Real Estate Leases (Portfolio 593)

Tax Management Portfolio, Real Estate Leases, No. 593-2nd, analyzes the tax issues encountered by both lessor and lessee in contemporary leases of real property.

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Tax Management Portfolio, Real Estate Leases, No. 593-2nd, analyzes the tax issues encountered by both lessor and lessee in contemporary leases of real property.

This Portfolio discusses issues to be considered in originating a lease, including §467 rental agreements. It also presents the lessor's and lessee's perspectives, with respect to tax principles, in determining who should pay for lessee improvements. Also discussed are the issues raised when a lease is modified, terminated, or transferred.

There are different reasons for using a sale of real property by its owner and the simultaneous leaseback of the property as a method of financing the property (as opposed to borrowing). This Portfolio analyzes the income tax consequences to the seller-lessee and the buyer-lessor, and outlines the various tax problems inherent in structuring such transactions. Special emphasis is placed on tax planning, from the standpoints of both the seller-lessee and the buyer-lessor, to maximize the tax benefits inherent in sale and leaseback and related transactions.

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Philip J. Holthouse, B.S., University of Southern California (summa cum laude, 1981); M.B.T., University of Southern California (1986); J.D., Loyola Law School — Los Angeles (Order of the Coif, 1993); adjunct professor, University of Southern California Master of Business Taxation Program (1988–2001); author of numerous articles on federal taxation; member of the American Bar Association, State Bar of California, American Institute of Certified Public Accountants, California Society of CPAs; partner, Holthouse Carlin & Van Trigt LLP (CPAs); partner, Sherry Meyerhoff Hanson & Crance LLP (Attorneys at Law).

Lisa Marie Starczewski, J.D. (summa cum laude), Villanova University School of Law; B.A. (magna cum laude), Smith College. Starczewski served as Editor-in-Chief of the Villanova Law Review (1987–1988) and has practiced law with Morgan, Lewis & Bockius and Schnader, Harrison, Segal & Lewis. She taught at Villanova University School of Law. Ms. Starczewski has authored and coauthored several Accounting Policy and Practice Portfolios, including 5101, Revenue Recognition: Fundamental Principles; and 5114, Accounting for Leases: Fundamental Principles. She has also authored numerous Tax Management Portfolios, including 565 T.M., Installment Sakes, 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules; 587 T.M., Noncorporate Alternative Minimum Tax, 752 T.M., Corporate Alternative Minimum Tax, 621 T.M., IRS National Office Procedures — Rulings, Closing Agreements, 550 T.M., At-Risk Rules, co-author, 517 T.M., Scholarships and Educational Expenses. She is also the author and co-author of numerous Tax Practice Series chapters. She has received the Tax Management Distinguished Author Award, is a member of the Tax Management U.S. Income Advisory Board, and is a consultant with Buchanan Ingersoll & Rooney PC.


Detailed Analysis

I. Introduction

A. What Is a Lease?

B. Types of Leaseholds

C. Rental Terms

II. Originating a Lease

A. Negotiations/Economics

1. Landlord's Perspective

2. Tenant's Perspective

3. Involving the Tax Advisor

B. Accounting Methods

1. Landlord's Perspective

a. Rental Income

(1) All Events Test Applied

(2) Advance Rentals/Prepaid Rent

(3) Advances as Loans

(4) Security Deposits Distinguished

b. General Expenses

c. Real Estate Taxes

d. Allocations Among Co–owners

2. Tenant's Perspective

a. Accrual Basis Tenant

b. Cash Basis Tenant

c. Receipt of Lease Incentives

3. Related Party Issues

a. Section 267

b. Constructive Receipt

c. Passive Loss Interplay

d. Excessive Rent

e. Section 482

4. Tenant Acquires Equity or Option

C. Transaction Costs

1. Landlord's Perspective

2. Tenant's Perspective

3. Other Landlord Expenses

D. Section 467 Rental Agreements

1. Background

2. A Cure Worse than the Disease?

3. Statutory Structure

4. Technical Advice Memoranda

5. Case Law

6. The Regulations

a. Section 467 Rental Agreements

b. Proportional Rent

c. Section 467 Loans and Imputed Interest

d. Rent Leveling

e. Dispositions and Recapture

7. Open Questions

a. Deferred Payments for Services

b. Lease Stripping

c. Timing Mismatches Favoring the Government

d. Contingent Payments

e. Modifications

8. Planning Principles

E. Financial Accounting Concepts

III. Who Should Pay for Tenant Improvements?

A. Economics

B. Tax Principles

1. Landlord's Perspective

a. Landlord/Tenant Devices for Funding Improvements

b. Depreciation of Landlord Owned Improvements

(1) In General

(2) Qualified Leasehold Improvement Property

(a) In General

(b) First-Year Bonus Depreciation

(i) 2008-2009 Bonus Depreciation

(ii) Bonus Depreciation for Tax Years 2001 Through 2005

(iii) Gulf Opportunity Zone and Kansas Disaster Area Property

(iv) Qualified Disaster Assistance Property

(v) Claiming or Electing Out of Bonus Depreciation

(c) 15-Year Recovery Period

(3) Qualified New York Liberty Zone Leasehold Improvement Property

c. Landlord Dispositions of Leasehold Improvements

d. Demolition Provisions

e. Section 109 and Section 1019

(1) In General

(2) Landlord

(3) Tenant

2. Tenant's Perspective

a. Landlord Payments to Tenant and Allowances

b. Section 110 Exclusion

c. Depreciation of Tenant Constructed Leasehold Improvements

d. Lessee's Treatment of Unrecovered Basis in Leasehold Improvements Upon Lease Termination

