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Net Leases aNd saLe-Leasebacks

A Guide to Legal, Tax and Accounting Strategies

Ken Miller

June 2018

Practising Law Institute New York City

#239408

This work is designed to provide practical and useful information on the subject matter covered. However, it is sold with the understanding that neither the publisher nor the author is engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

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Copyright © 2016, 2017, 2018 by Practising Law Institute. All rights reserved. Printed in the United States of America. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written consent of Practising Law Institute.

LCCN: 2016949816

ISBN: 978-1-4024-3137-1

vii

About the Author

Ken Miller graduated from Hamilton College summa cum laude with a bachelor of arts in 1978. He received his law degree from Stanford Law School in 1981. After his admittance to the California bar in 1981, he began his legal career in the real estate department of Adams, Duque & Hazeltine, where he represented life insurance companies in commercial mortgage transactions under the tute-lage of real estate mavens Gary York and Alan Wayte. Afterward, he worked for two years in the Kern County District Attorney’s office as a criminal prosecutor, and then started his own law firm, Gorman & Miller. By the mid-nineties, his practice focused on net lease trans-actions, including structured financing of net leased property. Since the mid-nineties, he has closed over $6 billion of net lease transac-tions and sale-leasebacks. He has represented investors in numerous sale-leasebacks with major retailers such as CVS, Rite Aid and Pep Boys, as well as with banking giants Citibank and Bank of Montreal (through its American subsidiary, BMO Harris Bank N.A.).

ix

Table of Chapters

Chapter 1 Economics of Net Leases and Sale-Leasebacks

Chapter 2 The Lease

Chapter 3 Bankruptcy Considerations

Chapter 4 Financing

Chapter 5 Tax Considerations

Chapter 6 Regulatory Considerations for the Owner-Landlord

Chapter 7 Financial Accounting Treatment

xi

Table of Contents

About the Author ......................................................................... vii

Table of Chapters .......................................................................... ix

Acknowledgments ....................................................................xxvii

Introduction ...............................................................................xxix

Chapter 1 Economics of Net Leases and Sale-Leasebacks

§ 1:1 What Is a Net Lease? ....................................................1-2§ 1:2 Types of Net Leases ......................................................1-2

§ 1:2.1 Bond Lease .............................................................1-2§ 1:2.2 Absolute Net Lease ................................................1-3§ 1:2.3 Triple Net Lease .....................................................1-3§ 1:2.4 Double Net Lease ..................................................1-3§ 1:2.5 The Allocation of Capital Expenses and

the Split Incentive Problem ....................................1-3§ 1:3 Pricing and Valuation of Net Leased Properties .............1-4

§ 1:3.1 Basic Formulas ......................................................1-4§ 1:3.2 The Two Meanings of Capitalization Rate .............1-5§ 1:3.3 Discounted Cash Flow Model ................................1-5§ 1:3.4 Determining the Market Capitalization Rate

of Long-Term Net Leases—Background ..................1-6[A] Ground Leases .......................................................1-7

§ 1:3.5 Determining the Market Capitalization Rate of Long-Term Net Leases Using Comparable Sales ..................................................1-7

§ 1:3.6 Pricing of Properties with Short-Term Net Leases .............................................................1-8

§ 1:4 Sale-Leasebacks ............................................................1-8§ 1:4.1 What Is a Sale-Leaseback? .....................................1-8§ 1:4.2 Sale-Leaseback As a Form of Financing ..................1-8

xii

NET LEASES AND SALE-LEASEBACKS

§ 1:4.3 Advantages of a Sale-Leaseback to the Seller-Tenant ..........................................................1-9

§ 1:4.4 Disadvantages of a Sale-Leaseback .......................1-10§ 1:4.5 Sale-Leaseback Pricing .........................................1-10

§ 1:5 Volume of Net Lease Sales ..........................................1-11

Chapter 2 The Lease

§ 2:1 Term Sheet ...................................................................2-3§ 2:2 Tenant’s Credit .............................................................2-3§ 2:3 Important Lease Provisions...........................................2-4

§ 2:3.1 Permitted Encumbrances .......................................2-4[A] Landlord’s Mortgage Financing Documents ...........2-4

§ 2:3.2 Permitted Use—Generally .....................................2-4[A] Exception—Tax-Exempt Use Property ....................2-4[B] Exception—Protection of Residual Value ................2-5

§ 2:3.3 Taxes—Generally ...................................................2-5[A] Possible Exception—Resales ...................................2-5[A][1] California Exception for Property Subject to

Long-Term Lease ................................................2-5[B] State Rental Taxes ..................................................2-6[C] Explicit Exclusion of Income, Estate and

Transfer Taxes ........................................................2-6[D] Gross Receipts, Capital Levies and Certain

Franchise Taxes—Negotiable .................................2-6§ 2:3.4 Insurance—Generally ............................................2-7

