When Is a Sale-Leaseback Treated as a Financing?

A sale-leaseback is documented as a deed and a lease. Whether it is reported that way is a different question, and it is asked twice: once by the accounting standards for your financial statements, and once by the tax law for your return. The two tests use different criteria, so a transaction can pass one and not the other. Neither conclusion is ours to give. This guide describes the risk factors so that you can raise them with your CPA, auditors and tax counsel while the terms are still open.

Financing treatment is not a legal defect and it does not undo the deal. The buyer still owns the building of record and you still pay under the lease. What changes is how the transaction appears in your financial statements and, on the tax side, which deductions each party is entitled to.

Under ASC 842-40, a seller-lessee accounts for a sale only if the buyer-lessor obtains control of the asset. Accounting guides identify the features that most often prevent that:

• The leaseback is a finance lease. If the leaseback would be classified as a finance lease by the seller-lessee, or a sales-type lease by the buyer-lessor, control is not considered to have transferred. A lease is a finance lease when it transfers ownership, includes a purchase option the lessee is reasonably certain to exercise, runs for a major part of the asset's remaining economic life, has payments whose present value amounts to substantially all of the asset's fair value, or covers an asset so specialized the lessor has no alternative use for it.
• Renewal options that are reasonably certain to be exercised. They are included in the lease term and can push a lease into finance classification.
• A seller repurchase option. It precludes sale accounting unless the exercise price is fair value at the time of exercise and substantially identical assets are readily available in the marketplace. Real estate is treated as unique, so the exception is generally not available for a building.
• A significant residual value guarantee by the seller-lessee, which can affect the control assessment.
• Off-market pricing. Adjusting a deal to fair value can cause a lease that would otherwise be operating to be classified as a finance lease.

Highly specialized buildings and very long leases deserve a careful look for the same reason. A purpose-built facility leased back for most of its remaining life can meet the finance lease criteria without any option in the deal at all.

If the transfer is not a sale, the seller-lessee's books look as though it borrowed against the building.

• The building is not derecognized. It stays on the balance sheet and the company continues to depreciate it.
• The cash received is recorded as a financial liability.
• No gain or loss is recognized on the transfer.
• Payments to the buyer-lessor are split between interest expense and reduction of the liability, with the interest rate adjusted as the rules require.

The assessment is revisited when facts change. If a repurchase option that prevented sale accounting expires unexercised, the company recognizes the sale at that point, removes the asset and the financial liability, and begins to account for the leaseback as a lease.

Why it matters commercially: an industry article on the model observes that finance obligations are typically included in leverage calculations while operating lease obligations typically are not, so a failed sale can affect debt covenants. If part of your purpose is to reduce borrowed money as your lenders measure it, a failed sale may not deliver that.

Federal tax law asks who owns the property in substance. The leading case is Frank Lyon Co. v. United States, decided by the Supreme Court in 1978. A bank arranged for an outside company to take title to its new headquarters and lease it back, with rent matched to the mortgage payments and options for the bank to repurchase at set prices. The IRS treated the arrangement as a financing and denied the buyer's depreciation and interest deductions.

The Court sided with the taxpayer. It held that where there is a genuine multiple-party transaction with economic substance, compelled or encouraged by business or regulatory realities, the government should honor the allocation of rights and duties the parties made, so long as the lessor retains significant and genuine attributes of traditional lessor status. Among the facts the Court pointed to: the buyer alone was liable on the mortgage, the rents and option prices were reasonable and negotiated at arm's length, the buyer bore real risk, and there was no understanding that the bank would exercise its options.

A Journal of Accountancy article on sale-leasebacks of real property lists practical tests drawn from this line of authority. It stresses that no single factor controls and that the overall facts and circumstances decide the question.

• The buyer must have taken an equity interest in the property and assumed the risk of loss.
• The useful life of the property must exceed the lease term, so that the buyer owns something of value when the lease ends.
• Any repurchase by the seller must be at fair market value, not at a discount.
• Renewal rent must be set at a fair rental value.
• The buyer should reasonably expect a profit from the price and the rent over the lease term.

The stakes for the seller sit in the rent deduction. The Internal Revenue Code allows a business deduction for rent paid on property to which the taxpayer has not taken or is not taking title, or in which it has no equity. A seller who keeps what amounts to an ownership stake, for example through a bargain repurchase right, raises the question of whether its payments are rent at all. How a recharacterized deal would be taxed in your case is a question for your tax advisor.

• ✓Does the seller have any option to repurchase, and is the price fixed, formula-based or fair market value at exercise?
• ✓Is there any understanding, written or not, that the seller will buy the building back?
• ✓Counting renewals we are reasonably certain to exercise, how does the lease term compare with the building's remaining economic life?
• ✓Does the present value of the rent approach the building's fair value?
• ✓Is the building so specialized that the buyer would have no alternative use for it?
• ✓Is the sale price at fair value and the rent at market, with evidence to support both?
• ✓Are renewal rents set at fair rental value?
• ✓Is the seller guaranteeing the building's residual value or otherwise protecting the buyer from ownership risk?
• ✓Are buyer and seller related parties?
• ✓Have the auditors and tax counsel seen the term sheet, not only the final documents?

Most of these features are requested for sound business reasons: an owner wants a path back to ownership, or a longer term for a better price. The point is not to avoid them at all costs but to know the reporting result before agreeing to them.

Several of the risk factors come down to market evidence: what the building is worth, what market rent is, and whether a renewal rent or an option price is fair. Those are real estate questions. We represent the seller and future tenant, so our contribution is to document price and rent against the market and to negotiate term, renewals and any purchase rights in coordination with your CPA and counsel, so the structure you sign is the one you intended to report.