IV. Modifications/Terminations

A. Introduction

B. Modifications

1. Landlord's Perspective

2. Tenant's Perspective

3. Modifications Under Section 467

C. Terminations

1. Landlord's Perspective

2. Tenant's Perspective

a. Tenant Receives Cancellation Payment

b. Tenant Makes Cancellation Payment

V. Transferring Lease Interests

Introductory Material

A. Landlord Transfers

1. Overview

2. Landlord's Perspective

3. Buyer's Perspective

4. Prorations/Whose Rental Income?

B. Tenant Transfers of Leasehold Interests

C. Transfers of Section 467 Leases

D. Obligation–Shifting Transactions

VI. Sale–Leaseback Transactions

A. Introduction

B. Business and Financial Considerations

1. Seller–Lessee's Perspective

a. Source of Capital

b. Financial Statement Presentation

(1) SFAS 13

(2) SFAS 98

(3) Synthetic Leases

c. Income Tax Considerations

d. Other Issues

2. Buyer–Lessor's Perspective

a. Business and Financial Considerations

b. Income Tax Considerations

C. Sale vs. Financing

1. Consequences of Recharacterization

2. Case Law

a. Frank Lyon Co. v. U.S.

b. Significant Factors

(1) In General

(2) Economic Substance v. Sham

(3) Economic Investment

(4) Purchase/Renewal Options

(5) Taxpayer Bound by its Form?

3. IRS Pronouncements

4. Summary and Planning Considerations

D. Tax Consequences of the Sale–Leaseback Transaction

1. Seller–Lessee

a. The Sales Transaction

(1) Tax Issues Related to the Sale

(2) Related Party Rules

b. The Lease Transaction

(1) Failure to Set Market Price or Rents

(2) Transaction Costs

2. Buyer–Lessor

a. The Purchase Transaction

b. The Lease Transaction

E. Like–Kind Exchanges

1. Tax Consequences

2. Leading Cases

a. Century Electric Co.

b. Jordan Marsh

c. Subsequent Decisions

d. Can Landlord Swap a Leasehold?

3. Summary

F. Other Concepts

1. Sale–Leasebacks Between Related Parties

2. Gift-Leasebacks

3. Contribution to Corporation and Leaseback

4. Equity Interest of the Buyer-Lessor

5. Condemnation and Leaseholds

a. Leaseback

b. Similar or Related In Use

6. Sale-Leaseback as a Partnership

a. In General

b. Co-Tenants as Partners

7. Sale-Leaseback with Tax-Exempts

VII. Passive Loss Rules

A. Background

B. Rental Activities

C. Real Estate Professionals

1. In General

2. Qualifying Real Estate Professionals

D. Material Participation

E. Recharacterization of Rental Income

1. Background

2. Rental of Nondepreciable Property

3. Passive Losses and Section 467 Leases

4. Material Participation and Self-Rental Property

F. Passive Gain on Sale?

VIII. Leasing to Tax-Exempts

A. Background

B. Tax-Exempt Use Property

C. The MACRS Penalty

D. Limitation on Losses

1. In General

2. Exception to Loss Limitation

a. Monetization Not to Exceed 20% of Taxpayer's Adjusted Basis

b. Substantial Equity Investment

c. Minimal Risk of Loss

d. Fair Market Value Purchase Option

IX. Tax Planning

A. Leasing in Lieu of Installment Sales

1. Installment Sale Provisions

a. The 1987 Act Provisions for Dealers

b. The 1987 Act Provisions for Nondealers in Real Property

2. Substituting Leases for Installment Sales

a. Leasing for Estate Planning

b. Leasing to Stretch Holding Periods

c. Leasing to Obtain Character of Income

d. Sale vs. Financing

(1) Avoiding Recharacterization

(2) Purchase/Renewal Options

B. Accelerating and Shifting Income

C. Equity Participations


Working Papers

Table of Worksheets

Worksheet 1 Long–Term Lease vs. Installment Sale Analysis

Worksheet 2 An Illustration of the Affirmative Use of Section 467 Rental Agreements.

Worksheet 3 IRS Publication 535 - Excerpt on Rent Expense

Worksheet 4 Business, Financial and Tax Considerations of Sales and Leasebacks.

Worksheet 5 Factors to Consider in Structuring a Sale–Leaseback Transaction to Avoid Having It Classified as a Financing Device.




Treasury Regulations:

Legislative History:

Treasury Rulings: