donald j. weidner1 mechanics lien acts much of the rhetoric around these laws is misleading. –much...

Donald J. Weidner1

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 at least 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.

Donald J. Weidner2

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.

Guignard Brick Works v. Gantt159 S.E.2d 850 (S.C. 1968).

LandownerLandowner Guignard Guignard BrickBrick

Contract to build house for $19,000

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

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?

GeneralGeneral

Donald J. Weidner3

Guignard Brick (cont’d)• Bricksupplier claimed a lien under Section 1 set out

in the Memorandum on Mechanics Liens (Supp. P.

97):– Saying it furnished bricks– That were actually used in the building– By virtue of an agreement with, or by consent of, the

owner.• Concluding, therefore, that it had a lien on the

building and upon the lot to secure the payment of the 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.

Donald J. Weidner4

Guignard Brick (cont’d)

• Section 2 (Supp. P. 97), on the other hand, refers to “[e]very laborer, mechanic, subcontractor or person furnishing material”– when an improvement has been authorized by

the owner– gives a “lien” that is – “subject to existing liens of which he has actual

or constructive notice”– “to the value of the labor or material so

furnished.”

Donald J. Weidner5

Guignard Brick (cont’d)

• Consider the last sentence in Section 4 (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.”

Donald J. Weidner6

Guignard Brick (cont’d)• Mechanics lien statutes typically provide that the liens of all

the subcontractors relate back to some earlier point prior to the point at which the materials or services were supplied or rendered.– Can you see why as a matter of policy this should be

so?• See 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).

Donald J. Weidner7

More on Supplement pages 97-98• B CLN & M L• B agrees to loan L• B Advance #1 L• B “I am not getting paid” Brick Co.• B Advance #2 L• What of the mechanics’ lien act?

– 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)

“Stop Notice” and Undisbursed Proceeds

• In states with statutory “stop notice” procedures: “A lender or owner holding constructions 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 statutes provide the exclusive remedy to subcontractors.

Donald J. Weidner8

“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).

Donald J. Weidner9

Donald J. Weidner10

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.

Donald J. Weidner11

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 1970 Seller BuyerPurchase A’ment for $225,000

July 20, 1970 Buyer Generalanticipating purchase, entered into contract

Sub

Sub K

July 30, 1970

August 3, 1970 Purchase closed

Seller Buyer PruDeed $PM (+Improvement $)

note

Court was faced with 2 issues:

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.”

Kloster-Madsen, Inc. v. Tafi’s Inc., 226 N.W.2d 603 (Minn. 1975).

Donald J. Weidner12

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.”

Donald J. Weidner13

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?

Donald J. Weidner14


• 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)

Donald J. Weidner15

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: Judgment liens against the mortgagor; Liens arising from after-acquired property clauses in prior mortgages

executed by the mortgagor; and Claims against the mortgagor for dower and homestead.

One Formalistic and Archaic Explanation: Instantaneous transit of seisin.

CR DebtorGets judgment lien on all real estate owned by Debtor

Seller DebtorPays $conveys fee

Purchase Money Mortgagee

Loans $Mortgage contemporaneous

Under the purchase money mortgage rule, the mortgage of the purchase money mortgagee has priority over the prior creditor’s judgment lien. Classically, seisin passed so quickly the prior judgment never took hold of it.


Donald J. Weidner16

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.

Donald J. Weidner17

Kloster-Madsen (cont’d)• 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 Kloster-Madsen:– 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.

Donald J. Weidner18

Kelly

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.

June 1972

Formal contract: W&W contracts to perform engineering services

Contacts with interest

in bldg. Apt. complex

Williams & Works, Inc. v. Springfield Corp.(Text p. 646)

ConveyFee Owners

Law Dev. Co.

Kelly M & Inv. Co.

Developer

Springfield

Mechanics Lien

Claimant

W & W

Engineers

8/29/72

Developer had the right to terminate the engineering contract at end of any phase

12 holes into ground, 6” diameter “staked”

Phase #1: Feasibility Studies

Phase #2: Finalize all plans

Actual knowledge of

W&W’s work

1/4/73 Sells and conveys land

City Nat’l Bank

Mortgages land to CNB

Records the 1st mortgage

Assigns Mortgage (unclear when)

2nd Mortgage

Records 2nd Mortgage Phase #3: Physical

Construction Begins; W&W supervises—sets stakes out

1/9/73

2/10/73

3/25/74 Files action to foreclose its mechanics lien

Developer

Springfield

Developer

Springfield

ML

ML

Donald J. Weidner19

Williams & Works (cont’d)• Another priority fight between the mechanics lien

claimant and the mortgagee when the claimant started work for the Developer before the Developer acquired title.

