Valuing Like Kind Exchanges: Is It Too Good to Be True?

The LKE benefit is the deferral of tax gains on sale of assets if the assets are replaced with like kind assets. The deferral of the tax gain means that the lessor does not pay tax on the gain immediately, but rather holds on to the deferred tax balance associated with the leased asset being sold. The deferred tax balance is an interest free source of funding ' it is a loan from the IRS. It partially funds a leased asset. The balance of the funding for a lease is from borrowed funds and stockholders equity. The higher the deferred tax balance, the lower the need for costly debt and equity.

To illustrate the savings assume a truck leasing company sells a truck coming off lease and uses the LKE benefit on a replacement truck lease, consider the example set forth in Table 1.

[IMGCAP(1)]

The pro forma balance sheets (in $000s) of a replacement lease without taking advantage of an LKE and a replacement lease with an LKE are set forth in Table 2 and Table 3.

[IMGCAP(2)]

[IMGCAP(3)]

The savings come from the reduced cost to fund the business as interest bearing debt is replaced by the cost free increased deferred tax balance resulting from the LKE benefit. The cumulative savings on one truck lease with the LKE benefit are $620. If one truck with the LKE benefit is added each year, the portfolio reaches a normalized state, where a new truck lease replaces a truck lease that terminates, in 5 years. At this point, the annual savings would be $620 on the portfolio. Extrapolating to a leasing business that generates $100 million in volume a year, the annual savings would be $620,000 per year! Note that this does not consider the costs of the LKE program, but the annual costs will not be significant.

The above is the total business benefit on a portfolio basis. That is an important analysis that must be done to determine if an LKE program creates an acceptable payoff. The LKE program can be used to increase profits, but it also gives the business manager a competitive price advantage. A leasing business manager also needs to know what the basis points benefits are to aid in pricing decisions. To calculate the basis points benefits we need to look at three cases and do analyses using a lease pricing program like SuperTRUMP:

• A No LKE case ' used to establish the basis for comparisons
• A LKE Keep case ' to show the yield/ROA benefits if the lessor keeps the LKE benefits
• A LKE Pass case ' to show how much the lessee's implicit rate declines if the LKE benefit is passed on to the lessee

See Table 4.

[IMGCAP(4)]

Discussion

The No LKE case is a calculation of the rent needed to give the lessor the targeted 6.5% pretax Multiple Investment Sinking Fund (“MISF”) yield. It assumes regular MACRS as it is meant to portray the lease market in 2005. The ROA is a byproduct of this analysis. Many lessors target ROA (ROA is an accounting measure and requires a lessor's borrowing cost assumption to do the calculation) to ensure that their pricing is in step with the accounting treatment of the lease as it will appear in their financial statements.

The LKE Keep case is the pricing of a replacement lease. The original lease was assumed to have had the 50% Bonus MACRS. The deferred gain of $17,120 is reflected in the pricing as an upfront tax deduction to show the tax benefit of deferring the gain. The remaining $2880 basis from the original lease's asset continues to be depreciated as though the asset was not sold using the original 50% Bonus MACRS schedule (“step in the shoes” depreciation). Regular MACRS is used to depreciate the new basis ' the amount of new funds invested ($80,000), which when added to the sales proceeds is equal to the $100,000 price of the replacement truck. The rents were frozen from the No LKE case. The ROA and MISF yields are calculated to show the LKE benefit to the lessor.

The LKE Pass case is also a pricing of a replacement lease, but in this case we target the original yield rate and solve for a new, lower level of rent reflecting the passing of the LKE benefit onto the lessee. The tax adjustments to reflect the proper depreciation are the same as in the LKE Keep case above. The pretax yield rate of 6.5% becomes the target return in the pricing run and the result is a new level of rent. The new lower implicit rate is calculated to show the lessee benefit if all the LKE benefit is passed on by the lessor. The ROA that results is an interesting comparison to show how accounting results and yield results don't move in direct relationship to one and other. See Table 5.

[IMGCAP(5)]

Discussion

Keeping the LKE benefits gives the lessor an improved yield of 30bps and an improved ROA of 17bps! These are impressive numbers in an environment when lessor's margins are thin due to competitive pressures.

Passing the LKE benefits on while maintaining the desired 6.5% yield gives the lessee a significant improvement in implicit rate of 25bps. The $13 save in rent expense per month adds up to almost 0.8% of the cost of the asset. These are significant numbers in a market where deals are won or lost by a few basis points. Note that the ROA declined when solving for yield. This is due to yield being influenced heavilyby tax benefits, and the LKE produces significant tax benefits. Lessors should note this difference as the financial markets are concerned about lessors' accounting returns, not tax yields, but this is a complex topic suitable for an article of its own.

The LKE benefit is being used by many of the vehicle leasing companies like auto manufacturers, auto lessors and auto rental companies. Increasingly, general equipment lessors are using the benefit. Those lessors will be formidable competitors if they use the LKE pricing advantages available to them.

How would you as a lessor like to increase your after tax income by millions of dollars? How would you as lessor like to increase spreads by 30 basis points? Would you like to do this without having to cut costs or take the risk of creating a new product, entering a new market and hiring lots of staff? The answer to these questions of course is “yes,” and it sounds too good to be true as the way to get there is to use a gift from the IRS ' implement a Like Kind Exchange (“LKE”) program in your leasing business.

The focus of this article is on how to value an LKE program.

