|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
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:
- Whether the seller/tenant originally sought a loan from the buyer/landlord;
- Whether the circumstances indicate a normal sale and lease arrangement (or do the circumstances
indicate a lender/borrower relationship);
- Whether the purchase price reflected the fair market value of the property (or was inflated to a
price necessary to finance the transaction);
- 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);
- 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:
- The "economic substance" of the transaction based upon the potential risks and gains
of the parties, and
- 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
- 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
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.
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