Sale-Leaseback Then 1031: Selling Your Business Real Estate and Staying On as the Tenant

A sale-leaseback turns the building into cash while the business stays put, and the exchange keeps that cash from being taxed

In the usual structure, the real estate entity that owns the building sells it to an investor at closing, and the operating company signs a long net lease with the new owner on the same day. The business does not move, its customers see no change, and the building's equity is released.

Without an exchange that equity is taxed: the depreciation layer at up to 25%, the rest at long-term capital gain rates, plus the 3.8% surtax above the thresholds. With an exchange, the proceeds go to a qualified intermediary and section 1031(a)(1) defers the gain if the selling entity buys like-kind real property within the deadlines in Reg. section 1.1031(k)-1(b).

The replacement does not have to be anything like a business building. Section 1031 treats real property held for business use or investment as like-kind to other such real property, so the proceeds can go into net-leased retail, apartments, industrial or interests in a Delaware statutory trust.

The investor has to really own the building, or the deal looks like a loan

The leading case is a 1978 Supreme Court decision on a bank headquarters sold to an investor and leased back (435 U.S. 561). The Court honored the sale because it was "a genuine multiple-party transaction with economic substance" driven by "business or regulatory realities" and not "shaped solely by tax-avoidance features," and because the investor kept "significant and genuine attributes of the traditional lessor status."

That deal survived even though the bank had repurchase options and the rent matched the investor's mortgage payments. What carried it was a real third party with its own capital at risk and real business reasons for the structure.

So the safest buyer is an unrelated investor paying a market price with its own money. A friendly buyer who will sell the building back on request, or whose return is fixed regardless of the property's value, makes it easier to argue that you borrowed against the building rather than sold it, and a loan cannot start an exchange.

Keep the lease at market rent and well short of thirty years

Reg. section 1.1031(a)-1(c) treats "a leasehold of a fee with 30 years or more to run" as like-kind to real estate. In a 1951 case (192 F.2d 155) the 8th Circuit treated a foundry sold and leased back for 95 years as an exchange of the fee for the leasehold, which denied the seller's loss.

Fair rent changes the result. In a 1976 case (539 F.2d 943) the 3rd Circuit accepted a sale with a 30-year leaseback as a sale, because the rent matched fair rental value and the leasehold therefore had no separate capital value. Selling an owner-occupied business building explains why owners keep the term and renewals comfortably below that line.

Rent structure matters for another reason. Section 467 reaches rental agreements with deferred or increasing rent once total payments exceed $250,000, and it treats a lease to anyone who had an interest in the property within the prior 2 years as a leaseback transaction. If a principal purpose of rising rent is tax avoidance, rent is accrued on a constant basis instead of as written. Flat or market-indexed rent avoids the question.

Selling to an entity you control costs ordinary income and can unwind the exchange

Owners sometimes ask whether they can sell the building to a second company they own and lease it back to the first. Section 1239 answers that for depreciable property: gain on a sale between a person and a corporation or partnership it owns more than 50% of is ordinary income, not capital gain.

Related-party exchanges are also restricted. Section 1031(f) removes the deferral if a related party and you exchange property and either side disposes of its property within 2 years.

The rent deduction has a condition too. Section 162(a)(3) allows rent for property "to which the taxpayer has not taken or is not taking title or in which he has no equity," so a lease that gives the operating company an equity build-up through bargain purchase terms risks losing it.

Worked example: a $4,000,000 building, a 15-year lease and a full exchange

These figures are hypothetical. A manufacturer's real estate LLC owns its plant, worth $4,000,000 with a $1,000,000 adjusted basis and a $1,000,000 mortgage. An unrelated investor buys it for $4,000,000, and the operating company signs a 15-year net lease at market rent with two 5-year renewals.

• Gain: $4,000,000 − $1,000,000 = $3,000,000, deferred in full if the LLC acquires at least $4,000,000 of replacement property and reinvests all $3,000,000 of net equity.
• Debt: the $1,000,000 payoff must be offset by new debt on the replacement or by added cash, or it is taxed as boot; debt inside a DST can count toward that.
• Lease: 15 years plus 10 of renewals is 25 years, below the thirty-year line, at rent the operating company can deduct each year.
• Run your own numbers with your CPA before you sign a letter of intent.

Lease terms that protect the business you are keeping, and where the proceeds can go

Once the building is sold, the lease is the only thing standing between your business and a move. Negotiate it as an operator, not as a seller trying to push up the price with high rent.

• Term and renewals long enough for your plans, but counted carefully against the thirty-year line.
• Assignment and subletting rights so a future buyer of your business can take over the lease.
• Clear repair and replacement duties for roof, structure and building systems under a net lease.
• Expansion, signage and alteration rights if the operation will change.
• A right of first offer if the investor sells, rather than a fixed-price buyback.