Synthetic leases: substance or chimera?By using a "synthetic" lease, many companies can magically (some might say chimerically chi·mer·i·cal also chi·mer·ic adj. 1. Created by or as if by a wildly fanciful imagination; highly improbable. 2. Given to unrealistic fantasies; fanciful. 3. ) simultaneously treat their financing arrangement as an operating lease Operating Lease A lease contract that allows the use of an asset, but does not convey rights similar to ownership of the asset. Notes: An operating lease is not capitalized it is accounted for as a rental expense. for financial reporting purposes (and thus keep the lease off the company's balance sheet) and as a loan for other purposes (such as tax, bankruptcy and commercial purposes). This type of transaction has long been used for acquisition of aircraft and other large equipment, but only recently in the real estate world - in part because of the loss of traditional sources of real estate financing. Under this arrangement, the lessee will enjoy the benefits of improved financial ratios, because the real estate asset and associated long-term debt Long-Term Debt Loans and financial obligations lasting over one year. Notes: For example debts obligations such as bonds and notes which have maturities greater than one year would be considered long-term debt. are not reported on its balance sheet under GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (GAAP). and the lessee may claim the tax benefits associated with real property ownership as well as an interest deduction Interest deduction An interest expense, such as interest on a margin account, that is allowed as a deduction for tax purposes. for interest paid (subject, of course, to any limitations on deductibility of interest contained in the Internal Revenue Code The Internal Revenue Code is the body of law that codifies all federal tax laws, including income, estate, gift, excise, alcohol, tobacco, and employment taxes. These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq. ). A synthetic lease Synthetic Lease An operating lease that is structured in a way so that it is not recorded as a liability on the balance sheet. Instead, it is considered to be an expense on the income statement. (the very name implies something illegitimate or unnatural) is a financing arrangement that is classified as a lease for financial accounting purposes and as a loan for tax purposes. It involves the purchase of real estate from a third party seller by a "special purpose entity" that then leases the property to the tenant. The landlord provides funding for acquisition and construction costs. The funds advanced by the landlord are repaid through the rentals paid by the tenant. A synthetic lease is structured to resemble economically a loan for a specified term with a balloon payment The final installment of a loan to be paid in an amount that is disproportionately larger than the regular installment. When a loan is made, repayment of the principal, which is the amount of the loan, plus the interest that is owed on it, is divided into installments due at . At the end of the term, the tenant can renew the lease, purchase the property or direct the sale of the property - perhaps at a profit, if there has been appreciation and the value of the property exceeds the remaining "debt." The tenant also has the option of purchasing or refinancing the balance of the debt. Since the tenant, however, is paying "interest" on a loan, the interest portion of its payments together with an allowance for depreciation are tax deductible; the "lease" does not appear as an asset or a liability on the tenant's balance sheet - it appears only in a footnote which discloses the annual lease payments as required by GAAP. The "landlord," who for this purpose is a lender, is often a passive investor, collecting the rent payments as interest and a return of principal. The "triple-net" feature of the lease requires the tenant to assume all responsibility (and risk) for the operation and management of the property - including the risk of reconstruction in the event of fire, earthquake, or other casualty. The tenant must retain the major benefits and burdens of ownership in order to receive the benefits of depreciation for federal income tax purposes. Because of their complexity and high transaction costs Transaction Costs Costs incurred when buying or selling securities. These include brokers' commissions and spreads (the difference between the price the dealer paid for a security and the price they can sell it). , synthetic leases are useful primarily for large, high credit companies, such as supermarket and "big box" chains, manufacturers, and other significant users of real estate who have specialized build-out and fixturization costs. Synthetic leases are often limited to newly constructed properties in the case of real estate. This limitation is a practical solution to avoiding the possible application of the more restrictive accounting rules applicable to sale-leasebacks of existing real property (including real property and associated personal property) under Financial Accounting Statement ("FAS") No. 98. These rules provide that the sale and leaseback sale and leaseback The sale of a fixed asset that is then leased by the former owner from the new owner. A sale and leaseback permits a firm to withdraw its equity in an asset