Gift- or Sale-Leaseback: Estate Freeze Technique

What is a sale-leaseback?

A sale-leaseback is a transaction where one party sells property to another party who then immediately leases the property back to the first party. A sale-leaseback is useful, for example, when a business owner needs to raise cash by selling assets but would like to continue to use those assets in his or her business.

If structured properly, a sale-leaseback transaction allows you, as the business owner, to raise cash by selling business assets, to continue to use those assets, to fully deduct the lease payments as a business expense.

Typically, with a sale-leaseback, you sell a substantial physical asset (such as your plant or piece of major machinery) to a third party for cash. You then enter into a lease agreement (at a fair market rental) with that third party to continue to use that asset, and then fully deduct the lease payments as a business expense. The asset is removed from the balance sheet and you have additional cash to invest in the business.

What is a gift-leaseback?

A gift-leaseback is a transaction where one party gives property to another party who then leases the property back to the first party. A gift-leaseback is an attractive strategy for someone who wishes to remove appreciating assets from his or her estate but needs to continue to use those assets.

With a gift-leaseback, you give a substantial physical asset (such as a medical office building in which you have your medical practice) directly to your children or to an irrevocable trust for the benefit of your children. You likely will incur gift tax on this transaction. You then enter into a fair market lease with your children or the trust to rent the building back. The lease payments are then deductible as a business expense. Your children or the trust receive the income from the lease payments and may be able to claim depreciation deductions with respect to the building. Because you no longer own the asset but merely lease it, the asset that may appreciate in the future is removed from your estate.

Transaction needs to be structured and documented very carefully to minimize IRS scrutiny

The IRS has scrutinized both sale-leaseback and gift-leaseback transactions very closely to determine if the entire transaction is genuine and not merely disguised as a sale. If the IRS determines that the transaction is not a sale but is really a loan, then the lease payments will not be fully deductible. If the transaction is recharacterized, the business owner will be able to deduct only that portion of the lease payment that was determined to be interest — just as with a loan. If the IRS determines that the transaction is a loan, then the purchaser of the building is considered a mortgagee and will not be considered the owner, and thus cannot deduct depreciation and expenses. The IRS will especially scrutinize transactions between related parties, such as family members or corporations and shareholders.

Lease terms very important

In both sale-leaseback and gift-leaseback transactions, the IRS will examine very closely the terms of the lease to make sure that the transaction is bona fide and has been negotiated in good faith. Therefore, the parties to a sale- or gift-leaseback should make certain first that there is a written lease agreement between the parties. Second, the terms of the lease should be the same as the terms of any standard commercial lease for that type of property. Third, the rental amount should be the fair market rental for that type of property, so the parties should obtain a qualified, independent appraisal of the market rental rate. Fourth, the lease agreement should specify that the terms of the lease will be renegotiated frequently (preferably every year) to adjust for changes in the fair market rental of the property. Finally, all the terms of the lease should be complied with strictly, and the agreement should provide that there will be penalties for late payments and other breaches of the agreement.

These types of provisions demonstrate that the transaction is bona fide; however, it is not necessary that parties include every single term (such as late fees). The inclusion of these types of provisions are especially important when the transaction is between related parties, such as family members or a corporation and its shareholders.

Terms of transaction must be negotiated at arm’s length

All of the terms of the sale- or gift-leaseback must be negotiated fairly and arrived at in an arm’s length manner. In other words, the sale price of the asset should be the fair market value of the property; the lease payments should be reasonable and based on comparable rentals; the financial arrangements should be straightforward; and the buyer should be the party to benefit from any future appreciation (and suffer the burden of any future loss in value) with respect to the property.

Sale-leaseback should be necessary business operation

With a sale-leaseback, the IRS will also scrutinize whether the transaction is a necessary business operation or merely an attempt to shift the tax burdens and responsibilities. The lease should have a bona fide business purpose. The Tax Court has held that if the assets sold were used in the business, then this would be sufficient to meet the business purpose test. However, two Federal Circuit Courts of Appeal have rejected the Tax Court’s approach. These two appellate courts found that where the lessee owned the property before the transaction, the subsequent rental of the same property after the sale was not “ordinary and necessary.” Therefore, you should consult with an attorney to determine if you live within the jurisdiction of either of these appellate courts. If so, then you may have to structure the transaction differently.