• FN. 5 has the “much amended” Section 1. • Do you see the language 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]

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”– Court: Section 1 does nothing more than

describe what is “lienable.”

Donald J. Weidner20

Donald J. Weidner21

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.”

Donald J. Weidner22

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?

• “[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)

Donald J. Weidner23

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.

Donald J. Weidner24

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.

Donald J. Weidner25

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.

Donald J. Weidner26

Wrongly Disbursed Funds

•Wrongful disbursal of funds by lender can result in the lender’s loss of priority as against a mechanics’ lien claimant (just as lender can lose its 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

Donald J. Weidner27

J.I.Kislak Mortgage Corp. v. William Matthews Builder, Inc. (Text p. 595)

Developer and Construction lender entered into a construction loan agreement1. Developer executed a construction loan note and

mortgage to construction lender2. Construction lender recorded the mortgage3. 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.

Donald J. Weidner28

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.”

• “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.”

Donald J. Weidner29

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 lender was “charged with knowledge of the law that mechanics’ liens relate back”

Donald J. Weidner30

Kislak Mortgage (cont’d)• Essentially the mechanics’ lien took priority to the

extent the lender made voluntary payments after knowledge that work had begun for which a mechanics lien 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.

Donald J. Weidner31

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.”

Donald J. Weidner32

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.”

Donald J. Weidner33

Landlords Must Capitalize the Cost of Obtaining Tenants

• Because we have a tax on income, 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 tenant’s lease will generate receipts for years.

– The landlord must attribute a portion of the cost of the lease to each year’s rent receipts

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 $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 rental receipts with the cost of

generating those receipts

Donald J. Weidner34

Donald J. Weidner35

Tenants Must Capitalize Payments to Obtain Favorable Leases

• Similarly, a bonus payment by a tenant to acquire a lease can not be deducted by the tenant; – 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).

Donald J. Weidner36

Tenants Depreciate their Investments in Buildings on Land they Lease

• Tenants often construct buildings on land that they lease (recall Penthouse, Cambridge).

• If a tenant invests in a building that is

1. used in its trade of business or

2. held for the production of income,

it is allowed to recover its investment in the building (basis) through depreciation (“cost recovery”) deductions. (See Text p. 693).

Donald J. Weidner37

Write-offs Available to Tenants Who Construct Improvements on Leased Land

• In short, a tenant may be doing all of the following:

1.amortizing its investment in a lease of land

2.deducting the rent it is paying under the lease of land and

3.depreciating its investment in the building it constructs on the leased land.

Donald J. Weidner38

Are Tenant-Constructed Improvements Rent to Landlord? The Chirelstein Hypo

FONFOLL

MFG TPays $800,000

Conveys tract of land

20 year ground lease

T to pay relatively low annual rentT to construct factory at minimum cost of $1,000,000Factory to become property of LL on termination of the lease [“thus…apparently… a form of ‘rent in kind’.”]

TConstructs building

With 25 year U.L. (5 years longer than the lease)That has an expected depreciated value of $200,000 at the time the 20-year lease expires

TLL Pays relatively low annual Cash Rentals

Donald J. Weidner39

General ConsiderationsIn 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?

Donald J. Weidner40

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 either1. prepaid rent2. prorated rent3. postpaid rent or4. no rent at all

Donald J. Weidner41

Possibility # 1: Prepaid Rent1. 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 you report the present value of the future payment in income at the beginning of the lease, you could consider the transaction closed at this point, with no further income to report when the lease ends.

Donald J. Weidner42

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), 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.

Donald J. Weidner43

Possibility # 2: Prorated Rent2. 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? • 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.

Donald J. Weidner44

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.

Donald J. Weidner45

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.

Donald J. Weidner46

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.

Donald J. Weidner47

Helvering v. Bruun309 U.S. 461 (1940)

1915

1929

1933

LL

LL

T

T

Leased lot & building for 99 years

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

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]

FMV building constructed by T is $64,000

LL’s “unamortized cost” of old bldg. is 13,000“Net FMV” [net “gain” $51,000 as at 7/1/33, says IRS]

LL regained possession of land and building} stipulation

Donald J. Weidner48

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.

