The IRS loves leases. First of all, when a person makes a 'spread' by sub-leasing a property, the landlord continues to 'write off' his expenses such as depreciation, non-capitalized expenses, insurance, taxes, etc. So would we. If we had to suffer a month's vacancy without any income, or pay for any repairs under $100, or pay for an eviction, we'd deduct these expenses from rents. At the end of the year, all our net rental profits would flow through Schedule E under the passive income rules. Thus, there would be no payroll taxes to pay. If we suffered net losses, we'd get to deduct $25,000 from all other sources of income. But wait, it gets even better.
Suppose that we signed a 5-year Lease at a super low rent because the house needed a new roof. Or a new carpet. Or furnace. Air conditioner, etc. The home owner would have to write these off over 27.5 years, but because of our Lease, we'd be able to deduct their full value as amortized capital expenditures in the final year of the Lease against the rents. If the Lease required that we leave everything, or remove it at our own expense, at the option of the owner, he could realize an untaxed profit in the form of abandoned improvements so long as they hadn't been installed in lieu of rent. Here's how that might be used creatively.
Dr. Feelgood has a high income tax bracket and a couple of kids who he'll have to send through college one day. He and his wife create an irrevocable Trust and fund it with a gift of $20,000 to each kid. With the $40,000, the Independent Trustee buys a building lot that he leases at fair market rents to Dr. Feelgood's LLC for 15 years (or until the kids need money for college, whichever comes first). In the interim, the Trustee distributes the Lease rents to the kids for spending money. Dr. Feelgood constructs a Medical Arts building on the leased lot that he uses in his business. He amortizes mortgage debt and the entire cost of land development and construction over the Lease term, and he expenses all his Lease payments. At the end of the 15 year period, he 'loses' his Lease, and the free and clear building remains with the free and clear land. The Trustee sells the property and distributes the gain to the kids for college expenses.
Let's look at another situation. Suppose I were a dealer in land and you wanted to buy a large parcel from me with a low down payment and monthly payments. According to the IRC, I'd have to pay ordinary income tax on the entire purchase price in the year of sale regardless of how little down payment I'd received. Instead of selling the land to you, I give you a long term Lease on the property. I might even pledge the land and Lease as additional security for a loan if all the economics made sense. Your Lease payments would compensate me both for my risk and my accommodation. In effect, they'd amount to an 'interest only' loan payment, with a balloon due in the form of a purchase Option that I'd give you if you ever wanted to sell the property. When all the smoke cleared, we'd have created the effects of an installment sale without the tax penalties associated with one. Of course, all the economics of this deal would have to pass muster as a sound business proposition entered into for purposes other than tax avoidance.