Why Lease Option Instead of Junior Carry Back?

Consider a standard $1m income property that a seller bought years ago for $700k and since depreciated to a book basis of $500k. The sale of this property could result in possible exposure to a capital gain tax on $500k.

A standard proposal by a buyer would be to offer $650k cash from a new loan, $150k down, and a $200k second note to the seller for the difference.

Issues for the seller:

A) The seller will have an issue with the capital gains tax on $800k plus the fair market value of the $200k note less than the $500k book basis.

B) Negotiations usually get bogged down between the buyer and the seller over the terms of the $200k note. The seller wants 20% interest and a 2-year term. The buyer wants 2% interest and a 20-year term. (The seller is exposed to the hard-money market to get the value for his note, which would normally be at a discount.)

Issues for the buyer:

A) One issue for the buyer is that part of the price must be allocated to land = non-depreciable for tax purposes.

B) The seller’s desire for high interest and high payments on the second gouge the cash flow out of the building’s operations.

The solution that is best for both:

The seller keeps the land and leases it to the buyer on soft but graduating terms. This makes it so the buyer’s cash flow will be better than if the buyer used a second mortgage. This can be rent-free or low rent for a short period, then stipulated rent bumps, and then adjusted to an index periodically (like consumer or industrial price changes).

The buyer gets an option to purchase the land after a time certain (2 years?) for $200k plus accelerators of one kind or another.

Benefits for the seller:

A) The seller has capital gains on $800k less $400k book basis (assuming he allocated $100k to land at purchase).

B) The seller retains leased land (usually for 55 years including options). Because it is real estate, it has an inflation proof NNN income with no management. For this reason, the seller might just keep it because it might be better for his heirs than cash.

C) He can 1031 exchange it for other real estate if he prefers to delay the tax on a value that is less than the book basis.

D) His NNN leased real estate is much more acceptable in the market place than a 2nd note. It can fit for passive investors, 1031 cash, or be used at full value as down payment on other purchases. The security for the owner of such leased land is the phrase, “would I love to foreclose” and get the buyer’s $150k equity for free?

Benefits for the buyer:

A) The buyer gets a big margin of cash flow in the beginning to facilitate the turnaround or ??

B) The buyer has an unlimited due date on the exercise of the option to buy the land (instead of normal due date on 2nd mortgage).

C) The buyer gets 100% depreciation basis on the purchase price of the building.

D) The buyer can trade his leasehold by 1031 so long as he has 30 years left including options.

E) The buyer can usually get soft terms first years better than on a note. The buyer can then face accelerators that might become a blessing instead of a due date.

Alternatives with such land leases that can solve other issues:

A) Some of the prices can be allocated to option payment so that the seller will not be taxed until the option is exercised or abandoned.

B) The term of the lease can be shortened to 5 or 10 years (including options) so as to get fast, straight-line depreciation on the building.

C) The rent can be prepaid for a period so that the buyer gets a deduction upfront and has no payment to make for that period. With this option, the seller pays ordinary income tax.

D) The buyer can negotiate for first right of refusal on the sale of the land by the seller.

E) The buyer might trade real estate for the land under the building and lease or option the other real estate from the seller. (This might work for buyer who intends to sell the other property soon and for the seller who wants cash for his land soon.) This alternative works in lieu of a contingent sale that is waiting for the other property to sell.

F) The seller might get an option to buy back the building (marked up) after buyer does a turnaround that the current seller can’t finance. The buyer gets his profit and can make it a capital gain for future planning.

It seems that if the seller has to have an all-cash payment, finding a buyer for the leased land instead of the second note would be much easier than finding the required 3rd leg to close. More often than not, the seller would close with his land leased and move it along later, after the terms of the rental income get better.

My personal experience with these is that the buyer finds it too easy to keep leasing and forgets about the accelerators in favor of the land owner. This usually results in a very good asset for the seller and the buyer has all his options available.

You can add a handful of alternative uses for land leases in lieu of junior notes and re-write this article in the future. However, pontificating transaction ideas is “like sex, talking about it is not the same as being there.”—Patrick Henry

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