and projections, plus adequately describe how the proceeds from the sale-leaseback will assist in the reorganization, then sale-leaseback investors could be an alternative.
A business owner who is considering selling his company may benefit by taking the real estate out of the company sales transaction to maximize the value of the real estate component and increase the overall proceeds. If the real estate is left in the transaction, the full value may not be realized because the buyer is assessing the cash flow and profitability of the operating business.
For instance, if an EBITDA multiple is used as the basis for a sales offer that includes the real estate, then the company’s real estate is not being valued at its fair market value. In this case, the buyer may not be interested in purchasing and managing the real estate asset. As a result negotiations may stall.
Alternately, sale-leaseback investors will typically make their offer price based on different metrics such as an appraisal, real estate market study, and a review of comparable market lease rates. As a result, the seller may benefit from a sale-leaseback by negotiating a long-term lease and extracting the real estate sale proceeds, or improve the company's balance sheet by repaying corporate debt before offering the business for sale.
Tax benefits and pitfalls
A seller may be considering a sale-leaseback as a means to secure various tax advantages including:
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