Are you soon coming out of a Section 1031 tax free exchange with a large gain? Have you thought about a 1031 sale leaseback (SL) as an alternative to a straight purchase to close out your 1031 this year? Why use an SL? Long term SLs qualify for tax free nonrecognition under Section 1031 and § 1.1031(a)-1(c) of the regulations. For those savvy enough to structure a 1031 SL correctly you can improve cash flow, reduce your risk, and free up credit for additional leveraged real estate purchases, all within the safety of a tax deferred Section 1031 exchange. But the IRS is watching these 1031 SL deals closely. So if you are interested in an SL and have a material gain coming out of a 1031 exchange stay tuned to TaxView, with Chris Moss CPA to find out why the IRS is so concerned about SLs and find out how to bullet proof your tax return from big IRS tax liability if your 1031 SL should get audited.
Why is the Government so concerned about SLs? It’s not about your 1031 and it’s not about your real estate SL. In fact, it’s not about you at all. It’s about bogus equipment deals set up by what appears to be unprincipled at best and worst dishonest tax advisors as in CMA v IRS US Tax Court (2005). This 128 page US Tax Court Opinion introduces us to “lease strips” and/or “rent strips” in a mind boggling series of worthless equipment leasing transactions that the Court concluded were without any substance or business purpose other than to evade tax. IRS wins big CMA loses. Here are just a few more reasons why the IRS is cynical: Santulli v IRS US Tax Court (1995), Heide v IRS US Tax Court (1998), John Hancock Life Insurance v IRS US Tax Court (2013), Nicole Rose Corp v IRS US Tax Court (2001) and Andantech LLC and Wells Fargo Finance vs IRS US Tax Court (2002).
As a result of these abusive equipment leasing cases, the Government regularly audits SLs and sadly looks closely at even the most honest of Section 1031 SL transactions. How can you protect your 1031 SL? Have your tax attorney review with you Frank Lyon Co v IRS, US Supreme Court 435 US 561 (1978) the gold standard of legitimate SL cases. The facts are simple: Worthen Bank and Trust of Little Rock Ark in 1967 was unable to build a headquarters on land it owned due to the Federal Reserve rule at the time that the investment could not be in excess of 40% of its capital and surplus. As a work around in 1968, a privately held company Lyon was approved by the Federal Reserve as an acceptable borrower and New York Life as the acceptable lender. Worthen would sell the building to Lyon for $7 Million as it was constructed and Worthen would lease the completed building back for 25 years from Lyon for a rent of $14 Million. Finally, Lyon, the borrower would pay approximately the same amount of $14 Million back to the lender New York Life.
Lyon deducted interest, depreciation and other legal expenses in connection with the purchase on its 1969 income tax return. The IRS audited and disallowed the deductions claiming that Lyon was not the real owner of the building and that the sale-and-leaseback arrangement was a sham. Lyon paid the tax, and then sued in Federal District Court in Arkansas with the Court finding for Lyon. The Government appealed to the 8th Circuit Court of Appeals which reversed the District Court and ruled in favor of the Government. Lyon appealed to the US Supreme Court on a writ of certiorari which the Court granted in Lyon v US 435 US 561 (1978).
Justice Blackmun who wrote the majority 7-2 Opinion for the Supreme Court in 1978 notes that despite the fact that Worthen had agreed to pay rent and that this rent equaled the amounts due from Lyon to New York Life, Lyon was nevertheless primarily liable on the mortgage with the obligation on the notes squarely on Lyon. Lyon furthermore exposed its very business well-being to this real and substantial risk. “The fact that favorable tax consequences were taken into account by Lyon on entering into the transaction is no reason for disallowing those consequences. We cannot ignore the reality that the tax laws affect the shape of nearly every business transaction.” Lyon wins IRS loses.
Do you see the IRS trap? If you are coming out of a 1031 exchange make sure your tax attorney bullet proofs the sale leaseback so that your landlord—not you—has the risk of ownership. It is that simple. Everything else will fall into place with the right tax attorney and the right qualified intermediary. (QI)
What does this mean for us? First have your tax attorney, qualified intermediary, real estate agent and banker all telephone conference or better yet meet within the 180 day window with plenty of time to spare with the replacement property-the property you will be leasing back-identified within 45 days of the relinquished property sale if a forward exchange. For a reverse exchange please consult your trusted QI. Second, make sure your landlord, the party that will be leasing back to you bears all the risk of ownership. Third have your tax attorney write up the transaction for insertion into your tax return to bullet proof the lease payments deductions in year one and every year thereafter. Finally, perhaps purchase a new additional rental property with your line of credit that you never used on the 1031 SL deal. Keep in mind that cost segregation comes into play as a tax strategy for new construction. Your Section 1031 SL deal is now bullet proof from a stray audit that might just come your way soon.. Happy 1031 to all and thank you for joining Chris Moss CPA on TaxView.
See you next time on TaxView,
Chris Moss CPA