Chapter 16 p. 921 Leverage & Leasing
Consider (remembering the Tufts case) the “tax sheltering” effects of:
Rapid income tax depreciation deductions.
Leveraging (with non-recourse debt) to have a high tax basis and limited amount of actual cash investment.
Consider the use of these deductions to offset gross income from other sources (e.g., compensation and investment income).
Purchase items for cost of 100x with 10x cash and 90x borrowed and 50 percent tax rate & rapid depreciation.
Purchase down payment of cash 10x
Effect of depreciation deduction 25x
(50% depreciation on 100x cost
times 50% tax rate)
Positive net cash flow: 15x
Estate of Franklin
Ltd. partnership acquires the Thunderbird motel in Arizona for $1,224,000. Prepaid interest but then deferral over ten years for large principal payments & balloon payment due is after 10 year period. Nonrecourse debt.
Warranty deed is placed in escrow. Leaseback with net lease payments approximating the P&I payments on the debt. No potential for equity growth for taxpayer?
Estate of Franklin, continued p.921
Tax Court: Transaction was an option and not a sale. Deed was never recorded and “benefits and burdens of property” still with “seller.”
Court of Appeals: Transaction can be a genuine sale and with genuine indebtedness.
But, must demonstrate that the purchase price is real, i.e., approximately equal to the fair market value of the property. Here FMV of the property not proved (fn.4). No real potential for creating an equity for buyer in the property.
Pleasant Summit Land Corp. p.926
Another example of
1) Nonrecourse financing (i.e., purchase price?), exceeding
Fair market value of property.
Should depreciation be disallowed only to the extent of the nonrecourse debt in excess of the fair market value of the property? This is the holding in Pleasant Summit.
Correct? Providing an incentive for tax gamble?
Problem, p. 929
Debt Exceeds Value
Building constructed for $2 million.
1.8 mil. nonrecourse construction financing (where is the $200,000) and no loan reduction.
$600,000 claimed depreciation (and adjusted basis & value of $1.4 million). Transfer of property subject to the $1.8 million mortgage.
(a) Boot paid for tax benefits?
(b) Tax results? If basis treated as not including debt, then no debt realized on the disposition event.
The “At-Risk” Limitation Provision p. 929
Code §465. No deduction for investment if the taxpayer is not “at risk” with respect to the investment. An accounting provision.
Full recourse debt enables at risk status.
Nonrecourse debt does not enable “at risk.”
However, exception for real estate for “qualified non-recourse debt. See §465(b)(6).
This is not a tax basis rule, but a timing of deductions rule.
Leasing, p. 933
Really a Lease?
Example: Lease of property from lessor to lessee:
99 year term
Lessee has option to purchase property at
the end of the lease for $1
Cash flow: rental payments equal loan
amortization (P&I) amount.
4) Triple net lease (“hell or high water”) for lessee to pay all expenses.
Leasing, p. 934
Frank Lyon case Sup. Ct.
Objection of bank regulators to ownership.
Bank leased land to Frank Lyon for 76 years.
Sale-leaseback of Worthen Bank & Trust building with Frank Lyon Co.
Leaseback for 25 year primary term and eight five year option terms. Net lease.
Rent paid equaled debt amortization amounts.
Held: Frank Lyon Co. was the owner of the property (reversing Court of Appeals).
Carol W. Hilton p. 937
Battle of the Experts
Sale-leaseback transaction – retailer sells store to investor-buyer-lessor & retailer leases back.
Buyer then syndicates interests in partnerships which then own the building subject to the lease.
Net lease for 30 years, with possible extension for another 68 years. Triple net lease.
Insurance companies loaned funds for property.
Cash from partners went to promoters.
Issue: What are the true economics (without income tax considerations)?
How Structure Acceptable Sale-Leasebacks? P.951
1) Minimum investment by the lessor.
Purchase options only at fail market value at
the time the option is exercised.
Lessee can not invest in the property or loan
funds for purchase or guarantee loans for purchase.
4) Positive cash flow to the lessor independent of the tax benefits.
Passive Activity Loss Limitation p. 955
Code §469 provides for limitation of the deductions from passive loss activities (PALs).
What is a passive activity for this purpose?
Trade or business activity where taxpayer is a passive investor and not a material participant, i.e., is not involved in the activity on a regular, continuous and substantial basis.
Therefore, does not include (1) active business activities and (2) passive investments (e.g., portfolio income). continued
Passive Activity Loss Limitation, continued
Objective of this provision:
Limit the deductibility of losses from passive activities to the amount of income from these activities.
Losses are deductible in the year of disposition.
Special “$25,000 offset fro rental real estate activities” where taxpayer is an active participant. §469(i).
Alternative Minimum Tax
Imposed on an individual in an amount by which (1) the tentative minimum tax exceeds (2) the regular income tax.
Minimum tax amount is determined on a broader tax base and calculated at a lesser tax rate.
Exemption is available.
To be repealed in 2017?