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:
- Timing Gain. A seller may choose a sale-leaseback to time the recognition of gains or losses. This provides the seller with the ability to use valuable tax benefits including net operating losses and business tax credits while still maintaining control and retaining the use of the property.
- Capital Gain-Ordinary Loss Treatment. Property held for use in a seller’s trade or business is unique in that it qualifies for capital gain and ordinary loss treatment. Section 1231 of the Internal Revenue Code provides that property, held longer than one year, will be taxable as long-term capital gains (certain exceptions apply). It is important to note that the gain will be taxable as ordinary income to the extent that prior depreciation is recaptured as income. Additionally, Section 1231 provides that when the sale results in a loss, it will be deductible in full as an ordinary loss.
- Deduction of Rental Payments. The most considerable tax benefit of a valid sale-leaseback is the deductibility of rental payments under the lease. Conventional financing limits a borrower's deduction to interest and depreciation. Principle payments are not recognized as an expense. As a result, the rental deduction may be advantageous when the property:
- consists mainly of a nondepreciable asset, such as land;
- has appreciated in value, or
- if the property is already fully depreciated.
Sale-leasebacks are subject to a higher level of scrutiny by the IRS. A major concern when considering a sale-leaseback is whether the IRS will respect the form of the transaction and accept that the buyer-landlord is the owner of the property. Historically, the IRS has recharacterized certain types of sale-leasebacks as either financing or as sham transactions.
In the event that the IRS recasts the sale-leaseback as a financing transaction, the transaction will be treated as a loan from the buyer to the seller. The seller will not recognize the gain or loss from the sale and the lease payments will only be deductible for the portion of the payment deemed interest on the implied loan. Any remaining portion of the rental payment will be considered a principal payment for income tax purposes.
The buyer-landlord loses the right to claim depreciation, but only recognizes taxable interest to the extent that payments are deemed interest. As a result, the seller-lessee will be entitled to continue any depreciation deduction that they were eligible for prior to the sale. Obviously, this can be disappointing for both parties. As a result, the following elements are suggested by the Bureau of National Affairs to avoid a successful challenge by the IRS of a sale-leaseback transaction:
- The property should be sold at fair market value, the amount of which is supported by an independent appraisal.
- Rent should be at fair market value and also supported by independent appraisal. Level or increasing rental payments are desirable.
- Multiple (more than two) parties are recommended:
- the seller-lessee,
- the buyer-lessor, and
- preferably an institutional lender.
- The lease term should not exceed the economic life of the property. Renewal options should provide for a fair market rental value at the time the option is exercised.
- There should be no repurchase options. If one is necessary, ideally it should be based on the fair market value of the property at the exercise date.
- All condemnation and insurance payments in excess of liabilities on the property should inure to the buyer-lessor.
- There should be a business purpose for the transaction and the formalities of the agreement should be followed. The agreement should avoid loan language or structure.
- A substantial cash return on the leaseback should be included, to avoid having the transaction viewed as being created solely for tax purposes.
- The lease should not be structured as a pure net lease.
- The sale-leaseback should be designed to qualify as an operating lease under GAAP.
- The leaseback should terminate in the event the property is destroyed.
- If possible, the term of the leaseback should be less than 30 years.
- Two entirely different sets of documents should be drafted, one for the sale of the real estate and one for the lease agreement.
- The buyer-lessor should make an equity investment in the property.
- The seller-lessee should not provide guarantees of the loans financing the purchase of the property (although a pledge of the lease would not be uncommon).
- The transaction should not be between related parties.
- The buyer-lessor should not have a put on the property.
- The seller-lessee should not possess the right to sell the property without the buyer-lessor's consent.
- The transaction should be structured so that the buyer-lessor can meet the so-called imprudent abandonment test. This means that the buyer-lessor must be able to demonstrate that he or she: has made more than a negligible investment in the property; possesses more than a negligible right to receive rents; and reasonably anticipates more than a negligible return from the right to enjoy the residual value of the property.
If you are considering this strategy, it is critical that you have the right team in place. Because of the expertise required to ensure success, your team should include an experienced real estate attorney, an experienced commercial real estate broker, a financial adviser and a CPA.
Richard Pasquantonio, CPA/CFF, CFE, CDFA (N.C. License Number 33577), is an associate at Adam Shay CPA, PLLC. He focuses on forensic accounting, fraud prevention and detection, and tax controversy resolution. He is also an AICPA CFF Champion. The purpose of the CFF Champion program is to inform the professional community about the vital role of forensic accounting professionals, the knowledge required to become a CFF, and the benefits of the CFF credential. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. Pasquantonio can also be reached by phone at (910) 256-3456.
Adam Shay, CPA (N.C. License Number 35961), MBA, is managing partner of Adam Shay CPA, PLLC. He focuses on minimizing taxes and improving the financial results of entrepreneurs, and is actively involved in supporting the Wilmington entrepreneurial and startup community. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. He can also be reached by phone at (910) 256-3456.