Given the serious tax consequences of having a sale-leaseback transaction re-characterized as an involuntary tax-deferred exchange, taxpayers are well advised to try to avoid the inclusion of the lease value as part of the seller's gain on sale.
The most effective manner in which taxpayers can avoid this inclusion has been to carve out the lease prior to the sale of the property but drafting it between the seller and a controlled entity, and then entering into a sale made subject to the pre-existing lease. What this strategy allows the seller is an ability to argue that the seller is not the lessee under the pre-existing agreement, and hence never received a lease as a portion of the sale, so that any value attributable to the lease therefore cannot be taken into account in computing his gain.
It is important for taxpayers to note that this strategy is not bulletproof: the IRS has a number of potential responses where this strategy has been employed. Given the complications inherent in sale-leaseback transactions, taxpayers would be well advised to consult their legal, tax and real estate professionals well in advance of drafting these transactions to get a sense for what the potential tax consequences may result from the terms of their particular proposed transaction.
Why The Exeter Group of Companies? Sales and Leasebacks in the context of the Exchange What is a sale-leaseback transaction? What is a tax-deferred exchange? The Tax Court, allowing the loss deduction, said that the transaction did not constitute a sale or exchange since the lease had no capital value, and promulgated the circumstances under which the IRS may take the position that such a lease did in fact have capital value: 1.
A lease may be deemed to have capital value where there has been a "bargain sale" or essentially, the sales price is less than the property's fair market value; or 2. The lease will be recorded as an asset and capitalized, and the obligation to make the future lease payments will be shown as a liability. Possible Relocation. At the end of a lease without any renewal options, the seller may have to negotiate an extension of the lease at current market rent or may be forced to relocate its business.
Loss of Flexibility. The seller loses the flexibility associated with property ownership, such as changing or discontinuing the use of the property or modifying a building. The sale-leaseback often restricts the seller's right to transfer the leasehold interest, and even if possible, generally it is more difficult to dispose of a leasehold interest than a fee-ownership interest.
Also, if a seller wants to improve the leased property, it may be difficult to obtain financing secured by a leasehold interest. Moreover, the leasehold may contain provisions that prohibit the seller from mortgaging the leasehold interest. High Rental Payment. If the rental market softens, the seller may be locked into the higher rental rate negotiated at the time of the sale-leaseback. Rental payments under the lease cannot be adjusted without the consent of the buyer, which means that the seller is tied to the interest rate implicit in the leaseback for the full lease term.
Higher Cost of Financing. The interest rate in a sale-leaseback arrangement generally is higher than what the owner would pay through conventional mortgage financing. The buyer assumes additional risks by financing percent of the property's fair market value. In addition, the buyer's investment in the leased property may be less liquid or marketable than a loan.
Finally, the cost of negotiating may be higher, because substantial time and effort may be required to tailor the transaction to the seller's needs. Tax Considerations A seller's decision to raise funds through a sale-leaseback frequently is based on substantial income-tax advantages. These savings are an additional source of cash that the seller may use. Deduction of Rental Payments. The main tax advantage of a valid sale-leaseback is that rental payments under the lease are fully deductible.
With conventional mortgage financing, a borrower deducts interest and depreciation only. The rental deduction may exceed the depreciation in three cases: if the property consists primarily of a nondepreciable asset, such as land although land is not depreciable, rental payments for the lease of land may be deducted ; if the property has appreciated in value while depreciation deductions are limited by the cost of the property, rental deductions may equal the fair market value of the property ; or if the property has been fully depreciated.
Timing Gain and Loss Recognition. A seller can use a sale-leaseback to time the recognition of gains or losses while retaining the use of a property. A business may want to recognize gains to use business credits or net operating loss carryovers. If the business owns appreciated property, a sale of assets will produce a gain that could be offset by the credits or net operating loss carryovers. However, if the adjusted basis of the assets exceeds its fair market value, a recognized loss will reduce tax liability.
Capital Gain-Ordinary Loss Treatment. Because the property involved in a sale-leaseback generally is held for use in the seller's trade or business, it qualifies for capital gain-ordinary loss treatment. Under Section of the Internal Revenue Code, if the property is held for the long-term holding period, gain on the sale, with some exceptions, will be taxable as long-term capital gain to the extent that the gain exceeds the losses in the same year from the sale of other Section property.
However, the gain will be taxable as ordinary income to the extent of recapture income. But in the case that the sale results in a loss, it will be deductible in full as an ordinary loss to the extent the loss exceeds Section gains from the sale of other property in the same year. This can be a substantial advantage to the seller in a sale-leaseback transaction. On the other hand, improper structuring of sale-leaseback transactions may result in adverse tax consequences to the seller.
