Tax Considerations for Buying and Selling Property With a Burdensome Lease

An economic downturn like the current one can cause fixed lease obligations to become burdensome and trigger a significant negative impact on leasing in many markets. Real property and other business assets may have been leased in a sale-leaseback transaction, or the lessee may have simply desired use but not ownership of the asset. Some lease contracts may provide favorable terms to the lessee in the early years, but the terms purposely turn unattractive in later years to ensure that lessees eventually purchase the property.

When a lease becomes burdensome (the obligation exceeds the benefits), a taxpayer may try to terminate it. If the lessee pays a cancellation fee, tax law generally allows a deduction, because no future benefit is created. As an alternative to cancellation, the lessee could buy the property from the lessor. Recent litigation demonstrates that the lessee’s tax treatment of such a purchase is unsettled, though the tax results of lease terminations from the landlord’s perspective are more predictable.

LESSEE PAYMENTS
The IRS may allow a lessee to deduct lease cancellation payments if they are not integrated in some way with the acquisition of another property right. In Letter Ruling 9607016 issued in 1996, the IRS said a lease termination payment could not be deducted in the year paid where it was part of an overall plan to acquire and relocate to another site. The IRS held that the lessee’s right to terminate was conditioned on acquiring a new site and starting construction. The IRS noted that in a prior case and ruling, termination payments had been deductible when they were paid to eliminate expenses or relieve a taxpayer from an uneconomic contract and those situations were not integrated with the acquisition of another property right.

When a lessee terminates a lease by buying the leased property, the acquisition of a property right is obviously integrated with the lease termination. Not surprisingly, the IRS will also require capitalization in this situation. Its rationale is that IRC § 167(c)(2) prohibits an allocation of a portion of the cost to the leasehold interest. The Tax Court agrees, but a district court recently allowed a lessee to deduct the portion of the purchase price allocable to a burdensome lease. In what circumstances may a lessee reasonably take the position that the amount paid for property in excess of its value is a deductible lease termination payment?

The Tax Court in Union Carbide Foreign Sales Corp. (115 TC 423 (2000)) considered a situation in which the lessee of a ship had the option to pay $135 million to terminate a burdensome lease or buy the ship for nearly $108 million. The ship’s fair market value without the lease was less than $14 million. The taxpayer exercised the purchase option and deducted nearly $94 million ($108 million − $14 million) as a lease termination expense. The Tax Court did not allow the deduction, with the result that the taxpayer had to recover the entire $108 million over the remaining life of the ship.

The IRS did not contest the taxpayer’s claim that the lease was burdensome. Instead, it argued that the statutory language in section 167(c)(2) prohibits a deduction for the part of the purchase price attributable to the onerous lease. That provision does not allow any of the basis to be allocated to the leasehold if “property is acquired subject to a lease.” The statute does not define “subject to a lease,” but the IRS and Tax Court interpret the phrase to mean subject to a lease prior to acquisition. The taxpayer unsuccessfully argued that the statute refers only to ongoing leases and that because its acquisition of the ship ended the lease, the taxpayer was entitled to the deduction.

However, there is precedent for a deduction in the Sixth Circuit. In Cleveland Allerton Hotel (36 AFTR 862 (6th Cir. 1948)), a tenant paying excessive rent of about $15,000 per year and with 80 years remaining on the lease negotiated an acquisition of the property for an amount that exceeded the fair market value by $241,250. The Sixth Circuit overturned the Tax Court and allowed a deduction while chiding the IRS for elevating form over substance in requiring a taxpayer to capitalize an asset at more than double its fair market value.

In cases cited in this article, the amount paid to terminate the lease and purchase the property far exceeded the property’s fair market value. However, there is no bright line to identify when a lease becomes burdensome or onerous.

ABC BEVERAGE
The U.S. District Court for the Western District of Michigan recently followed Cleveland Allerton and allowed a business deduction for the portion of the purchase price attributable to a tenant’s excessive lease (ABC Beverage Corp. v. U.S., 102 AFTR2d 2008-5905, 8/27/08; see also “Tax Matters: Lease Buyout Portion of Purchase Ruled Deductible,” JofA, Dec. 08, page 94). A subsidiary of ABC acquired a lease with a rent escalator clause and purchase option. The $6.25 million difference between a negotiated minimum price of $9 million and the property’s market value was allowed as a business deduction by the district court.

The IRS again argued that a deduction was not allowable because section 167(c)(2) prohibits an allocation of part of the purchase price to the leasehold interest. But the court, whose decisions are appealable to the Sixth Circuit, said the phrase “subject to a lease” in section 167(c)(2) applies to a third-party purchaser who steps into a reversion in the continuing lease but not to a lessee whose purchase ends the lease.

The district court also went to some lengths to counter the IRS’ contention that the Cleveland Allerton precedent had been nullified by the Supreme Court in Millinery Center Building Corp. (350 U.S. 456, 49 AFTR 171 (1956)). In that case, the Supreme Court affirmed the Second Circuit, denying a taxpayer deduction. In ABC, the IRS contended that Millinery Center established the principle that the cost of buying out a burdensome lease via a property purchase is not deductible. But the district court in ABC said the deduction in Millinery Center was not disallowed because of section 167(c)(2) but because the taxpayer failed to prove the lease was burdensome. Thus, the court in ABC said, the split between the circuits was not resolved, and the Cleveland Allerton precedent allowing a deduction still stands. Other circuits besides the Sixth and the Second have been silent on the issue.

