Making the Most of Sale and Leasebacks in 2010 and Beyond

The year 2010 could be a good time for taxpayers owning appreciated property to take advantage of existing tax rates and consider a sale/leaseback transaction.The lease payments would be deducted at the higher rates in 2011 and subsequent years. In addition,there is strong sentiment in Washington to extend the additional first year depreciation on certain leasehold improvements, which expired at the end of 2009, for an additional year.

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Why engage in a sale and leaseback?: A primary motivation for a seller-lessee is to “unlock” the increase in the equity in the property and to deploy it in the business to finance an expansion, or perhaps, to decrease debt and the accompanying interest expense. As a result, the balance sheet of the seller-lessee is improved greatly. Another advantage of entering into this type of a transaction for the seller-lessee is that the company remains in the same property, which could be vital if it is engaged in a retail business where customers are used to coming in order to patronize the business.

From a tax standpoint it is advantageous for the seller-lessee to enter into such an arrangement because the appreciation over the original purchase price is generally taxed favorably as an IRC Section 1231 gain. Moreover, if the seller of the property is an individual taxpayer, that part of the gain that is equal to the depreciation taken (“unrecaptured IRC Section 1250 gain”) is taxed at no more than 25%. Then, when the property is leased back, the entire amount of the lease payments is deductible at the ordinary rates. It should be noted that the lease payment presumably is for the entire property – building and land. In contrast, prior to the sale, the owner of the property could take depreciation only on the building. Thus, the lease payment deduction after the sale and leaseback has been entered into could be considerably larger than the depreciation deduction prior to its sale.

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Tax environment in 2010-2011: There is a unique tax opportunity in 2010-2011. Both ordinary tax rates and long-term capital gains rates for individual taxpayers are scheduled to increase in 2011. For those individuals who own appreciated property who would like to enter into a sale and leaseback, they should enter into these transactions in 2010. That way, the gain will be taxed at the lesser rates than will be in effect in 2010. Then, the lease payments (which presumably would be greater than the depreciation deduction that they could have taken prior to the transaction) would be deducted at the higher rates in 2011 and subsequent years. Of course, the lease payments in 2010 will be deducted at the lower tax rates in effect for 2010.

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Effect of state income taxes in 2010-2011: Because of diminishing revenues for almost all states, there is a likelihood that state income tax rates will be increasing in the future. As a result, individuals who would like to enter into a sale and leaseback are encouraged to execute such a transaction in order to have their gains are taxed at a lesser rates than currently exist, and then make lease payments deducted at higher rates which are projected for the future.

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RELATED LINKS: For more information, see 1-4 Federal Taxes Affecting Real Estate § 4.05

For more information, see LexisNexis Tax Advisor -- Federal Topical § 1G:1.02