Can A Master Lease Really Help You Defer Capital Gains and Depreciation Recapture?

At a networking event this morning, the speaker said he’d purchased property on a master lease, which helped the elderly seller defer capital gains tax and depreciation recapture.

The idea was, when the seller died, his heirs would inherit the property at a stepped-up basis. At that time, the heirs would be on the hook for paying inheritance tax, nothing more.

Given that federal capital gains tax can be 15-20%, state tax another 9-10% and depreciation recapture as much as another 25%, this piqued my interest.

It almost sounds like a contract-for-deed, but without the hit of the depreciation recapture in the first year.

So what is a master lease?

A master lease is a landlord-tenant arrangement. You, the owner, lease the entire property to a single tenant (often an investor or operator), who then has the right to sublease the individual units and collect the rent themselves.

You’re still on title. You’re still the legal owner. What’s changed is who’s managing the day-to-day and who’s collecting rent from the actual occupants.

Because you still own the property, there’s no sale. And the theory goes, if there’s no sale, there’s no capital gains event and no depreciation recapture. That part is true, and it’s the seed of the idea that a master lease is a tax deferment tool.

Of course, since title doesn’t change hands with this method, that also means the seller didn’t get a large chunk of cash from a sale. It can, however, provide passive monthly income in the form of lease payments.

Objectively, the version of the master lease people are usually really asking about isn’t a plain is a master lease with an option (or obligation) for the tenant to buy the property. While the terms are negotiable, lease payments are often credited toward the purchase price.

This is where the IRS’s substance-over-form doctrine comes in. The IRS doesn’t just look the paperwork.  It looks at what the deal actually does. If a master-lease-to-own arrangement has the hallmarks of a sale, it can be recharacterized as one. The longer it goes, the more the deal looks like an installment sale than a lease.

If the deal gets recharacterized, all the consequences of a regular sale may be triggered. The gain and recapture may end up being recognized in the year the contract started. If any length of time has passed since then, the IRS may also assess interest and even possibly penalties.

If the goal is to manage the tax hit on selling your duplex, there are real, IRS-recognized paths for that like a 1031 Exchange, Installment Sale (contract-for -deed), Section 121 Exclusion (for owner occupancy) and Opportunity Zone Reinvestment.

In other words, a master lease is a legitimate tool for transitioning management or bridging a sale timeline. It just may not be a very good tax strategy.

As always, you must speak with your tax advisor before entering into any sale of multifamily or any other kind of investment property. The consequences of not doing so may cost you greatly.