Franchisees Who Sell the Real Estate and Keep the Franchise

Selling the real estate and keeping the franchise is a sale-leaseback, and only the real estate is exchanged

Many franchisees hold each site in a real estate entity that leases it to the operating company. Selling that entity's land and building to an investor, with a new lease from the investor to your operating company, releases the equity and leaves the restaurant or service business running without interruption.

Section 1031(a)(1) defers the gain on the real estate if the selling entity acquires like-kind real property through a qualified intermediary within 45 and 180 days. The franchise is a section 197 intangible, the equipment is personal property, and neither is sold, so neither creates tax in this transaction.

The mechanics of the sale-leaseback itself, including what makes the investor a real owner rather than a lender, are covered in sale-leaseback then 1031. This page covers what a franchise adds.

Read the franchise agreement before the lease: term, renewal, transfer and purchase rights

The franchise rule at 16 CFR 436.5 requires the disclosure document's Item 17 table to summarize the length of the franchise term, renewal and its conditions, termination, transfer by the franchisee and the conditions for franchisor approval, the franchisor's right of first refusal to acquire your business and any option to purchase it. Pull that table and the matching sections of your signed agreement before you talk to buyers.

Three questions matter most. Does the franchise term, with renewals you are likely to get, outlast the lease you are about to sign, or will you owe rent on a site you can no longer operate? Does the agreement require a remodel or relocation that the new landlord must allow? And does the franchisor have site approval rights, or rights to buy the business, that a sale of the real estate triggers or affects?

Item 11 also discloses whether the franchisor helps with locating sites and negotiating leases, which tells you whether its approval will be needed for a new lease on an existing site. Ask early; a franchisor's consent process can be slower than a buyer's due diligence.

Draw the line between the building and the operating equipment before the price is set

Reg. section 1.1031(a)-3 treats land, buildings and their structural components as real property, and lists paved parking areas and inherently permanent outdoor lighting among other inherently permanent structures. Kitchen equipment, furniture and point-of-sale systems are not, and in a sale-leaseback they normally stay with your operating company anyway.

Items in between, such as walk-in coolers, drive-through canopies, menu boards and pylon signs, are decided by the regulation's factors: how the item is affixed, whether it is designed to be removed, the damage removal would cause and the time and expense to move it. Agree in the contract which items convey, because anything the investor buys that is not real property is not like-kind.

Small amounts of personal property sold with the building do not spoil identification: under Reg. section 1.1031(k)-1(c)(5), property typically transferred with a larger item and worth no more than 15% of it is treated as part of it. Any gain on that personal property is still taxed.

Lease terms an investor will price, and terms the operator needs

Investors buying franchise real estate underwrite the lease and the operator's credit. Your operating company needs the lease to fit the franchise. Those interests overlap more than they conflict, but a few terms need deliberate choices.

• Term and renewals that cover the franchise term and expected renewals, while staying below 30 years in total under Reg. section 1.1031(a)-1(c).
• Assignment rights that let a future buyer of your franchise business take over the lease with the franchisor's approval.
• Remodel and alteration rights matching the franchisor's image requirements.
• Flat or market-indexed rent; section 467 can recast rising rent on a leaseback whose payments exceed $250,000 when tax avoidance is a principal purpose.
• An unrelated buyer: section 1239 makes gain ordinary income on depreciable property sold to an entity you own more than 50% of, and section 1031(f) restricts exchanges with related parties.

Worked example: three sites, $6,000,000 of real estate and $1,500,000 of debt

These figures are hypothetical. A franchisee's real estate LLC owns three sites worth $6,000,000 in total, with a $1,800,000 adjusted basis and $1,500,000 of mortgage debt. An investor buys all three on the same day with 20-year leases and one 5-year renewal each.

• Gain: $6,000,000 − $1,800,000 = $4,200,000, deferred in full if the LLC acquires at least $6,000,000 of replacement property, reinvesting all $4,500,000 of equity and replacing the $1,500,000 of debt with new debt or cash.
• Timing: one closing means one 45-day and one 180-day period. If the sites closed weeks apart in one exchange, all three would run on the first site's dates.
• Operating cost: the operating company now pays rent on all three sites, deductible under section 162(a)(3), in place of the debt service the LLC paid before.
• Run your own numbers with your CPA, including rent coverage at each site.

Where the equity goes: away from your own concept and your own sites

The point of selling is often to stop having all your wealth tied to one brand in one trade area. Replacement property in different sectors, such as net-leased retail with other tenants, industrial or multifamily, does that.

Interests in Delaware statutory trusts qualify as like-kind replacement property under Rev. Rul. 2004-86. Single-tenant and portfolio DSTs differ in how much one tenant's performance drives income, and traditional DST exchanges can absorb proceeds on a closing date set by the buyer. DSTs are illiquid, depend on the sponsor and tenants, and may carry debt that counts toward replacing yours.

If the sites are restaurant buildings, restaurant building exchanges covers how buyers price them and how kitchen equipment and build-outs are taxed when a whole restaurant is sold.