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NET LEASES ANDSALE-LEASEBACKS

A Guide to Legal, Tax andAccounting Strategies

Ken Miller

June 2017

Practising Law InstituteNew York City

#206158

This work is designed to provide practical and usefulinformation on the subject matter covered. However, it issold with the understanding that neither the publishernor the author is engaged in rendering legal, accounting,or other professional services. If legal advice or otherexpert assistance is required, the services of a competentprofessional should be sought.

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

LCCN: 2016949816

ISBN: 978-1-4024-2949-1

About the Author

KEN MILLER graduated from Hamilton College summa cum laudewith a bachelor of arts in 1978. He received his law degree fromStanford Law School in 1981. After his admittance to the Californiabar in 1981, he began his legal career in the real estate departmentof Adams, Duque & Hazeltine where he represented life insurancecompanies in commercial mortgage transactions under the tutelage ofreal estate mavens Gary York and Alan Wayte. Afterwards, he workedfor two years in the Kern County District Attorney’s office as a criminalprosecutor, and then started his own law firm, Gorman & Miller. By themid-nineties his practice focused on net lease transactions, includingstructured financing of net leased property. Since the mid-nineties, hehas closed over $5 billion of net lease transactions and sale-leasebacks.He has represented investors in numerous sale-leasebacks with majorretailers such as CVS, Rite Aid and Pep Boys as well as with banking giantsCitibank and Bank of Montreal (through its American subsidiary, BMOHarris Bank N.A.).

vii

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

ix

Table of Contents

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

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

Acknowledgments ..........................................................................xxv

Introduction ...................................................................................xxvii

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 ofLong-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§ 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 and Sale-Leasebacks ............1-11

xi

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..................................................... 2-8[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 inBond Leases—Generally ......................................... 2-10

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

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

§ 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

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§ 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 ....... 2-16§ 2:3.12 Right to “Go Dark”................................................. 2-17§ 2:3.13 Environmental Costs.............................................. 2-17§ 2:3.14 Covenant of Quiet Enjoyment................................ 2-18§ 2:3.15 Third-Party Leases .................................................. 2-19§ 2:3.16 Alterations .............................................................. 2-19§ 2:3.17 Assignment and Subletting..................................... 2-20§ 2:3.18 Subordination, Non-Disturbance and

Attornment Agreements ......................................... 2-20§ 2:3.19 Indemnity Provision ............................................... 2-21

[A] Indemnification After the LandlordAssigns the Lease.................................................... 2-22

§ 2:3.20 Compliance with Law ............................................ 2-22§ 2:3.21 Tenant Estoppel Certificate .................................... 2-23§ 2:3.22 Easements............................................................... 2-23§ 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.... 2-24[B] Fixed Price Tenant Purchase Option—

Comparison to Call Feature in Corporate Bond..... 2-25[C] Fixed Price Tenant Purchase Option—Tax

Consequences ......................................................... 2-25[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............ 2-26

§ 2:4.2 Right of First Refusal and Right of First Offer........ 2-27[A] ROFR and ROFO—Landlord Drafting

Considerations........................................................ 2-27§ 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 .......................................................... 2-29

xiii

Table of Contents

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......................................... 3-4[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....... 3-6[C] Limited Protection in a Parent Bankruptcy .............. 3-7

§ 3:2.4 Letter of Credit ......................................................... 3-7[A] The Independence Principle ..................................... 3-7[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.................. 3-14

§ 3:2.6 Credit Default Swaps.............................................. 3-15[A] Generally ................................................................ 3-15[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.............................. 3-18

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NET LEASES AND SALE-LEASEBACKS

§ 3:3 Recharacterization of a Lease in Bankruptcy................. 3-19§ 3:3.1 Background............................................................. 3-19§ 3:3.2 Tenant’s Motivation to Seek Recharacterization .... 3-20§ 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 theProperty .................................................................. 3-23

[B][1] In re PCH Associates—9th Circuit .................... 3-23[B][2] United Airlines, Inc. v. HSBC Bank USA,

N.A.—7th Circuit............................................... 3-24[C] Recharacterization to Avoid a Forfeiture................. 3-25

§ 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 Possessionin a Section 363 Sale.............................................. 3-27

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

§ 4:1.5 Zero Cash Flow Investments andPhantom 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 DebtService Payments .................................................... 4-11

[A][1] Exception: 5% Balloon........................................ 4-11[A][2] Exception: Residual Value Insurance .................. 4-11

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Table of Contents

[B] The Lease Must Be Non-Cancellable Duringthe 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 ExpensesDuring 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 FlowInvestments ............................................................ 4-16

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

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

§ 4:2 Residual Value Loans..................................................... 4-19§ 4:2.1 Background............................................................. 4-19§ 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......... 4-22§ 4:2.5 Securing the Collateral—Title Insurance and

UCC Insurance ...................................................... 4-22§ 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

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NET LEASES AND SALE-LEASEBACKS

§ 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 ............................................... 4-29§ 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................................. 4-31[B][2] Qualified Pay-Down Transaction........................ 4-32

Chapter 5 Tax Considerations

§ 5:1 Ownership of Net Leased Property forIncome Tax Purposes....................................................... 5-5

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

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

§ 5:1.3 Loss Potential ........................................................... 5-6§ 5:1.4 IRS Guidelines for Advance Ruling on

Equipment Leases..................................................... 5-7[A] Minimum Unconditional At-Risk Investment ......... 5-7[B] No Puts or Calls ....................................................... 5-8[C] Investment by Lessee................................................ 5-8[D] No Lessee Loans or Guarantees ............................... 5-8[E] Expectation of Profit ................................................. 5-8

§ 5:2 Depreciation .................................................................... 5-8§ 5:2.1 Generally .................................................................. 5-8§ 5:2.2 Determining Amount of Basis—467 Loans ............. 5-9§ 5:2.3 Determining the Basis of Property Received in a

Tax-Free Exchange .................................................... 5-9§ 5:2.4 Allocating Basis Between Land and

Improvements......................................................... 5-10

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Table of Contents

§ 5:2.5 First Placed in Service............................................. 5-10§ 5:2.6 Depreciation Method.............................................. 5-11§ 5:2.7 Recovery Period ...................................................... 5-11

[A] Exception for Tax-Exempt Use Property ................. 5-11[A][1] Definition of Tax-Exempt Use Property ............. 5-11[B] Exception for Qualified Leasehold Improvements,

Qualified Retail Improvements and QualifiedRestaurant Properties.............................................. 5-12

[C] Additional Deduction for Qualified LeaseholdImprovements, Qualified Retail Improvementsand Qualified Restaurant Properties ....................... 5-13

[D] Bonus Depreciation ................................................ 5-13[D][1] “Qualified Property” ........................................... 5-14[D][2] Sale-leaseback Property ...................................... 5-15[D][3] Exclusions .......................................................... 5-15

§ 5:2.8 Depreciation Convention ....................................... 5-15§ 5:2.9 Land Improvements................................................ 5-15§ 5:2.10 Requirement of Ownership for Improvement

Property Deductions ............................................... 5-16§ 5:2.11 Landlord Capital Improvements—Effect of Lease.... 5-17§ 5:2.12 Ground Leases ........................................................ 5-17

[A] Ground Leases—Cost of Improvements ................. 5-17[A][1] Exception—Improvements Placed in Service

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

Interest ................................................................... 5-18§ 5:2.13 Cost Segregation Study........................................... 5-19

[A] Example: Hospital Corp. of America v.Commissioner......................................................... 5-19

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

Exchanges—Generally .......................................... 5-21§ 5:2.18 Depreciation Recapture—Like-Kind

Exchanges—Section 1245 Property andSegregated Cost Studies ........................................... 5-22

§ 5:2.19 Depreciation Recapture—Like-KindExchanges—Section 1250 Property ......................... 5-22

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

Diagram 5-1 Section 467 Rental Agreement Analysis................. 5-24

xviii

NET LEASES AND SALE-LEASEBACKS

§ 5:3.2 Is the Lease a Section 467 Rental Agreement? ........ 5-24[A] Increasing or Decreasing Payments ........................ 5-24[B] Prepaid or Deferred Rent ........................................ 5-25[C] Rent Holidays and Contingent Rent Provisions ..... 5-26[C][1] Certain Rent Holidays........................................ 5-26[C][2] Certain Contingent Rent Provisions .................. 5-26

§ 5:3.3 Is the Lease a Disqualified Leaseback or aDisqualified Long-Term Agreement? ...................... 5-27

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

§ 5:3.4 Does the Lease Provide Adequate Interest onFixed Rent? .............................................................. 5-30

§ 5:3.5 Section 467 Rents................................................... 5-31[A] Constant Rental Accrual ........................................ 5-31[B] Proportional Rental Accrual.................................... 5-32

§ 5:3.6 Section 467 Loans—Generally ............................... 5-34[A] Section 467 Loans—Principal Balance

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

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

[A] Generally ................................................................ 5-38[B] Example .................................................................. 5-39[C] Section 467 Recapture in a Like-Kind Exchange .... 5-40

§ 5:3.8 Using a 467 Rental Agreement to Reduce theLandlord’s Phantom Income in a ZeroCash Flow Net Lease Investment ......................... 5-40

§ 5:4 Sales and Exchanges ...................................................... 5-41§ 5:4.1 Loss on Sale............................................................ 5-41

[A] Generally ................................................................ 5-41[B] Ordinary Loss on Sale of Property Used in a

Trade or Business.................................................... 5-41[C] Definition of “Used in a Trade or Business” .......... 5-42

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Table of Contents

[D] Rental Property Is Generally ConsideredProperty Used in a Trade or Business..................... 5-42

[E] Exception: Ownership of One Long-TermNet Leased Property Is Generally NotConsidered a Trade or Business.............................. 5-42

[F] Compare: Ownership of a Portfolio ofNet Leased Property May Be Considered aTrade or Business.................................................... 5-42

§ 5:4.2 Gain on Sale........................................................... 5-43[A] Generally ................................................................ 5-43[B] Exception for Dealer Property................................. 5-43[C] Exception for Depreciation Recapture and

Unrecaptured Section 1250 Gain ........................... 5-44§ 5:4.3 Section 1031 Exchanges ......................................... 5-44

[A] Generally ................................................................ 5-44[B] Deferred Exchanges ................................................ 5-46[C] Reverse 1031 Exchanges ......................................... 5-46[D] Qualified Exchange Accommodation

Arrangement........................................................... 5-47[E] Limitation on 1031 Tax-Free Exchanges for

Tax-Exempt Use Property..................................... 5-47[F] Section 467 Loan.................................................... 5-48[G] Same Taxpayer Requirement and Single

Member LLCs......................................................... 5-49§ 5:5 Tax-Exempt Investors and Unrelated Business

Taxable Income.............................................................. 5-50§ 5:5.1 UBTI—Background ................................................ 5-50§ 5:5.2 UBTI and Dealer Property...................................... 5-50§ 5:5.3 UBTI and Debt Financed Property—General Rule .... 5-51§ 5:5.4 UBTI and Debt Financed Property—

Exception for Qualified Organizations .................. 5-51[A] Qualified Organization ........................................... 5-51[B] No Sale-Leaseback .................................................. 5-52[C] Fractions Rule ......................................................... 5-52[D] Additional Requirements ........................................ 5-53

§ 5:5.5 Using a Corporate Blocker to Avoid UBTICharacterization ..................................................... 5-53

[A] Foreign and Domestic Non-REITCorporations—Not Effective Blockers..................... 5-54

[B] REIT Blocker .......................................................... 5-54[B][1] Exception—Pension Held REIT ......................... 5-55[B][2] Exception—Dealer Property ............................... 5-55

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§ 5:5.6 Avoiding UBTI: Loan from theTax-Exempt Entity .................................................. 5-56

[A] Caveat—Tax-Exempt Entity May NotControl the Fund ................................................. 5-56

[B] Caveat—Recharacterization of Loan As Equity ...... 5-56§ 5:6 Interest Deductions on Commercial Real

Estate Loans .................................................................. 5-57§ 5:6.1 Generally ................................................................ 5-57§ 5:6.2 Limitation on Deductibility of Nonrecourse

Mortgage Loan Interest........................................... 5-57§ 5:6.3 Deductibility of Accruing Interest on

Residual Value Loan ............................................... 5-58[A] Exception: Lender and Borrower Are Related ......... 5-58[B] At-Risk Limitations ................................................ 5-59

§ 5:7 Transfer Tax................................................................... 5-60§ 5:7.1 Generally ................................................................ 5-60§ 5:7.2 Transfer Tax Treatment of a Sale-Leaseback ........... 5-60

[A] Exception for Long-Term Leasebacks—Pennsylvania and California................................... 5-60

[B] Exception for Financing Transactions—Pennsylvania and California................................... 5-61

§ 5:7.3 Transfer Tax Treatment of the Sale of aNet Leased Property................................................ 5-61

[A] Exemption—Transfer of an Ownership Interest ..... 5-61[A][1] Florida ................................................................ 5-62[A][2] Maryland............................................................ 5-62[A][3] Pennsylvania ...................................................... 5-63[B] Exemption for Property Subject to a

Long-Term Lease—California ............................... 5-63[C] Exemption for Transfer of a Leasehold Interest ...... 5-64[D] Seller in Bankruptcy ............................................... 5-64

§ 5:8 Net Investment Income Tax.......................................... 5-66§ 5:8.1 Generally ................................................................ 5-66§ 5:8.2 Definition of Net Investment Income.................... 5-66§ 5:8.3 Trade or Business Exception ................................... 5-66

[A] Nonpassive to the Taxpayer.................................... 5-67[B] Trade or Business.................................................... 5-67[B][1] Safe Harbor for Certain Real

Estate Professionals ............................................ 5-67

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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 ..................................................... 6-3§ 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..... 6-4[C] Investments in Which There Is No Significant

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

§ 6:1.5 Structuring a Pension Plan Investment inReal 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% orMore of an Investment Fund....................................... 6-7

§ 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 ............................................................... 6-8§ 6:2.3 Functional Equivalent of Lending—S&L

Regulations ............................................................... 6-9[A] Definition of Net Lease .......................................... 6-10[B] Definition of Full-Payout Lease .............................. 6-10[C] Definition of Realization of Investment ................. 6-11

§ 6:3 Tenants in the Marijuana Business ............................... 6-11§ 6:3.1 Background............................................................. 6-11§ 6:3.2 Criminal Liability and Forfeiture............................ 6-11§ 6:3.3 Spending Limitation on Federal Medical

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

Spending Limitation ............................................... 6-14§ 6:3.4 Lease Clauses and Forfeiture Proceedings .............. 6-15

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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

§ 7:1.3 Operating Lease Treatment....................................... 7-5[A] Requirements for Operating Lease Treatment .......... 7-5[A][1] The 90% Test ....................................................... 7-6

§ 7:1.4 Consolidation Rules—Variable Interest Entities ....... 7-7[A] Background ............................................................... 7-7[B] Summary .................................................................. 7-7[C] Variable Interest Entities—Generally ........................ 7-8[D] Variable Interest Entities—Equity Requirement........ 7-8[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, andExpected Variability................................................. 7-10

[H] Variability—Residual Value Guarantee orPurchase 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 .............................................. 7-13§ 7:2.1 Background............................................................. 7-13§ 7:2.2 Definition of Lease ................................................. 7-14§ 7:2.3 Lease Classification ................................................ 7-14§ 7:2.4 Lease Term ............................................................. 7-15§ 7:2.5 Tenant’s Balance Sheet ........................................... 7-15

[A] Lease Liability ......................................................... 7-15[B] Right-of-Use Asset—Initial Measurement.............. 7-18

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[C] Right-of-Use Asset—Subsequent Measurement ..... 7-18[C][1] Finance Lease ..................................................... 7-18[C][2] Operating Lease.................................................. 7-19

§ 7:2.6 Income Statement .................................................. 7-19§ 7:2.7 Example—Measurement of the ROU Asset and

the Lease Liability................................................... 7-20§ 7:2.8 Tenant’s Treatment of Leases Previously

Classified As Operating Leases............................... 7-21[A] Example—Treatment of Pre-Existing

Operating Lease ...................................................... 7-22§ 7:3 Arranging Transactions to Avoid Lease Treatment........ 7-23

§ 7:3.1 Background............................................................. 7-23§ 7:3.2 Structuring Strategies ............................................. 7-23§ 7:3.3 Example—Using a Logistics Contract in Lieu of

Leasing a Distribution Facility ............................... 7-24§ 7:3.4 Example—Using a Power Purchase Agreement in

Lieu of Leasing a Power Plant .................................. 7-25

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

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

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

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

Appendix D Calculating Expected Variability ofReturns Under GAAP..................................App. D–1

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

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

NET LEASES AND SALE-LEASEBACKS

xxiv

Acknowledgments

The author wishes to acknowledge the invaluable assistance ofChadwick McCombs, Jun Kwon, Hen Amir, and Damian Martin inthe research and writing of this book. The author also wishes to thankGary York, Roy Geiger, Shirley Yu, and Jacob Metric for their helpediting this work.

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Introduction

The hallmark of a net lease is the shifting of property-related risksand expenses to the tenant. When properly structured, the result ofthis shift is a real estate investment that is not only passive but also,in the case of a credit tenant, financeable with low interest, highleverage financing that is not available for conventional multi-tenantproperties. Given their particular characteristics, net lease invest-ments may be regarded as belonging to their own asset class. Com-pared with other investment real estate, which typically requiresactive management, net lease investments are remarkably passive. Con-sequently, the net lease market is a national market and the brokers,attorneys and investors in this market generally practice and invest on anational basis. In addition, there are a number of tax, financing andregulatory issues that are unique to net lease investments, and the real-estate professionals practicing in this area need to be familiar with theseissues. One example is section 467 of the Internal Revenue Code, whichimposes a set of complex rules on those leases—called 467 RentalAgreements—in which rent is allocated in a manner that differs fromtheir payment schedule. While 467 Rental Agreements are commonin certain types of net leases, they rarely occur in other types of realestate leases. Whether the lease is a “true lease” for tax, bankruptcy andaccounting purposes is another set of issues that is peculiar to netleases. The requirements of a credit tenant loan—which is exclusivelyavailable for certain net leased properties—is yet another.

This book covers all aspects of the ownership, financing, docu-mentation, taxation and accounting for net leases with a focus onthose areas where the treatment of net leases differs from the treat-ment of other forms of real estate investment. Chapter 7, on account-ing, covers recently adopted changes to U.S. financial accounting rulesfor leases (effective for fiscal years beginning after December 15, 2018)under which all leases with a term exceeding one year will have to bereflected on the tenant’s balance sheet. It has been estimated thatthe new accounting treatment of leases will add $2 trillion to thebalance sheets of U.S.-based corporations. Possible structures avoidingon-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 credittenant loan. A credit tenant loan generally allows a debt servicecoverage ratio of 1:1. As a result, in a credit-tenant loan, the monthlydebt service payments are often equal to the monthly rent paymentsunder the lease covering the premises. In such cases, because theentire rent is used to make debt service payments, the property willproduce no cash flow until the loan is repaid. If net lease investmentsare considered to make up their own asset class, then perhaps zerocash-flow properties should be considered an asset sub-class. Theseinvestments are typically sold subject to the existing debt and aregenerally priced at a percentage of the debt. Buyers generally acquirethem, at least in part, for tax reasons. In many cases, the transfer ofthese investments is structured as the sale of the ownership interestsin the limited liability company that owns the property rather than asa conveyance of the property by deed. The unique structure of zerocash-flow investments creates the possibility of yet another form offinancing. Because the credit tenant loan that encumbers a zero cash-flow investment is often self-amortizing, the residual value of theproperty—that is, the value of the property beginning when the credittenant loan is paid off—is available to collateralize a mezzanine loancalled a “residual value loan.” Such loans are covered in section 4:2of this book. Finally, because zero cash-flow investments eventuallyproduce taxable income (that is, the rental income eventually exceedsthe interest and depreciation deductions), they eventually subject theowner to “phantom income,” which is taxable income without cashflow. Structures to avoid or reduce “phantom income” in zero cashflow properties are also addressed in chapter 4.

This book also covers all aspects of real estate sale-leasebacktransactions. Sale-leasebacks are often a desirable form of financingfor publicly traded tenants because, among other reasons, the financingis off-balance sheet under current U.S. accounting regulations whenproperly structured. However, the transaction will be on-balance sheetfor the tenant if the lease does not qualify as an operating lease or if thetenant is required to consolidate the landlord under generally acceptedaccounting principles. In addition, if the transaction is improperlystructured, the landlord’s interest and depreciation deductions maybe disallowed through a recharacterization of the lease as a financingfor income tax purposes. Such recharacterization can also occur in

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

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

Introduction

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