If trust is used, trustee should be completely independent from grantor of trust

If you would like to give or to sell property to your children, you might be hesitant to transfer direct ownership of the property to them, especially if they are minors. One solution is to set up a trust and name your children as beneficiaries. If you do set up a trust, it is extremely important that the trustee be completely independent, perhaps a bank or an independent fiduciary. The IRS will be extremely wary of either a sale- or gift-leaseback transaction where the trustee of the trust is related in some way to the person who creates the trust (the grantor).

If trust is used, property should not come back to grantor at the end of some period

If you decide to set up a trust for the benefit of your children and then sell or gift property to the trust with a leaseback provision, you should not have a provision in the trust where the property will revert (return) to you at some point in the future (called a reversionary interest trust). If there is such a provision in the trust agreement, then the IRS does not consider this arrangement to be a true sale or gift. The tax benefits of a gift- or sale-leaseback would not apply.

Tangible assets used in trade, business, or profession are best type of property to use in a gift- or sale-leaseback

The types of property you should use in a sale- or gift-leaseback are physical assets that you make use of in your trade, business, or profession, for example, a medical building that you use as an office for your medical practice. Other types of physical assets may include office equipment, land, machinery, or trucks. These are the types of assets that are rented or leased all the time by businesses and for which it is easy to determine fair market values.

Tax considerations

Income Tax

Tax must be paid at time of sale

In a sale-leaseback, if the property has been sold for more than its adjusted basis, then the seller must pay the full capital gains tax due at the time of the sale. There are no special tax breaks given to a sale-leaseback.

Lease payments may be fully deductible by lessor

If the sale-leaseback or gift-leaseback of a business asset is structured and documented properly, the lessor (the former owner of the property) can fully deduct the lease payments as an ordinary and necessary business expense. This may result in substantial tax savings for the lessor.

Lessee will have to report lease payments as income

The lessee (the person or entity to whom the property was sold) will have to report the lease payments as income. Depending on the type of property that is acquired, the lessee may be able to depreciate the asset and offset at least some of the lease income. If the lessee has financed the purchase of the asset, he or she may also have interest deductions to offset some of the income.

Estate Tax

Value of asset sold not included in gross estate of seller

If a sale-leaseback or a gift-leaseback has been structured and documented properly, then the asset transferred is not included in the gross estate of the seller. Instead, the consideration you received in exchange for the asset will be included in your gross estate, except to the extent you consume or otherwise remove it. If you own an asset that you think may appreciate in the future, a sale- or gift-leaseback may be an excellent way to remove that asset from your estate. You will still be able to use that asset in your business or profession. However, you should be aware that taxable gifts made during the lifetime of the donor are added back into the donor’s gross estate. You are also given a credit for any gift tax that may have been paid. Furthermore, any appreciation in the value of the gift after the time of the gift is not included in your taxable estate.

Gift Tax

In a gift-leaseback, a gift tax may be due on fair market value of asset transferred

With a gift-leaseback, you may be liable for the gift tax on the fair market value of the asset transferred. You will either have to use the gift tax applicable exclusion amount or pay the gift tax due, if the entire exclusion has been previously used. The payment of the tax may pose a problem if you do not have sufficient liquid assets.

In a sale-leaseback, a gift tax may be due if property is sold for less than fair market value

With a sale-leaseback, if the property is sold for less than its fair market value, then the difference is considered to be a gift. Federal gift and estate tax may be due on the transaction if the gift exceeds the $15,000 (in 2018 and 2019) annual gift tax exclusion and your applicable exclusion amount has been fully used (the exclusion amount is $11,400,000 in 2019, $11,180,000 in 2018).

How to do it

Consult a competent and experienced legal advisor

As with any transaction of this type, a competent and experienced attorney should be hired to draft the necessary legal documents to document the transaction and especially the terms and conditions of the lease. If it is a gift-leaseback and you plan to set up a trust to receive the gift, then an attorney experienced in trusts and estates should be hired to draft the trust document. The requirements for establishing and maintaining trusts can be very complicated, and only an experienced attorney should handle these issues.

Appraiser should be hired to determine fair market value of assets and fair rental value

An independent, unbiased, and experienced appraiser should be hired to determine the fair market value of the asset that will be sold or given away. Caution: If the asset is sold for less than fair market value, it may be considered a partial gift, and gift tax may be due. The appraiser should also determine the fair market rental value of the asset. It is critically important that the rent be set at a market rate. The IRS scrutinizes these transactions very closely to see if the lease terms have been arrived at in a bona fide, arm’s length manner.

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