Mechanics Lien Acts
• Much of the rhetoric around these laws is misleading.
– Much of it is couched in terms of the need to give
lien protection to those who supply the labor and
materials to construct buildings.
• Many of the acts do just as much, or more, to protect
– owners and
– construction lenders.
• Hence, many of these acts are now called
“construction lien acts” to avoid any implication that
they are primarily for the benefit of mechanics and
materialmen.
1
Donald J. Weidner
Guignard Brick Works v. Gantt
159 S.E.2d 850 (S.C. 1968).
Landowner
Contract to build house for
$19,000
General
Guignard
Brick
22,000 bricks
delivered to site
Paid $7,000 on
the contract
Used 7,000 bricks and then ABANDONED
the project
Used remaining 15,000 bricks to complete
construction, knowing they have not been paid for.
Spent $29,000 to complete construction
Sued Landowner, claiming “a lien for only
the brick which has not been used in
construction when the contract was
abandoned by [General. Landowner] knew
before he used these bricks” that Guignard
Brick had not been paid.
QUESTIONS:
What is Guignard Brick’s
argument on the basis of the
statute at Supp. 97-98?
Did not Guignard Brick
furnish the brick with the
“consent” of the owner?
2
Donald J. Weidner
Guignard Brick (cont’d)
• Bricksupplier said that, under Section 1 of the barebones
Mechanics Lien Act at Supp. P. 97:
– It “furnished” bricks
– That were “actually used” in the building
– “by virtue of an agreement with, or by consent of, the
owner of such building” such that it
• “shall have a lien upon such building . . . and upon
the interest of the owner . . . of the lot on which it is
situated to secure the payment of debt”
• What is the Owner’s response to Bricksupplier’s claim
under Section 1?
– Bricksupplier is a subcontractor and subcontractors do
not fall under Section 1.
3
Donald J. Weidner
Guignard Brick (cont’d)
• Section 2 (Supp. P. 97), on the other hand, refers to a lien
of “[e]very laborer, mechanic, subcontractor or person
furnishing material”
– when an “improvement has been authorized by the
owner”
– “shall have a lien” on the real estate
– “to the value of the labor or material so furnished”
– “subject to existing liens of which he has actual or
constructive notice”
• The lien may be enforced “as provided herein.”
4
Donald J. Weidner
Guignard Brick (cont’d)
• Consider the last sentence in Section 4 of the
barebones act (Supp. P. 98):
– It states that the lien given by Section 2 attaches
– When the laborer or materialman gives written
notice to the owner of the furnishing of labor or
material and its value
– “But in no event shall the aggregate amount of
liens set up hereby exceed the amount due by the
owner on the contract price of the improvement
made.”
5
Donald J. Weidner
Guignard Brick (cont’d)
• Mechanics lien statutes typically provide that the liens of all
the subcontractors relate back to some earlier point in the
development or construction process, that is, prior to the
point at which most of the materials were supplied or the
services were rendered.
– Can you see why as a matter of policy this should be
so?
• Barebones Act Section 7 for the “relation-back” mechanism:
“Such a lien shall not avail or be of force against any
mortgage actually existing and duly recorded prior to the
date of the contract under which the lien is made.”
– Highly atypical provision because it relates the lien back
to the potentially invisible date of the contract (with the
general contractor?).
• Statutes more commonly provide that mechanics liens
relate back to the commencement of construction (or to the
filing of a notice of commencement of construction).
6
Donald J. Weidner
More on Supplement pages 97-98
•
•
•
•
•
B
B
B
B
B
CLN & M
L
agrees to loan L
Advance #1 L
“I am not getting paid”
Advance #2 L
Brick Co.
• What does the barebones act provide?
– Section 5 states that “no payment by the owner to
the contractor [after having been given notice]
shall operate to lessen the amount recoverable by
the person so giving the notice.”
• What about a payment to a subcontractor?
– Is Advance #2 a payment “by the owner?”
• What of the “optional/obligatory” distinction?
– Recall Florida Statute 697.04(1)(a) (Supp. P. 99)
7
Donald J. Weidner
“Stop Notice” and Undisbursed Proceeds
• A number of states have statutory “stop notice”
procedures: “A lender or owner holding construction
funds who fails to honor an unpaid supplier’s stop
notice demand that it withhold sufficient funds to
satisfy the supplier’s claim will be personally liable to
the supplier for the amount owed.” Text at 657.
• Some courts impose an equitable lien on
undisbursed funds.
– Others say that equitable liens are not permitted because
the mechanics’ lien and stop notice statutes provide the
exclusive remedy to subcontractors.
8
Donald J. Weidner
“Stop Notice” and Undisbursed Proceeds
• “The remedy is statutory, and . . . often the claimant
must file a bond to indemnify the lender against
damages that might result from a wrongful claim.
[Depending upon state law, the Lender might file “a
corresponding bond and discharge the stop notice.”]
The lender may simply pay the claim and discharge
the stop notice, but if the claim is disputed or there
are insufficient funds to pay all stop notice claims,
litigation may be necessary.” Nelson & Whitmire, Real
Estate Finance Law (5th ed. sec. 12.6).
9
Donald J. Weidner
Commencement, Mechanics’ Liens and Purchase Money
Mortgages
Kloster-Madsen, Inc. v. Tafi’s Inc., 226 N.W.2d 603 (Minn.
1975), was an action to foreclose a mechanics lien
Brought by Kloster-Madsen, a General Contractor that
furnished labor and material to remodel a 3-story
building for its New Buyer. A Subcontractor began
work prior to the time Buyer acquired title or the loan to
finance it.
The case involved a priority battle between the mechanic
lien claimant General Contractor and lender Prudential
Life Insurance Company, which had closed a loan that
was part purchase-money loan and part improvement
loan.
General Contractor had begun work prior to the time the
New Buyer acquired title.
10
Donald J. Weidner
Kloster-Madsen, Inc. v. Tafi’s Inc., 226 N.W.2d 603 (Minn. 1975).
July 1970 Seller Purchase
A’ment for
$225,000
1.
Whether the electricians work on
July 30 constituted an
“improvement’ to the premises
and “the actual and visible
beginning of the improvement on
the ground” within the meaning of
the Mechanics Lien Act and
2.
If yes, whether “a purchase
money mortgage interest filed
subsequent to the beginning of
such improvement is entitled to
priority if neither the vendor nor
the purchase money mortgagee
authorized the commencement of
the work constituting the
improvement.”
General
Sub K
Commenced work on the
light fixtures (cut four
holes in ceiling and crawl
space without:
1)knowledge or
authorization of lender or
2) authorization of seller
[but, held, seller had
knowledge])
July 30,
1970
Seller
Court was faced with 2 issues:
anticipating
Buyer purchase,
entered into
contract
July 20, 1970
August 3, 1970
Buyer
Sub
Purchase closed
Deed
$PM (+Improvement $)
Buyer
note
11
Pru
Donald J. Weidner
Kloster-Madsen (cont’d)
• First, was the work on the light fixtures an
“improvement”?
• Second, was the improvement “visible”?
– Contractor argued that you could see it.
– Prudential argued, it was “not good enough” that it
be visible “to the naked eye”
• it had to be visible “to the mind’s eye.”
12
Donald J. Weidner
Kloster-Madsen (cont’d)
• The Court upheld the trial court’s finding that the
improvement was “visible”:
“The test for determining visibility is not, as Prudential
argues, that the improvement, although ‘visible to the
naked eye, must also be discernible to ‘the mind’s eyes
insofar as they tell one’s mind that an improvement has
been commenced.’ Rather, the test is whether the
person performing the duty of examining the premises
to ascertain whether an improvement has begun is able
in the exercise of reasonable diligence to see it.”
• What the “mind’s eye” would see if the naked eye
had been used with reasonable care in a search for
the commencement of construction?
13
Donald J. Weidner
Kloster-Madsen (cont’d)
• Third, is a pre-existing mortgage or mechanics lien
defeated by Prudential’s purchase money mortgage?
– Prudential relied on the special treatment given to
purchase money mortgages
– In general, purchase money mortgages are special
because they are preferred to certain pre-existing
claims against the buyer/purchase money mortgagor.