The ABC court granted summary judgment to the taxpayer but then vacated the order to allow trial on the issue of when economic performance occurred. On Dec. 22, 2008, at the end of a three-day trial, a jury found all issues in favor of the taxpayer, including that the property was “delivered or accepted, as evidenced by beneficial ownership in 1997,” the year the deduction was claimed. The government had argued that economic performance did not occur until 1999.

LESSOR-SELLERS
Lessors that receive payment from the sale of real property realize capital gains or losses if the property sold qualifies as a capital asset. IRC § 1234A treats any payment received by the lessor to terminate or cancel any lease associated with the property as a sale or exchange of a capital asset. Therefore, when a lessee, as in ABC Beverage, chooses to exercise its option to acquire leased property, the entire transaction results in a capital gain or loss to the lessor.

The legislative history suggests that section 1234A was changed in response to inconsistent treatment by the courts of the disposition of rights and obligations associated with capital assets. In particular, there were many instances where transactions were not regarded as sales or exchanges, and therefore no capital gain or loss could result. Section 1234A states that “gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset.”

The word “property” was substituted in 1997 for “personal property” to correct what Congress viewed as inequitable treatment for similar and related transactions. This change overrode the Supreme Court’s decision in Hort v. Commissioner (313 U.S. 28, 25 AFTR 1207 (1941)) that treated lease termination payments received by lessors as ordinary income. In addition, because both the property sale and the lease termination receive sale or exchange treatment, there is no need for the seller to argue that these events are the same capital transaction, as was the case prior to 1997 (see Gurvey v. U.S., 57 AFTR2d 86-1062).

It should be noted that section 1234A does not apply to the sale of a right or obligation. For example, if a lessor sold a lease contract to a third party, the proceeds must produce ordinary income to the lessor. To treat it otherwise would allow a seller to easily convert ordinary lease income into a capital gain simply by selling the contract.

When owners hold rental property as trade or business assets, gains or losses from the sale of the real property are section 1231 gains or losses. Payments received from the termination of lease contracts would then fall outside the scope of section 1234A, producing section 1231 gains or losses, as the associated property is not a capital asset as defined in section 1221. Net section 1231 gains, of course, receive capital gain treatment, while net section 1231 losses are ordinary (see “Best of Both Worlds?” JofA, March 09, page 64). Whether owners hold real property as trade or business assets versus capital assets is determined by whether substantial services beyond basic property management tasks are performed on behalf of tenants.

THIRD-PARTY BUYERS
Should a third party step into the shoes of the lease-holding landlord, payments for the property and accompanying lease contract do not receive separate treatment. As noted earlier, section 167(c)(2) provides that if any property is acquired subject to a lease, no portion of the adjusted basis shall be allocated to the leasehold interest. The entire adjusted basis is used for computing depreciation on the property subject to the lease. Treatment under IRC § 197, Amortization of Goodwill and Certain Other Intangibles, is precluded by section 167(c)(2). Thus, the property’s adjusted basis is recovered via depreciation. Lease payments received would be ordinary income. If the lease contract alone was acquired by a third party in a transaction not including the property itself, section 197(e)(5)(a) disqualifies the lease interest from amortization under section 197.

LOOKING AHEAD
Since the tax treatment for lessees who buy property with a burdensome lease is unsettled, CPAs should closely monitor any IRS guidance. Also, future litigation outside the Second and Sixth circuits could be illuminating.

Practice Tips
In a period of declining real estate values, CPAs of both lessees and lessors should be alert to the tax planning implications of property acquisition opportunities.

Structuring a property acquisition as two contracts, one for the value of the lease and one for the property, could bypass the Tax Court objection to allowing a deduction in the year of acquisition. However, the IRS could counter with the step-transaction doctrine.

CPAs with Sixth Circuit clients (Michigan, Ohio, Kentucky and Tennessee) can find some court precedent supporting the taking of a deduction for the portion of a lessee’s purchase price attributable to a burdensome lease. However, because of the Millinery Center case, Second Circuit taxpayers (New York, Connecticut and Vermont) may be in a weaker positionto take such a deduction. CPAs may want to evaluate the authorities and make a judgment whether to claim substantial authority for a deduction position or to capitalize the costs.

EXECUTIVE SUMMARY

  When a lessee terminates a lease by purchasing the leased property, the IRS requires capitalization of the entire purchase price. However, some courts have allowed the excess of the price over the fair market value to be deducted as the cost of buying out a burdensome lease.

  Under IRC § 1234A, lessors receiving payment from a lessee purchasing the leased property realize a capital gain or loss on the entire transaction if the property qualifies as a capital asset.

  However, this treatment would not apply when the lessor sells a lease contract to a third party. In that case, the seller would recognize ordinary income from the sale’s proceeds.

  A third party that acquires property subject to a lease must record the entire adjusted basis for tax purposes and recover it by depreciation. Lease payments received would be ordinary income.

Larry Maples, DBA, is a professor of accounting at Tennessee State University in Nashville, Tenn. Mark Turner, CPA, DBA, CMA, is an associate professor of accounting at the University of St. Thomas, Houston. Beth Howard, Ph.D., is an assistant professor of accounting at Tennessee Tech University, Cookeville, Tenn. Their e-mail addresses, respectively, are lmaples@tnstate.edu, turnerma@stthom.edu and bethhoward@tntech.edu.

AICPA RESOURCES

JofA articles

The Tax Adviser and Tax Section
The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at www.aicpa.org/TAX. The current issue of The Tax Adviser is available at www.aicpa.org/pubs/taxadv.