Sales-Leasebacks: The Devil Is In The Details

A sale-leaseback happens when a business sells a possession to a lessor then and rents it back. The leaseback may be for the entire asset or a portion of it (as in property) and for its whole staying useful life or for a shorter duration.


Sale-leaseback accounting addresses whether the property is derecognized (eliminated) from the seller's balance sheet, whether any revenue or loss is recognized on the sale and how the leaseback is capitalized back on the seller-lessee's balance sheet.


Under FAS 13 and ASC 840, if the present value of the leaseback was 10% or less of the asset's fair market worth at the time of the sale, any earnings resulting from the sale could be recognized entirely and the leaseback would stay off the lessee's balance sheet due to the fact that the resulting leaseback would be dealt with as an operating lease.


If the leaseback was greater than 10% and less than 90%, a gain might be recognized to the level it went beyond today worth of the leaseback, while the leaseback remained off the balance sheet due to the fact that it was reported as an operating lease. In essence any gain that was less than or equivalent to the PV of the leaseback was delayed and amortized over the leaseback term. The gain would essentially be acknowledged as a reduction to balance out the future rental expense.


For leasebacks equal to or higher than 90%, the property would remain on the lessee's balance sheet, no gain could be reported and any proceeds would be dealt with as loans to the lessee from the buyer.


Under FAS 13 and ASC 840, sale-leasebacks of property and equipment thought about integral to real estate consisted of an included caveat. If the leaseback consisted of any kind of repaired cost purchase option for the seller/lessee, it was ruled out a sale-leaseback.


Therefore, even if the sale was a valid sale for legal and tax functions, the property remained on the lessee's balance sheet and the sale was treated as a funding or borrowing versus that possession. The FASB's position was based on what was then called FAS 66 "Accounting for Sales of Real Estate" which highlighted the various unique methods which realty sale transactions are structured. Additionally, the FASB kept in mind that many such property deals resulted in the seller/lessee redeeming the possession, hence supporting their view that the sale-leaseback was merely a form of financing.


Sale-leasebacks Under ASC 842


Accounting for sale-leaseback transactions under ASC 842 aligns the treatment of a possession sale with ASC 606 relating to profits recognition. As such, if a sale is acknowledged under ASC 606 and ASC 842, the full profit or loss may thus be recorded by the seller-lessee.


ASC 842 is stated to in fact enable more sale and leaseback transactions of property to be considered a sale under the brand-new set of standards, provided the sale and leaseback does not include a fixed cost purchase option.


On the other hand nevertheless some deals of possessions aside from realty or devices important to real estate will be considered a stopped working sale and leaseback under ASC 842. As mentioned above, those sales and leasebacks that include a repaired price purchase choice will no longer be thought about a 'successful' sale and leaseback.


A failed sale-leaseback occurs when


1. leaseback is categorized as a financing lease, or
2. a leaseback consists of any repurchase option and the asset is specialized (the FASB has shown that property is usually considered specialized), or
3. a leaseback includes a repurchase alternative that is at besides the possession's reasonable worth determined "on the date the option is worked out".


This last product implies that any sale and leaseback that consists of a fixed rate purchase alternative at the end will stay on the lessee's balance sheet at its amount and categorized as a set property instead of as a Right of Use Asset (ROUA). Although a possession may have been lawfully offered, a sale is not reported and the possession is not gotten rid of from the lessee's balance sheet if those conditions exist!


Note likewise that extra subtleties too various to address here exist in the sale-leaseback accounting world.


The accounting treatments are explained further listed below.


IFRS 16 Considerations


IFRS 16 on the other hand has a slightly different set of standards;


1. if the seller-lessee has a "substantive repurchase choice" than no sale has happened and
2. any gain acknowledgment is restricted to the amount of the gain that connects to the buyer-lessors recurring interest in the hidden possession at the end of the leaseback.


In essence, IFRS 16 now likewise prevents any de-recognition of the asset from the lessee's balance sheet if any purchase choice is supplied, besides a purchase alternative the worth of which is figured out at the time of the exercise. Ironically IFRS 16 now requires a limitation on the quantity of the gain that can be acknowledged in a similar fashion to what was allowed under ASC 840, specifically the gain can only be recognized to the extent it surpasses the present value of the leaseback.


Federal Income Tax Considerations


In December 2017, Congress passed and the President signed what has ended up being known as the Tax Cuts and Jobs Act (TCJA). TCJA offered a renewal of perk devaluation for both brand-new and secondhand properties being "utilized" by the owner for the very first time. This indicated that when a taxpayer initially positioned an asset to use, they could claim reward devaluation, which starts now at 100% for properties which are acquired after September 27, 2017 with particular restrictions. Bonus devaluation will start to phase down 20% a year beginning in 2023 till it is gotten rid of and the revert back to standards MACRS.


