Real Estate Finance Lease and Mortgage Lending

Differences in Taxation

There are two main types of financing available to companies that plan to acquire real estate for their activity (premises, warehouse or office): purchase with a mortgage loan, which is the traditional method, and real estate finance lease (also known as real estate capital lease), which has been gaining popularity in recent years thanks to its flexibility and the possibility of financing up to 100% of the cost of the property. In finance lease, it is the finance company (a bank) that purchases the asset and transfers its use, in exchange for the payment of a series of instalments, for a determined period, at the end of which the user (lessee) has the option to acquire the ownership of the asset, which can be exercised for a very reduced amount (residual value).

The main criterion is the financial and fiscal cost

The criterion that will decide the choice between a mortgage loan and a real estate finance lease will be fundamentally its financial cost. However, when making this analysis, we should not lose sight of the different taxation of one and the other, which can have a very relevant influence on the after-tax financial cost of each operation: although the interest that the banks apply in finance lease is normally higher than that of the loans, this difference is usually offset by the higher tax benefits of finance lease in Corporate Income Tax (IS).

In this article we will outline these differences in the taxation of both types of financing, distinguishing between those that affect their formalization (VAT, Transfer Tax [TPO], Stamp Duty [AJD]) and the use of the property (deduction of amortisation and interest in IS).

1. Tax cost of the formalization of a real estate purchase with mortgage loan and real estate finance lease

1.1. Purchase of the real estate

A real estate purchase financed with a mortgage loan involves two operations:

  1. the purchase itself, which is concluded between the seller of the property and the purchasing company; and
  2.  the mortgage loan, which is formalised in a deed by the financial entity and the buyer -mortgage debtor-. We leave aside the cancellation of the mortgage, which only generates notary and registry expenses, but not tax ones, as it is exempt from AJD.

On the other hand, a real estate finance lease is made up of three transactions:

  1. a purchase, which is concluded between the seller of the property and the financial entity -this is an essential difference compared to a purchase with a mortgage loan: in a real estate finance lease, it is the financial entity that acquires the property;
  2. the finance lease itself, which is a leasing contract that is formalised, normally in a public deed, between the financial entity -lessor- and the user company -lessee-; and
  3. the exercise of the purchase option by the lessee, once the minimum duration of the lease has been completed, by virtue of which it acquires ownership of the property by paying the lessor the agreed residual value.

Therefore, both the purchase with a mortgage loan and the real estate finance lease start with the purchase of the property. This purchase is taxed as follows:

  • If the seller is a businessperson for VAT purposes, we distinguish according to the type of real estate sold:
    • If it is a developable plot or a new building (first delivery), the purchase will be subject to and not exempt from VAT, and subject to AJD (at the general tax rate approved by the relevant Autonomous Community). Normally, in the purchase with a mortgage loan, the buyer can deduct this VAT; in a real estate finance lease, the buyer can deduct it in full, because, as we will see, leasing payments are never exempt from VAT. Therefore, the only effective fiscal cost will be the AJD, assuming that all the VAT is deductible.
    • If it is a rustic or non-developable plot, or a used building (second or subsequent delivery), the purchase will be exempt from VAT and subject to TPO (at the tax rate approved by the relevant Autonomous Community, which is always much higher than the AJD). Here lies the first difference between buying with a mortgage loan and real estate financial leasing: In the latter, an exemption in TPO applies as long as the buyer is a company habitually dedicated to carrying out financial leasing operations, the property is a building (it does not apply to land), the seller and the financial lessee are different (that is, it does not apply in case of lease-back) and the seller, the lessor and the lessee are not related to each other (therefore, it does not apply in the cases of real estate sold by estate agencies linked to banks, when it is that bank that acts as the financial lessor). But both in the purchase with mortgage loan and in the finance lease when the requirements of the TPO exemption are not fulfilled, the TPO can be replaced by the AJD (whose rate is much lower than the TPO) by means of the waiver of the VAT exemption.
  • If the seller is not a businessman for VAT-purposes (e.g. a private individual), the purchase is not subject to VAT, and therefore subject to TPO (the tax rate varies depending on the Autonomous Community). In this case, the VAT exemption cannot be waived and the TPO exemption provided for real estate finance lease does not apply, so the tax cost is the same in both operations (purchase with a mortgage loan and finance lease).

Thus, the taxation of the purchase is very similar in both scenarios. Only if the asset is a used building and the three parties are not related to each other; the real estate finance lease will save the cost of AJD.

Naturally, in real estate financial leasing, the tax cost is borne by the purchasing financial entity, but in all cases, it will be passed on to the lessee.

