Leveraged leases a financing tool for the RE industry.

Leveraged leases can be a complex and intricate vehicle for financing equipment in today's marketplace. Simply put, a leveraged lease is a transaction where the lessor puts in a part (usually 20-40 percent) of the funds necessary to purchase the equipment and a third party lender supplies the remainder, hence the lessor's investment is leveraged with third party debt. Usually the third party loan is a non-recourse loan to the lessor, which means the lender can only look to the lessee's stream of rental payments that have been assigned to it and the equipment for repayment. The lessor has no repayment responsibility, even if the lessee defaults and the loan becomes uncollectible. Although this sounds risky for the lender, normally a non-recourse loan will not be made unless the lessee is proven creditworthy.

Tax treatment is a major issue for leveraged leases. There are significant tax advantages when a transaction is structured as a leveraged lease as opposed to a regular sale. If a transaction is structured as a leveraged lease the income is picked up over time in accordance with leasee's payments, and the lessor can take depreciation and interest expense against the income, which will create loss for the first few years. If a sale is done the full amount of any gain will have to be picked up in current year. See below for example.

A leasing company is considering the purchase of equipment whose cost is $1,000,000. The asset will be purchased with $200,000 of the company's equity and with $800,000 of debt. The interest expense is 9.213 % for 15 years.

The company will lease out the equipment for $110,000 per year for 15 years with option for purchase in the 16th year for $300,000. The company will depreciate the asset over a seven year life (basis $1,000,000).

Due to the depreciation and interest expense the lessor will generate net losses of approximately $621,000 over the first seven years of the lease. Assuming this is the only operation of the lessor, the loss carry forward will offset the income generated from year 8 to 15. The lessor will pay a tax on the exercise of the option in year 16. Thus, by structuring a lease instead of a sale, the lessor was able to benefit from significant tax losses generated by the depreciation and interest expense.

In a recent Revenue Procedure issued by the IRS, six guidelines were introduced which the IRS will use to determine if a leveraged lease transaction qualifies for an advanced ruling to recognize its existence as a lease for tax purposes. The guidelines are as follows:

1. There must be a minimum unconditional "at risk" investment in the leased property by the lessor, generally equal to at least 20 percent.

2. The lease term must include all renewal or extension periods except renewals and extensions at the option of the lessee at the fair rental value at the time of the renewal or extension.

3. No member of the "lessee group" may have a contractual right to purchase the property from the lessor at a price less than its fair market value at the time the right is exercised.

4. Rules must be specified concerning the permitted investment in the property by the lessee, including specifications regarding severable and nonseverable improvements to the property.

5. No member of the lessee group may loan funds to the lessor to acquire the property.

6. The lessor must represent and demonstrate that it expects to receive a profit from the transaction beyond the value of the tax deductions, allowances, credits, and other tax attributes arising from the transaction. In meeting this rule, overall profit and positive cash flow requirements must also be met.