How Sale/Leasebacks Get Respect

Overruling one of its examiners, the Internal Revenue Service rules in favor of a land-owning taxpayer.
Robert WillensJanuary 3, 2012

The late comedian Rodney Dangerfield often complained that no one gave him respect. Corporate taxpayers often may feel the same when they attempt to get the Internal Revenue Service to recognize certain transactions as sale/leasebacks. With accounting standards moving toward a converged requirement that corporations must record leases on their balance sheets, the matter may be one of increasing concern. In a 2010 letter ruling, however, the IRS described the conditions it imposes in order for a certain sale/leaseback to be respected as such.

In the case the IRS considered, the taxpayer (TP), a specialty retailer of consumer electronics that owns retail stores throughout the United States, owned land upon which it constructed a building on a “ground owned” basis.

In a ground owned transaction, the taxpayer owns the land upon which it constructs a building. Following construction and an appraisal, the taxpayer transfers title to the land and the building to an institutional investor for cash consideration. The taxpayer then leases back the property. Rent for the renewal terms is predetermined and substantial.

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In the case of TP’s ground owned transaction, an IRS examiner found that the sale/leaseback transactions were financings, not sales, because the term of the leaseback (22 years with two 10-year optional renewal periods) exceeded the useful life of the property. That would have been disadvantageous to TP in terms of its taxes. In a letter ruling on July 9, 2010, however, the IRS’s national office disagreed with the examiner.

The sale/leaseback transactions entailed both land and leasehold improvements. Land, however, does not have “finite useful life,” according to the national office. The lease agreements provided for two 10-year renewal terms following an initial 22-year term. If TP does not exercise its renewal rights, the leasehold improvements revert to the landlord, who has certain remarketing rights. These facts, the national office concluded, prove that the useful life of the property extends beyond the initial lease term. Thus, the IRS ruled that ground owned transactions constitute sales — and TP got some respect.

Robert Willens,  founder and principal of Robert Willens LLC, writes a tax column for CFO.