Synthetic Leases: Structured Finance, Financial Accounting and Tax Ownership

The term "synthetic lease" is in vogue in the world of commercial real estate finance. In a synthetic lease transaction, money is borrowed based on the financial strength of a tenant and on that tenant's agreement to pay rent. The lender expects the debt to be serviced from the rental obligation of the tenant rather than from the financial resources of the nominal owner and borrower. The lease is "synthetic" insofar as it is designed to achieve a blended treatment: the tenant reports it as an operating lease for financial accounting purposes but as a mortgage for federal income tax purposes. This article explains synthetic lease transactions in the broader context of asset securitization and structured finance and contrasts the treatment of synthetic leases under financial accounting standards, mortgage law and federal income tax law. Although leases have long been treated differently for financial accounting purposes and tax law purposes, the article takes the position that the present divergence is too great. It takes the position that what needs fixing is not the tax law but the standards of the Financial Accounting Standards Board ("FASB"). It argues that FASB should eliminate the sharp distinction between sale-leaseback transactions and transactions in which an SPE acquires title from a third party. In particular, it argues that FASB should require balance sheet disclosure when the sine qua non of a transaction is an ex ante agreement that the tenant, not the landlord, will report that it is the substantive owner of an encumbered asset for federal income tax purposes.