Chapter 16 p.921 Leverage & Leasing

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1 Chapter 16 p.921 Leverage & Leasing Consider (remembering the Tufts case) the tax sheltering effects of: 1) Rapid income tax depreciation deductions (or immediate expensing). 2) 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). 4/26/2018 (c) William P. Streng 1

2 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 Effect of depreciation deduction (50% depreciation on 100x cost times 50% tax rate) Positive net cash flow: 10x 25x 15x 4/26/2018 (c) William P. Streng 2

3 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 4/26/2018 (c) William P. Streng 3

4 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. 4/26/2018 (c) William P. Streng 4

5 Pleasant Summit Land Corp. p.926 Another example of: 1) Nonrecourse financing (i.e., purchase price?), exceeding 2) 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? 4/26/2018 (c) William P. Streng 5

6 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. 4/26/2018 (c) William P. Streng 6

7 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. 4/26/2018 (c) William P. Streng 7

8 Leasing, p. 933 Really a Lease? Example: Lease of property from lessor to lessee: 1) 99 year term 2) Lessee has option to purchase property at the end of the lease for $1 3) Cash flow: rental payments equal loan amortization (P&I) amount. 4) Triple net lease ( hell or high water ) for lessee to pay all expenses. 4/26/2018 (c) William P. Streng 8

9 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). 4/26/2018 (c) William P. Streng 9

10 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)? 4/26/2018 (c) William P. Streng 10

11 How Structure Acceptable Sale-Leasebacks? P.951 1) Minimum investment by the lessor. 2) Purchase options only at fail market value at the time the option is exercised. 3) 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. 4/26/2018 (c) William P. Streng 11

12 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 4/26/2018 (c) William P. Streng 12

13 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). 4/26/2018 (c) William P. Streng 13

14 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. 4/26/2018 (c) William P. Streng 14

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