[A] Property Insurance .................................................2-7[A][1] Earthquake Insurance .........................................2-7[A][2] Other Coverages .................................................2-8[B] Liability Insurance .................................................2-8[C] Issuer Requirements ..............................................2-8[D] Insurance Clauses ..................................................2-9[E] Waiver of Subrogation ............................................2-9[F] Self-Insurance ........................................................2-9

§ 2:3.5 Casualty ................................................................2-9§ 2:3.6 Major Condemnations .........................................2-10

[A] Condemnation Clause in Bond Leases—Generally................................................2-10

[B] Condemnation Clauses in Bond Leases—Financial Accounting Concerns ..............2-11

[C] Condemnation Clauses in Bond Leases—Alternate Form .......................................2-11

xiii

Table of Contents

§ 2:3.7 Minor Condemnations ........................................2-12[A] Minor Condemnations—Division of

Condemnation Award ..........................................2-12§ 2:3.8 Intangibles ...........................................................2-14§ 2:3.9 Repairs and Maintenance ....................................2-14§ 2:3.10 Mechanic’s Liens .................................................2-15

[A] Exception—Missouri and Illinois Properties ........2-15[B] Problematic Contest Provisions ...........................2-16

§ 2:3.11 Waiver of Statutory Lease Termination Rights .....2-17§ 2:3.12 Right to “Go Dark” ..............................................2-17§ 2:3.13 Environmental Costs ...........................................2-17§ 2:3.14 Covenant of Quiet Enjoyment .............................2-19§ 2:3.15 Third-Party Leases ...............................................2-19§ 2:3.16 Alterations ...........................................................2-20§ 2:3.17 Assignment and Subletting ..................................2-20§ 2:3.18 Subordination, Non-Disturbance and

Attornment Agreements ......................................2-21§ 2:3.19 Indemnity Provision ............................................2-22

[A] Indemnification After the Landlord Assigns the Lease .................................................2-22

§ 2:3.20 Compliance with Law ..........................................2-23§ 2:3.21 Tenant Estoppel Certificate ..................................2-23§ 2:3.22 Easements ...........................................................2-24§ 2:3.23 Net Lease Clause .................................................2-24§ 2:3.24 Security Deposit ..................................................2-24

§ 2:4 Optional Lease Provisions ...........................................2-24§ 2:4.1 Tenant Purchase Option ......................................2-24

[A] Fixed Price Tenant Purchase Option—Generally .... 2-25[B] Fixed Price Tenant Purchase

Option—Comparison to Call Feature in Corporate Bond ....................................................2-25

[C] Fixed Price Tenant Purchase Option—Tax Consequences ......................................................2-26

[D] Fixed Price Tenant Purchase Option—Tenant’s Financial Accounting Treatment ..........................2-26

[E] Fixed Price Tenant Purchase Option—Landlord’s Financing .............................................................2-26

[F] Fair Market Value Tenant Purchase Option ..........2-27§ 2:4.2 Right of First Refusal and Right of First Offer ......2-27

[A] ROFR and ROFO—Landlord Drafting Considerations ....................................................2-28

xiv


§ 2:5 When the Investor Is the Tenant Under a Ground Lease .............................................................2-28

§ 2:5.1 Generally .............................................................2-28§ 2:5.2 The Shirt Tail Requirement .................................2-29§ 2:5.3 The Sublease .......................................................2-30

Chapter 3 Bankruptcy Considerations

§ 3:1 Fundamentals of a Tenant Bankruptcy..........................3-2§ 3:1.1 The Automatic Stay ...............................................3-2§ 3:1.2 Assuming or Rejecting the Lease—Generally .........3-3§ 3:1.3 Rejecting the Lease—Damages Cap .......................3-3§ 3:1.4 Rejecting the Lease After Assuming It ...................3-4

§ 3:2 Tenant Credit Enhancements .......................................3-4§ 3:2.1 Background ............................................................3-4§ 3:2.2 Cash Security Deposits Are Rarely Used ................3-4

[A] Too Costly for the Tenant ......................................3-5[B] May Preclude Off-Balance Sheet Treatment

for the Tenant ........................................................3-5[C] Limited Protection for the Landlord .......................3-5

§ 3:2.3 Parent Guarantee ...................................................3-6[A] Does Not Preclude Off-Balance Sheet Treatment .....3-6[B] Advantageous Treatment in Tenant Bankruptcy .....3-7[C] Limited Protection in a Parent Bankruptcy ............3-7

§ 3:2.4 Letter of Credit ......................................................3-7[A] The Independence Principle ...................................3-8[B] Structuring a Tenant Letter of Credit .....................3-8[C] Accounting Treatment of a Tenant

Letter of Credit ......................................................3-8[D] Comparison of a Tenant Letter of Credit and

a Cash Security Deposit .........................................3-9[E] Application of the Bankruptcy Cap to Letter

of Credit Proceeds ..................................................3-9[F] Structuring a Standby Letter of Credit

As a Net Lease Enhancement ..............................3-10[F][1] Tax Consequences of Acceleration ....................3-11[F][2] Effect of Acceleration on Tenant’s

Accounting .......................................................3-12§ 3:2.5 Lease Bonds and Mortgage Insurance ..................3-13

