Tax Considerations for Buying and Selling Property with a Burdensome Lease
Maples, Larry, Turner, Mark, Howard, Beth, Journal of Accountancy
* When a lessee terminates a lease by purchasing the leased property, the IRS requires capitalization of the entire purchase price, However, some courts have allowed the excess of the price over the fair market value to be deducted as the cost of buying out a burdensome lease,
* Under IRC [section] 1234A, lessors receiving payment from a lessee purchasing the leased property realize a capital gain or loss on the entire transaction if the property qualifies as a capital asset.
* However, this treatment would not apply when the lessor sells a lease contract to a third party, In that case, the seller would recognize ordinary income from the sale's proceeds,
* A third party that acquires property subject to a lease must record the entire adjusted basis for tax purposes and recover it by depreciation. Lease payments received would be ordinary income.
An economic downturn like the current one can cause fixed lease obligations to become burdensome and trigger a significant negative impact on leasing in many markets. Real property and other business assets may have been leased in a sale-leaseback transaction, or the lessee may have simply desired use but not ownership of the asset. Some lease contracts may provide favorable terms to the lessee in the early years, but the terms purposely turn unattractive in later years to ensure that lessees eventually purchase the property.
When a lease becomes burdensome (the obligation exceeds the benefits), a taxpayer may try to terminate it. If the lessee pays a cancellation fee, tax law generally allows a deduction, because no future benefit is created. As an alternative to cancellation, the lessee could buy the property from the lessor. Recent litigation demonstrates that the lessee's tax treatment of such a purchase is unsettled, though the tax results of lease terminations from the landlord's perspective are more predictable.
The IRS may allow a lessee to deduct lease cancellation payments if they are not integrated in some way with the acquisition of another property right. In Letter Ruling 9607016 issued in 1996, the IRS said a lease termination payment could not be deducted in the year paid where it was part of an overall plan to acquire and relocate to another site. The IRS held that the lessee's right to terminate was conditioned on acquiring a new site and starting construction. The IRS noted that in a prior case and ruling, termination payments had been deductible when they were paid to eliminate expenses or relieve a taxpayer from an uneconomic contract and those situations were not integrated with the acquisition of another property right.
When a lessee terminates a lease by buying the leased property, the acquisition of a property right is obviously integrated with the lease termination. Not surprisingly, the IRS will also require capitalization in this situation. Its rationale is that IRC [section] 167(c)(2) prohibits an allocation of a portion of the cost to the leasehold interest. The Tax Court agrees, but a district court recently allowed a lessee to deduct the portion of the purchase price allocable to a burdensome lease. In what circumstances may a lessee reasonably take the position that the amount paid for property in excess of its value is a deductible lease termination payment?
The Tax Court in Union Carbide Foreign Sales Corp. (115 TC 423 (2000)) considered a situation in which the lessee of a ship had the option to pay $135 million to terminate a burdensome lease or buy the ship for nearly $108 million. The ship's fair market value without the lease was less than $14 million. The taxpayer exercised the purchase option and deducted nearly $94 million ($108 million-$14 million) as a lease termination expense. The Tax Court did not allow the deduction, with the result that the taxpayer had to recover the entire $108 million over the remaining life of the ship. …