Although sale-leaseback agreements can be designed in various ways, a simple sale-leaseback could benefit both the lessor and the seller. Before moving forward, both parties should consider the tax and business benefits, drawbacks, and risks of this kind of deal.
When it comes to the usual sale leaseback equipment, an owner of a property sells the property used for its business to a private investor or institution, the sale is also accompanied by a leaseback. The owner returns the property for an agreed-upon period, typically between 20 and 30 years.
The sale-leaseback can include either as well the property as well as the improvements.
The most common type of transaction is a triple net-lease arrangement. In most sale-leaseback deals, the seller can renew the lease and, sometimes, buy the property.
A sale-leaseback arrangement gives property owners a variety of advantages for business.
Converts equity into cash.
With a sale-leaseback, the seller can use capital that would otherwise be held in the property’s ownership, provided that the seller maintains the property and continues to use it throughout the lease term.
The seller typically receives more cash from the sale-leaseback option than traditional mortgage financing. If a deal includes land and enhancements, then the buyer gets 100% of the property’s value (minus the capital gain tax). In contrast, the conventional mortgage typically will not fund more than 70 or 80 per cent of the property’s worth.
Since capital gains tax is a part of the proceeds from the sale and a sale-leaseback in which you sell the house for only a modest gain or loss, it generally is beneficial.
Alternative to conventional financing.
The seller can usually arrange the lease’s initial term to an amount in line with the requirements without the added burden of balloon payments, refinancing, call provisions or other issues with conventional financing. Furthermore, the seller can avoid the high costs of conventional financing, such as appraisal fees, points, and even some legal fees.
Possibility of better financing.
Under a sale-leaseback arrangement, a buyer might get more favourable mortgage terms than the owner of the property. If the owner fails to pay in the future, the buyer can make payments to protect its equity. Therefore, the lender may be willing to offer the buyer the interest at a lower rate, which could lead to lower rent payments for the vendor.
So, a higher current ratio can improve the seller’s ability to borrow further funds.
If you count the lease as a capital loan, the benefits of a sale-leaseback deal change a lot from an accounting point of view. A statement of Financial Accounting Standards No. 13 on the accounting for leases requires that capital leases be classified as an asset and capitalized. It is also required to make future lease payments to be recorded as an obligation.
Beware of Debt Restrictions.
Businesses restricted from borrowing additional money under previous bond or loan agreements may be able to avoid the restrictions with the sale-leaseback. Rent payments made under the sale-leaseback are typically not considered indebtedness in these circumstances. Therefore, a company can fulfil its cash requirements with the sale-leaseback without infringing on prior agreements.
A deterrent to corporate takeovers.
Corporate raiders often go after a company’s real estate that is undervalued in its books. The prompt liquidation of assets via a sale-leaseback deal could be a deterrent, giving management the funds to thwart the acquisition. Additionally, the long-term lease is not as appealing to robbers as undervalued real estate.
Does not violate the Usury limitations.
Because a sale leaseback is not a loan, the state’s usury laws are not applicable. A sale-leaseback purchaser could get a better return than it would have earned when it made a traditional home loan—the property owner.
Loss of residual property value.
The fact that the seller gives the title to the buyer may be the biggest problem with the sale-leaseback plan. Owners can mitigate this drawback by incorporating a repurchase option within the leaseback. Repurchase options change the way the sale-leaseback arrangement is reported for accounting reasons. The lease will be reported as an asset and capitalized, and the commitment to pay instalments to the lease in future will be recorded as an obligation.
At the end of a lease with no extension options, the vendor might be required to agree to extend the lease at market rent or relocate their business.
The loss of flexibility.
The seller loses the freedom that comes with ownership of the property, which includes the possibility of changing or ending the usage of the property or altering a building. The sale-leaseback usually limits the rights of the seller to sell the leasehold, and, if it is possible, typically, it’s more difficult to sell the leasehold interest than it is a fee-owned interest. Also, if the seller wants to improve the leased property, it might be hard to get financing if the property is leased. The leasehold could also contain clauses restricting the owner from mortgaging the leasehold interest.
The High Rent Payment.
If the rental market is soft, the seller might be locked into the more expensive rental rate negotiated during the sale leaseback. Lease payments for a rental cannot be modified without the purchaser’s approval, which implies that the vendor will be tied to the interest rate specified in the leaseback throughout the lease.
Higher cost of financing.