[A] Lease Bond Versus Letter of Credit ......................3-14[B] Lease Bond Versus Mortgage Insurance................3-15

xv

Table of Contents

§ 3:2.6 Credit Default Swaps ...........................................3-16[A] Generally .............................................................3-16[B] Cash Settlement ..................................................3-16[C] Physical Settlement .............................................3-16[D] Vanilla CDS .........................................................3-17[E] Using a Vanilla Credit Default Swap to

Enhance the Credit of a Tenant ...........................3-19§ 3:3 Recharacterization of a Lease in Bankruptcy ...............3-20

§ 3:3.1 Background ..........................................................3-20§ 3:3.2 Tenant’s Motivation to Seek Recharacterization ..... 3-21§ 3:3.3 Federal Appellate Court Recharacterizations ........3-22

[A] “True Lease” Analysis ..........................................3-22[B] Recharacterization Where Landlord Did Not

Have the Principal Risks and Benefits of the Property .........................................................3-23

[B][1] In re PCH Associates—2d Circuit .....................3-23[B][2] United Airlines, Inc. v. HSBC Bank USA,

N.A.—7th Circuit .............................................3-25[C] Recharacterization to Avoid a Forfeiture ..............3-26

§ 3:4 Landlord Bankruptcy Concerns for the Tenant ...........3-27§ 3:4.1 Tenant’s Right to Retain Possession

Following Landlord Lease Rejection .....................3-27§ 3:4.2 Tenant May Lose Its Right to Possession in a

363 Sale of the Premises ......................................3-27§ 3:4.3 A Non-Disturbance Agreement Protects

the Tenant Against Loss of Its Right to Possession in a Section 363 Sale ..........................3-28

Chapter 4 Financing

§ 4:1 Credit Tenant Loans .....................................................4-3§ 4:1.1 Generally ...............................................................4-3§ 4:1.2 Regulatory Background ..........................................4-3§ 4:1.3 Summary of NAIC Requirements ..........................4-3§ 4:1.4 Advantages of CTL Financing ................................4-4

[A] Lowering Cost of Capital .......................................4-4[B] Acquiring Higher Value Assets ...............................4-5[C] Satisfying the “Value” Requirement of a

Section 1031 Tax-Free Exchange ............................4-5[D] Minimizing Estate Tax ...........................................4-6

xvi


§ 4:1.5 Zero Cash Flow Investments and Phantom Income ..................................................................4-9

[A] Mitigating Phantom Income ................................4-10§ 4:1.6 Specific Requirements for CTL Loan ...................4-10

[A] Rental Payments Must Match or Exceed Debt Service Payments .................................................4-11

[A][1] Exception: 5% Balloon ......................................4-11[A][2] Exception: Residual Value Insurance ................4-11[B] The Lease Must Be Non-Cancellable During

the Primary Term.................................................4-12[B][1] Exception: Tenant Covenant to Pay Off Loan .....4-12[C] The Loan Must Be Secured by a First Mortgage

with an Assignment of Rents ...............................4-13[D] Tenant Must Have an Investment

Grade Rating ........................................................4-13[E] Tenant Must Be Obligated to Maintain the

Property and Pay All Property-Related Expenses During the Lease Term .........................4-13

§ 4:1.7 Customary CTL Loan Terms ...............................4-13[A] Standard Borrower Covenants .............................4-13[B] Lease Supremacy Clause ......................................4-14[C] Bankruptcy Remote Borrower and Springing

Guaranty .............................................................4-14§ 4:1.8 Securitizing CTL Loans .......................................4-15

[A] Background ..........................................................4-15[B] Selecting a Structure ............................................4-15[C] REMIC for Multiple-Maturity Pools ....................4-15[D] Grantor Trust for Single Maturity Pools ...............4-16

§ 4:1.9 Ownership Transfers of Zero Cash Flow Investments .........................................................4-16

[A] Potential Advantages to an Ownership Transfer of a Mortgaged Real Property Investment ...............4-17

[B] Risks of Acquiring a Mortgaged Real Property Investment by Ownership Transfer ......................4-18

§ 4:2 Residual Value Loans ..................................................4-20§ 4:2.1 Background ..........................................................4-20§ 4:2.2 Loan Structure .....................................................4-20

Diagram 4-1 Structure of Residual Value Loan .........................4-21§ 4:2.3 Basic Requirements..............................................4-21§ 4:2.4 Securing the Collateral—Springing Guaranty ......4-21§ 4:2.5 Securing the Collateral—Title Insurance

and UCC Insurance .............................................4-22

xvii

Table of Contents

§ 4:2.6 Securing the Collateral—Intercreditor Agreement with Senior Lender .............................4-23

[A] Intercreditor Agreement—Transfer Rights ...........4-23[B] Intercreditor Agreement—Foreclosure Rights ......4-23[C] Intercreditor Agreement—Consent Rights ...........4-24[D] Intercreditor Agreement—Cure Rights ................4-25[E] Intercreditor Agreement—Purchase Rights ..........4-25

