In last month’s article, I attempted to show practitioners how to address the legal issues associated with proving that saleleaseback transactions cannot demonstrate the actual market value of the underlying real estate. Regardless of the case law, however, most assessors still want to consider such transactions as being relevant to the assessments of real estate encumbered by lease payments which are typically fixed to provide for amortization of the purchase price over the term of the lease plus a specified return rate on the buyer’s investment. To educate assessors as to why they must reject such sales, it is wise to arm yourselves with talking points demonstrating various reasons why the real estate is not the only thing involved in a sale-leaseback. I have found the following points to be helpful in my practice and wanted to devote this month’s article to sharing them with my colleagues.
Converts Equity into Cash. With a saleleaseback, the seller regains use of the capital that otherwise would be tied up in property ownership; at the same time, the seller retains possession and continued use of the property for the lease term.
Improves Balance Sheet and Credit Standing. In a sale-leaseback, the seller replaces a fixed asset (the real estate) with a current asset (the cash proceeds from the sale). If the lease is classified as an operating lease, the seller’s rent obligation usually is disclosed in a footnote to the balance sheet rather than as a liability. This results in an increase in the seller’s ratio of current assets to current liabilities, which often serves as an indicator of a borrower’s ability to service its short-term debt obligations. Thus, an increased current ratio improves the seller’s position for borrowing future additional funds.
Avoid Debt Restrictions. Businesses restricted from incurring additional debt by prior loan or bond agreements may be able to circumvent these limits by using a sale-leaseback. Rent payments under a sale-leaseback usually are not considered indebtedness for such purposes, thus a business can meet its cash needs through the sale-leaseback without violating any previous agreements.
Deduction of Rental Payments. A seller’s decision to raise funds through a sale-leaseback frequently is based on substantial income tax advantages. The main tax advantage of a valid sale-leaseback is that rental payments under the lease are fully deductible. With conventional mortgage financing, a borrower deducts interest and depreciation only. The rental deduction may exceed the depreciation in three cases: if the property consists primarily of a non-depreciable asset, such as land (although land is not depreciable, rental payments for the lease of land may be deducted); if the property has appreciated in value (while depreciation deductions are limited by the cost of the property, rental deductions may equal the fair market value of the property); or if the property has been fully depreciated.
Capital Gain-Ordinary Loss Treatment. Because the property involved in a sale-leaseback generally is held for use in the seller’s trade or business, it qualifies for capital gain-ordinary loss treatment. Under Section 1231 of the Internal Revenue Code, if the property is held for the long-term holding period, gain on the sale, with some exceptions, will be taxable as long-term capital gain to the extent that the gain exceeds the losses in the same year from the sale of other Section 1231 property. However, the gain will be taxable as ordinary income to the extent of recapture income. But in the case that the sale results in a loss, it will be deductible in full as an ordinary loss to the extent the loss exceeds Section 1231 gains from the sale of other property in the same year. This can be a substantial advantage to the seller in a sale-leaseback transaction.
Higher Return Rate. The buyer usually receives a higher rate of return in a sale-leaseback than in a conventional loan arrangement. Also, the buyer may be able to circumvent state usury laws that limit the rate of interest charged with conventional financing. In addition, at the end of the lease term, the buyer receives the benefit of any appreciation in the value of the property. Finally, the buyer can leverage the purchase with mortgage financing; this may further magnify the return rate on the cash invested.
Ownership of the Reversion. The buyer owns the reversionary interest in the property. If the seller has an option to purchase or an option to renew the lease, this may limit or postpone the time that the buyer actually realizes the profit potential. The buyer also bears the risk that the property value actually might decline over the lease term.
Built-in Tenant. Finally, in purchasing the property, the buyer has a built-in tenant, namely the seller.
By using these talking points in your discussions with assessors, you may be able to convince them that the value of the brick and mortar should be determined by actual market sales of similar properties, not the investment value of business transactions in which the value of the real estate is often not even considered – much less relied upon – by the actual market participants.