Thursday, November 5, 2009

LILO transactions abridged

The paper I linked to earlier (pdf here) concerning lease-in lease out (LILO) transactions is a very good read.  It is also relatively easy to follow if you have a basic knowledge of finance. 

If you are interested in just what it is that Jill Chambers thinks MARTA officers are too dumb to understand, I'll try and summarize:
  1. A tax-exempt organization like MARTA has property and assets that it owns.  Let's call them the "owner".
  2. The owner leases the property to an investor.  Let's call him the "taxpayer".  (I'm borrowing terms from the Yale paper.)
  3. The taxpayer takes out a loan for the present value of the lease obligations, and pays it to the owner up front instead of making annual payments.  The taxpayer takes out a loan to make this payment, so he'll owe principal and interest on it over the course of the arrangement.
  4. The taxpayer then leases the property back to the owner.
  5. The owner takes that lump sum (the present value of the lease obligations), and invests it in bonds.  He'll use this investment to pay for the sub-lease he made with the taxpayer.   
The annual cash flows look like this:
  1. The invested lump sum throws of interest, which the owner (MARTA) uses (in conjunction with part of the invested amount) to pay the taxpayer for the lease.  
  2. The taxpayer uses this payment to pay back principal and interest on the loan he took out to finance the lump sum payment in the beginning. 
  3. The owner (MARTA) doesn't get anything on an annual basis - remember, they got everything up-front in order to invest it.
So shouldn't all this stuff equal out?  Why is anyone making any money on this deal?  I'll quote from the paper:
My analysis reveals that the underlying source of tax benefits is the arbitrage created because a LILO is effectively two sequential loans: the taxpayer borrows money from third parties, lends the money to the owner as a prepayment, and the owner then lends the money back to third parties. Tax arbitrage is created because the taxpayer deducts interest on the funds used to make the prepayment whereas the owner pays no taxes on the interest earned on that prepayment.
Make sense?  While it may look like the taxpayer is the only person making money here (because he's the only one getting tax savings), these savings can then get distributed between the partners if you wanted.  Indeed, MARTA has made $119 million on these deals so far.

The paper notes that the total tax savings are about 10%-15% of the value of the asset.  Assuming the taxpayer/partner stays in business to keep making payments, why wouldn't you expect a cash-strapped entity like MARTA to try and make money on its assets?

Unsurprisingly, the IRS doesn't like these deals, since they are the ones getting screwed.

UPDATE: Atlanta Unfiltered has a link to The Tax Foundation's article about SILO (Sale-in, Lease Out) deals, which are a variation on the LILO deal. In a SILO deal, the owner/agency sells the asset to the investor, who can then deduct the depreciation as an expense.  At the end of the deal, the original owner of the asset typically has the right to buy back the asset for a nominal amount ($1). 

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