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M O R E    R E S O U R C E S

Alternative Real Estate Financing

Alternative Real Estate Financing
by William Bronchick

Secrets of a Real Estate Lawyer

Secrets of a Real Estate Lawyer
by William Bronchick

Article by William Bronchick

How to Structure Sale-Leaseback

 The sale/leaseback is a financing technique that has been used in the United States since the 1940's. Sale/leaseback transactions provide alternative methods of ownership, investment, financing and risk allocation

 The transaction, in its most basic form, involves the sale of a property to an investor who holds title and leases the property back to the former owner. The lease is typically a long-term "net" lease, with the seller/tenant having the option of repurchasing at a later time. The seller/tenant reaps the benefit of favorable 100% "financing" and still retains the use of the property. The buyer/landlord receives the tax benefit of depreciation and a guaranteed long-term rental. A sale/leaseback, however, can turn into a disaster if the seller/tenant files bankruptcy or either party is audited by the IRS. In either case, the transaction can be recharacterized by the Court as a "disguised" financing transaction. This article will attempt to suggest some guidelines for avoiding this recharacterization.

 Recharacterization in the Context of Seller/Tenant's Insolvency

 If the seller/tenant is unable to make payments on the lease, the buyer/landlord may try to evict the seller/tenant and extinguish his interest. In this case, the seller/tenant can file for protection under the Federal Bankruptcy laws. His attorney will argue that the sale/leaseback should be recharacterized as a financing transaction. If the Bankruptcy Court agrees, the buyer/landlord will be considered a mortgagee, and title will revert back to the seller/tenant. The recharacterization, while beneficial to the seller/tenant, will result in unintended, and often disastrous consequences to the buyer/landlord.

 The Bankruptcy Court will look to the intent of the parties to the transaction, rather than the actual paperwork, in determining whether the sale/leaseback was intended to be a financing arrangement. The key factors are:

  1. Whether the seller/tenant originally sought a loan from the buyer/landlord;

  2. Whether the circumstances indicate a normal sale and lease arrangement (or do the circumstances indicate a lender/borrower relationship);

  3. Whether the purchase price reflected the fair market value of the property (or was inflated to a price necessary to finance the transaction);

  4. Whether the lease reflected the fair market value of the property (or was based on the amortization and intended rate of return on buyer/landlord's investment);

  5. Whether the option to repurchase was set so far below market value as to effectively compel the seller/tenant to exercise;

 The court will balance all of these factors and take a "substance over form" approach.

 Recharacterization for Tax Purposes

 If either party to a sale/leaseback is audited, the IRS can recharacterize the sale/leaseback as a financing arrangement. This will result in an immediate recapture of buyer/landlord's depreciation of the property and imputed interest on the seller/tenant's rental payments. The seller/tenant will lose the deduction for his rental payments, since the payments will be reclassified and principal repayment of a loan.

 The guidelines for IRS recharacterization are not as clear as those for Bankruptcy recharacterizations, and it is clearly a case-by-case analysis. The United States Supreme Court, in the landmark case of Frank Lyon Co. v. United States, stated the following factors to be considered for recharacterization:

  1. The "economic substance" of the transaction based upon the potential risks and gains of the parties, and
  2. Whether there was a purpose other than tax avoidance for the transaction.

 Guidelines for Structuring the Transaction

  • While the above standards set forth by the courts are not crystal clear, there are a few guidelines that we can follow to avoid recharacterization by the IRS or a Bankruptcy Court:
  • Make certain that the purchase price of the property is for fair market value;
  • Make certain the lease payments are for fair market rent, and that the lease arrangement is typical of the area and the intended use;
  • Have reasons (other than tax avoidance) for the transaction and state those reasons in the preamble of your agreement;
  • If seller/tenant has an option to repurchase, make certain that it is based upon fair market value and not on a declining basis with unusually large rent credits (i.e., make sure it doesn't look like a loan payoff);
  • Make certain that the buyer/landlord has the rights of any typical landlord in a comparable lease arrangement (including the right to have the property back at the end of the lease!);
  • Make certain that there is nothing in the sale/leaseback arrangement that prevents the buyer/landlord from selling, mortgaging or assigning his interest or from benefitting from the appreciation of the property.

 There is no real way to guarantee that a Court or IRS auditor will agree with your characterization of a transaction as a sale/leaseback. Use your best judgment, follow the guidelines set forth by the courts and remember . . . if it looks like a duck, and it quacks like a duck - well, you know the rest!

Copyright 1998 All Rights Reserved.  No part of this publication may be copied
or reprinted without the express written permission of the Author.

William Bronchick, Esq.
Legalwiz Publications
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