– The purchase money mortgage’s priority was explained
historically in terms of instantaneous transitory seisin
(which is what Prudential argued)
14
Donald J. Weidner
Kloster-Madsen (cont’d)
Purchase Money Mortgages are special because they often permit the
purchase-money mortgagee to defeat pre-existing claims against the
buyer/mortgagor. A purchase money mortgage takes precedence over:
1. Judgment liens against the mortgagor;
2. Liens arising from after-acquired property clauses in prior mortgages
executed by the mortgagor; and
3. Claims against the mortgagor for dower and homestead.
One Formalistic and Archaic Explanation: Instantaneous transit of seisin.
CR Gets judgment
lien on all real
estate owned by
Debtor
Seller
Pays $
conveys
fee
Debtor
Debtor
Loans $
Mortgage
Purchase contemporaneous
Money
Mortgagee
Under the purchase money mortgage rule, the purchase money mortgage
has priority over the prior creditor’s judgment lien. Classically, seisin passed
so quickly the prior judgment never had a chance to take hold of it.
15
Donald J. Weidner
Kloster-Madsen (cont’d)
• Court: the purpose of the doctrine of instantaneous
seisin is “to protect mortgagees from hidden or
undiscoverable liens.”
– The mechanic’s lien here is not hidden or
undiscoverable
• “Prudential is chargeable with constructive
notice of the attachment of a lien when the
actual beginning of visible improvements
occurs prior to the mortgage transaction.”
• Further, the court said: the mechanics lien act does
not make any distinction between purchase money
mortgages and other mortgages.
16
Donald J. Weidner
General Rule: Purchase Money Mortgage
Defeats Prior Mechanic’s Lien
• Contrary to Kloster-Madsen, the general rule is: a
purchase money mortgage, whether in favor of the grantor
or a third party, takes precedence over a mechanics’ lien.
• An additional rationale for rejecting the outcome in KlosterMadsen:
– A mechanics’ lien statute does not include a contracting
vendee in possession within the meaning of “owner” of
an interest in the property to which the lien could
attach.
• In short, Kloster-Madsen was an extreme case insofar as
the mechanics’ lien was preferred to a purchase money
mortgagee who neither authorized nor knew of the
improvements, when the Seller knew of but did not
authorize the improvements.
17
Donald J. Weidner
Williams & Works, Inc. v. Springfield Corp.
(Text p. 646)
Convey
Developer
Fee Owners
Developer had the
right to terminate the
engineering contract
at end of any phase
Law Dev. Co.
8/29/72
Kelly M & Inv.
Co.
12 holes into ground,
6” diameter “staked”
Actual knowledge of
W&W’s work
1/4/73
1/9/73
Assigns
Mortgage
(unclear
when)
Kelly
2/10/73
3/25/74
Kelly holds the 1st
Mortgage and the
2nd Mortgage, both
of which Kelly
acquired after actual
knowledge of the
work W & W had
previously
performed.
18
June 1972
W&W
contracts to perform
engineering services
Formal contract:
Mechanics
Lien
Claimant
W&W
Engineers
Phase #1:
Feasibility Studies
Phase #2:
Finalize all plans
Sells and conveys land
City
Nat’l
Bank
Springfield
Contacts with interest
in bldg. Apt. complex
Mortgages
land to CNB
Developer
Springfield
Records the
1st mortgage
2nd Mortgage
Records 2nd
Mortgage
Developer
Springfield
Phase #3:
Physical
Construction Begins;
W&W supervises—sets
stakes out
Files action to
foreclose its
mechanics lien
ML
ML
Donald J. Weidner
Williams & Works (cont’d)
• Like Kloster-Madsen, this is a lien priority dispute between
the mortgagee and a mechanics lien claimant who started
work for the Developer before the Developer acquired
title.
• FN. 5, p. 647, has the “much amended” Section 1.
• Do you see the language in Section 1 that embraces a
general contractor?
– “Every person who shall, in pursuance of any contract .
. . existing between himself as contractor, and the
owner . . . .”
– General is called simply “contractor” for most of the
statute
– [but is also referred to as “original or principal
contractor” in other parts]
19
Donald J. Weidner
Williams & Works (cont’d)
• Do you see the language that specifically embraces
subcontractors? Near the end of Section 1:
– “and every person who shall be subcontractor,
laborer, or material man . . . to such original or
principal contractor”
• Section 1 specifically refers to “any engineering plan”
• However, the court held that Section 1 does nothing
more than describe what is “lienable.”
20
Donald J. Weidner
Williams & Works (cont’d)
• Section 9[3] of the mechanics’ lien act in fn. 1
contains a priority rule.
• Consider the lien priority (relation-back) point:
– Mechanics’ liens shall take priority over other liens
“which shall either be given or recorded
subsequent to the commencement of said building
. . . or improvement.”
• “Improvement” is defined in statute at FN. 6 to include
“designs or engineering plans.”
21
Donald J. Weidner
Williams & Works (cont’d)
• Engineers Williams & Works—argue that their mechanics
lien is superior to the mortgages that were both given and
recorded after their “improvement” (their “engineering
plan”) was begun.
• Given the statute, how could the mechanics lien claimants
possibly lose this case?
• Held: “[N]on-visible, off-site engineering services . . .
although lienable under Michigan law, do not signal
‘commencement’ of a building . . . or improvement for the
purpose of fixing priority under Michigan’s Mechanics’ Lien
Law.”
– The “improvement” was not an “improvement” for lien
priority purposes
• Michigan legislature subsequently specifically embraced
the Williams v. Works result (p. 655)
22
Donald J. Weidner
Summary of Construction Lien Concepts
(Text p. 655)
• When does a lien attach?
– The three most common possibilities are the date
• when the general contract is first executed
• when construction begins, or
• when a claim for payment is first filed.
• What must be done to perfect a lien?
– Typically, a lien must be perfected by filing the
underlying claim within a certain amount of time after
the work has been performed or construction
completed.
• How much time is allowed to foreclose a perfected lien?
– Also varies from jurisdiction to jurisdiction.
23
Donald J. Weidner
Construction Lien: Concept Summary (cont’d)
• As of what time does the perfected lien take priority?
Depends upon the state. Typically, as of:
– A. Commencement of Construction; or
– B. Filing of a Notice of Commencement of
Construction
• The Uniform Construction Lien Act (similar to
Florida) requires the owner to file a “Notice of
Commencement” prior to the beginning of work.
– In Florida, the subcontractors, in turn, must file a
“Notice to Owner” (and lender) that they are about
to begin work
• If a lien claimant subsequently records a lien, the
priority of that lien is as of the date of the
recording of the Notice of Commencement.
24
Donald J. Weidner
Construction Lien: Owner v. Subcontractor
Recap
• In many states, the term “general contractor” is not
used in the construction lien statute. Rather, a
“contractor” is defined as someone in privity with the
owner
– Florida uses the privity concept
• Lienors in privity can recover on their contract with the
owner
• The owner’s liability to lienors who are not in privity
with it (subcontractors) can often be summarized as
follows:
Contract Price
Minus: Proper Payments (at least those prior to any notice)
Minus: Reasonable Cost to Complete (upon “abandonment”)
Equals: Extent of owner’s liability to all non-privity lienors.
25
Donald J. Weidner
Wrongly Disbursed Funds
•
Wrongful disbursal of funds by lender can result in
the lender’s loss of lien priority as against a
mechanics’ lien claimant
–
•
just as wrongful disbursal might cause a lender to lose its
lien priority as against a subordinator
The same considerations apply as in the case of a
priority fight between a construction lender and a
subordinator
– including whether the optional vs. obligatory
distinction applies
26
Donald J. Weidner
J.I.Kislak Mortgage Corp. v. William Matthews
Builder, Inc. (Text p. 595)
Developer and Construction lender entered into a construction
loan agreement
1. Developer executed a construction loan note and
mortgage to construction lender
2. Construction lender recorded the mortgage
3. Construction subsequently began
• Construction lender’s draw inspector fraudulently
authorized progress payments for work that was not done
– Some subcontractors were fully paid
– Masonry subcontractor was paid nothing
• Developer defaulted on the loan and Construction lender
filed to foreclose.