§ 4:3 CMBS Loans ...............................................................4-26§ 4:3.1 Generally .............................................................4-26§ 4:3.2 Balloon Risk ........................................................4-26§ 4:3.3 Reserves—Non-Investment Grade Tenant ...........4-27§ 4:3.4 Reserves—Investment Grade Tenant ...................4-27§ 4:3.5 Cash Sweep Triggers—Non-Investment

Grade Tenant .......................................................4-27§ 4:3.6 Cash Sweep Triggers—Investment

Grade Tenant .......................................................4-27[A] Tenant Goes Dark—Need for Cash Sweep ...........4-28[B] Tenant Goes Dark—Borrower Concern ...............4-28[C] Tenant Goes Dark—Capping the Cash Sweep .....4-28

§ 4:3.7 Lease Supremacy Clause ......................................4-29§ 4:3.8 Underwritten Cash Flow and Financial Ratios ......4-29§ 4:3.9 REMICs—Generally ............................................4-30§ 4:3.10 REMICs and Partial Lien Releases .......................4-30

[A] No Significant Modification .................................4-31[B] 80% Test and Qualified Pay-Down Transaction .....4-31[B][1] Grandfathered Transaction ...............................4-32[B][2] Qualified Pay-Down Transaction ......................4-32

Chapter 5 Tax Considerations

§ 5:1 Ownership of Net Leased Property for Income Tax Purposes .................................................................5-6

§ 5:1.1 Generally ...............................................................5-6§ 5:1.2 Profit Potential .......................................................5-6

[A] Tenant Purchase Options .......................................5-6[B] Tenant Renewal Options ........................................5-7

§ 5:1.3 Loss Potential ........................................................5-7§ 5:1.4 IRS Guidelines for Advance Ruling on

Equipment Leases ..................................................5-8[A] Minimum Unconditional At-Risk Investment .......5-8[B] No Puts or Calls ....................................................5-9[C] Investment by Lessee .............................................5-9

xviii


[D] No Lessee Loans or Guarantees .............................5-9[E] Expectation of Profit ..............................................5-9

§ 5:2 Depreciation .................................................................5-9§ 5:2.1 Generally ...............................................................5-9§ 5:2.2 Determining Amount of Basis—467 Loans .........5-10§ 5:2.3 Determining the Basis of Property Received

in a Tax-Free Exchange ........................................5-10§ 5:2.4 Allocating Basis Between Land and

Improvements .....................................................5-11§ 5:2.5 First Placed in Service ..........................................5-11§ 5:2.6 Depreciation Method ...........................................5-12§ 5:2.7 Recovery Period ....................................................5-12

[A] Exception for Tax-Exempt Use Property ...............5-12[A][1] Definition of Tax-Exempt Use Property ............5-12[B] Additional Deduction for Qualified

Real Property .......................................................5-13[C] Bonus Depreciation .............................................5-14[C][1] Property Placed in Service Before 2018 .............5-14

§ 5:2.8 Depreciation Convention .....................................5-16§ 5:2.9 Land Improvements .............................................5-16§ 5:2.10 Requirement of Ownership for Improvement

Property Deductions ............................................5-16§ 5:2.11 Landlord Capital Improvements—Effect

of Lease ................................................................5-18§ 5:2.12 Ground Leases .....................................................5-18

[A] Ground Leases—Cost of Improvements ..............5-18[A][1] Exception—Improvements Placed in

Service Before 1987 ..........................................5-18[B] Ground Leases—Cost of Acquiring

Leasehold Interest ................................................5-19§ 5:2.13 Cost Segregation Study ........................................5-19

[A] Example: Hospital Corp. of America v. Commissioner .....................................................5-20

§ 5:2.14 Depreciation Recapture—Generally .....................5-20§ 5:2.15 Depreciation Recapture—Section 1245 Property ..... 5-21§ 5:2.16 Depreciation Recapture—Section 1250 Property ..... 5-21§ 5:2.17 Depreciation Recapture—Like-Kind

Exchanges—Generally .........................................5-22§ 5:2.18 Depreciation Recapture—Like-Kind

Exchanges—Section 1245 Property and Segregated Cost Studies .......................................5-22

§ 5:2.19 Depreciation Recapture—Like-Kind Exchanges—Section 1250 Property ......................5-23

xix

Table of Contents

§ 5:3 Section 467 Rental Agreements ..................................5-23§ 5:3.1 Generally .............................................................5-23

Diagram 5-1 Section 467 Rental Agreement Analysis ..............5-25§ 5:3.2 Is the Lease a Section 467 Rental Agreement? ......5-25

[A] Increasing or Decreasing Payments ......................5-25[B] Prepaid or Deferred Rent ......................................5-26[C] Rent Holidays and Contingent Rent Provisions .....5-27[C][1] Certain Rent Holidays ......................................5-27[C][2] Certain Contingent Rent Provisions .................5-27

§ 5:3.3 Is the Lease a Disqualified Leaseback or a Disqualified Long-Term Agreement? ....................5-28

