Sale-Leaseback Transactions Under the New Accounting Standards

By Sophie Kim

A sale-leaseback consists of a contract between a seller and a buyer to sell an asset, and a subsequent second contract for the seller (now a lessee) to lease the asset back from the buyer (a lessor). It is an attractive way to structure a transaction to benefit both the seller/lessee and the buyer/lessor.

Under this arrangement, the seller benefits from an immediate inflow of the cash from an appreciated asset while still retaining the use of the asset. This cash can be used for other areas in operations or invested for higher yields. The seller can also recognize the gains from the sale on the financial statement and have more flexibility in the restrictions and terms in the agreement than in conventional financing. From an income tax perspective, the deduction of the rent expenses is often higher than the deduction of depreciation expenses. The seller may also eliminate the costs to manage and maintain the fixed assets. On the buyer’s part, the reduced risks and tax benefits such as depreciation are the advantages over a conventional financing arrangement. A cost segregation study can increase the tax benefit even further by accelerating depreciation. The buyer will have a consistent flow of rental income, with a guaranteed residual value at termination.

Although there are some disadvantages of a sale-leaseback such as possible income tax on capital gains on the seller and the added burdens on the buyer/lessor in case of the seller’s bankruptcy, in general, the benefits of a sales-leaseback potentially outweigh the possible costs for many potential sellers and buyers.

A sale-leaseback has been always popular in real estate but with the adoption of two new accounting standards, FASB ASC Topic 606, Revenue from Contracts with Customer and FASB ASC Topic 842, Leases, those who want to take advantage of the benefits of a sale-leaseback need to pay close attention in order to structure the transaction successfully.

In order to qualify as a sale-leaseback transaction, the transaction should qualify as a “sale” under ASC 606 and as an “operating lease” under ASC 842. Pursuant to ASC 842-40-25-1, there are two requirements in the transfer of an asset to be accounted for as a sale of the asset under Topic 606, that is, the existence of the contract and a transfer of the control of an asset. As stipulated under Topic 606, the sale should have commercial substance to be recognized as a sale. That means the sale must result in a complete change of control from the seller/lessee to the buyer/lessor. There should be no repurchase options, or other provisions where control reverts back to the seller, and the transaction price should be determined and paid (or intended to be paid). If the transaction lacks the commercial substance of a sale, it is considered as a financing arrangement instead of a sale. In that case, no gains are recognized, the asset stays on the seller’s book, and the proceeds are considered a financing obligation.

To qualify as an operating lease under ASC 842, none of the five following criteria of Paragraph 842-10-25-2 for a financing lease should exist.

• There is a transfer of ownership of the asset to the lessee at the termination of the lease;
• The lessee has an option to purchase the asset that is reasonably certain to be exercised;
• The lease term constitutes a major part of the remaining economic life of the asset;
• The present value of the sum of the lease payments and guaranteed residual value by the lessee must equal or exceed substantially all of the fair value of the underlying asset; and
• The underlying asset must be of a specialized nature precluding any alternative use to the lessor at the termination of the lease period.

If the leaseback to the seller constitutes a financing lease, then there was not an effective transfer of the asset, and the transaction is treated as a financing pursuant to Paragraph 842-40-25-4. This would require that the seller recognizes a financial liability instead of gains, the asset remains on the seller’s book, and the seller continues to record depreciation expense.

ASC 842-40-30-2 poses one more consideration for the buyer/lessor to note. If the sale-leaseback transaction is not made at fair value, the sale price of the asset needs an adjustment in accounting. If the purchase price is less than the fair value of the asset, the difference should be recognized as prepaid rent on the buyer’s book. If the price is higher than the fair value of the asset, the excess should be considered a loan to the lessee (financial liability). The rental payment would be allocated pro rata between the lease liability and the financial liability. If the purchase price is at fair value, a seller can account for the gain or loss in the same way with a sale without a leaseback.

To avoid a failure, a sale-leaseback transaction should be structured properly to meet both requirements from ASC 606 and ASC 842. There should be no residual value guarantees that might trigger the lease classification to a finance lease, and no renewal option under the lessee’s control should be allowed in the contract. They should be either carefully evaluated or removed if possible.

Any potential seller/lessee or buyer/lessor should consider the goals of the transactions to be achieved from the sale-leaseback and their benefits over conventional mortgage financing. If a sale leaseback seems to be a better option, a consultation with a qualified CPA is necessary to avoid the pitfall of a failed sale-leaseback transaction.