without giving up use of the asset. Also called leaseback. of real estate will qualify as an operating lease under GAAP only if most of the risks and benefits of ownership are transferred to the purchaser-landlord (which would defeat the purposes of the transaction). The presence of certain forms of continuing involvement by the lessee with the leased property, such as purchase options, will result in a determination for accounting purposes that most of the risks and benefits of ownership of the leased property have not been transferred. In order to satisfy the FASB FASB See: Financial Accounting Standards Board FASB See Financial Accounting Standards Board (FASB). requirements for "new" construction, a tenant (borrower) may have to create a separate company (a special purpose entity, or SPE SPE - Software Practice and Experience ) to own the property and lease it to the tenant. The SPE typically makes at least a three percent equity investment (in order to avoid consolidation with the lessee under FAS 94) and obtains financing for the remainder, usually through bank debt or commercial paper. In order to be treated as an operating lease for financial reporting purposes, the Financial Accounting Standards Board Financial Accounting Standards Board (FASB) Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). ("FASB") has adopted four criteria, each of which must be absent from the lease transaction. If any of the four factors exists, the lease will be treated as a capital (non-operating) lease. These four factors (and the typical means of providing "failure" of each) are as follows: Ownership of the property is transferred to the tenant by the end of the term (to avoid this factor yet permit a transfer, the lease will often grant the tenant an option to purchase the property at fair value at the end of the term, a right of first refusal Right of First Refusal In general, the right of a person or company to purchase something before the offering is made available to others. Notes: For example, a football team may have the right of first refusal on a player's contract. , or a right to direct an arm's length arm's length adj. the description of an agreement made by two parties freely and independently of each other, and without some special relationship, such as being a relative, having another deal on the side or one party having complete control of the other. sale to a third party); The lease grants the tenant an option to purchase the property at a bargain price (to avoid bargain purchase options, the lease will grant an option with a purchase price not lower than the reasonably expected market value of the property at the time of exercise; an appraisal is customarily obtained at the beginning of the lease to support the option price and allow the price to be fixed; if the property is sold to a third party, the tenant must typically guarantee any difference between the selling price and the amount originally advanced by the landlord - investor); The lease term is equal to or greater than 75 percent of the estimated economic life of the property, including any years of use prior to the synthetic lease transaction (therefore the non-cancelable portion of the term can be rather short, such as five to seven years); and the present value of the rents and other minimum payments (including tenant guarantees) under the lease equal or exceed 90 percent of the fair market value of the property at the beginning of the lease (therefore the synthetic lease must be structured so that the present value of all minimum lease payments Rental payments over the lease term including the amount of any bargain purchase option, premium and any guaranteed residual value and excluding any rental relating to costs to be met by the lessor and any contingent rentals. , including any residual payment due upon termination, is less than 90 percent of the value of the property). Synthetic leases are undergoing increased scrutiny by the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. . For federal income tax purposes, the person who bears the benefits and burdens of ownership of the leased property will be regarded as its owner and entitled to depreciate depreciate v. in accounting, to reduce the value of an asset each year theoretically on the basis that the assets (such as equipment, vehicles or structures) will eventually become obsolete, worn out and of little value. (See: depreciation) or amortize the cost of the property. In general, as long as a lessee pays a fair rental value rental value n. the amount which would be paid for rental of similar property in the same condition in the same area. Evidence of rental value becomes important in lawsuits in which loss of use of real property or equipment is an issue, and the rental value is the (and nothing more) for the use of the leased property, the arrangement will be treated as a lease for tax purposes. To the extent the lessee pays more than a fair market rental value, holds an option to acquire the property at less than its (anticipated) fair market value at the time of exercise, or has otherwise undertaken obligations in excess of fair rental value, the lease may be regarded as a secured loan to or installment purchase by the lessee. In this case, the lessee will be regarded as the tax owner of the property. In a synthetic lease, the lessee or a special purpose entity landlord (discussed below) will generally be the owner of the property for tax purposes. There are other complexities with synthetic leases. Bankruptcy courts have sometimes concluded that the lease is not an operating lease, but a financing device - which is not subject to rejection under Section 365 of the Bankruptcy Code Bankruptcy Code may refer to:
usury In law, the crime of charging an unlawfully high rate of interest. In Old English law, the taking of any compensation whatsoever was termed usury. rules, antideficiency protections, or other laws governing loans apply? Also, what is the position of a third-party institution that made a loan to the landlord (investor)? If the landlord that granted the lien to the institution is not truly the "owner" of the property, is the institutional lender's lien invalidated or otherwise impaired? Because of issues raised by the possibility of recharacterization, title companies have difficulty deciding whether to insure the transaction as a loan (where in the case of a default, the remedy of foreclosure would be appropriate) or a lease (where other remedies for default are required). The title company may want to add an exception to the title policies issued to the various parties for any possible "recharacterization" of the lease. Even if it does not, the title company may later claim that it has no duty to defend the insured because the "defect" that arises (i.e., the "recharacterization") is not one of title, but of the underlying relationships of the parties (which it may assert is not covered not covered Health care adjective Referring to a procedure, test or other health service to which a policy holder or insurance beneficiary is not entitled under the terms of the policy or payment system–eg, Medicare. Cf Covered. by title insurance). Title companies will, under the proper circumstances, issue special indorsements to cover these issues. In addition to the above-mentioned aspects of synthetic leases, consideration must be given to other issues involving sales tax sales tax, levy on the sale of goods or services, generally calculated as a percentage of the selling price, and sometimes called a purchase tax. It is usually collected in the form of an extra charge by the retailer, who remits the tax to the government. (if personal property is involved), property tax (such as Proposition 13 reassessment issues), and conveyance taxes. Such taxes must be analyzed at the time of inception of the lease (or, if a sale-leaseback, at the time of the initial sale) as well as upon disposition of the property at lease termination. As the above discussion indicates, the proper structuring of a synthetic lease transaction involves a complex convergence of accounting, tax, bankruptcy, title, and business considerations. Accordingly, the costs of structuring and documenting the transaction are relatively high. It is not for those averse to the use of lawyers or accountants. But for those who wish to achieve enhanced financial ratios and retain the tax benefits of ownership, a synthetic lease may truly be the best of both worlds. Gary York is a Shareholder and the Real Estate Practice Group head at Buchalter, Nemer, Fields & Younger. He is currently on the Executive Committee of the Real Property Section of the Los Angeles County Bar Association and is a member of the American College of Real Estate Lawyers The American College of Real Estate Lawyers (ACREL) [1] is the premier organization of U.S. real estate lawyers. Admission is by invitation only after a rigorous screening process. . Mr. York has served as past Chair of the Real Estate Finance Section of the American Bar Association American Bar Association (ABA), voluntary organization of lawyers admitted to the bar of any state. Founded (1878) largely through the efforts of the Connecticut Bar Association, it is devoted to improving the administration of justice, seeking uniformity of law , and is a member of the Lender's Counsel Group of the American Land Title Association The American Land Title Association or ALTA, is a national trade association representing the interests of the abstract of title and title insurance industries. In addition to active members engaged in the title industry, associate members cover a wide range of businesses . He is a frequent author and lecturer on real estate financing topics. Mr. York can be reached at Buchalter, Nemer, Fields & Younger at (213) 891-5089, or you can e-mail him at gyork.bnfy@mcimail.com. Greg Keever is a Shareholder at Buchalter, Nemer, Fields & Younger. He has extensive experience in the representation of businesses and investors in connection with private capital, joint ventures, and mergers and acquisitions in a variety of industries. Mr. Keever also advises clients in connection with tax, general commercial secured and unsecured financing, equipment leasing, and real estate financing. Recently his practice has involved the financing of high technology entertainment products, cable television, aircraft leasing, and mergers and acquisitions in a variety of industries. Mr. Keever is a member of the Business Law Section and the Tax Section of the American Bar Association. Mr. Keever can be reached at Buchalter, Nemer, Fields & Younger at (213) 891-5094, or you can e-mail him at gkeever.bnfy@mcimail.com. |
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