Capital Gain or Ordinary Income?

[Uncle Sam]

A client owns commercial property (medical office building) and vacant acres attached. This property was
originally a partnership, in which initially my client was a 20% partner at the time he came into it.
Then through deaths of other partners, he acquired additional interests - 20% at a time.
When he became a 60% partner, that's when I took over as the accountant. Subsequently he
purchased 2 other 20% interests from widows of deceased partners. He now owns it directly, no LLC.

He has a professional practice of his own in one unit. As of 2 years ago, he moved a C corporation
(completely different entity) of which he has 100% control in another unit. There are 2 other regular rent paying tenants.

He is now considering selling most of the vacant land to a tax exempt institution located in the
neighborhood, and wishes to still possess the building. Cash deal, no installment sale.

Prospective buyers, in discussing the parameters of arriving at a total price, suggested that instead of purchasing only the
vacant land, wish also to buy the building, and part of the settlement would be that my client
would have rent free use of building for, say 10 years of space presently occupied by him (both units).
So price would be vacant acreage $ x
free rent y

No question about it - the free rent is 100% taxable income, 1099nd to be amortized over term of agreement.

My question is - is the 1099nd annual "free rent" - capital gain, or ordinary income?

[Golden Rocket]

Capital Gain

Sam, I'm going to take a shot at this, because if it suited their agenda, the IRS would not allow a transaction to be re-characterized by some strings attached to the future. The only difference is this time, recharacterization would be to the IRS advantage (more than likely).

Obviously, the sale price should be impacted upward if there were no 10-year rental agreement. I guess if were me, I might even take the FMV of rent over a ten-year period, deflate it into discounted cash flow, and regard a portion of the amortization as ordinary interest income, with the rest of it being installment-type reporting, even though no cash transpires.

Question also turns to 1099 for rent. If the logic above applies, this wouldn't really be rent. Additionally, I believe the requirements for a 1099 might apply to cash payments only and not to amortization-type income.

Don't know whether there would be a court decision on this or not. Might be found in classic "form versus substance" cases, but even then, there is a supportable economic reason for cash not to transpire in the future which I think would defeat the "form versus substance" argument.

[Gary2]

If they paid the cash-equivalent to granting the free rent, that would be treated as a payment on an installment plan. Why would paying in free rent as opposed to paying in cash change this?

[Roland Slugg]

If there is imputed income equal to the free rent, then there is also imputed rent expense. The amounts offset, although the income might be capital ... i.e. deemed to be additional sums received from the sale of the property ... whereas the rent expense would be an ordinary deduction.

The proposed scheme you have described appears to be a deferred sale and leaseback, and these are covered in considerable detail by Code §467 and Regs §1.467-1 and §1.467-3.

[Uncle Sam]

I appreciate all of your thoughts. Keep them coming, please. The more thoughts
the more consideration to varying aspects. I do appreciate that.

I hadn't considered the imputed interest issue - associated with an installment sale.

My client is the recipient of the free rent. So the free rent has 2 components -
imputed interest (ordinary income) and rental income (capital gain) - like you
would in an installment sale.

Again folks - please keep the ideas coming.

This decision won't be taking place until the earliest mid July.

[Gary2]

I'll add two more things: First, check with an attorney on whether there are any advantages or disadvantages, perhaps separate from tax issues, for structuring the deal as two independent transactions: an installment sale and a rental agreement, where it just happens that the annual payments under the installment sale happen to equal the agreed upon rent.

Second, I believe it's fairly uncommon for a commercial property to be leased at a fixed rent for a ten year period. The one example I know of has the lease renewable in five year periods, with the rent predetermined based on the market conditions at the time of the renewal. So I don't think you'll be able to treat the imputed rent as the same for the first year and the last year.