Can I buy a replacement property and lease it back to the seller?

A leaseback is a rental from day one, which is what replacement property needs

Publication 544 requires the property you receive to be held for investment or for productive use in a trade or business. A building that you own and lease to an operating tenant meets that, whether the tenant is a stranger or the person who just sold it to you.

Nothing in the regulations requires the tenant to be new. What matters is that you acquire real property and hold it as an investment, with the lease as its income.

For the seller this is a sale of their building, and any exchange planning on their side is separate from yours. The seller's view, including the long-lease issue, is in the owner-occupied building guide.

You have to own the building in substance, not just lend against it

In Frank Lyon the Supreme Court honored a sale-leaseback where it was a genuine multiple-party transaction with economic substance, and held that 'so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.'

The reverse risk is that a leaseback structured as a loan is treated as one. If the seller can buy the property back at a fixed price, pays rent that simply amortizes your purchase price, and leaves you no stake in the property's value, you may be treated as a lender. A lender has not received real property, and an exchange needs real property.

Keep the risks and rewards of ownership with you: residual value, market rent and, if offered at all, any repurchase option priced at fair market value when exercised.

A related seller turns the deal into a related-party exchange

Section 1031(f)(4) denies deferral to any transaction structured to avoid the related-party rules. In Rev. Rul. 2002-83 a taxpayer whose intermediary paid a related seller cash for the replacement property was denied deferral.

The Form 8824 instructions list your spouse, children, grandchildren, parents, grandparents, siblings and related entities. Buying your parent's building and leasing it back to them usually fails for this reason; see buying replacement property from a relative.

If the seller is unrelated, the leaseback raises no section 1031(f) issue. Leasing to your own business afterwards is a separate question, covered in renting the replacement to family or your business.

Worked example: a $2,000,000 building leased back for ten years

Hypothetical, round figures. You have $1,200,000 with your intermediary from a sale with an $800,000 mortgage paid off. You buy a $2,000,000 building from a business owner, with an $800,000 loan, and sign a ten-year lease to the seller's company at market rent with fair-market renewal options.

Price, equity and debt all match what you sold, so nothing is recognized. Suppose instead the seller credits you $50,000 at closing for a security deposit and first month's rent. You need $50,000 less from the intermediary, and that $50,000 is left over as boot.

Have the tenant pay the deposit and first rent to you directly after closing, and let the full price come from the exchange and the loan. Run your own numbers with your CPA.

Underwrite the tenant, because the lease is most of what you are buying

With one occupant, the building's value depends on that business's credit and on how re-leasable the space is if it leaves. Read the seller's financial statements and get a lease that makes the tenant responsible for taxes, insurance and maintenance if that is the market norm for the property type; see single-tenant net lease properties.

If you want leased commercial property without negotiating one tenant's lease yourself, a Delaware Statutory Trust interest, accepted as real property by Rev. Rul. 2004-86, is another replacement. It is illiquid, carries sponsor fees and depends on its own tenants; read single-tenant versus portfolio DSTs before choosing.