Upon the passing of TCJA, a question arose as to whether a lessee could declare reward devaluation on a rented asset if it got the asset by exercising a purchase choice.


For instance, assume a lessee is renting an asset such as a truck or device tool or MRI. At the end of the lease or if an early buyout choice exists, the lessee may work out that purchase choice to obtain the possession. If the lessee can then immediately write-off the worth of that property by claiming 100% bonus offer depreciation, the after tax cost of that asset is immediately minimized.


Under the existing 21% federal corporate tax rate and following 100% benefit depreciation, that indicates the possession's after tax cost is minimized to 79% (100% - 21%). If nevertheless the property is NOT qualified for bonus offer devaluation due to the fact that it was formerly used, or must we state, utilized by the lessee, then the expense of the possession begins at 100% minimized by the present value of the future tax deductions.


This would imply that a rented property being bought might result in an inherently higher after-tax expense to a lessee than a property not rented.


Lessors were worried if lessees might not claim bonus offer depreciation the value of their assets would become depressed. The ELFA brought these issues to the Treasury and the Treasury reacted with a Notification of Proposed Rulemaking referenced as REG-104397-18, clarifying that the lessee can claim benefit depreciation, provided they did not formerly have a "depreciable interest" in the asset, whether devaluation had actually ever been claimed by the seller/lessee. The IRS requested discuss this proposed rulemaking and the ELFA is responding, however, the final rules are not in location.


In numerous renting deals, seller/lessees collect a variety of similar properties over an amount of time and then get in into a sale and leaseback. The present tax law allowed the buyer/lessor to deal with those assets as new and thus under prior law, received bonus devaluation. The arrangement followed was typically called the "3 month" whereby as long as the sale and leaseback took place within 3 months of the property being placed in service, the buy/lessor could likewise claim reward devaluation.


With the advent of bonus offer devaluation for utilized assets, this rule was not essential considering that a buyer/lessor can declare the benefit depreciation despite for how long the seller/lessee had previously used the property. Also under tax rules, if a property is acquired and after that resold within the very same tax year, the taxpayer is not entitled to declare any tax depreciation on the asset.


The introduction of the depreciable interest concept tosses a curve into the analysis. Although a seller/lessee might have owned a property before getting in into a sale-leaseback and did not claim tax devaluation due to the fact that of the sale-leaseback, they likely had a depreciable interest in the property. Many syndicated leasing transactions, especially of automobile, followed this syndication method; lots of possessions would be collected to achieve an important dollar value to be offered and leased back.


As of this writing, all assets originated under those circumstances would likely be ineligible for reward devaluation ought to the lessee exercise a purchase alternative!


Accounting for a Failed Sale and Leaseback by the lessee


If the transfer of the property is not considered a sale, then the property is not derecognized and the profits gotten are treated as a financing. The accounting for an unsuccessful sale and leaseback would be different depending on whether the leaseback was identified to be a finance lease or an operating lease under Topic 842.


If the leaseback was figured out to be a finance lease by the lessee, the lessee would either (a) not derecognize the existing property or (b) record the capitalized worth of the leaseback, depending upon which of those approaches produced a higher asset and offsetting lease liability.


If the leaseback was identified to be an operating lease by the lessee, the lessee would derecognize the property and delay any gain that might have otherwise resulted by the sale, and then capitalize the leaseback in accordance with Topic 842.


Two cautions exist relating to how the financing portion of the stopped working sale-leaseback should be amortized:


No unfavorable amortization is allowed Essentially the interest cost acknowledged can not surpass the part of the payments attributable to principal on the lease liability over the much shorter of the lease term or the financing term.
No built-in loss may result. The carrying value of the hidden property can not go beyond the financing commitment at the earlier of completion of the lease term or the date on which control of the hidden property transfers to the lessee as purchaser.


These conditions might exist when the failed sale-leaseback was caused for example by the existence of a fixed price purchase option during the lease, as was highlighted in the basic itself.


Because case the rates of interest needed to amortize the loan is imputed through an experimentation method by also considering the carrying worth of the asset as gone over above, instead of by computing it based solely on the aspects related to the liability.


In effect the existence of the purchase option is dealt with by the lessee as if it will be worked out and the lease liability is amortized to that point. If the condition causing the stopped working sale-leaseback no longer exists, for example the purchase alternative is not worked out, then the carrying quantities of the liability and the underlying possession are adjusted to then use the sale treatment and any gain or loss would be recognized.


The FASB example is as follows:


842-40-55-31 - An entity (Seller) offers a possession to an unassociated entity (Buyer) for cash of $2 million. Immediately before the transaction, the possession has a bring amount of $1.8 million and has a staying helpful life of 21 years. At the exact same time, Seller participates in a contract with Buyer for the right to use the asset for 8 years with yearly payments of $200,000 payable at the end of each year and no renewal alternatives. Seller's incremental interest rate at the date of the transaction is 4 percent. The contract includes an option to redeem the possession at the end of Year 5 for $800,000."


Authors comment: An easy estimation would conclude that this is not a "market-based deal" considering that the seller/lessee might just pay 5-years of lease for $1,000,000 and after that buy the possession back for $800,000; not a bad offer when they sold it for $2 million. Nonetheless this was the example offered and the leasing market determined that the rate required to meet the FASB's test was determined utilizing the following table and a trial and error approach.


In this example the lessee should utilize a rate of roughly 4.23% to get here at the amortization such that the financial liability was never ever less than the asset net book value up to the purchase alternative workout date.


Since the entry to tape the failed sale and leaseback includes establishing an amortizing liability, at some time a repaired rate purchase option in the agreement (which triggered the failed sale and leaseback in the first location) would be


If we assume the purchase alternative is exercised at the end of the fifth year, at that time the gain on sale of $572,077 would be acknowledged by getting rid of the staying lease liability of $1,372,077 with the workout of the purchase alternative and payment of the $800,000. The previously tape-recorded ROU possession would be reclassified as a fixed asset and continue to be depreciated throughout its staying life.


If on the other hand the purchase option is NOT worked out (assuming the transaction was more market based, for instance, assume the purchase option was $1.2 million) and basically expires, then presumably the staying lease liability would be gotten used to reflect the present worth of the remaining leas yet to be paid, marked down at the then incremental interest rate of the lessee.


Any difference between the then outstanding lease liability and the recently computed present worth would likely be a change to the remaining ROU asset, and the ROU possession would then be amortized over the remaining life of the lease. Assuming today worth of the 3 staying payments utilizing a 4% discount rate is then $555,018, the following adjustments need to be made to the schedule.


Any failed sale leaseback will require analysis and analysis to completely understand the nature of the deal and how one need to follow and track the accounting. This will be a relatively manual effort unless a lessee software application bundle can track when a purchase option ends and produces an automatic adjusting journal entry at that time.


Apparently for this reason, the FASB also attended to adjusted accounting for deals previously accounted for as stopped working sale leasebacks. The FASB recommended when embracing the brand-new standard to analyze whether a transaction was previously a failed sale leaseback.


Procedural Changes to Avoid a Failed Sale and Leaseback


While we can get fascinated in the triviality of the accounting information for a stopped working sale-leaseback, acknowledge the FASB introduced this somewhat troublesome accounting to derecognize just those assets in which the deal was plainly a sale. This process existed previously just for real estate transactions. With the advent of ASC 842, the accounting also should be obtained sale-leasebacks of devices.


If the tax rules or tax analyses are not clarified or altered, lots of existing properties under lease would not be qualified for bonus offer depreciation simply because when the initial sale leaseback was performed, the lessees managed themselves of the existing transaction rules in the tax code.


Moving forward, lessors and lessees need to establish brand-new techniques of administratively executing a so-called sale-leaseback while thinking about the accounting issues intrinsic in the brand-new standard and the tax guidelines gone over previously.


This may need a prospective lessee to organize for one or lots of possible lessors to underwrite its brand-new leasing company ahead of time to prevent getting in into any form of sale-leaseback. Obviously, this indicates much work will need to be done as soon as possible and well ahead of the positioning for any devices orders. Given the asset-focused specialties of many lessors, it is not likely that one lessor will prefer to deal with all types of devices that a prospective lessee may prefer to lease.


The concept of an unsuccessful sale leaseback ends up being complex when considering how to account for the deal. Additionally the resulting prospective tax implications may develop several years down the road. Nonetheless, given that the accounting requirement and tax rules exist as they are, lessees and lessors should either adjust their methods or comply with the accounting requirements promulgated by ASC 842 and tax guidelines under TCJA.


In all probability, for some standardized transactions the techniques will be adapted. For larger deals such as property sale-leasebacks, creative minds will once again examine the repercussions of the accounting and simply consider them in the method they get in these transactions. In any event, it keeps our market interesting!