[A] Leasebacks ...........................................................5-28[B] Long-Term Agreements ........................................5-29[C] “Disqualified”—Generally ....................................5-29[D] “Disqualified”—Tax Avoidance ............................5-29[E] “Disqualified”—Safe Harbors ...............................5-30[E][1] Uneven Rent Test .............................................5-30[E][2] Rent Holidays ...................................................5-30[E][3] Contingent Rent ...............................................5-31

§ 5:3.4 Does the Lease Provide Adequate Interest on Fixed Rent? ..........................................................5-31

§ 5:3.5 Section 467 Rents ................................................5-32[A] Constant Rental Accrual ......................................5-32[B] Proportional Rental Accrual .................................5-33

§ 5:3.6 Section 467 Loans—Generally .............................5-35[A] Section 467 Loans—Principal Balance

Calculation ..........................................................5-35[B] Section 467 Loans—Interest Calculation .............5-36[C] Section 467 Loans—Example ...............................5-36[D] Section 467 Loans—Dispositions and

Depreciation ........................................................5-38§ 5:3.7 Section 467 Recapture .........................................5-39

[A] Generally .............................................................5-39[B] Example ...............................................................5-39[C] Section 467 Recapture in a Like-Kind

Exchange ...........................................................5-41§ 5:3.8 Using a 467 Rental Agreement to Reduce the

Landlord’s Phantom Income in a Zero Cash Flow Net Lease Investment ........................5-41

§ 5:4 Sales and Exchanges ...................................................5-42§ 5:4.1 Calculation of Gain or Loss on the Sale of

Real Property .......................................................5-42

xx


§ 5:4.2 Loss on Sale .........................................................5-43[A] Generally .............................................................5-43[B] Ordinary Loss on Sale of Property Used in a

Trade or Business .................................................5-43[C] Definition of “Used in a Trade or Business” .........5-43[D] Rental Property Is Generally Considered

Property Used in a Trade or Business ...................5-44[E] Exception: Ownership of One Long-Term

Net Leased Property Is Generally Not Considered a Trade or Business ...........................5-44

[F] Compare: Ownership of a Portfolio of Net Leased Property May Be Considered a Trade or Business .................................................5-44

§ 5:4.3 Gain on Sale ........................................................5-45[A] Generally .............................................................5-45[B] Exception for Dealer Property ..............................5-45[C] Exception for Depreciation Recapture and

Unrecaptured Section 1250 Gain .........................5-46[D] Exception for Carried Interests ............................5-46[D][1] Generally ..........................................................5-46[D][2] What Is a Carried Interest? ..............................5-46[D][3] Interaction with Section 83 ..............................5-47

§ 5:4.4 Section 1031 Exchanges.......................................5-48[A] Generally .............................................................5-48[B] Deferred Exchanges .............................................5-49[C] Reverse 1031 Exchanges ......................................5-50[D] Qualified Exchange Accommodation

Arrangement ........................................................5-50[E] Limitation on 1031 Tax-Free Exchanges for

Tax-Exempt Use Property ....................................5-50[F] Section 467 Loan .................................................5-51[G] Same Taxpayer Requirement and Single

Member LLCs ......................................................5-52§ 5:5 Tax-Exempt Investors and Unrelated Business

Taxable Income ...........................................................5-53§ 5:5.1 UBTI—Background .............................................5-53§ 5:5.2 UBTI and Dealer Property ...................................5-53§ 5:5.3 UBTI and Debt-Financed Property—

General Rule ........................................................5-54§ 5:5.4 UBTI and Debt-Financed Property—

Exception for Qualified Organizations .................5-54[A] Qualified Organization ........................................5-54

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[B] No Sale-Leaseback ...............................................5-55[C] Fractions Rule ......................................................5-55[D] Additional Requirements .....................................5-56

§ 5:5.5 Using a Corporate Blocker to Avoid UBTI Characterization ........................................5-57

[A] Foreign and Domestic Non-REIT Corporations—Not Effective Blockers ..................5-57

[B] REIT Blocker .......................................................5-58[B][1] Exception—Pension Held REIT ........................5-58[B][2] Exception—Dealer Property ..............................5-58[B][3] Exception: Funds with Concentrated

Ownership ........................................................5-59§ 5:5.6 Avoiding UBTI: Loan from the Tax-Exempt

Entity ...................................................................5-59[A] Caveat—Tax-Exempt Entity May Not

Control the Fund .................................................5-60[B] Caveat—Recharacterization of Loan As Equity ......5-60

§ 5:6 Interest Deductions on Commercial Real Estate Loans ...............................................................5-61

§ 5:6.1 Generally .............................................................5-61§ 5:6.2 Limitation on Deductibility of Nonrecourse

Mortgage Loan Interest ........................................5-61§ 5:6.3 Deductibility of Accruing Interest on

Residual Value Loan .............................................5-62[A] Exception: Lender and Borrower Are Related .......5-62[B] At-Risk Limitations .............................................5-62