• Masonry subcontractor intervened in the foreclosure,
asserting that it had a mechanics’ lien that should take
priority over the lien of the construction loan mortgage.
27
Donald J. Weidner
Kislak Mortgage (cont’d)
• “In the usual case it is apparent that a mortgage lien
would take priority over a mechanics’ lien that was filed
after the effective date of the mortgage provided none of
the work covered by the mechanics’ lien was done prior
to the recording of the mortgage.”
– That is, from the lender’s point of view, everything started out as
it should to give the lender first lien priority.
• “However, there is an exception to the rule which
applies when . . . some of the disbursements are
voluntarily made at a time subsequent to the effective
date of the mechanics’ lien.”
28
Donald J. Weidner
Kislak Mortgage (cont’d)
• “Where a mortgage is recorded prior to the time that a
mechanics’ lien attaches to the property and it is optional
with the mortgagee as to whether a further advance is to
be made, and where the mortgagee has made an advance
with knowledge of the fact that the mechanics’ lien has
already attached, to the extent of such later advances, the
mortgage is inferior to the mechanics’ lien.
– Even though the lender “did not have actual notice of
attachment at the time that the advancements were
made”
• The court appears to be saying that, even though there is “no
actual notice,” there is “constructive knowledge”
– The lender was “charged with knowledge of the law that
mechanics’ liens relate back”
29
Donald J. Weidner
Kislak Mortgage (cont’d)
• Essentially the mechanics’ lien took priority to the extent the
lender made voluntary payments after knowledge that work
had such that mechanics liens could be filed.
• “As between a subcontractor which did not have the
protection of a construction loan agreement and a
mortgage lender which did not avail itself of the protection it
had under the agreement it is not inappropriate . . . that the
mortgage lender bear the loss.”
• Note, in this case, the lender did not even ask for receipts
when it made the voluntary payments.
– So Lender bore the risk of loss when its draw inspector took a
bribe?
30
Donald J. Weidner
Wrongly Disbursed Funds (cont’d)
• Compare Guaranty Mortgage Co. of Nashville v.
Seitz (Text p. 657):
“The lien of a deed of trust securing a construction loan
has priority over mechanics’ and materialmen’s liens
only to the extent that:
a) the funds disbursed actually went into the
construction, or
b) to the extent that the construction lender used
reasonable diligence in disbursing the
construction loan.”
– Can the lender use reasonable diligence and
still have money stolen by an employee?
31
Donald J. Weidner
Also Compare: Florida Statute on
Mortgages for Future Advances (Supp. P. 99)
697.04 Future advances may be secured. -• “(1)(a) Any mortgage or other instrument given for
the purpose of creating a lien on real property, or on
any interest in a leasehold upon real property, may,
and when so expressed therein shall, secure not only
existing indebtedness, but also such future advances,
whether such advances are obligatory or to be
made at the option of the lender, or otherwise, as
are made within 20 years from the date thereof, to
the same extent as if such future advances were
made on the date of the execution of such mortgage
or other instrument . . . . Such lien, as to third
persons without actual notice thereof, shall be valid
as to all such indebtedness and future advances from
the time the mortgage or other instrument is filed for
record as provided by law.”
32
Donald J. Weidner
Landlords Must Capitalize the Cost of Obtaining
Tenants
• We have a tax on income, rather than, by contrast a tax
on gross receipts. The basic idea behind income is an
enhancement in wealth. Therefore, the tax law attempts
to match receipts with the cost of generating those
receipts.
• A landlord must capitalize the cost of obtaining a tenant
and amortize that cost over the life of the lease that will
generate receipts (See text p. 693).
– That is, the landlord is not permitted to expense
(currently deduct) all of the cost of obtaining a tenant
because the cost is for a lease that will generate
receipts for years.
– The landlord must attribute a portion of the cost of the
lease to the rent receipts that will be received every
year.
33
Donald J. Weidner
Landlord Must Capitalize Cost of
Obtaining Tenant (cont’d)
• For example, at the beginning of year 1, Landlord
Pays Tenant $10 to enter into a 10-year lease
– Landlord may not deduct the full $10 payment in
year one.
– Rather, Landlord must “capitalize” the $10
payment (the landlord gets basis in the lease
asset)
– Landlord then deducts the payment $1 at a time-$1 per year for each of the 10 years of the lease
– Thus matching the rent receipts with the cost of
generating those receipts
34
Donald J. Weidner
Tenants Must Capitalize Payments to Obtain
Favorable Leases
• Similarly, a tenant may not deduct a bonus it pays to
acquire a lease ;
– The bonus payment is treated as a cost of acquiring
the lease and must be capitalized (treated as the cost
(basis) of the asset—the leasehold estate) and then
amortized over each year of the life of the lease. (See
Text p. 693).
• However, a tenant’s payment of advance rent to a
landlord at the acquisition of the lease is taxable to the
landlord when the landlord receives it. (See Text p. 693).
35
Donald J. Weidner
Tenants Depreciate their Investments in
Buildings on Land they Lease
•
Tenants often construct buildings on land that they
lease (recall Penthouse, Cambridge).
• A tenant who invests in a building that is
1. used in its trade of business or
2. held for the production of income,
is allowed to recover its investment in the building (basis)
through depreciation (“cost recovery”) deductions. (See
Text p. 693).
36
Donald J. Weidner
Write-offs Available to Tenants Who
Construct Improvements on Leased Land
• In short, a tenant who leases land and constructs a
building on it may be doing all of the following:
1. amortizing its investment in the ground lease
2. deducting the rent it is paying under the ground
lease and
3. depreciating its investment in the building it
constructs on the leased land.
37
Donald J. Weidner
Are Tenant-Constructed Improvements Rent the
Landlord Must Include in Income?
The Chirelstein Hypo
FO
Pays
$800,000
Conveys tract of
land
NFO
LL
20 year ground
lease
MFG T
T to pay relatively low annual
rent
T to construct factory to
cost at least $1,000,000
Factory to become property of LL on termination of
the lease [“thus…apparently… a form of ‘rent in
kind’.”]
Constructs building
LL
T
With 25 year U.L. (5 years longer than
the lease)
That has an expected depreciated
value of $200,000 at the time the 20year lease expires
Pays relatively low annual Cash
Rentals
38
T
Donald J. Weidner
General Considerations
In defining income, Glenshaw Glass emphasized a
“realized” disposable increase in wealth:
– “Here we have instances of undeniable accessions to
wealth, clearly realized, and over which the taxpayers
have complete dominion.”
• Is the factory building constructed by the tenant
“income” to the Landlord? Is it an
– “accession to wealth,”
– “clearly realized,”
– “over which the taxpayer has complete dominion”?
• What is the “right result?”
– If it is income, when are these criteria met?
– If it is income, in what amount?
39
Donald J. Weidner
The Realization Requirement
•
•
Chirelstein: “because the realization requirement
exists, the income tax is a tax on transactions
instead of being a tax on income in the economic
sense.”
There are four possible answers to the question of
when a tenant-constructed building is income to the
landlord. It can be taxed as either
1. prepaid rent
2. prorated rent
3. postpaid rent or
4. no rent at all
40
Donald J. Weidner
Possibility # 1: Prepaid Rent
1. Possibility #1: The Landlord receives Prepaid Rent in
the year in which the building is constructed.
• How much rent?
– The present value of the right to get the building at the
end of the lease term.
Assume the building is expected to be worth $200,000 at
the end of 20 years.
– reduce that $200,000 payment at the end of year 20 to
its present value.
•
Using an 8% discount rate, the present value is about
$50,000.
– If the landlord reports the present value of the future
payment in income at the beginning of the lease, you
could consider the transaction closed at this point, and
not require the landlord to report any further income
when the lease ends.
41
Donald J. Weidner
Possibility # 1: Prepaid Rent (cont’d)
• As soon as the landlord reports the building in
income, the landlord receives a $50,000 basis in it.
– Sometimes referred to as a “tax cost basis”
• Landlord’s basis in the building at the termination of
the lease at the end of year 20 would be $50,000, the
amount previously included in income.