If the sale-leaseback transaction gives the seller an option to repurchase the property or if the seller retains substantial ownership rights, the Internal Revenue Service may view the transaction as a mortgage. If the leaseback was determined to be a finance lease by the lessee, the lessee would either a not derecognize the existing asset or b record the capitalized value of the leaseback, depending on which of those approaches created a greater asset and offsetting lease liability.
If the leaseback was determined to be an operating lease by the lessee, the lessee would derecognize the asset and defer any gain that might have otherwise resulted by the sale, and then capitalize the leaseback in accordance with Topic Two caveats exist regarding how the financing portion of the failed sale-leaseback must be amortized:. These conditions may exist when the failed sale-leaseback was caused for instance by the existence of a fixed price purchase option during the lease, as was illustrated in the standard itself.
In that case the interest rate required to amortize the loan is imputed through a trial and error approach by also considering the carrying value of the asset as discussed above, rather than by calculating it based solely on the factors associated with the liability. In effect the existence of the purchase option is treated by the lessee as if it will be exercised and the lease liability is amortized to that point. If the condition causing the failed sale-leaseback no longer exists, for instance the purchase option is not exercised, then the carrying amounts of the liability and the underlying asset are adjusted to then apply the sale treatment and any gain or loss would be recognized.
In this example the lessee must use a rate of approximately 4. Since the entry to record the failed sale and leaseback involves establishing an amortizing liability, at some time a fixed price purchase option in the agreement which caused the failed sale and leaseback in the first place would be. The previously recorded ROU asset would be reclassified as a fixed asset and continue to be depreciated during its remaining life. Any difference between the then outstanding lease liability and the newly calculated present value would likely be an adjustment to the remaining ROU asset, and the ROU asset would then be amortized over the remaining life of the lease.
Any failed sale leaseback will require scrutiny and analysis to fully understand the nature of the transaction and how one must follow and track the accounting. This will be a fairly manual effort unless a lessee software package can track when a purchase option expires and creates an automatic adjusting journal entry at that time.
Apparently for this reason, the FASB also provided for adjusted accounting for transactions previously accounted for as failed sale leasebacks. The FASB suggested when adopting the new standard to examine whether a transaction was previously a failed sale leaseback. While we can get engrossed in the minutia of the accounting details for a failed sale-leaseback, recognize the FASB introduced this somewhat cumbersome accounting to derecognize only those assets in which the transaction was clearly a sale.
This process existed previously only for real estate transactions. Under the previous guidance, Topic , application of its extensive provisions and related disclosures were difficult to implement for many entities.
Here, FASB in Paragraphs - 40 - 55 - 40 through - 40 - 55 - 44 has streamlined the onerous provisions of the preceding guidance with respect to criteria underlying whether control is deemed to have passed from a seller - lessee to a buyer - lessor in transactions involving assets under construction.
Despite the new guidance, application of these provisions in more complicated leasing arrangements will continue to pose challenges to many entities. As a result of the coronavirus pandemic, FASB has voted to delay by one year the effective dates of its lease accounting standard for certain entities.
The effective date for public not-for-profits, which have issued or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or an over-the-counter market and that have not yet issued financial statements, would be fiscal years starting after Dec. Robert Singer is a professor of accounting, and Steven Coleman is an associate professor of accounting, both at the Robert W. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA 's editorial director, at Kenneth.
Tysiac aicpa-cima. For more information or to make a purchase or register, go to aicpastore. AICPA lease accounting page. Making the right moves now can help you mitigate any surprises heading into Worldwide leaders in public and management accounting.
Toggle search Toggle navigation. Breaking News. Accounting for sale and leaseback transactions New revenue recognition and lease accounting standards have affected the way these transactions are reported.
Benefits for the seller - lessee include: An immediate inflow of cash that can be deployed in some area of the entity's business; and A cheaper form of financing owing to the ability of the parties to structure the transaction in a manner that reduces the cost of conventional financing e. Benefits for the buyer - lessor from leasebacksinclude: Reduced default risk due to the ability to directly investigate the seller - lessee's credit; The ability to more easily terminate the contract than would be the case under conventional financing; Important tax advantages — depreciation; and Guaranteed residual value at termination.
The criteria underlying classification of the transaction as a finance lease are: There is a transfer of ownership of the asset to the lessee at the termination of the lease; The lessee has an option to purchase the asset that is reasonably certain to be exercised; The lease term constitutes a major part of the remaining economic life of the asset; The present value of the sum of the lease payments and guaranteed residual value by the lessee must equal or exceed substantially all of the fair value of the underlying asset; and The underlying asset must be of a specialized nature precluding any alternative use to the lessor at the termination of the lease period.
Smith-Jones sale and lease terms. Journal entry based on amortization table. Journal entries for seller-lessee.
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