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How Businesses Can Convert Real Estate into Cash and Continue to Operate at the Property

The impacts of COVID-19 on businesses are being felt across industries and around the globe. The impacts to many US businesses have been profound and quick access to cash has become of critical importance to many companies. At the same time companies’ cash needs have spiked, traditional lenders have tightened loan requirements and reduced loan to value ratios (loaning less money per dollar of real estate value).  This has created an unfortunate “perfect storm” as far as liquidity needs.

However, businesses with good long-term prospects that own real estate can access cash for the full value of the real estate without going through lender underwriting review by entering into a sale-leaseback transaction.

What Is a Sale-Leaseback?

A “sale-leaseback” is a transaction in which a property-owner sells its real estate to a real estate investor and then simultaneously leases that property back under a long-term lease. Generally, the seller receives the full fair market value of the property and the seller continues to operate its business at the property. The buyer receives an asset with a going concern tenant that is familiar with operating and managing the property and gains a long-term stable return on its investment in the form of rent payments.

What Are the Benefits?

The key benefits of a sale-leaseback is that the company selling the property retains the use and control over its real estate while gaining liquidity with an infusion of capital to use as it sees fit. The money can be used for any purpose such as to reduce outstanding debt, recapitalizing the company, acquiring inventory or equipment, retaining key employees, etc.

Yet another benefit is that the seller can obtain capital equal to 100% of the fair market value of the property. In conventional financing arrangements, the lender will generally impose a loan-to-value ratio to protect against devaluation of the property during an economic downturn or against the borrower’s default. At the same time, the buyer acquires a property with a going concern that provides it with a steady return of investment for the life of the lease. The buyer is able to review the seller’s financials to gauge its viability and stability as its prospective tenant. Because the lease is generally structured as a triple net lease, the landlord-buyer is able to limit its involvement in the property’s management. The tenant usually retains the responsibility to maintain and insure the property, and pay the taxes.

What Are the Tax Impacts to Seller/Tenant and Buyer/Landlord?

Provided that the sale-leaseback is properly structured from a tax perspective (and not a disguised loan or financing transaction), the seller/tenant generally will recognize gain from the sale and will be able to deduct its new lease payments as operating expenses.  The buyer/landlord will be able to take depreciation deductions for the value of the purchased tangible property (including the building, building improvements, and certain land improvements) and will recognize rental income for the lease payments.  Whether the sale-leaseback is respected as a “true lease” for tax purposes depends on the facts and circumstances of each transaction and is beyond the scope of this article.  Notably, the property should not automatically revert to the original seller at the end of the lease term and the seller should not have an option to purchase the real estate during or at the end of the lease term for a bargain purchase price.

Risks to Note

Of course, there are some risks and concerns associated with sales-leaseback transactions.  These include:

  • Loss of Potential Increase in Property Value
    • In entering into a sale-leaseback arrangement, the seller loses the possibility of earning any long-term gain associated with the property’s future appreciation in value.
  • Continued Costs
    • Certain costs continue for the seller. Typically, the seller and buyer will enter into a “triple net lease” under which the seller, as tenant, is indirectly responsible for paying the taxes, maintenance fees, and insurance costs associated with the property.
  • Recharacterization by the IRS as a Financing Transaction
    • If a sale-leaseback is characterized by the IRS as a financing device, the transaction will be treated as a loan from the buyer to the seller (and a subsequent sale if the buyer ultimately retains ownership at the end of the lease term).  The seller will be treated as the owner of the property and any taxable gain or loss resulting from the sale aspect of the sale-leaseback will not be recognized.  The only portion of the lease payments paid by the seller that will be deductible for tax purposes will be the portion deemed interest on the implied loan.  The remaining portion of the lease payments will be treated as a payment of principal on the implied loan.

Conclusion

Sale-leasebacks offer an effective and streamlined way to monetize real estate and can be a very attractive option, particularly in light of COVID-19 impacts on lending practices and procedures.

 


We are here to help answer specific questions and offer advice on your options. Feel free to contact any member of our Real Estate Group.

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