A synthetic lease is a financing arrangement that is classified as a lease for financial accounting purposes and as a loan for tax purposes. This type of lease is sometimes referred to as a “tax ownership/operating lease or an “off balance sheet” financing. A synthetic lease involves the purchase of real estate from a third party seller by a Special Purpose Entity (SPE) that then leases the property to the lessee. The lessor provides acquisition and construction funding. The funds advanced by the lessor are repaid through the rent that the lessee pays. If the lease is properly structured, the lessee/borrower will be recognized as a lessee under the accounting rules and as an owner and borrower under applicable federal income tax code provisions.
Synthetic lease transactions usually resemble leveraged sale-leaseback transactions, so a description of the recharacterization risk encountered in sale-leasebacks is useful to understand the title industry’s approach to synthetic leases. Many sale-leaseback transactions contain features that could persuade a court to determine that the transaction created a financing instead of a lease. In these cases, the court may decide to recharacterize the transaction to a financing by interpreting the interest of the lessee as a fee interest and the interest of the lessor as a mortgage lien.