What is it?
A sale-leaseback is a transaction where one party sells property to another party who then immediately leases the property back to the first party. A gift-leaseback is a transaction where one party gives property to another party who then leases the property back to the first party. A sale-leaseback is useful, for example, when a business owner needs to raise cash by selling assets but would like to continue to use those assets in his or her business. A gift-leaseback is an attractive strategy for someone who wishes to remove appreciating assets from his or her estate but needs to continue to use those assets.
If structured properly, a sale-leaseback transaction allows you, as the business owner, to raise cash by selling business assets, to continue to use those assets, to fully deduct the lease payments as a business expense, and to remove those assets from your taxable estate. The gift-leaseback may be a strategy to consider if you have assets that you expect to appreciate in the future, you would like to remove those assets from your estate, you need to continue to use those assets, and you have children or other beneficiaries to whom you would like to give the property. Typically, with a sale-leaseback, you sell a substantial physical asset (such as your plant or piece of major machinery) to a third party for cash. You then enter into a lease agreement (at a fair market rental) with that third party to continue to use that asset, and then fully deduct the lease payments as a business expense. The asset is removed from the balance sheet and you have additional cash to invest in the business.
With a gift-leaseback, you give a substantial physical asset (such as a medical office building in which you have your medical practice) directly to your children or to an irrevocable trust for the benefit of your children. You likely will incur gift tax on this transaction. You then enter into a fair market lease with your children or the trust to rent the building back. The lease payments are then deductible as a business expense. Your children or the trust receive the income from the lease payments and may be able to claim depreciation deductions with respect to the building. Because you no longer own the asset but merely lease it, the asset that may appreciate in the future is removed from your estate.
Transaction needs to be structured and documented very carefully to minimize IRS scrutiny
The IRS has scrutinized both sale-leaseback and gift-leaseback transactions very closely to determine if the entire transaction is genuine and not merely disguised as a sale. If the IRS determines that the transaction is not a sale but is really a loan, then the lease payments will not be fully deductible. If the transaction is recharacterized, the business owner will be able to deduct only that portion of the lease payment that was determined to be interest — just as with a loan. If the IRS determines that the transaction is a loan, then the purchaser of the building is considered a mortgagee and will not be considered the owner, and thus cannot deduct depreciation and expenses. The IRS will especially scrutinize transactions between related parties, such as family members or corporations and shareholders.
Terms of transaction must be negotiated at arm's length
All of the terms of the sale- or gift-leaseback must be negotiated fairly and arrived at in an arm's length manner. In other words, the sale price of the asset should be the fair market value of the property; the lease payments should be reasonable and based on comparable rentals; the financial arrangements should be straightforward; and the buyer should be the party to benefit from any future appreciation (and suffer the burden of any future loss in value) with respect to the property.
Lease terms very important
In both sale-leaseback and gift-leaseback transactions, the IRS will examine very closely the terms of the lease to make sure that the transaction is bona fide and has been negotiated in good faith. Therefore, the parties to a sale- or gift-leaseback should make certain first that there is a written lease agreement between the parties. Second, the terms of the lease should be the same as the terms of any standard commercial lease for that type of property. Third, the rental amount should be the fair market rental for that type of property, so the parties should obtain a qualified, independent appraisal of the market rental rate. Fourth, the lease agreement should specify that the terms of the lease will be renegotiated frequently (preferably every year) to adjust for changes in the fair market rental of the property. Finally, all the terms of the lease should be complied with strictly, and the agreement should provide that there will be penalties for late payments and other breaches of the agreement. These types of provisions demonstrate that the transaction is bona fide; however, it is not necessary that parties include every single term (such as late fees). The inclusion of these types of provisions are especially important when the transaction is between related parties, such as family members or a corporation and its shareholders.
Strengths
Sale-leaseback is a good way for companies to turn assets into cash
A sale-leaseback may be an excellent way for a company that is asset rich but cash poor to turn some of those assets into ready capital. The company would have the further benefit of being able to continue to use those assets. Most major airline companies, for example, use the sale-leaseback technique to finance their fleets of planes.
Example(s): Old Time owns a manufacturing plant that it estimates has a fair market value of $1 million. Old Time would like to upgrade and modernize its plant but does not have sufficient cash flow to finance the modernization. Old Time would prefer not to mortgage the plant. One solution for Old Time would be to find a buyer and then do a sale-leaseback. Old Time could sell the plant for $1 million, receive the cash up front, and then enter into an agreement with the buyer to lease the plant back at a fair market rental amount. If the sale-leaseback is structured properly, Old Time could fully deduct the lease payments as business expenses. They would then have enough money to modernize the facility.
Gift- or sale-leaseback can reduce size of gross estate
Either the sale-leaseback or the gift-leaseback may be used to reduce the size of your taxable estate. With both a sale and a gift, the asset is removed from your estate. With a sale, the property you receive in exchange for the asset you sold would likely be included in your gross estate. With a gift, a gift tax may have to be paid at the time of the gift. However, if the asset is appreciating rapidly, it may make sense for you to remove that asset as soon as possible. It's important to note that at your death, the value of all your taxable gifts made during your lifetime is added back into your gross estate. You are also given a credit for any gift tax that you have paid. However, any appreciation in the value of the gifts after the time of the gift is not included in your gross estate.
Tradeoffs
Seller will have to pay taxes on gain at time of sale
In the case of a sale-leaseback, the seller of the property will have to pay the taxes on any gain realized. Therefore, if you own an asset with a low adjusted basis and you sell that asset, you will have to pay the taxes due just as with any other sale.
Example(s): The Old Time Manufacturing Company owns a plant with an adjusted basis of $100,000. It plans to structure a sale-leaseback to raise cash to modernize the facility, and arranges to sell the plant for $1,000,000. In the year of the sale, Old Time will have to pay taxes on the gain of $900,000.
In a gift-leaseback, the donor may have gift tax liability
In a gift-leaseback transaction, when the donor makes the gift, gift taxes may be incurred at the time of the transfer. There may also be gift tax liability in a sale-leaseback transaction if the selling price is less than the fair market value (FMV).
Example(s): Hal owns the building in which his medical practice is located. He would like to transfer ownership of the building to an irrevocable trust for the benefit of his children. He gifts the building to the trust. The building has an FMV of $500,000. He has already fully used the gift tax applicable exclusion amount through past gifts. At the time of the transaction, Hal owes a gift tax on the $500,000 gift. Similarly, if he had sold the building to the trust for $200,000, then he would owe gift taxes on the $300,000 difference.
Seller will not benefit from any appreciation in value of asset
One of the tradeoffs to doing a sale-leaseback is that the seller of the asset will not benefit from any appreciation of that asset in the future. One alternative to the sale-leaseback is to mortgage the property. This will also raise cash, and you can probably deduct the interest portion of the loan payments. You will also receive the benefit of any appreciation of the asset in the future. Therefore, if you are in a position where you may need the asset in the future, you should not do a sale-leaseback transaction. Simply mortgaging the asset may be a better way to go.
How can Wealth Advisory Lab help?
If it is a gift-leaseback and you plan to set up a trust to receive the gift, then an attorney experienced in trusts and estates should be hired to draft the trust document. If you already have a trust, updates can be very complicated, and the coordination with the existing plan should be comprehensive. Unlike many estate and financial planning firms, we are a fee-based firm committed to providing transparency with our custom designed solutions and strategies.