Separating Commonly-Owned Property from Operations (Again)
About 10 years ago, thanks to the Enron debacle, the Financial Accounting Standards Board (FASB) issued a statement requiring operating companies in the above scenario to include the separate real estate entity in its consolidated financial statements. This was not quite the intended purpose of the pronouncement, but it was an unfortunate by-product. This proved problematic for many operating businesses, particularly those that had other operating debt, as various ratios were put in jeopardy (debt-to-equity and working capital, for example). Companies either had to obtain waivers or have their covenants rewritten to contend with this presentation.
Fast forward to 2014 – the FASB has provided relief to nonpublic companies in this situation. In an update issued earlier this year, the FASB will now permit qualifying entities to NOT consolidate the separate real estate entity simply because of the existence of the guaranty. To qualify for non-consolidation treatment, the entities must meet four criteria:
- The lessee and lessor must be under common control
- There must be a lease arrangement between the lessee and the lessor
- Substantially all activities between the lessee and the lessor are related to leasing activities (including supporting leasing activities) between those two entities
- The amount guaranteed does not exceed the value of the asset leased at the time the guaranty was made
It is pretty clear that the situation described above meets the criteria. The two entities are obviously under common control and there would certainly be a lease between the entities. In this specific situation, it is also clear that there are no other activities between the two entities, as the lessor merely holds the building and has no other operations. But, what about the last criterion? When the operating entity is the sole tenant, the answer is easy, since the lender would not lend in excess of the property value. However, there may be a situation where the operating entity only occupies a portion of the property, and the rest of the property is leased to unrelated entities. For example, the operating entity leases 30% of the property, while guarantying the entire mortgage, presumably 70-80% of the property value. On the surface, it would seem that the situation would not qualify. However, the FASB update addressed this exact scenario. The lessee need not occupy the entire space, but only some space within the property subject to the mortgage.
This pronouncement is effective for annual periods beginning with calendar year 2015. However, early application is permitted. If you are interested in reporting operations separate from the property, as could be done 10 years ago, the opportunity has returned.
NEED MORE INFORMATION?
If you have any questions about this real estate update, please contact your WithumSmith+Brown professional or a member of WS+B’s Real Estate Services Group or email us at [email protected].
Rebecca Machinga, CPA, Partner
Practice Leader
609.520.1188
[email protected]
Learn more about our Real Estate Services >>
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
