Chapter 16               p.921 Leverage & Leasing

Consider (remembering the Tufts case) the “tax sheltering” effects of:

Rapid income tax depreciation deductions (or immediate expensing).

Leveraging (with non-recourse debt) to have a high income tax basis and a 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).

Leveraging Example

Purchase items for cost of 100x with 10x cash and 90x borrowed and 50 percent tax rate & rapid depreciation.  

Cash flow:

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
p.921

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 is due 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. Any potential for equity growth for the taxpayer?

continued

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 value for buyer in 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 is 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. 

§469(g).

Special “$25,000 offset for rental real estate activities” where taxpayer is an active participant.  §469(i).

Alternative Minimum Tax
p.960

Code §55. 

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.

Repealed in 2017 for corporations.