Sale or Gift Leasebacks
A sale or gift leaseback involves 1 party selling or giving property to another and then leasing back the same property. Sale or gift leasebacks are often used in estate planning, because it can be an effective way to reduce income and/or gratuitous transfer taxes. A leaseback is used when the property owner owns a lot of assets, but needs more cash flow; or the property owner earns a higher income, subject to a high marginal tax rate, and wants to transfer some of that income to family members in lower tax brackets, which will yield greater after-tax income for the family. Additionally, if the property is rapidly appreciating, the leaseback can be an effective way to save on estate taxes on the appreciation.
Real estate is the most common type of property for leasebacks, since it is a type of property that is commonly leased and appreciates in value. Thus, transferring the property to a beneficiary will remove the appreciation from the gross estate of the taxpayer, while he can make deductible lease payments to the beneficiary. This saves both income taxes and employment taxes for the taxpayer while the income to the beneficiary is subject only to ordinary tax, which will be taxed at a lower rate if the beneficiary is in a lower tax bracket, as is often the case.
To withstand IRS scrutiny, the lessee should pay the entire lease and the lease should be reasonable; lease provisions, especially the payments, should be strictly enforced; and the sale price should be the fair market value (FMV) of the property. The lease payment calculation should be documented.
In the case of the sale-leaseback, the transaction should be a bona fide business operation. The transaction cannot simply be a means to transfer income to a family member in a lower tax bracket. The courts use several tests to determine if the buyer is a bona fide party in the sale-leaseback:
- Does the buyer have significant equity in the property (the lack of equity would support a financing arrangement rather than a sale-leaseback)?
- Is the useful life of the property longer than the lease term?
- Is the lease renewal or purchase option based on a formula representing the fair market value of the property?
- Are the tax savings for the investors less than their initial cash investment?
- Can investors in the sale-leaseback at least break even considering the residual value of the equipment plus the cash flow generated by the rental or lease?
- Is the agreement a lease or a conditional sales contract?
- Will the investor realize a profit or loss on the sale of the equipment or will the seller realize a fixed amount, which is indicative of a financing transaction?
To be treated as such, the sale-leaseback must have economic substance and must have a substantial purpose other than to save on taxes. Failure to meet both tests may subject the transaction to a 20% penalty, or 40% if not properly disclosed, of the underpayment of tax.
The tax consequences of a proposed sale-leaseback will be determined by whether the relationship is actually a lease, sale or gift, loan, or valid debt, regardless of what the taxpayers called the transaction. If the transaction is really a lease, then the following should be true:
- portions of the periodic payments will not be allocated to equity;
- the lessee will not acquire title after paying a certain amount;
- the rental payments do not exceed fair rental value;
- no portion of the lease payments will be considered interest, whether called that or not; and
- any repurchase option should be at market prices.
Gift-leasebacks have other requirements:
- the donor of the property cannot retain any control over the property
- the leaseback must have a bona fide business purpose
- if a trust is used, then the trust must have an independent trustee who is unrelated to the grantor
- the property title should be in the name of the trust or the beneficiary and should be recorded
- the leaseback agreement should be written and provide a reasonable lease, which should be obtained from a professional appraiser who specializes in the type of property in the gift-leaseback
Note that the kiddie tax rules may apply to the gift-leaseback if the donee is younger than 18 or 24 if a full-time student. The leaseback will especially be scrutinized if the lessor and lessee are related parties, which can include spouses; parents and children; partnerships and partners; a corporation and its stockholders; affiliated corporations with common stockholders; and taxpayers using foundations or trusts where relatives serve as trustees.
A gift-leaseback can be effective in transferring wealth to a child or other dependent. If the business owner has a valuable asset, then the property can be gifted to a child, where lease payments can be deducted by the business owner as a business expense. Although the child must report the lease payments as income, it will not be subject to employment taxes and, presumably, the child will be in a lower tax bracket, which allows the family to retain more wealth by paying lower taxes. However, if the child is younger than 18, or younger than 24 and a full-time college student, then the income may be subject to the kiddie tax, where it is taxed at the parent's highest rate.
If a trust is used in the leaseback, then the lease should be set at current market rates and the trust document should state that lease payments are required and should be enforced. The trustee should be independent of the grantor. If lease payments are irregular or the property reverts to the grantor at the end of some period or if the trust or trustee is controlled by the grantor, then the income will be taxed to the grantor, since there is no evidence that total control was relinquished over the trust.
If the taxpayer is audited, then the IRS will seek to determine if the leaseback is a disguised loan or actual sale. If the transaction is adjudged to be a loan, then only the interest portion can be taken as a tax deduction. If the leaseback is for investment purposes, then the interest will be considered investment interest, which will be deductible only to the extent of investment income. If a business interest, then there is no limit to the interest deduction. If the transaction is judged to be a sale, then the seller-lessee must pay taxes on any realized gain and any recapture of accelerated depreciation. If the lease is for business, then the payments will be deductible. The buyer-lessor may claim depreciation or cost recovery deductions to the extent that the purchase price is allocable to buildings or improvements and all expenses can be deducted relating to the maintenance and operation of the property. If the transaction is considered a loan, then the buyer will not be entitled to any of these deductions, since he will be considered a mortgagee rather than as a property owner. If the IRS treats the transaction as a sale, but at less than the fair market value of the property, then the difference may be considered a gift, subject to gift tax.
For a leaseback to be treated as such, it should have a true economic benefit, and the parties should act as lessors and lessees ordinarily would. There is a safe harbor for leasebacks. The lessor must be a C corporation and have an at-risk investment of at least 10% of the adjusted basis of the property. Additionally: the term of the lease cannot exceed certain limits; the property must be leased within 3 months of its acquisition, or, if a sale-leaseback, it must be purchased by the lessor within 3 months of the lessee’s acquisition for a price not exceeding the adjusted basis of the property for the lessee. Any repurchase option by the seller must be at arm's length; otherwise, the transaction will be treated as if the property was mortgaged rather than sold, then leased. The buyer must benefit from the appreciation of the property and if part of the lease payment is for the repurchase of the property, then it should be at realistic market rates. If the donor retains any control over the property after it is transferred, then the sale-leaseback will not be considered genuine.
The advantages of the leaseback over mortgaging the property is that the interest rate could be lower and the entire lease payment would be deductible. Furthermore, unlike a mortgage, the leaseback will not lower the creditworthiness of the company, and the leaseback property will not be subject to creditors of the lessee. The lessee may also be able to get more cash from the sale than from a mortgage.
If the property is transferred via an installment note, then interest deductions and cost recovery may reduce the taxable income of the lessor. The lessee will be able to deduct lease payments as ordinary and necessary business expenses. The lessee must report interest income and if the property is reacquired by the lessee after it was sold, then it will be subject to recapture, just as if the lessee never relinquished ownership of the property. If the lessor is a related-party to the lessee, then any resale of the property within 2 years will be taxable gain to the original seller, who is now the lessee.
If the transaction is a sale or a gift, then the lessee will have no right to repayment nor will there be any guarantees for repayment, such as putting funds in an escrow account. If no sale or gift took place, then the lessee's payments are really loans that must be repaid to the lessee, so the payments will not be deductible.
If the transaction was intended to be a loan, then there should be written evidence of the debt based on a written loan agreement that requires a scheduled repayment, and part of the payment should be identifiable as interest. Consideration will also be given to whether there are any other indications that the parties intended for the transaction to be a loan.