The Like Kind Exchange tax benefit derived from section 1031 in the IRS Code has been used in real estate transactions for years and more recently in large ticket tax lease transactions like commercial aircraft. Increasingly, it is being used by equipment lessors that have portfolios of assets under tax leases. The benefits of an LKE program have traditionally been in cases where the leased assets were assets that retained strong residual values like aircraft, rail equipment, trucks, trailers, autos, construction equipment, and lift trucks. Now with Bonus Modified Accelerated Cost Recovery Systems (“MACRS”), LKE programs even show benefits for PC and copier leases as those leases are showing tax gains on termination, especially early terminations. The challenges in implementing an LKE program in a medium to small ticket leasing business are complexity, volume and the cost/benefit, but those challenges can be overcome through the use of experienced LKE software and service providers. They advise on the tax rules, set up the systems to comply with the tax rules and handle the volume. Often their costs are low enough to create high value.

The LKE benefit is the deferral of tax gains on sale of assets if the assets are replaced with like kind assets. The deferral of the tax gain means that the lessor does not pay tax on the gain immediately, but rather holds on to the deferred tax balance associated with the leased asset being sold. The deferred tax balance is an interest free source of funding ' it is a loan from the IRS. It partially funds a leased asset. The balance of the funding for a lease is from borrowed funds and stockholders equity. The higher the deferred tax balance, the lower the need for costly debt and equity.

To illustrate the savings assume a truck leasing company sells a truck coming off lease and uses the LKE benefit on a replacement truck lease, consider the example set forth in Table 1.

[IMGCAP(1)]

The pro forma balance sheets (in $000s) of a replacement lease without taking advantage of an LKE and a replacement lease with an LKE are set forth in Table 2 and Table 3.

[IMGCAP(2)]

[IMGCAP(3)]

The savings come from the reduced cost to fund the business as interest bearing debt is replaced by the cost free increased deferred tax balance resulting from the LKE benefit. The cumulative savings on one truck lease with the LKE benefit are $620. If one truck with the LKE benefit is added each year, the portfolio reaches a normalized state, where a new truck lease replaces a truck lease that terminates, in 5 years. At this point, the annual savings would be $620 on the portfolio. Extrapolating to a leasing business that generates $100 million in volume a year, the annual savings would be $620,000 per year! Note that this does not consider the costs of the LKE program, but the annual costs will not be significant.

The above is the total business benefit on a portfolio basis. That is an important analysis that must be done to determine if an LKE program creates an acceptable payoff. The LKE program can be used to increase profits, but it also gives the business manager a competitive price advantage. A leasing business manager also needs to know what the basis points benefits are to aid in pricing decisions. To calculate the basis points benefits we need to look at three cases and do analyses using a lease pricing program like SuperTRUMP:

• A No LKE case ' used to establish the basis for comparisons
• A LKE Keep case ' to show the yield/ROA benefits if the lessor keeps the LKE benefits
• A LKE Pass case ' to show how much the lessee's implicit rate declines if the LKE benefit is passed on to the lessee

See Table 4.

[IMGCAP(4)]

Discussion

The No LKE case is a calculation of the rent needed to give the lessor the targeted 6.5% pretax Multiple Investment Sinking Fund (“MISF”) yield. It assumes regular MACRS as it is meant to portray the lease market in 2005. The ROA is a byproduct of this analysis. Many lessors target ROA (ROA is an accounting measure and requires a lessor's borrowing cost assumption to do the calculation) to ensure that their pricing is in step with the accounting treatment of the lease as it will appear in their financial statements.

The LKE Keep case is the pricing of a replacement lease. The original lease was assumed to have had the 50% Bonus MACRS. The deferred gain of $17,120 is reflected in the pricing as an upfront tax deduction to show the tax benefit of deferring the gain. The remaining $2880 basis from the original lease's asset continues to be depreciated as though the asset was not sold using the original 50% Bonus MACRS schedule (“step in the shoes” depreciation). Regular MACRS is used to depreciate the new basis ' the amount of new funds invested ($80,000), which when added to the sales proceeds is equal to the $100,000 price of the replacement truck. The rents were frozen from the No LKE case. The ROA and MISF yields are calculated to show the LKE benefit to the lessor.

The LKE Pass case is also a pricing of a replacement lease, but in this case we target the original yield rate and solve for a new, lower level of rent reflecting the passing of the LKE benefit onto the lessee. The tax adjustments to reflect the proper depreciation are the same as in the LKE Keep case above. The pretax yield rate of 6.5% becomes the target return in the pricing run and the result is a new level of rent. The new lower implicit rate is calculated to show the lessee benefit if all the LKE benefit is passed on by the lessor. The ROA that results is an interesting comparison to show how accounting results and yield results don't move in direct relationship to one and other. See Table 5.

[IMGCAP(5)]

Discussion

Keeping the LKE benefits gives the lessor an improved yield of 30bps and an improved ROA of 17bps! These are impressive numbers in an environment when lessor's margins are thin due to competitive pressures.

Passing the LKE benefits on while maintaining the desired 6.5% yield gives the lessee a significant improvement in implicit rate of 25bps. The $13 save in rent expense per month adds up to almost 0.8% of the cost of the asset. These are significant numbers in a market where deals are won or lost by a few basis points. Note that the ROA declined when solving for yield. This is due to yield being influenced heavilyby tax benefits, and the LKE produces significant tax benefits. Lessors should note this difference as the financial markets are concerned about lessors' accounting returns, not tax yields, but this is a complex topic suitable for an article of its own.

The LKE benefit is being used by many of the vehicle leasing companies like auto manufacturers, auto lessors and auto rental companies. Increasingly, general equipment lessors are using the benefit. Those lessors will be formidable competitors if they use the LKE pricing advantages available to them.