• Landlord’s depreciation deductions for the last five
years of the building’s useful life (after the lease
expires and the landlord’s interest in it becomes
possessory), on a straight-line method, would be:
$50,000/5 = $10,000 per year.
• Note: To implement this prepaid rent approach, there
must be a prediction of the value the building will
have at the end of 20 years.
42
Donald J. Weidner
Possibility # 2: Prorated Rent
2. Possibility #2: The Landlord receives rent that is prorated
over the life of the lease.
– How much rent?
• The anticipated value of the building at the end of the lease term,
$200,000.
– When?
• Require the landlord to include some of the building’s value in income for
each year of the lease.
Ex., $10,000 for each of 20 years ($10,000 X 20 =
$200,000).
• Landlord’s basis in the building on termination of the lease
would be $200,000—the amount previously included in
income (a “tax cost basis”).
• Landlord’s depreciation for the remaining 5 years of useful
life after the lease expires: $200,000/5 = $40,000 per year
(using a straight-line method of computing depreciation).
• The Prorated Rent approach requires, as did the Prepaid
Rent approach, a prediction of the value of the building at
the end of the 20 year lease term.
43
Donald J. Weidner
Possibility # 3: Postpaid Rent
3. Possibility #3: The Landlord receives Postpaid Rent.
• When is the income realized?
– At the end of the 20 year lease, when the Landlord’s reversion in
the building becomes possessory.
• How much rent?
– The fair market value of the building when the lease terminates.
– If the building’s actual value turns out to equal the anticipated
value, that amount is $200,000 in this hypothetical.
• Landlord’s basis in the building would be $200,000, the
amount included in income.
– Again, a “tax cost basis”
• Landlord’s depreciation deduction for each of the
remaining 5 years of the building’s useful life: $200,000/5
= $40,000 per year.
44
Donald J. Weidner
Postpaid Rent (cont’d)
• The Postpaid Rent alternative has the advantage in
that it does not require an initial estimate of the value
at the end of 20 years.
– But it still requires an appraisal of the property at
the end of the lease.
– The Postpaid Rent alternative is the approach the
first IRS regulations took: that the expiration of the
lease was the landlord’s realization event.
• When the landlord’s reversion in the building became
possessory.
– The courts initially rejected this approach.
45
Donald J. Weidner
Pre-Helvering v. Bruun
• Cases prior to Bruun held that there was no taxable
realization to the lessor either
– when the leasehold improvements were installed
by the tenant or
– when the improvements vested in the lessor at the
expiration of the lease.
• The idea was that the building could not be severed
and disposed of separately from the land, and thus
was not “portable and detachable” unless it was torn
down and scrapped.
• Another way of stating the notion is that “profit” must
be severed from “capital” to be taxed.
• The realization requirement turns what might have
been a tax on economic enhancement in wealth into
a tax on transactions.
46
Donald J. Weidner
Helvering v. Bruun
309 U.S. 461 (1940)
1915
LLLeased lot & building for 99 years T
T may, on giving bond to secure 2
years’ rent, remove or tear down any
bldg.
On termination of the lease, T to
surrender all land, buildings, and
improvements
T
1929
1933
LL
Removed existing buildings and constructed a new
bldg with a UL of 50 years. [85 years left on the
lease]
T
defaulted
[nonpayment of rent & taxes]
LL regained possession of land and building
FMV building constructed by T is
$64,000
stipulation
LL’s “unamortized cost” of old bldg. is 13,000
“Net FMV” [net “gain”
as at 7/1/33, says IRS]
$51,000
47
}
Donald J. Weidner
Bruun and Its Aftermath: From Possiblility # 3 to
Possibility # 4
• Bruun held for the IRS, concluding that the landlord
had income when the tenant defaulted and the
landlord’s reversion became possessory (Possibility
#3).
• One might ask what would happen if, upon the
tenant’s default, the value of the land had decreased.
– Would the landlord have been allowed a deduction?
• Congress reversed Bruun by enacting sections 109
and 1019
– thus adopting Possibility # 4.
48
Donald J. Weidner
Possibility #4: No Rent
4. Possibility # 4: The Landlord has No Rent At All
from the Building Constructed by the Tenant.
– The building is treated as unrealized appreciation
that is not taxed as “rent” at any time.
• With nothing included in income, the landlord’s basis
in the building at the expiration of the lease is zero.
• Because the landlord’s basis in the building is zero,
the landlord gets no depreciation deductions during
the remaining useful life of the building.
49
Donald J. Weidner
Sections 61, 109 and 1019 in A Nutshell
• Sec. 61 regulations provide that, if a tenant
pays any of the landlord’s expenses, the
payments are additional rental income to the
landlord.
• Further, if a tenant places an improvement
on the real estate that is a substitute for rent,
the improvement is additional rental income
to the Landlord.
– The test for whether it is rent is the intent of the
parties.
50
Donald J. Weidner
Sections 61, 109 and 1019 (cont’d)
• Sec. 109 states that, on termination of a lease, the
landlord does not have income on account of the
value of an improvement erected by a tenant (See Text
p. 693, Supp. P. 187).
• The regulations provide:
– “However, where the facts disclose that such
buildings or improvements represent in whole or in
part a liquidation in kind of lease rentals, the
exclusion shall not apply to the extent that such
buildings or improvements represent such
liquidation.”
• This regulation has never been vigorously
enforced.
51
Donald J. Weidner
Sections 61, 109 and 1019 (cont’d)
• Sec. 1019 is a basis rule that is consistent with the
Section 109 exclusion of what could otherwise be
seen as income.
– Section 109 states that there is no income and
– Section 1019 states that, as a consequence, there
is no basis increase (no tax cost incurred, hence
no “tax cost basis”). (Supp. P. 187).
52
Donald J. Weidner
World Publishing Co. v. Commissioner
(Supplement p. 188)
Net lease for 50 years
1928
OFO
Annual rental averaged $28,500
T
Tenant must construct a 6 story
building costing at least $250,000
Building to become part of the
realty on construction.
1950
Tenant agrees to subordinate to
a mortgage up to a stated
percentage of ground value.
Sold all its
interest in 1950
$700,000, subject
to the lease to T,
which had 28 more
years to run
Taxpayer:
WORLD
PUBLISHING
NFO
ACCEPTED: The FMV of the land alone was $400,000.
QUESTION: What did TX, the New Fee Owner, purchase with the extra $300,000?
STIPULATED: When the NFO, World Publishing Co., purchased whatever it purchased,
the remaining useful life of the building “was not greater than the unexpired term of the
lease.” That is, the remaining useful life of the building was equal to, or shorter than, the
remaining term of the lease.
53
Donald J. Weidner
World Publishing (cont’d)
•
•
•
Is there anything facially confusing about NFO’s claim
for “Depreciation and Amortization?”
Recall, a depreciation deduction is only available if the
property is
1. used in a trade or business, or
2. held for the production of income.
IRS position is: NFO has merely a reversionary interest,
which is not sufficiently possessory to be depreciated.
– The person claiming a depreciation deduction must
have something akin to a substantial present
possessory interest.
• Recall IRS argued this in Bolger
54
Donald J. Weidner
World Publishing (cont’d)
•
Blackmun rejected the argument that NFO did not
have a sufficient possessory interest.
1. Consider the analogy of a building constructed
by a landlord and then leased:
• “Where an owner of land erects a building on it and
then leases it, he is still entitled to recover the cost
of the improvement by depreciation deductions.”
–
Even though the present possessory interest in the building
is in the tenant.
•
Thus, the normal landowner/building owner is not
required to have a present possessory interest in a
building to depreciate the landowner/ building
owner’s investment in it.
2. The facts of the particular tenant constructed
improvement matter:
• Here, taxpayer “clearly owned the building in more
than a bare-legal-title sense.”
55
Donald J. Weidner
Then-Judge Blackmun’s Factors
Judge Blackmun: the NFO had invested in an ample bundle
of sticks to claim a depreciable interest:
1. The building became a part of the land and thus the
Lessor’s on construction.
–
State law provided that a building permanently affixed to the
realty becomes a part of the realty.
2. Lessor had the right to inspect, reject and amend plans
for the building.
3. Lessor was a named insured of the building.
4. Lessor had a right to subject the building, and not just
the fee, to a mortgage.
