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SALE LEASEBACK AND OPTION TO REPURCHASE 

  1. When a seller-in-foreclosure on an owner-occupied one-to-four unit residential property is given an OPTION TO REPURCHASE THE PROPERTY, a loan has been negotiated since the arrangement contains a yield (interest and principal paid as rent) and a due date (final/balloon payment of principal on exercise of option) as a condition for returning title.  Thus the EP investor becomes a lender holding title as security, not a buyer with the rights of an owner. (Calif. Civil Code #1695.12).
  1. As a lender, the EP investor would be unable to secure the TAX BENEFITS available to an owner of rental property (Haggard v. Commissioner, 9th Circuit 196, 241 F2d 288.

Also, an EP investor who receives title and gives the owner-in-foreclosure a lease and an option to repurchase the property does not own the property, and must later obtain written permission from the owner before he

Encumbers the property; or Grant an interest in the property to another person (CC #1695.6(e)

Should the owner default on the lease, an eviction would leave the EP investor with title and no legal ability to convey—without the owner’s approval. If he does, the money damages collectible by the seller are based on the value of the property at the time the property is transferred without the seller’s consent (Segura v. McBride, (1992), 5 CA4th 1028).

A seller-in-foreclosure with a repurchase option may only deny an EP investor permission to encumber or grant an interest in the property with good reason.  Generally, when one party to a contract.  Generally, when one party to a contract has discretionary authority over another, that party must apply his discretion reasonably and in good faith. (Kendall v. Ernest Pestana, Inc. (1985) 40 C3d 488).

SALE LEASEBACK RECHARACTERIZED

Inherent in an EP sale-leaseback is the risk the loan transaction will be misinterpreted by the local assessor, the existing lender, or the IRS.

REASSESSMENT of the property occurs on execution of a sale-leaseback (Pacific Southwest Realty Co v. County of Los Angeles (1991) 1 C4th 155.

However a sale-leaseback intertwined with an option to repurchase is correctly recharacterized as a single FINANCING ARRANGEMENT, rather than two consecutive sales transactions.  Thus, no change of ownership occurs, even though title is revested, and no reassessment takes place—if the financing scheme is brought to the attention of the assessor. (Calif. Revenue & Taxation Code #62©.

Title Insurers will not issue title insurance to an investor in an EP transaction unless the seller-in-foreclosure signs an estoppel affidavit declaring the EP transaction is a conveyance to the investor and not merely a loan.

Thus, if the seller-in-foreclosure is given a repurchase option, the sale-leaseback is viewed as a financing arrangement.  The EP investor will not be able to obtain title insurance, even though he appears as the vested owner of the property—if the title company is aware of the repurchase option.

EXISTING LENDERS CANNOT CALL THE LOAN

Existing lenders view a sale-leaseback, with or without a repurchase option, as an opportunity to call or recast a loan under their due-on-sale clause—should they become aware of the facts since the two-step transaction (two sales) is in law a mortgage and the transaction is a loan.  If the “loan” is on a one-to-four unit residential property which is owner occupied, the due-on-sale first trust deed lender cannot call the loan.

However, an EP investor should consider including a contingency in the EP agreement calling for a due-on-sale waiver from the existing lender prior to closing.

FEDERAL TAX CONSEQUENCES

The IRS also treats sale-leasebacks as loan transactions, not sales or purchases, when the seller-in-foreclosure is given an option to repurchase.  Taxwise,  the sale-leaseback is a financing arrangement when:

      Rental payments under a long term lease equal an amortization of the fair market value over the term of the lease when title is to be reconveyed; or

      The final/balloon payment required to exercise a repurchase option equals principal and accrued interest which would be economically similar to the due date payoff under a note and trust deed (M & W Gear Co. v. Commissioner 7th cir. 1971, 446 F2d 841).

       The EP investor’s tax consequences on recharacterization of a sale-leaseback and purchase option as a financing arrangement include:

         Denial of any depreciation deductions for the EP investor.

         Imputing of interest income reportable at 110% of the Applicable Federal Rate (AFR) Internal Revenue Code #1274(e).

          Reporting of would-be rental income as investment/portfolio category interest income on a loan; and

          Denial of rental operating expenses, since the transaction is a loan.

For the EP investor to receive the tax benefits of owning real estate, he must

  1. limit the leaseback to a periodic tenancy (month to month) or a
  2. tenancy with a fixed date for the tenant to vacate the premises—no repurchase allowed.

NO REPURCHASE OPTIONS

An EP investor structuring a sale-leaseback without a repurchase option reduces the risk the transaction will be recharacterized as a financing arrangement if:

  1. The seller-in-foreclosure is given the lease in exchange for his equity (or rental payments)
  2. The rent exchanged or charged is the current fair market rate: and
  3. The leaseback agreement sets a “fixed” time period for the lease to  terminate and possession to be transferred to the EP investor (Camp v. Matich, (1948) 87 CA2d 660.
  4. If the Seller in foreclosure does not have a repurchase option and remains in possession of the property after the lease termination date, the EP investor can begin an unlawful detainer action without prior notice to the seller to vacate. (Ryland v. Appelbaum (1924) 70 CA 268.
  5. As in any lease, the leaseback agreement should provide for payment of increased rent if the seller-in-foreclosure does not vacate on expiration of the lease or a notice to vacate under a month-to-month rental agreement.
 
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