How Is a Sale-Leaseback Taxed?

This guide describes the general federal income tax framework using IRS publications and the Internal Revenue Code. It is not tax advice. State and local taxes, your entity type and your own history with the property all change the result, and your CPA should run the numbers before you commit to a price.

A sale-leaseback has a sale and a lease, and each has its own tax treatment. At closing, the seller has disposed of real property and computes gain or loss. From the next day, the seller is a tenant paying rent. The first event is a one-time tax cost, or occasionally a tax loss. The second changes your deductions every year for the length of the lease.

All of this assumes the transaction is respected as a true sale and a true lease. A deal that is in substance a loan can be treated differently, which we cover in a separate guide.

IRS Publication 544 states the basic rule. A gain is the amount you realize from a sale that is more than the adjusted basis of the property. A loss arises when the adjusted basis is more than the amount realized.

• Amount realized is the total of the money you receive plus the fair market value of any property or services received. It also includes any of your liabilities the buyer assumes, such as a mortgage. Selling expenses reduce it.
• Adjusted basis is your original cost or other basis, increased by certain additions and decreased by items such as the depreciation deductions you have taken.

The second point is the one that catches long-time owners. A building that has been depreciated for many years can have a low adjusted basis, so the taxable gain can be much larger than the difference between what you paid and what you are selling for. Recognized gains must be included in gross income.

Sales of real property and depreciable property used in a trade or business are reported on Form 4797.

Once the gain is computed, the next question is its character, because ordinary income and long-term capital gain are taxed under different rate rules. Publication 544 describes several layers.

• Section 1231. Gains and losses from sales of business real property that meets the holding-period rules are generally section 1231 gains and losses. If your section 1231 transactions for the year net to a gain, it is generally treated as long-term capital gain. If they net to a loss, it is an ordinary loss.
• The five-year lookback. A net section 1231 gain is ordinary income up to the amount of your nonrecaptured net section 1231 losses from the previous five years. If the business has deducted section 1231 losses recently, tell your CPA.
• Section 1250 recapture. Depreciable real property is section 1250 property. Land is not, because it is not depreciable. Gain is ordinary income to the extent of additional depreciation, meaning depreciation taken in excess of the straight-line amount.
• Unrecaptured section 1250 gain. Generally, the part of the long-term capital gain on real property that is due to depreciation is a separate category in the capital gain rate rules. Publication 544 notes that it cannot be more than the net section 1231 gain.
• Section 1245 recapture. Section 1245 property is depreciable property that generally does not include buildings, such as equipment and certain other tangible property. Gain on it is ordinary income to the extent of depreciation allowed or allowable. If components of your facility were depreciated as personal property, or if equipment is being sold with the building, this rule applies to those items.
• Corporations. Corporations other than S corporations must recognize an additional amount as ordinary income on the disposition of section 1250 property.

We are deliberately not quoting tax rates here. They vary by taxpayer type and year, and several of these categories carry their own rate limits. Your CPA will apply the current ones.

The purchase price has to be allocated among land, building and any equipment or other property included in the sale. That allocation drives how much gain falls in each category, so settle it with your CPA and attorney before the purchase agreement is final.

A sale below adjusted basis can produce a loss, and a net section 1231 loss is an ordinary loss. There is a specific trap for sale-leasebacks, however. Treasury regulations treat a leasehold with 30 years or more to run as like-kind to real estate, and a court has treated a sale combined with a very long leaseback, counting renewals, as a like-kind exchange in which the loss could not be recognized. If recognizing a loss matters to you, have your tax advisor review the lease term and renewal options before they are agreed. Our guide on 1031 exchanges explains the issue.

As an owner you deducted depreciation on the building and interest on any mortgage. As a tenant you deduct rent. Section 162(a)(3) of the Internal Revenue Code allows a deduction, as an ordinary and necessary business expense, for rentals required to be paid for the continued use of property to which the taxpayer has not taken or is not taking title, or in which it has no equity.

Whether the trade improves your annual deductions depends on the facts. A Journal of Accountancy article on sale-leasebacks of real property points out why it often does for long-held buildings: depreciation applies only to the building, not the land, and is based on original cost, while rent is typically based on the fair market value of both land and building. For a property that is largely depreciated, the rent deduction can be much larger than the depreciation it replaces. For a recently purchased or recently improved building, the comparison can be closer.

The wording of section 162(a)(3) is also a reminder that the deduction belongs to a tenant with no equity in the property. Terms that leave the seller with an ownership-like stake, such as a bargain repurchase right, invite the question of whether the payments are really rent.

A sale-leaseback between a closely held company and its own shareholders gets particular attention. The same article notes that the IRS carefully scrutinizes transactions between closely held corporations and their controlling shareholders, and that price and rent should reflect fair market terms.

• ✓What is our adjusted basis in the land, the building and any equipment included in the sale?
• ✓How much depreciation have we taken, and was any of it faster than straight-line or taken on components classified as personal property?
• ✓How will the price be allocated among land, building and other property?
• ✓How much of the gain is ordinary income under the recapture rules, and how is the rest characterized for our entity type?
• ✓Do we have nonrecaptured section 1231 losses from the past five years?
• ✓What state income taxes apply to the gain?
• ✓What are the estimated net proceeds after federal and state income tax, transfer taxes, debt payoff and closing costs?
• ✓How does annual rent compare with the depreciation and interest deductions we are giving up?
• ✓Does any term of the lease, including its length with renewals or any purchase right, put sale treatment or the rent deduction at risk?

Price and rent are negotiated as a pair, and both feed these calculations. When we represent a seller, we bring the tax and accounting advisors into the term-sheet stage so that the after-tax proceeds, not only the headline price, drive the negotiation.