5. Lessor could prevent lessee from making major
($10,000 or more cost) changes to the building without
Lessor’s consent.
56
Donald J. Weidner
World Publishing (cont’d)
• IRS also argued: New Fee Owner can not purchase more of an interest
than its seller had.
– Here, the seller (OFO) did not have a depreciable interest in the
building.
• IRS also argued: it would be anomalous to have both the tenant and the
new landlord (NFO) depreciating the same building.
– The tenant already has a depreciable interest in the building (the
tenant paid to have it built)
• Blackmun fails to see the anomaly: “each taxpayer has made a separate
wasting investment which meets the statutory requirements for
depreciation.”
– Each is recovering his own investment.
• “That each is concerned with the same building is of no relevance.”
• Analogy: two taxpayers who own separate, undivided interests in real
estate.
57
Donald J. Weidner
M. DeMatteo Constr. Co. v. United States
(Supplement p. 197)
• Same essential facts as World Publishing.
– The tenant-constructed building has a useful life no greater than
the unexpired term of the lease.
• The New Fee Owner argued it was entitled to
depreciation
• The court rejected World Publishing, saying: “the selling
lessor has nothing to sell except bare legal title and the
purchaser buys nothing more.”
• The New Fee Owner might have argued it could
amortize the premium it paid for a favorable lease:
– “It is the lease which produces the income, not a building which
the lessee constructed and which is going to reach the end of its
useful life before the taxpayer obtains possession.”
• However, the court said the NFO could not on appeal
raise the new argument of “a premium lease
amortization theory”
58
Donald J. Weidner
Geneva Drive-In Theater, Inc.
(Supplement p. 199)
•
Here, the tenant-constructed improvements have a useful
life that is 5 years longer than the remaining (4-year) term
of the lease.
1950 OFO 20-year lease
T
Pursuant to lease, builds
T
1965 OFO sells for $200,000 above
NFO
price for land alone.
What did the NFO buy for the extra $200,000?
NFO claimed: It purchased the improvements and could
immediately depreciate its investment in them.
IRS claimed: NFO purchased a future interest: the right to
acquire the depreciable assets at the end of the lease.
The investment in the future interest is not depreciable
until the interest becomes possessory at the end of the
lease.
59
Donald J. Weidner
Geneva Drive-In (Tax Court)
• First statement of the court: “To qualify for [the
depreciation] deduction the taxpayer has the burden of
proving that he has a depreciable interest in the property in
the sense that he has made an investment in it and will
suffer the economic loss resulting from its deterioration
through obsolescence.”
– Focus on the words “will suffer the economic loss”
• It could mean that the taxpayer must suffer an
economic loss
– The latter meaning is hard to square with prior
case law
• It could mean “whatever economic loss there is”
• Did the taxpayer in Geneva Drive-In have more or less of
an economic investment in the asset than the taxpayers in
Mayerson, Bolger and Tufts?
60
Donald J. Weidner
Geneva Drive-In (Tax Court)(cont’d)
• Second statement of the court: “[The improvements] were
not [1] used in his trade or business or [2] held for the
production of income.”
– “The rent which he received compensated him only for
the use of the land, a nondepreciable asset.”
– Since the tenant constructed the building, the tenant
would not have paid rent for it.
• Third statement of the court: NFO purchased only so
much of an interest as the OFO had.
– And the OFO did not have a depreciable interest
61
Donald J. Weidner
Geneva Drive-In (Tax Court)(cont’d)
• Consider why we do not see the OFO as having a
depreciable interest.
• Is it because, under our tax law, we fail to see OFO as
having realized income with respect to the tenantconstructed improvement?
– Thus the court said: “Other than this reversionary
interest, [NFO] acquired no present interest in the
theatre improvements.”
– Compare World Publishing, in which Blackmun said
that many fee owners get to depreciate buildings that
are encumbered by long-term leases
• Nor did NFO show “that they paid any premium for the
assignment of the lease which would entitle them to
amortization deductions for the remainder of its term.”
62
Donald J. Weidner
Geneva Drive-In (Tax Court)(cont’d)
• In explaining why this was neither [1] trade or business
nor [2] production of income property, the Tax Court
stated:
– “The improvements could produce no income for [the NFOs] until
the lease terminated and their interest ripened into ownership of
the improvements. Their interest in the improvements did not
diminish in value as a result of the passage of time but, instead,
[the NFOs’ interest in them] increased in value as the time for the
actual enjoyment of the improvements approached.”
• However, the same is not generally said in cases of
lessor-constructed improvements that are subjected to a
lease.
63
Donald J. Weidner
Geneva Drive-In (Tax Court)(cont’d)
• In the alternative: even if the improvements
deteriorated in value prior to the expiration of the
lease, the NFOs “did not suffer any economic loss
because of that deterioration.”
– Because the purchase price “no doubt” took into
account that they would not receive the property
until the end of their lease, and that it would then
be in a deteriorated state.
• The NFO “acquired none other than the reversionary
interest,” which “was not a depreciable one.”
64
Donald J. Weidner
Geneva Drive-In (Tax Court)(cont’d)
• The court said the lessee bore the risk of economic
depreciation during the unexpired lease term
because the lessee was required to surrender the
building in as good a condition as when it was
constructed.
– “therefore, whatever depreciation occurred [during
the unexpired term of the lease] was suffered by
the lessee.”
65
Donald J. Weidner
Geneva Drive-In (Tax Court)(cont’d)
• “There may be situations where lessee-constructed
improvements enhance the value of real property
acquired subject to a lease. Such improvements, for
example, may provide added assurance that the land rent
to which the purchaser becomes entitled will be
collectible. * * * In the final analysis, however, the
existence of improvements in such circumstances adds
value to the lease which produces income to the
purchaser, and in appropriate cases the courts have
indicated that the premium value of the lease is
amortizable.”
• “On the other hand, in other cases, where the purchaser
may be required to remove or rebuild deteriorated or
obsolete structures, their existence may be a negative
factor in their purchase.”
66
Donald J. Weidner
Geneva Drive-In (Tax Court and 9th Circuit)
• Tax Court said, and 9th Circuit agreed: World
Publishing allowed amortization, not depreciation.
• Tax Court added: even if World Publishing allowed
depreciation, it is distinguishable because the NFO in
World Publishing purchased a larger bundle of sticks:
– the NFO in World Publishing could
• borrow money and secure it by a mortgage to which the
tenant agreed to subordinate; and
• attach whatever clauses its mortgagee would require to
the lessee’s insurance policies.
67
Donald J. Weidner
Geneva Drive-In (conclusion)
• Apparently, the court concluded that the NFO in World
Publishing had more of a present possessory interest
than the NFO in Geneva.
• Ninth Circuit affirmed, with one correction:
– “[T]he Tax Court said: ‘[The taxpayer’s] interest in
the improvements did not diminish in value as a
result of the passage of time but, instead, increased
in value as the time for the actual enjoyment of the
improvements approached.’”
– “Insofar as [the Tax Court opinion] makes
entitlement to depreciation depend upon actual
changes in market value, it is erroneous.”
68
Donald J. Weidner
Section 1031 and Sale-Leasebacks
(Supplement p. 212)
• Century Electric, Jordan Marsh and Leslie involve
attempts by the IRS to disallow “losses” claimed by
taxpayers who “sell” property and “lease” it back.
– The IRS weapon of choice in each of these three
cases was the Code’s best known nonrecognition
provision: Section 1031.
• Century Electric and Jordan Marsh represent the classic
split in the Circuits on how to interpret Section 1031. The
most recent of the three cases, Leslie, sided with Jordan
Marsh.
• Consider first the basic rules in section 1031(a)-(d) and
then consider a series of hypotheticals.
69
Donald J. Weidner
Section 1031
• Section 1031(a) states that there shall be no recognition
of gain or loss if property held for productive use in a
trade or business or for investment is exchanged “solely”
for like-kind property that will itself be held for use in a
trade or business or for investment.
• That is, even though we can perceive “income” (or loss)
because there has been an exchange that satisfies the
realization requirement, section 1031(a) states that the
income (or loss) that has been realized will not be
recognized (at least not at the time of the exchange).
