By Jahn S. Brodwin & Scott Drago,
FTI Consulting, Inc.
High-value real estate deals bring high-dollar tax liability, driving commercial property owners to seek ways to minimize tax burdens.
Brokers who are aware of the tax advantages of certain property dispositions and restructuring opportunities can provide greater value to clients and bring more deals to the closing table.
Depending on the scenario, using Section 467 leases or 1031 Exchanges can generate valuable tax savings for sellers.
A 467 lease (named after IRC section 467) is a lease structuring approach that monetizes low-basis or substantially appreciated real estate, while maintaining tax deferral.
In short, 467 leases enable owners to defer the gain on the sale of the property and have immediate access to cash. The seller leases the property to the buyer and receives substantial upfront cash payments at the closing and recognizes annual lease payments at a small tax cost over the term of the lease, until the tenant/buyer purchases the property at an agreed-upon future date.
During the lease term, the seller may take depreciation deductions, and the tenant gets a rental deduction.
The landlord/seller and tenant/buyer can agree to allocate that prepayment over the lease term, with the initial prepayment treated as a tax-free loan to the landlord.
This loan, together with interest, will be repaid from deemed rental payments made by the tenant over the term of the lease.
The rules also require the parties to adjust the rent to factor in deemed interest on the loan. If, at the end of the lease period, the tenant does not exercise its right to buy the property, then the landlord may continue the lease or if agreed upon at the beginning of the lease, exercise an option to sell the property to the tenant.
The rules covering a 467 lease are complex. A broker should discuss the basics of the economic arrangement to determine if the seller is interested in exploring a 467 lease.
If a seller is interested, then getting the seller’s tax and legal advisors involved would be the next step.
Disposition of like-kind property under IRC section 1031 allows an investor to sell real property and reinvest the proceeds in new real property on a tax-deferred basis.
This applies strictly to real property held for investment or for use in a trade or business in which the taxpayer is engaged (not property held for sale and certain uses such as personal use).
Therefore, brokers should understand what the client intends with regard to the property before exploring this alternative in depth.
Generally, most real property will be considered like-kind for this purpose. However, foreign property is not like-kind to U.S. property for 1031 Exchanges.
There are strict timing rules to qualify for tax deferral. The replacement property must be identified within 45 days of the sale of the old property; and the new property must be purchased within 180 days of closing on the old property and the due date of the taxpayer’s return, whichever comes earlier.
If the 1031 Exchange is done at the end of the year, the taxpayer’s return may be put on extension in order to use the entire 180 days.
In a 1031 Exchange, all cash must go directly to a qualified intermediary and is then used to purchase the new property.
Any non-like kind property the taxpayer receives in the Exchange — money, installment note, debt relief, or personal property — is called “boot” and may be taxable.
If the taxpayer acquires new property of equal or greater value than the net sale price of the old property and spends all the old property proceeds on the new acquisition, the transaction will be fully tax-deferred.
Brokers who arrange for the sale of the old property (and possibly on the purchase of the new property) should be compensated in the ordinary course (subject to negotiation with the seller).
Commercial real estate brokers who know and understand the tax-saving opportunities these structures provide, and who can share those insights with sellers, buyers, and tenants, will create the potential for more creative deals that benefit all parties involved.