The Synthetic Lease: What is a Synthetic Lease

How do you get the tax benefits of facility ownership without having anything appear on the balance sheet? You might consider a synthetic lease.

A synthetic lease is off-balance-sheet financing that is classified as a lease for financial purposes and as a loan for tax purposes. Building your own facility can be costly; however, the synthetic lease offers a way to make the process less expensive.

A typical synthetic lease transaction operates in the following manner. First, the need for a new facility is identified. The facility is constructed by a developer. Next, a capital source or lessor buys the real estate from the developer and leases it to the corporate user. At the termination of the lease, the user may buy the property at a predetermined price.

On the surface, it’s simple; however, there is a lot to be aware of before signing on the dotted line. If the lease does not meet critical accounting guidelines, then it cannot deliver the intended advantages. For example, if any of the following exist in the lease, then it will be treated, not as a synthetic lease, but as a capital lease, and therefore would not offer the same benefits (as a capital lease, it would appear on the balance sheet).

– Ownership of the property is transferred to the tenant before the end of the term. To avoid this factor yet permit a transfer, the lease will often grant the tenant an option to purchase the property at fair value at the end of the term, a right of first refusal, or a right to direct an arm’s-length sale to a third party of the user’s choice, such as a subsidiary or partner. That way, if the tenant does not want the property, they can direct its sale in a manner so as to continue to benefit from it.

– The lease grants the tenant an option to purchase the property at a bargain price. To avoid bargain purchase options, the lease will grant an option with a purchase price not lower than the reasonably expected market value of the property at the time of exercise.

– The present value of the rents and other minimum payments (including tenant guarantees) under the lease equal or exceed 90 percent of the fair market value of the property at the beginning of the lease. Therefore the synthetic lease must be structured so that the present value of all minimum lease payments, including any residual payment due upon termination, is less than 90 percent of the value of the property.

Following those guidelines, some of the advantages that can be gained from synthetic leases are:

– A stronger balance sheet. The lease payments are reported as current expenses; the balance sheet shows neither the leased property nor the associated liability. These steps result in better financial ratios.

– Tax benefits. For federal income tax purposes, the business is considered the owner. This allows the business to take depreciation and to deduct the interest portion of the lease payment.

– Total Control. The business controls all the functions of ownership, including potential gain and loss, operational control and responsibility for expenses.

Before using a synthetic lease, be sure to consult real estate, legal and financial professionals who have experience working with synthetic leases. The more familiar they are with the ins and outs of synthetic leases, the less likely you will be to run into complications down the road.

Important note: the material provided here is for informational purposes only and is not professional tax advice. It is intended for our readers in the United States. Please consult a professional tax advisor to discuss your specific tax situation.