Sale and Leaseback of Real Property

he IRS carefully scrutinizes transactions between closely held corporations and their controlling shareholders to make sure such transactions benefit the corporations, not simply the shareholders. One strategy that could provide tax and financial advantages to both a corporation and its controlling shareholder is a sale and leaseback of real property in which the corporation sells real estate with a building on it to the shareholder, who, in turn, leases both back to the company.

TAX ISSUES

The corporation’s rental deduction vs. its depreciation deduction. If the real property has been in service for many years, a sale and leaseback could generate a much larger rental expense deduction for the corporation than its current depreciation deduction. In the latter situation, the corporation would depreciate only the building (not the land) and the amount of the depreciation would be based on its original cost. In a sale and leaseback, the rent paid by the corporation typically is based on the fair market value of both the land and the building, and the deduction, therefore, is usually larger.

Shareholder’s depreciation. After a sale and leaseback, the shareholder’s basis in the property will be its fair market value, which usually is higher than the price the corporation originally paid (if the land and building have gone up in value). Thus, the shareholder’s depreciation deduction on the building may be substantially higher than that previously available to the corporation.

Rental income as passive income. A sale and leaseback may enable the shareholder to generate passive rental income to offset passive losses he or she may have. However, whether the shareholder may characterize the rental income as passive depends on both his or her ownership interest in the corporation and material participation in its business.

VALIDITY OF THE SALE AND LEASEBACK

To take advantage of the benefits of a sale and a leaseback, both must be valid. No one factor controls; the overall facts and circumstances surrounding the transactions determine their validity. Ultimately, the determination will center on whether the transactions have economic substance and have been based on reasonable market conditions.

Sale. For the sale to be valid, the controlling shareholder must have taken an equity interest in the property and assumed the risk of loss. An equity interest exists if the funds for the purchase of the property came from the shareholder or if he or she borrowed money to make the purchase. The shareholder’s purchase of an insurance policy on the property would show assumption of the risk of loss.

Leaseback. For a leaseback to be valid, four tests must be met:

The useful life of the leased property must exceed the term of the lease.

If the corporation repurchases the property at the end of the lease, it must do so at fair market value and not at a discount.

If the transaction allows for a renewal at the end of the original lease term, the renewal rate must be set at a fair rental value.

The shareholder must have a reasonable expectation that he or she will generate a profit from the sale and leaseback, considering both the value of the property when it is eventually sold and the rent received during the lease term.

For a detailed discussion of these transactions, see “Sale-and-Leaseback of Real Property,” by Philip Fink, in the May 2001 issue of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser