This article discusses the purchaser’s perspective of an investment in distressed obligations that are secured by leases on tangible property. As many banks are looking to unload so-called bad loans from their balance sheets, buyers of these discounted debt instruments need to address the tax treatment of these purchased loans. While much has been written on the tax treatment of distressed debt secured by real estate, there are fewer discussions relating to distressed debt backed by leases. In the recent turmoil of distressed debt, these investments are an emerging trend. This article explores various tax avenues when dealing with this type of debt.

In addition to mortgages, banks provide loans to companies purchasing tangible assets, such as farm equipment, tractors, or trailers. One reason for these loans is to manage a company’s cash flow. Tax benefits are another reason, depending on the deal’s structure. However, the facts and circumstances of a deal can lessen these tax benefits. A typical deal is described in Example 1.

Example 1: M corporation agrees with corporation N to make set payments over a certain period of time in exchange for use of equipment manufactured by N. P bank agrees to pay N a discounted total sum in exchange for N’s right, assignment, title, and interest in the equipment and transfer of all payments due or to become due from M.

In form, it appears M is making lease payments to N, who subsequently assigns its stream of payments to P, while, in substance, the transaction is essentially a conditional “sale” of the equipment rather than a lease. Certain conditions, such as the fact that all rights, interest, and title transfer to P; that it is unreasonable to assume that P intends to go into the business of leasing the equipment; and the total rental payments’ exceeding the equipment’s fair rental value lead to a conclusion that a sale has occurred as opposed to the creation of a true lease.1

Facts and circumstances determine the substance of a transaction rather than the mere tax-motivated form.2 From M’s point of view, if the transaction is treated as a lease, M has a rental expense for each payment made for the duration of the lease, which could be two to three years. If the transaction is treated as a sale, M would have to record the equipment as an asset on its books and depreciate it over five years using MACRS depreciation. Absent first-year bonus depreciation or a Sec. 179 deduction, M would get the tax benefit of the payments over a longer period than if it is treated as a lease. The IRS views the above transaction as a sale rather than a lease.

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