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Sales and Leasebacks in the Context of the 1031 Exchange

In the current tightening credit market, sale-leaseback transactions have re-emerged as an attractive vehicle for owners and investors of real estate to tap a readily available source of capital. In addition, in light of the current cautious investment climate with respect to other investment vehicles, the sale-leaseback financing structure has a rooted history, and its widespread acceptance makes the sale-leaseback structure a compelling alternative for borrowers and investors.

Traditionally, sale-leaseback transactions have primarily been available to only investment grade or near investment grade type companies, because of the purchasers' strong desires to have well-established and reliable income streams. Today, however, as numerous investors have entered the sale-leaseback arena, all with varying motivations and investment objectives, more below investment grade transactions are being completed, and even leveraged buyout purchasers of companies are finding investors for their targets' real estate assets. They are thus able to employ real estate sale-leaseback transactions as a means of obtaining additional financing for their acquisitions.

In its most basic form, a sale-leaseback of real estate involves the sale of improved or unimproved real estate to an investor that in turn leases the real estate back to the original owner pursuant to a long-term triple net lease. The transaction permits the seller-lessee to liquidate its equity in the real estate while creating a stable investment opportunity for the investor. Aside from serving as a viable alternative to other, less stable investments, sale-leaseback transactions have become increasingly useful in providing replacement property under Internal Revenue Code § 1031 tax-free exchange programs. The net or "bondable" leased property inherent in the sale-leaseback structure is an attractive acquisition for sellers who need to identify a replacement property within the time constraints imposed under the 1031 Exchange.

From the seller-lessee's perspective, the sale-leaseback structure allows the seller-lessee to generate an infusion of cash from an otherwise illiquid investment. The sale-leaseback structure allows the seller-lessee to obtain 100 percent financing of the property by converting all of the seller-lessee's equity in the property into immediate cash. This factor alone makes the sale-leaseback structure more appealing than conventional mortgage financing, in which lenders rarely allow loan-to-value ratios to exceed 75-80 percent of the fair market value of the property.

The sale-leaseback structure also allows the seller-lessee to improve its financial balance sheet. Oftentimes, the property to be sold into the sale-leaseback structure has appreciated in value, but is reflected on the seller-lessee's financial statements at historical cost (less depreciation). In reality, however, the property may have appreciated greatly and have a fair market value well in excess of its historical cost figures. Accordingly, proceeds received from such a sale can have a direct and positive impact on the seller-lessee's financial picture.

The sale-leaseback structure also has some favorable tax characteristics for the seller-lessee. Structured properly, the sale-leaseback allows the seller-lessee to deduct 100 percent of all rental payments made under the subsequent leaseback. These deductions make the sale-leaseback structure more appealing than conventional financing, in which the borrower is only entitled to deduct the interest portion of its debt service payments, but not that portion relating to the repayment of principal.

If the initial sale involves unimproved property with the improvements to be thereafter constructed by or for the seller-lessee, and provided that the initial term of the leaseback is not less than the recovery period of the improvements (or useful life, if applicable), the seller-lessee may be able to depreciate the improvements on an accelerated basis (provided all other rules for accelerated depreciation apply). If the initial sale involves improved property that has already been partially or fully depreciated, the seller-lessee may be able to gain a tax advantage by replacing the limited remaining depreciation deductions with rental expense deductions over the term of the lease.

From the buyer-lessor's perspective, the sale-leaseback provides a secure income stream and a predictable return from a lessee often having investment grade credit. The leaseback is typically structured as a "triple net" or "bondable" lease with all operating responsibilities being assumed by the lessee, thus passing through any expenses of ownership.

The basic rental rate under the leaseback is often determined based on a rental constant for the term of the lease. Rent is typically increased by inflation or other agreed upon escalations every one to five years during the initial term. The duration of the initial term is often determined on the basis of an amortization of the buyer-lessor's initial investment. The number, duration and pricing of any extension options will often be affected by among other factors, the seller-lessee's desired accounting treatment of the leaseback.

Perhaps the most obvious drawback to the sale-leaseback structure from the seller-lessee's perspective is the seller-lessee's relinquishment of its reversionary interest in the property. In a sale-leaseback transaction the seller-lessee converts a fee interest in the property to a leasehold interest for a stated term, thus relinquishing any rights in and to the property after the stated expiration of the term.

The seller-lessee also incurs immediate negative tax consequences by having to recognize all of the gain on the initial sale of the property into the sale-leaseback structure. In addition, by converting its fee interest into a leasehold, the seller-lessee foregoes the benefit of any long-term appreciation of the property. Appreciation, however, is a two-way street, and the relinquishment of the reversionary interest may prove over time to be an advantage to the seller-lessee in the event of any depreciation or less-than-expected appreciation of the property.

The drawbacks to the sale-leaseback structure from the buyer-lessor's perspective are similar to the risks typically associated with any lending decision, most notably the risk of default. Aside from risk of default, additional risk unique to the sale-leaseback structure comes in the form of the uncertainty of the residual value in the property. By holding legal title to the property, the buyer-lessor retains both the "downside" risk of any depreciation or less-than-expected appreciation of the property and the "upside" advantage of any more-than-expected appreciation. Because of these risks, the buyer-lessor will typically discount substantially the assumed residual value of the property. Despite these drawbacks, a properly structured sale-leaseback can yield significant rewards to both seller-lessee and buyer-lessor.

In structuring the details of the sale-leaseback transaction, the seller-lessee and buyer-lessor have competing concerns that require careful attention. In any such case, the seller-lessee may want to negotiate for the right to cause the sale of any one or more under-performing properties out of the sale-leaseback or replace the under-performing properties with viable substitute properties. However, the buyer-lessor's concern lies in the residual value of the properties comprising the sale-leaseback. Thus, in any such instance the buyer-lessor would want to impose strict controls over the seller-lessee's sale or substitution rights so as to preserve the anticipated aggregate residual value of all properties comprising the sale-leaseback.

Both the seller-lessee and the buyer-lessor are concerned with the vesting of title to any improvements to the property subject to the sale-leaseback. In transactions wherein the improvements pre-date the sale-leaseback, the buyer-lessor will want title to such improvements to vest in the buyer-lessor at the outset of the transaction, thereby allowing the buyer-lessor to depreciate the improvements.

With its widespread and historical acceptance in the real estate community, sale-leaseback transactions allow the seller-lessee to realize the full value of their properties. At the same time, sale-leaseback financing provides the buyer-lessee with a secure, long-term income stream with the potential for property appreciation, thus giving it a distinct advantage to other current investment opportunities. These factors and others have and will continue to cause the resurgence of the sale-leaseback transaction.

Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.

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