The buyer takes on additional risks by financing 100 % of the property’s market value. Additionally that the property owned by the buyer is the property that is leased and may not be as liquid or more marketable as compared to the loan; additionally, the cost of negotiation could be more expensive as a lot of time and effort could be required to customize the purchase to meet the needs of the seller.
The decision of a seller to raise funds via sale-leasebacks is often due to the substantial tax advantages. These savings can be another source of money that the seller can utilize.
Deduction of rental payments.
The main tax benefit of a legitimate sale-leaseback is that rents made under the lease are tax-deductible. When financing a conventional mortgage, the borrower can only deduct the interest and depreciation. The deduction for rental may be greater than the depreciation amount in three instances where the property is predominantly of an asset that is not depreciable such as land (although it is not depreciable, rent payments made for land leases could be deductions). If the property has increased in value (while the price of the home caps deductions for depreciation, the deduction for rental could be equal to what the house’s market price is) or if the property is completely depreciated.
A company may want to report gains to use business credits or keep net operating losses from the previous year. If the company has an appreciated asset, selling the asset will result in an income offset by credits or carryovers of net operating losses. If the basis of the assets is more than what they are worth on the market, an acknowledged loss can reduce tax obligations.
Sale-Leaseback may not be acknowledged.
Suppose the sale-leaseback transaction gives the seller an option to purchase the property or the seller holds substantial ownership rights. In that case, the Internal Revenue Service may view the sale as an eviction. In that situation, the seller couldn’t deduct rent but can deduct deductions for depreciation and some of the rent payments as interest.
Loss Cannot be Reported.
If the lease period is 30 or more years, the deduction for ordinary losses allowed in a sale-leaseback deal could be denied because it’s a non-taxable exchange of similar-kind property following IRC Section 1031. However, the seller could depreciate its leasehold basis during the lease term.
Deductions Could be Rectified.
The validity of a leaseback sale is often dependent on the consequences of the transaction for the buyer. A well-planned sale-leaseback deal gives the buyer many advantages and advantages.
Higher Return Rate.
The buyer usually receives a greater return on an arrangement for sale-leaseback than the conventional loan arrangement. In addition, the purchaser may be able to avoid the laws governing usury in states that restrict the rate of interest that can be charged for conventional financing. Additionally, when the lease term is over, the lease period the purchaser will receive the benefits of any increase in the property’s price. In addition, the purchaser can leverage the purchase using mortgage financing.
Affordable as well as Secure Return Rate.
The long-term net lease allows the buyer to calculate the projected yield accurately. Also, the longer lease period protects buyers from changes in the real estate market and inflation if the property’s value increases over time.
Eliminates Usury Issues.
In a sale-leaseback arrangement, the buyer can eliminate the state-related usury issues lenders face when cash is scarce. Both parties can agree on the rental level.
The Ownership Rights of the Reversion.
The buyer owns the interest in the property that is reversible. When the owner has the option to buy the property or extend the lease, it could make it harder or take longer for the buyer to make money. Buyers also have to take on the risk that their property value could decrease over the lease’s duration.
Finally, in buying an investment property, the purchaser will have an in-built tenant, specifically the seller.
While there are many advantages for the buyer when negotiating a sale-leaseback deal, there are also disadvantages to consider.
Possibility of Seller Failure.
Perhaps the biggest danger for the buyer is the possibility that the seller could fail to pay the rent, resulting in the buyer not having a tenant. If the seller declares bankruptcy, it is the buyer who will be considered to be a general creditor. If the deal was a traditional mortgage and the buyer was classified as a secured creditor. In a down market, if the seller goes bankrupt, it might be hard for the buyer to find a new tenant.
A required Management must manage the property.
In most instances, the seller takes on the responsibility and costs of managing the property during the lease period. But the buyer has to ensure that the seller pays property taxes on time and that the taxes will be looked at and, if necessary, contested. Additionally, the buyer must regularly check to see if the property has insurance and if any repairs are necessary.
The most basic tax implications from the perspective of buyers are simple.
The availability of deductions and Tax credits.
The buyer can partially offset the rent income by taking advantage of credits and deductions. The buyer can get depreciation tax deductions, assuming the property qualifies. Mortgage interest could be deducted with certain restrictions. The purchaser may be eligible for certain tax credits if they remain available. The passive loss restrictions and rules for at-risk may restrict the deductions available to certain taxpayers.