70
Donald J. Weidner
Section 1031 (cont’d)
• A quick read of section 1031(a) suggests that, for it to
apply, there must be:
– 1) an exchange;
– 2) of qualified properties;
– 3) that are of like kind.
• The exchange of real estate held for investment with
real estate held for productive use in a trade or
business may be a like kind exchange if the
transaction is otherwise qualified.
71
Donald J. Weidner
Mixed Exchanges
• What if the exchanges are not solely of like kind
properties?
• Section 1031(b) states that the taxpayer will recognize
some gain if it receives some “other property or money”
as part of the mix.
• Section 1031(c) states that the taxpayer may not
recognize any loss if it receives any “other property or
money”.
72
Donald J. Weidner
Mixed Exchanges (cont’d)
• To recap: if the taxpayer receives some
unqualified property as part of the mix in the
exchange
– There can be some recognition of gain
– There can be no recognition of loss
73
Donald J. Weidner
Ex. #1. A owns Ableacre, property with a FMV of $3,000 in
which A has an Adjusted Basis of $1,000. A
exchanges it for B’s like-kind property, Bakeracre,
A which is also worth $3,000.
B
Bakeracre
$3,000
FMV
FMV $3,000
Ableacre
$1,000 AB
How much gain has A realized?
$3,000 Amount Realized
-1,000 Adjusted Basis
$2,000 Realized Gain
How much, if any, of the realized gain is
recognized?
74
Donald J. Weidner
Example 1 (Cont’d)
The realized gain is not recognized if §1031(a)(1) applies.
§1031 provides nonrecognition of gain or loss to an
exchange of properties held for productive use in a trade or
business or for investment.
A’s gain is realized (we see it) but is not recognized (we will
ignore it for the time being) at the time of the exchange.
– The gain does not disappear, it is simply postponed.
– A’s basis in the property A received from B, Bakeracre,
becomes $1,000. See §1031 (d).
– It is “substituted basis property” (7701(a)(42)) that is
“exchanged basis property” (7701(a)(44))(basis is
determined “by reference to other property held . . . by
the person for whom basis is to be determined” ).
– If A later sells Bakeracre for $3,000 cash, the
postponed $2,000 gain would be recognized on that
subsequent sale.
75
Donald J. Weidner
Example #2
Assume A’s property, Ableacre, was worth only $2,000 so that
A also had to give $1,000 cash (referred to as boot) to get
Bakeracre, B’s property with a FMV of $3,000.
A
B
Bakeracre
$1,000 cash
Ableacre + $1,000 cash
+
$2,000
FMV
FMV $3,000
Property
Ableacre
$1,000 AB
A, in effect, transferred Ableacre for a 2/3 interest in Bakeracre and paid $1,000
cash for the other 1/3 interest in Bakeracre. His gain on the transfer of Ableacre is
$1,000. It is realized but not recognized. Because A also paid $1,000 in cash, A’s
basis in the total interest in Bakeracre is the basis he had in Ableacre, $1,000,
increased by the $1,000 cash paid, to $2,000.
Thus, if A subsequently sold Bakeracre for $3,000 cash, A would recognize a $1,000
gain at the time of that sale:
$3,000 Amount Realized
-2,000 Adjusted Basis
$1,000 Realized Gain
76
Donald J. Weidner
Example #3
Assume, now, that A’s property, Ableacre, is worth
$3,500, so that B gives A $500 cash as “boot”:
A
$3,500 FMV
$1,000 AB
B
Bakeracre + $500 cash
Ableacre
$3,000 FMV
+
500 CASH
A has a realized gain of $2,500. How much is recognized?
The exchange is no longer solely in kind as required by §1031(a).
§1031(b) says that the $2,500 realized gain is recognized to the extent of
the $500 boot received.
What is A’s basis in the property A received?
§1031(d) says that the basis of the property A received (Bakeracre) is:
Basis of property given up
$1,000
- money received
- 500
+ any gain recognized
+ 500
- any loss recognized
Basis in property received
77
$1,000
Donald J. Weidner
Example #3 (Cont’d)
Thus, if A later sells Bakeracre for $3,000 [the value it
had when A took it in the exchange from B], A will
recognize the additional $2,000 gain.
$3,000 Amount Realized on sale of Bakeracre
- 1,000 Adjusted Basis in Bakeracre
$2,000 Gain Recognized on sale of Bakeracre
Thus, the realized gain on the exchange was
recognized in two installments:
$ 500 at the time of the exchange
$ 2,000 at the time of the eventual sale of the
property received
The end result of the exchange followed by the sale is
that A has $3,500 cash with $3,500 basis in it.
78
Donald J. Weidner
Century Electric Co. v. Commissioner
(Supplement p. 216)
• CE
“Sold” Mfg. facility for $150,000
Paid $150,000 cash
Got a 95-year lease back
College
College
College
CE Reported
$ 150,000 Amount Realized on Sale of the Mfg. facility
- 531,700 Adjusted Basis in that Mfg. facility
$(381,700) Loss on Sale
• To say there was a $381,000 “loss” is to say the entire property
was sold for only $150,000, leaving the seller with $381,000 in
unrecovered investment/basis
– Recall: basis is unrecovered investment for tax purposes—
the loss was the unrecovered basis
• Because the IRS disallowed the claim of a loss, the $381,000 in
unrecovered basis would have to be accounted for in some
other way--allocated to some property or account.
– The taxpayer’s basis would not simply disappear
79
Donald J. Weidner
Century Electric (further facts)
Century Electric involved a “sale” by the Century of:
• A building that was custom-designed for Century.
• That was essential to the operation of its profitable
business.
• Century’s sine qua non was to retain the use of the
building.
• The sale of the real estate improved Century’s ratio of
current assets to current liabilities.
• The sale also generated a tax loss.
• The building was never publicly offered for sale.
• Century sought a “friendly landlord.”
• The “sale” price was 30% below assessed value.
80
Donald J. Weidner
Century Electric Issue # 1: Sale versus Like-kind
Exchange
The Eighth Circuit’s approach:
• Congress was not defining “sales” and “exchanges.”
• “It was concerned with the administrative problem involved
in the computation of gain or loss in transactions of the
character with which the section deals.”
• The “controlling policy” of [1031] is “the non-recognition of
gain or loss in transactions where neither is readily
measured in terms of money, where in theory the taxpayer
may have realized gain or loss but where in fact his
economic situation is the same after as it was before the
transaction.”
81
Donald J. Weidner
Sale versus Exchange (cont’d)
The Eighth Circuit’s approach (cont’d):
• The excepted securities category [under 1031(a)(2)] [Supp.
p. 212] [inventory, stocks, bonds, notes, etc.] indicates that
[1031] does not apply if the gain or loss is readily measured
in terms of money.
• “[I]n the computation of gain or loss on a transfer of
property held for productive use in trade or business for
property of a like kind to be held for the same use, the
market value of the properties of like kind involved in the
transfer does not enter into the equation.”
• Don’t separate the transaction into its component parts.
• Rather, look at “what actually was intended and
accomplished.”
– Has the economic situation changed?
82
Donald J. Weidner
Sale versus Exchange (cont’d)
The Eighth Circuit said that Century Electric both
intended and accomplished
– an exchange of a fee for a) a long-term lease back
plus b) $150,000
– with no change in possession or control
– of property that, both before and after the transfer,
was necessary to continue its business.
– “The only change” was in Century Electric’s
“estate or interest” in the factory.
83
Donald J. Weidner
The Section 1031 Regulations: The Black Letter
The basic Section 1031 regulations are the same today
as they were at the time of Century Electric. They
provide:
1. “[T]he words ‘like kind’ [refer] to the nature or
character of the property and not to its grade or
quality.”
–
For example, real property versus personal property
2. “The fact that any real estate involved is improved
or unimproved is not material, for such fact relates
only to the grade or quality of the property and not
to its kind or class.”
– Thus, a building exchanged for a vacant lot
qualifies because both are real property.
– Note the great breadth of the section—how many
transactions can be brought within it.
