When taxpayers enter into complex real estate transactions, they are often unaware of how those deals can trigger unexpected tax consequences.
For instance, when a Section 1031 like-kind exchange (Exchange of Property Held for Productive Use or Investment) is coupled with a sale/leaseback arrangement, the IRS could feasibly disregard the transaction because it fails the “substance over form” test. That’s because the primary tax benefit of a like-kind exchange is deferred gains from a property sale, and when this exchange is coupled with a sale/leaseback (SILO) or lease-in/lease-out (LILO) transaction, the IRS could determine that it should be classified as a loan – not a like-kind exchange.
Let’s take a more detailed look at how the IRS determines the substance of sale/leaseback transactions. Assume Taxpayer A sells a property for a large taxable gain. In order to defer recognition of a taxable gain, Taxpayer A identifies and acquires replacement property within the required time limits to be considered by the IRS as a like-kind exchange (45 days to identify / 180 days to acquire). As part of this arrangement, the owner of the replacement property (Company Z), leases the property to Taxpayer A for a term exceeding the useful life of the property, in exchange for a lump-sum cash payment. Taxpayer A then subleases the property back to Company Z. As part of the deal, Company Z returns a portion of the lump-sum cash payment to Taxpayer A as prepayment of the sublease, with another cash portion set aside to allow Company Z to purchase back the property when the sublease ends (cancellation option).
In essence, this is a circular flow of money, through which Taxpayer A funded the transactions with its own funds before receiving those funds back in a short period of time. This ensured that Taxpayer A would be in the same cash position as if it had taken out a loan to finance the transaction. Additionally, the deal did not transfer the benefits and burdens of ownership to Taxpayer A. In other words, Taxpayer A did not face any significant risks of ownership, meaning that the “substance” of the transactions were not consistent with the actual “form” under which they occurred.
In summary, the agreement between Taxpayer A and Company Z should be characterized as a loan, not a true lease. For that reason, the taxpayer would be seen as having exchanged property for an interest in financial instruments, and not a “like-kind” property exchange. Thus, Taxpayer A is required to recognize the full gain on sale of the original property. Depending on specific circumstances, the taxpayer could also be liable for a negligence penalty under Internal Revenue Code Section 6662: Imposition of Accuracy Related Penalty on Underpayments.
To avoid similar tax headaches, it’s wise to engage a CPA or other qualified financial advisor before selling a property, since that partner can explain the tax consequences of such transactions.
March 20, 2017