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Sale And Leaseback – When Are You Crossing The Line
Sale and leaseback is a technique to finance real estate that is frowned upon these days.
It started being practiced in the 1940s and involves a property investor buying a property and leasing it back to the seller.
The investor would technically become the new owner as he will hold the title, but the seller will then have a option to repurchase the property in future at an agreed price.
The question on people’s minds when seeing this structure will be – Why?
A sale-leaseback arrangement enables an investor to reap the cash flow and tax benefits of depreciation. At the same time, a long term tenant who is emotionally attached to the house is secured.
The tenant (seller) in return obtains full financing for the house and continues to use the property as his home.
How it might be structured is basically like this:
The buyer commits to a contract to buy the property from the seller, then signs a contract to sell to an investor.
Often with double closing, the investor would lease it back to the buyer (landlord) with an option to repurchase, who in turn sublease it back to the seller with a lease option.
As you can see, it is obviously a very elaborate way to deal with a transaction. Yet no major changes are made other than getting more parties involved and money moving around.
While a transaction like this is not illegal in a capitalistic world and benefits all parties, it is frown upon by industry watchdogs and government agencies because it is obviously a play to game the system.
In response to a rise to such transactions taking place in the real estate industry, the IRS may request an audit and recharacterize sale and leaseback as a typical financing deal.
This would result in the recapture of depreciation expense being exploited from the deal, along with the imputed interest of rental paid.
In such circumstances, rental paid might be reclassified as repayment of a loan towards it’s principal.
So widespread was this issue being a problem that a case was taken to as far as the Supreme Court in the infamous landmark case of Frank Lyon Co. v. United States.
While the practice of sale and leaseback was not made illegal, it should serve as a reminder to those considering this funding technique to be careful with them.
If you simply have to do it anyway, here are some things to keep in mind to minimize your risks.
Fair market value
The moment a property’s market value is $500,000 but transacted at $400,000, it would raise eyebrows to any observer.
The purchase price should be at least fair market value.
The same goes with the repurchase price in the option.
Fair market rent
If a rental property is worth $1000 in monthly rental, having a tenant that pays half of that can be a sign of suspicious activity.
If you need to go to such great lengths to profit from real estate, you shouldn’t be in the business of real estate investing.
Fair market rent should take into account factors including location, size, market rent, etc.
Justifiable reasons for such transactions
There must be reasons for all parties to participate in such arrangements other than for the purpose of tax avoidance.
With these things in mind, it will be ultimately down to the decision of the buyer/landlord whether to get involved in sale and leaseback transactions in the first place.