84
Donald J. Weidner
The Section 1031 Black Letter Concerning A
30-year Leasehold
3. “No gain or loss is recognized if . . . a taxpayer who is
not a dealer in real estate exchanges
– city real estate for a ranch or farm, or
– a leasehold of a fee with 30 years or more to run
for real estate, or
– improved real estate for unimproved real estate.”
4. “Under the Treasury interpretation a lease with 30 years
or more to run and real estate are properties of ‘like
kind.’”
– That is, both are treated as real property.
– Does this regulation dispose of Century Electric?
•
Not if you insist on finding an “exchange”
–
Such as a reciprocal transfer of properties that have “capital value” (See Jordan
Marsh)
85
Donald J. Weidner
Century Electric Issue #2: Given the Loss Was
Disallowed Where Did the Basis Go?
• Century Electric wanted to allocate the $381,700 loss that
was disallowed (its unrecovered basis) between the factory
and the land
– and be permitted to depreciate the portion allocated to the factory.
• Note: it is awkward to talk of allocating the “loss.”
• First, the court said there was no loss.
• Second, the court was really allocating Century Electric’s
unrecovered basis in the factory immediately prior to the
transaction, $531,700, reduced by the $150,000 cash
Century Electric received, for $381,700 in basis still not
recovered.
86
Donald J. Weidner
Century Electric: Allocating the Remaining
Basis (cont’d)
• Court said Century Electric no longer “has an identifiable
capital investment in the improvements on the land
covered by the lease.”
– “Its capital investment is in the leasehold and not its
constituent properties.”
– Accordingly, the taxpayer was given a basis in the
leasehold estate
• And required to amortize its investment in the leasehold oOver
its 95 year life
– It was not permitted to depreciate the building over its
much shorter life
• Is this inconsistent with the first holding: that nothing of
consequence happened?
87
Donald J. Weidner
Jordan Marsh v. Commissioner
(Supplement p. 221)
1944
JM
“Sold” 2 parcels and building
Vee
$2.3 million cash
“concededly,” the FMV
30 year, 3 day lease back
Contemporaneous in 1944
“full and normal rentals”
Additional 30-year
extension if JM erects
new building
JM does not get an option
to repurchase
Jordan Marsh reported a “loss” on the sale. IRS said there was an “exchange”
rather than a “sale” and that the exchange falls within 1031
There are two issues, according to the court:
1. Was there a sale as opposed to an exchange?
2. If there was an exchange, did it fall within 1031? (were the properties of like kind as to
their “nature or character”?)
88
Donald J. Weidner
Jordan Marsh: Sale versus Exchange
• The IRS said that, in substance, the transaction was
– An exchange of a fee for a long term lease
– Both the fee and the lease were trade or business properties
– And they were of like kind
– With the result that Section 1031 prevents the recognition of loss.
• Recall, Section 1031(c), which applies to exchanges not solely in
kind, states that no loss may be recognized if “other property or
money” is received.
– Jordan Marsh received a large amount of money
• The IRS emphasized the black letter law of the Regulation stating
that a leasehold of more than 30 years to run is the equivalent of a
fee.
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Donald J. Weidner
Jordan Marsh: Sale versus Exchange
The Second Circuit first considered statutory intent:
• Section 1031 is an exception to the general rule, which
is: the entire amount of gain or loss realized on a sale
or exchange is to be recognized.
• Section 1031 originally required recognition whenever
the property received in exchange had a “readily
realizable market value.”
– The “readily realizable market value” test was
stricken from the statute because its application was
too indefinite.
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Donald J. Weidner
Jordan Marsh (more sale versus exchange)
• Current Section 1031 requires recognition if the
property received is notes or securities that are
“essentially like money.”
– See Section 1031(a)(2), stating that Section 1031
shall not apply, for example, to any exchange of
stocks, bonds, other securities or evidence of
indebtedness.
• Section 1031 also requires recognition if the property
received represents a different kind of investment.
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Donald J. Weidner
Jordan Marsh (more sale versus
exchange)
• “[B]ut if the taxpayer’s money is still tied up in the
same kind of property as that in which it was
originally invested, he is not allowed to compute and
deduct his theoretical loss on the exchange, nor is
he charged with a tax upon his theoretical profit.”
• “The calculation of the profit or loss is deferred until it
is realized in cash, marketable securities, or other
property not of the same kind having a fair market
value.”
92
Donald J. Weidner
Jordan Marsh (Statutory Intent)
• The court in Jordan Marsh was concerned with a
taxpayer whose money is tied up with a continuing
investment of the same sort (whereas the court in
Century Electric was concerned for the need to avoid
difficult valuations).
• The Jordan Marsh court stated:
– “These considerations [of avoiding the recognition of
gain or loss if the taxpayer has money tied up in a
continuing investment of the same sort], rather than
concern for the administrative task of making the
valuations necessary to compute gains and losses,
were at the root of the Congressional purpose . . . .”
93
Donald J. Weidner
Jordan Marsh (Statutory Intent)
• A purpose to avoid valuation would have suggested
nonrecognition for all exchanges, said Jordan Marsh,
and not merely for those involving like-kind
properties.
• Further, a purpose to avoid valuation would have
meant that 1031 would not have provided for the
recognition of gain in exchanges not wholly in kind
– Under 1031, the amount of gain realized must be
computed whenever a taxpayer receives any
nonqualifying property: the properties must be
valued to compute the gain (part of which will be
recognized and part of which will be deferred)
94
Donald J. Weidner
Jordan Marsh (cont’d)
• Section 1031 asks whether, “in a popular and economic
sense,” “there has been a mere change in the form of
ownership”
– such that the taxpayer has not really cashed in on the
theoretical gain or closed out a losing venture.
• This sounds at least a little bit like Century Electric
• Had Jordan Marsh “closed out a losing venture?”
• Should it matter that Jordan Marsh remained in
possession of the property?
95
Donald J. Weidner
Jordan Marsh (cont’d)
• The court concluded that Jordan Marsh’s investment
was completely liquidated for cash
– In other words, value matters (the cash equaled
the full value of the property)
• Because the lease back was at “full and normal”
rental, the leasehold interests that “devolved upon”
the taxpayer “were of no capital value.”
– Doesn’t that follow from the fair market value sale
price?
– As opposed to subjective value?
96
Donald J. Weidner
Jordan Marsh (cont’d)
• The taxpayer “finally closed out a losing venture.”
– “It cannot be said that the economic situation of
the petitioner was unchanged by a transaction
which substituted $2,300,000 in cash for its
investment in real estate and left it under a liability
to make annual payments of [market] rent for
upwards of thirty years.”
• But don’t the 1031 regulations say it still has an interest
in the real estate, a lease with more than 30 years to
run?
97
Donald J. Weidner
Jordan Marsh (cont’d)
• The statute includes the word “exchange” and we
must look to its meaning
• An exchange is a reciprocal transfer of properties
• An exchange is not “the return of a lesser interest” in
the very property you have just transferred
• Thus, like-kind properties must be exchanged, not
merely implicated, for 1031 to apply
• There might have been an exchange if the leaseback
had had a premium value
98
Donald J. Weidner
Leslie v. Commissioner
(Supplement p. 227)
March 1967 Leslie bought land for new factory in Parsippany
October 1967
Leslie
Contract to sell land and building to Pru for $2,400,000
or actual cost of land and improvements, whichever is
lower
Building specified, plans and
specifications to be approved by Pru
(Pru “did not approve the original
plans.”) Actual cost was $3,200,000.
Pru
Contemporaneous with purchase: 30 year lease back
All Condemnation Awards go to Pru, without deduction
for Leslie’s leasehold interest.
Promise to pay “absolute net rental” of $190,560 per year
if the purchase price is $2,400,000 [or annual net rental of
7.94% of the purchase price, if it is lower than $2,400,000].
Two, 10-year options to renew the lease at net rent of
$72,000 [or 3% of the purchase price, if it is less than
$2,400,000]
Leslie can make “rejectable offers to purchase” at end of
Yr. 15 – for $1,798,000
Yr. 20 – for $1,592,000
Yr. 25 – for $1,386,000
Yr. 30 – for $1,180,000 (This amount has a $154,580 Present value
[assuming a 7% discount rate])
If the offer is rejected, Leslie’s
lease obligations terminate.