§ 5:6.4 Limitation on Interest Deductions in the 2017 Tax Act .......................................................5-63

[A] Generally .............................................................5-63[B] Business Interest ..................................................5-64[B][1] Trade or Business .............................................5-64[B][2] Electing Out .....................................................5-64[B][3] Consequences of Electing Out ..........................5-64[C] Adjusted Taxable Income .....................................5-64[D] Small Business Exemption ...................................5-65[E] Indefinite Carryforward .......................................5-65[F] Application to Partnerships ..................................5-65[F][1] Treatment of Excess Business Income

Allocated to a Partner .......................................5-65[F][2] Adjusted Taxable Income ..................................5-66[F][3] Basis Adjustment .............................................5-66

xxii


§ 5:7 Transfer Tax ................................................................5-66§ 5:7.1 Generally .............................................................5-66§ 5:7.2 Transfer Tax Treatment of a Sale-Leaseback .........5-66

[A] Exception for Long-Term Leasebacks— Pennsylvania and California ................................5-67

[B] Exception for Financing Transactions— Pennsylvania and California ................................5-67

§ 5:7.3 Transfer Tax Treatment of the Sale of a Net Leased Property ....................................................5-68

[A] Exemption—Transfer of an Ownership Interest ......5-68[A][1] Florida ..............................................................5-69[A][2] Maryland ..........................................................5-69[A][3] Pennsylvania ....................................................5-69[B] Exemption for Property Subject to a Long-Term

Lease—California ................................................5-70[C] Exemption for Transfer of a Leasehold Interest ......5-70[D] Seller in Bankruptcy .............................................5-71

§ 5:8 Net Investment Income Tax .......................................5-72§ 5:8.1 Generally .............................................................5-72§ 5:8.2 Definition of Net Investment Income ..................5-73§ 5:8.3 Trade or Business Exception ................................5-73

[A] Non-passive to the Taxpayer ................................5-73[B] Trade or Business .................................................5-74[B][1] Safe Harbor for Certain Real Estate

Professionals ....................................................5-74§ 5:9 Partnership Tax Issues ................................................5-74

§ 5:9.1 Choice of Entity ...................................................5-74[A] Tax Classification of Multi-Member Limited

Liability Companies .............................................5-77§ 5:9.2 Tax Allocations ....................................................5-77

[A] Generally .............................................................5-77[B] Substantial Economic Effect .................................5-77[B][1] Capital Account Maintenance ..........................5-78[B][2] Substantiality and Net Lease Income ...............5-78[C] Allocations with Respect to Contributed

Property ...............................................................5-80[D] Partnership “Book-Ups” and Reverse 704(c)

Allocations ...........................................................5-82§ 5:9.3 Grant of a Partnership Interest for Services ..........5-83

[A] Background ..........................................................5-83

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[B] Safe Harbor for Interests with No Liquidation Value—Revenue Procedure 93-27 .........................5-83

[B][1] Inapplicability of the Safe Harbor to a “High-Quality Net Lease” ................................5-84

[B][2] Other Exceptions to the Safe Harbor ................5-84[C] Adjusting the Liquidation Waterfall to

Eliminate Liquidation Value .................................5-85[D] Grant of a Nonvested Partnership Interest ...........5-85[D][1] Grant of a Nonvested Partnership Profits

Interest Falling within the Safe Harbor of Revenue Procedure 93-27 .................................5-86

[E] Granting Partnership Profit Interests to Service Partners Outside of the Safe Harbor .....................5-86

§ 5:10 Deduction for Qualified Business Income ...................5-87§ 5:10.1 Generally .............................................................5-87§ 5:10.2 Trade or Business Requirement ............................5-88§ 5:10.3 Calculating the Business Income Deduction .......5-88§ 5:10.4 Combined Qualified Business Income .................5-88

[A] Qualified REIT Dividends ....................................5-88[B] Qualified Business Income ..................................5-89[C] Wage and Property Based Limit on Qualified

Business Income for High Earners .......................5-89[C][1] Qualified Property and Commercial Real

Estate Investments ...........................................5-89[C][2] Example of Application of the Wage and

Property Based Limit ........................................5-90[D] Taxpayers with Taxable Income Below

the Threshold ......................................................5-90[E] Phase-In of the Wage and Property Based

Limit for Certain Taxpayers .................................5-91§ 5:10.5 Sunset ..................................................................5-91

Chapter 6 Regulatory Considerations for the Owner-Landlord

§ 6:1 ERISA and the “Look Through” Rule ............................6-2§ 6:1.1 The “Look Through” Rule—Generally ...................6-2§ 6:1.2 Fiduciary Duty, Prohibited Transactions and

Self-Dealing Under ERISA .....................................6-3§ 6:1.3 Penalties for Violating the Prohibited

Transaction Rules ..................................................6-4

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§ 6:1.4 Exceptions to the “Look Through” Rule .................6-4[A] Investments That Are Not Equity Investments ......6-4[B] Investments That Are Publicly Traded Securities .....6-5[C] Investments in Which There Is No Significant