1.2. Means of funding

Once the property has been purchased, the second transaction is different depending on the financing method chosen:

  • Mortgage loan: In the purchase with mortgage loan, a mortgage loan deed is formalized between the financial entity and the buyer-debtor. The mortgage loan is subject to AJD, the tax base being the guaranteed responsibility, which includes not only the principal, but also up to 5 years of ordinary interests, up to 5 years of default interest and a percentage of the principal for expenses and costs in case of default. Although from 2018 the taxable person is the lender, since it is a business-to-business transaction, it can be agreed that the borrower shall bear this tax, and this will be precisely what the creditor will demand as a general rule.
     
  • Real estate financial leasing: in the financial leasing, the periodic instalments that the lessee pays to the lessor are always subject to and not exempt from VAT. VAT is due on each instalment (also on the part of the instalment corresponding to the finance cost), and the lessee is generally entitled to deduct it. If, as is normally the case, the finance lease is formalised in a public deed (a prerequisite for registration in the Land Registry), it will be subject to AJD, its tax base being the sum of all the instalments, i.e. the part corresponding to the recovery of the cost of the property and the part of the financial cost, but not VAT or the residual value at which the purchase option may be exercised.

1.3. Exercise of the purchase option

Finally, the exercise of the purchase option by the lessee will always be subject to and not exempt from VAT, and therefore, when it is formalised in a public deed, it will be taxed by AJD. The tax base of the AJD will be, according to the majority opinion, only the amount of the residual value.

Thus, the total AJD in real estate financial leasing will depend on the sum of the total amount financed, the financial cost and the residual value, while in the mortgage loan it will vary according to the loan amount and the other concepts that make up the mortgage liability (usually 30-40% of the principal). In short, the cost for AJD will be equivalent in both operations. Only the VAT taxation of the leasing instalments (as opposed to the exemption of the interest of the mortgage loan) will make the purchase with a mortgage loan more attractive from a tax point of view if the buyer is not entitled to a total VAT deduction.

Notary and registration costs will also be very similar in both figures. In the purchase with a mortgage loan there will be two deeds with economically quantifiable content (plus the cancellation of the mortgage, whose cost is comparable to a deed with no economically quantifiable content), while in real estate financial leasing there will be three deeds with economically quantifiable content, although the cost of the notarization and registration of the purchase option exercise, referring to the residual value, should be very low.

2. Differences in Corporate Income Tax between mortgage lending and real estate financial leasing

The most relevant differences are in the deduction to with the company is entitled in Corporate Income tax (IS), both for the amortisation of the property and for the financial costs (interest in the mortgage loan). It should be recalled that, although in the financial leasing the lessee is not the owner of the asset, for accounting purposes he is considered as such and, therefore, must register the property as an asset and amortise it accordingly.

2.1. Rules applicable to mortgage lending

When purchasing real estate with a mortgage loan, the general rules apply:

  • Depreciation of the property: The buyer will amortise the property (excluding the value of the land), as a general rule according to the straight-line method, the maximum annual straight-line coefficient being 3% for industrial buildings and 2% for all other buildings. If, at the time of purchase, the property is more than 10 years old, the maximum coefficient is doubled. It also doubles if the property is new and the buyer is entitled to the special regime for small-sized entities.
     
  • Deduction of the interests: The interest on the loan will be deductible with the general limits, i.e., 30% of the EBITDA (with no limit on the first million euros of financial expenses for each year).

2.2. Rules applicable to the real estate financial lease

The above conditions are improved for real estate finance lease agreements that meet certain requirements, including the following: the lessor must be a credit institution (Spanish or foreign) or a special lending institution (establecimiento financiero de crédito; Spanish, not foreign) and the agreement term must be at least 10 years. The applicable rules are as follows:

  • Depreciation of the property: The part of the instalment corresponding to the recovery of the cost of the property (excluding the part relating to the land, which cannot be amortised) is deductible up to the maximum annual straight-line coefficient indicated above multiplied by 2 (and in turn doubled if the construction is more than 10 years old and additionally multiplied by 1.5 if the lessee is subject to the special regime for small-sized entities, whether the property is new or not). In other words, real estate financial leasing allows for accelerated amortisation of the property (in half or, in the case of small companies, in a third of the time compared to an ordinary purchase). The excess that cannot be deducted in one financial year can be deducted in the following years without any time limit.
     
  • Deduction of the instalment: The part of the instalment corresponding to the financial cost is fully deductible, without the limits on the deductibility of financial expenses being applicable.

Therefore, real estate leasing allows the investment to be converted into a deductible expense more quickly, through accelerated amortisation and thanks to the non-application of the limit on the deductibility of financial expenses. This tax effect (which is not strictly speaking a saving but a deferral of taxation) increases the financial profitability of the company and must be taken into account as a fundamental factor when deciding between a real estate finance lease and a purchase financed with a mortgage loan.