99
Donald J. Weidner
Leslie Co. v. Commissioner (cont’d)
• Leslie first explored other financing sources, without
success.
• The present value of the right to receive $1,180,000 (the
rejectable offer price at the end of 30 yrs.), assuming a 7%
discount rate, is $154,580.
• Leslie reported: AR = $2.4 million
-AB = 3.2 million (cost)
Loss = ( .8 million)
• IRS denied the loss. IRS would only “allow the loss as a
cost of obtaining the 30-year lease and permit it to be
amortized over the period of the lease.”
– IRS allocated the unrecovered basis to the lease, as
Century Electric did (only the lease here is much shorter)
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Donald J. Weidner
Leslie (cont’d)
• Stipulated: the useful life of the building was 30 years
(although Prudential depreciated it over a 50-year useful
life).
– That is, Leslie had the right under the lease to possess
the building for its entire useful life.
• On its books: Leslie capitalized and amortized $800,000 of
unrecovered cost of plant construction over 30 years
(rather than currently deduct it as a loss on sale).
– The IRS wanted Leslie to do a variation of the same
thing for tax purposes: capitalize the $800,000 as the
cost of acquiring a 30-year lease.
• Leslie sold its old plant for $600,000 when it moved into the
new plant in Parsippany
– Hence, it was only out-of-pocket $250,000
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Donald J. Weidner
Leslie (Tax Court)
The Tax Court’s approach sounds like Jordan Marsh:
• The general rule is that gains and losses must be
recognized when there is a sale or an exchange.
– The nonrecognition provision of Section 1031 is an
exception to this general rule requiring recognition and
so must be strictly construed.
• Section 1031, by its terms, only applies if there is an
exchange,
– which the IRS regulations define as “a reciprocal transfer
of property.”
• A transfer of property for cash does not qualify as an
exchange.
102
Donald J. Weidner
Leslie (Tax Court cont’d)
• Although the leaseback was “a necessary condition,” it
“did not have any separate capital value which could be
properly viewed as a portion of the consideration paid or
exchanged.”
– So, although it may have had value (it clearly was
Leslie’s sine qua non of the transaction), it did not
have the right kind of value—it did not have capital
value
103
Donald J. Weidner
Leslie (Tax Court cont’d)
• IRS did not challenge the assertion that the fair
market value of the property at date of sale was
equal to the $2.4 million that Prudential paid for the
land and building.
• Nor did the IRS challenge the assertion that the
rental approximated fair rental value of comparable
properties.
104
Donald J. Weidner
Leslie (Tax Court cont’d)
• The treatment of condemnation awards was consistent
with these stipulations of value: the condemnation clause
provided that all proceeds would be paid to Prudential
without deduction for the leasehold interest, further
suggesting the leasehold lacked “capital value.”
– Clever lawyers stipulating this in anticipation of the IRS
challenge?
• The Tax Court concluded that the $ 800,000 was “clearly
attributable” to the land and building, not to the leasehold.
– And so there was a genuine sale at a loss.
• And rejecting the IRS position that there was an
exchange of a fee for a lease
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Donald J. Weidner
Leslie (Tax Court cont’d)
• It did not matter that, on its books, Leslie did not write
off a $800,000 loss on a sale.
– On its books: Leslie amortized $800,000 of
unrecovered cost of plant construction over 30
years.
• “It is not uncommon to find that the book and tax
treatment of a given transaction differ.”
106
Donald J. Weidner
Leslie (Tannenwald Dissent)
• Judge Tannenwald analyzed the case differently
than either the taxpayer or the IRS.
• Judge Tannenwald’s dissent, FN 3, suggests that
Section 1031 does not apply to this kind of
situation: Because the building was constructed to
be sold to Prudential, Leslie never held it “for
productive use in a trade or business or for
investment.”
– Hence, Section 1031 does not apply and
therefor can not be the vehicle for denying
Leslie’s claim of a loss:
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Donald J. Weidner
Leslie (Tannenwald Dissent)
• In lieu of 1031, Judge Tannenwald’s dissent, FN 4, states
two alternative grounds for holding that Leslie may not
claim a “loss” on a “sale”:
1. This was a financing transaction
• A $2,400,00, 30-year, constant payment, selfamortizing mortgage at 7% interest has annual
Debt Service of $190,800 (virtually identical to the
“absolute net rent” for the 30 year base term of the
leaseback).
– Recall, in FN 7, Judge Irwin speculated that the IRS
accepted the stipulation of FMV to avoid having the
transaction characterized as “financial” (as a
mortgage)
» It did not want Leslie to claim depreciation deductions
2. Leslie acted as Prudential’s agent in constructing the
building.
108
Donald J. Weidner
Leslie (Tannenwald Dissent)
• Judge Tannenwald’s dissent, FN 5, states a third
reason to deny Leslie’s claim of a “loss” on the “sale”:
3. Even if there was a “sale’ here, there was no
“loss” in the Jordan Marsh sense of “closing out a
losing venture.”
– Leslie got everything it was after.
• This was the beginning of a transaction, not its
end.
• Leslie paid an $800,000 bonus for a favorable
lease.
109
Donald J. Weidner
Leslie: Tax Court dissents (cont’d)
• Judge Wilbur, dissenting in FN 4, rejected the idea that
the lease rentals reflected fair rental value
– The rent not only failed to escalate, it decreased.
– “Granted it was a net lease, it is still hard to believe
that, aside from this package transaction and
Prudential’s financing role, an owner of real estate in
this area would agree to a fixed ‘rent’ for years nearly
a half century into the future equal to 3 percent of the
property’s current value.”
110
Donald J. Weidner
Leslie (3d Circuit) (Supp. p. 241)
• Third Circuit affirmed the Tax Court’s holding that there
was a sale and that the lease back was simply a condition
precedent to the sale (rather than a part of the
consideration received in an exchange).
• Third Circuit sounded like Jordan Marsh, beginning with:
“The Threshold question is whether the transaction
constitutes an exchange.”
• Note FN 6 of Judge Garth’s opinion in the 3d Circuit. By
amended petition, Leslie argued: if it is not a sale, it is a
mortgage.
– Because both courts held it was a sale, they never got
to Leslie’s alternative argument that it was a mortgagor
and, hence, entitled to depreciation deductions.
111
Donald J. Weidner
Revenue Ruling 90-34
(Supplement p. 247)
• Taxpayer and Y entered into a contract that required
Taxpayer to transfer Blackacre to Y.
– Blackacre had a Fair Market Value of $1Million and had been used
by Taxpayer in Taxpayer’s trade or business.
• The contract also required Y to transfer to Taxpayer
property that was not yet identified (that the Taxpayer had
not yet picked out), that was to be of like kind and worth
$1Million.
• The contract required Taxpayer to locate and identify such a
property for Y to purchase within 45 days of Taxpayer’s
transfer of Blackacre to Y.
– section 1031(a)’s 45-day “identification period” (pick it out)
• The contract required Y to purchase the identified property
and transfer it to Taxpayer before the earlier of 180 days
from the date Taxpayer transferred Blackacre or the due
date for Taxpayer’s tax return for the year in which Taxpayer
transferred Blackacre.
– section 1031(a)’s 180-day “exchange
period” (transfer it)
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Donald J. Weidner
Rev. Rul. 90-34 (cont’d)
•
•
•
If Taxpayer failed to identify the property or Y failed to
purchase and transfer it to Taxpayer, Y must instead pay
Taxpayer $1M in cash.
Neither Taxpayer nor Y contracted to exchange Blackacre
with any other party.
Within the appropriate time periods:
1. Taxpayer identified Whiteacre, owned by Z, as property for Y to buy.
2. Y paid Z and directed Z to transfer Whiteacre to Taxpayer before the
end of the exchange period.
3. Z transfered Whiteacre to Taxpayer.
•
•
Taxpayer holds Whiteacre for use in its trade or business.
The “exchange” is good, and not a direct purchase by
Taxpayer, even though:
– Y paid Z for Whiteacre pursuant to Taxpayer’s instruction.
– Y never held title to Whiteacre.
– Z transferred Whiteacre directly to Taxpayer.
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Donald J. Weidner