Participation—The 25% Limit ...............................6-5[D] Real Estate Operating Companies ..........................6-6[D][1] Exception—For Net Lease Investments ..............6-6

§ 6:1.5 Structuring a Pension Plan Investment in Real Estate to Avoid Application of the “Look Through” Rule .............................................6-6

Diagram 6-1 Avoiding Application of the “Look Through Rule” When Benefit Plan Investors Own 25% or More of an Investment Fund .............6-8

§ 6:2 Banks and Savings and Loans .......................................6-8§ 6:2.1 Financing Leases—In General ................................6-8§ 6:2.2 Functional Equivalent of Lending—Banking

Regulations ............................................................6-9§ 6:2.3 Functional Equivalent of Lending—S&L

Regulations ..........................................................6-10[A] Definition of Net Lease ........................................6-10[B] Definition of Full-Payout Lease ............................6-11[C] Definition of Realization of Investment ...............6-11

§ 6:3 Tenants in the Marijuana Business .............................6-12§ 6:3.1 Background ..........................................................6-12§ 6:3.2 Criminal Liability and Forfeiture .........................6-12§ 6:3.3 Spending Limitation on Federal Medical

Marijuana Prosecution .........................................6-13[A] United States v. McIntosh ....................................6-14[B] The Need for Annual Reenactment of the

Spending Limitation ............................................6-15§ 6:3.4 Lease Clauses and Forfeiture Proceedings ............6-16

Chapter 7 Financial Accounting Treatment

§ 7:1 Current Accounting Treatment for the Tenant..............7-2§ 7:1.1 Background ............................................................7-2§ 7:1.2 Sale-Leaseback Accounting—Generally ..................7-3

[A] Consequences of Sale-Leaseback Accounting .........7-3[B] Requirements for Sale-Leaseback Accounting ........7-3[B][1] Continuing Involvement—Summary .................7-4[B][2] Continuing Involvement—Examples ..................7-4

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Table of Contents

§ 7:1.3 Operating Lease Treatment ....................................7-5[A] Requirements for Operating Lease Treatment ........7-5[A][1] The 90% Test .....................................................7-7

§ 7:1.4 Consolidation Rules—Variable Interest Entities ......7-7[A] Background ............................................................7-7[B] Summary ...............................................................7-8[C] Variable Interest Entities—Generally .....................7-8[D] Variable Interest Entities—Equity Requirement .......7-9[E] Variable Interest Entities—Equity Requirement

and Landlords Under Credit Tenant Leases ...........7-9[F] Variable Interests ...................................................7-9[G] Variability—Calculation of Expected Losses,

Expected Residual Returns, and Expected Variability ..............................................7-10

[H] Variability—Residual Value Guarantee or Purchase Options.................................................7-10

[I] Primary Beneficiary—Generally ...........................7-11[J] Primary Beneficiary—Off-Balance Sheet

Sale-Leasebacks ...................................................7-11[K] Primary Beneficiary—Leases with Residual

Value Guarantee or Purchase Options ..................7-12[K][1] FASB Example—Operating Lease with

Residual Value Guarantee and Purchase Option ...............................................7-12

§ 7:2 New Lease Rules—On-Balance Sheet Accounting Treatment for the Tenant ............................................7-14

§ 7:2.1 Background ..........................................................7-14§ 7:2.2 Definition of Lease ..............................................7-14§ 7:2.3 Lease Classification .............................................7-15§ 7:2.4 Lease Term ..........................................................7-15§ 7:2.5 Tenant’s Balance Sheet ........................................7-16

[A] Lease Liability ......................................................7-16[B] Right-of-Use Asset—Initial Measurement ...........7-19[C] Right-of-Use Asset—Subsequent Measurement ......7-19[C][1] Finance Lease ...................................................7-19[C][2] Operating Lease ................................................7-19

§ 7:2.6 Income Statement ...............................................7-20§ 7:2.7 Example—Measurement of the ROU Asset

and the Lease Liability .........................................7-20

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§ 7:2.8 Tenant’s Treatment of Leases Previously Classified As Operating Leases ............................7-22

[A] Example—Treatment of Pre-Existing Operating Lease ...................................................7-23

§ 7:3 Arranging Transactions to Avoid Lease Treatment ......7-24§ 7:3.1 Background ..........................................................7-24§ 7:3.2 Structuring Strategies...........................................7-24§ 7:3.3 Example—Using a Logistics Contract in Lieu

of Leasing a Distribution Facility .........................7-25§ 7:3.4 Example—Using a Power Purchase

Agreement in Lieu of Leasing a Power Plant ........7-26

Appendices ........................................................................... App.–1

Appendix A Deriving the Simplified Formula for Perpetual Cash Flows ..................................App. A–1

Appendix B US Corporate Average Fifteen-Year Cumulative Default Rates 1981–2013 (%) .....App. B–1

Appendix C Description of Long-Term Issuer Ratings from the Major Ratings Agencies ............... App. C–1

Appendix D Calculating Expected Variability of Returns Under GAAP ................................. App. D–1

Appendix E Net Lease ....................................................App. E–1

Index ........................................................................................... I–1

xxvii

Acknowledgments

The author wishes to acknowledge the invaluable assistance of Chadwick McCombs, Jun Kwon, Hen Amir, and Damian Martin in the research and writing of this book. The author also wishes to thank Gary York, Roy Geiger, Shirley Yu, and Jacob Metric for their help editing this work.

xxix

Introduction

The hallmark of a net lease is the shifting of property-related risks and expenses to the tenant. When properly structured, the result of this shift is a real estate investment that is not only passive but also, in the case of a credit tenant, financeable with low interest, high leverage financing that is not available for conventional multi-tenant properties. Given their particular characteristics, net lease investments may be regarded as belonging to their own asset class. Compared with other investment real estate, which typically requires active management, net lease investments are remarkably passive. Consequently, the net lease market is a national market and the bro-kers, attorneys and investors in this market generally practice and invest on a national basis. In addition, there are a number of tax, financing and regulatory issues that are unique to net lease invest-ments, and the real estate professionals practicing in this area need to be familiar with these issues. One example is section 467 of the Internal Revenue Code, which imposes a set of complex rules on those leases—called 467 Rental Agreements—in which rent is allo-cated in a manner that differs from their payment schedule. While 467 Rental Agreements are common in certain types of net leases, they rarely occur in other types of real estate leases. Whether the lease is a “true lease” for tax, bankruptcy and accounting purposes is another set of issues that is peculiar to net leases. The requirements of a credit tenant loan—which is exclusively available for certain net leased properties—is yet another.

This book covers all aspects of the ownership, financing, documen-tation, taxation and accounting for net leases with a focus on those areas where the treatment of net leases differs from the treatment of other forms of real estate investment. Chapter 7, on accounting, covers recently adopted changes to U.S. financial accounting rules for leases (effective for fiscal years beginning after December 15, 2018) under which all leases with a term exceeding one year will have to be reflected on the tenant’s balance sheet. It has been estimated that the new accounting treatment of leases will add $2 trillion to the balance sheets of U.S.-based corporations. Possible structures avoid-ing on-balance sheet treatment for the tenant are addressed in this chapter.

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Chapter 4 covers all aspects of financing net leased investments. One form of financing that is available to certain net leased invest-ments, but not to other types of real estate, is the so-called credit tenant loan. A credit tenant loan generally allows a debt service cov-erage ratio of 1:1. As a result, in a credit tenant loan, the monthly debt service payments are often equal to the monthly rent payments under the lease covering the premises. In such cases, because the entire rent is used to make debt service payments, the property will produce no cash flow until the loan is repaid. If net lease investments are considered to make up their own asset class, then perhaps zero cash-flow properties should be considered an asset sub-class. These investments are typically sold subject to the existing debt and are generally priced at a percentage of the debt. Buyers generally acquire them, at least in part, for tax reasons. In many cases, the transfer of these investments is structured as the sale of the ownership interests in the limited liability company that owns the property rather than as a conveyance of the property by deed. The unique structure of zero cash-flow investments creates the possibility of yet another form of financing. Because the credit tenant loan that encumbers a zero cash-flow investment is often self-amortizing, the residual value of the property—that is, the value of the property beginning when the credit tenant loan is paid off—is available to collateralize a mezzanine loan called a “residual value loan.” Such loans are covered in section 4:2 of this book. Finally, because zero cash-flow investments eventually produce taxable income (that is, the rental income eventually exceeds the interest and depreciation deductions), they eventually subject the owner to “phantom income,” which is taxable income without cash flow. Structures to avoid or reduce “phantom income” in zero cash flow properties are also addressed in chapter 4.

This book also covers all aspects of real estate sale-leaseback trans-actions. Sale-leasebacks are often a desirable form of financing for publicly traded tenants because, among other reasons, the financing is off-balance sheet under current U.S. accounting regulations when properly structured. However, the transaction will be on-balance sheet for the tenant if the lease does not qualify as an operating lease or if the tenant is required to consolidate the landlord under gener-ally accepted accounting principles. In addition, if the transaction is improperly structured, the landlord’s interest and depreciation deduc-tions may be disallowed through a recharacterization of the lease as a financing for income tax purposes. Such recharacterization can also

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Introduction

occur in bankruptcy court, resulting in loss of secured creditor status to the landlord’s lender. Consequently, proper structuring of a net lease transaction is critically important to the tenant, landlord, and lender. These issues are addressed in the applicable chapters of the book: the accounting issues in chapter 7, the tax issues in chapter 5 and the bankruptcy issues in chapter 3.

While this book provides in-depth coverage of all aspects of net lease investment, it does assume some basic understanding of the law and practice of real estate acquisitions. Many aspects of real estate acquisitions—such as the conduct of due diligence and the negotiation of an asset purchase agreement—are guided by the same principles in a net lease transaction as they are for other forms of real estate investment. As a result, those areas are not covered in this book.