Donald J. Weidner49

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.

Donald J. Weidner50

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.

Donald J. Weidner51

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.

Donald J. Weidner52

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).

Donald J. Weidner53

1928

1950

OFO TNet lease for 50 years

Annual rental averaged $28,500

Tenant must construct a 6 story building costing at least $250,000

Building to become part of the realty on construction.

Tenant agrees to subordinate to a mortgage up to a stated percentage of ground value.

Taxpayer: WORLD

PUBLISHING

NFO

Sold all its interest in 1950

$700,000, subject to the lease to T, which had 28 more years to run

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.

World Publishing Co. v. Commissioner (Supplement p. 188)

Donald J. Weidner54

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

Donald J. Weidner55

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.”

Donald J. Weidner56

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.

Donald J. Weidner57

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.

Donald J. Weidner58

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 a premium 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”

Donald J. Weidner59

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 T1965 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.

Donald J. Weidner60

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 word “the”

• It could mean “whatever economic loss there is”• It could mean that the taxpayer must suffer an

economic loss– The latter meaning is hard to square with prior

case law• 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?

Donald J. Weidner61

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

Donald J. Weidner62

Geneva Drive-In (Tax Court)(cont’d)• Recall 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 tenant-constructed 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 long-term leased to tenants

• 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.”

Donald J. Weidner63


• 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

Donald J. Weidner64


• 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.”

Donald J. Weidner65


• 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.”

Donald J. Weidner66


• “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.”

Donald J. Weidner67

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 lessor in World Publishing could borrow

money and secure it by a mortgage to which the tenant was subordinated; and

– the lessor in World Publishing could attach whatever clauses its mortgagee would require to the lessee’s insurance policies.

Donald J. Weidner68

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.”

Donald J. Weidner69

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.

Donald J. Weidner70

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 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).

Donald J. Weidner71

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.

Donald J. Weidner72

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”. – Jordan Marsh states: “even the receipt of

cash . . . is not enough to permit the taxpayer to recognize loss.”

Donald J. Weidner73

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

Donald J. Weidner74

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, which is also worth $3,000.

FMV $3,000

A B$3,000 FMV

$1,000 AB

Bakeracre

Ableacre

How much gain has A realized?

How much, if any, of the realized gain is recognized?

$3,000 Amount Realized

-1,000 Adjusted Basis

$2,000 Realized Gain

Ex. #1.

Donald J. Weidner75

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.

Example 1 (Cont’d)

Donald J. Weidner76

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.

FMV $3,000

A B

$2,000 FMV

$1,000 AB

Bakeracre

Ableacre + $1,000 cash $1,000 cash

+Property Ableacre

Because A had to pay an additional $1,000, A’s gain on the exchange of Ableacre for a 2/3 interest in Bakeracre is now only $1,000. It is realized but not recognized. However, because A also paid the $1,000 cash for a 1/3 interest in Bakeracre, A’s basis in Bakeracre is increased by $1,000, 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

Example #2

Donald J. Weidner77

Assume, now, that A’s property, Ableacre, is worth $3,500, so that B gives A $500 cash as “boot”:

Example #3

$3,000 FMV

+

500 CASH

A B$3,500 FMV

$1,000 AB

Bakeracre

Ableacre

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

- money received

+ any gain recognized

- any loss recognized

Basis in property received

$1,000

- 500

+ 500

$1,000

+ $500 cash

Donald J. Weidner78

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.

Example #3 (Cont’d)

Donald J. Weidner79

Century Electric Co. v. Commissioner (Supplement p. 216)

• CE “Sold” Mfg. facility for $150,000 College Paid $150,000 cash College Got a 95-year lease back 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 cost/investment/basis– Recall: basis is unrecovered investment for tax

purposes—the loss was the unrecovered basis• Presumably, if 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.– The taxpayer’s basis would not simply disappear

Donald J. Weidner80

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.

Donald J. Weidner81

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.”

Donald J. Weidner82

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.”

Donald J. Weidner83

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.

Donald J. Weidner84

The Section 1031 Regulations 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.”

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!– Note the great breadth of the section—how

many exchanges it embraces.

Donald J. Weidner85

The Section 1031 Regulations 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.’”– Does this regulation dispose of Century Electric?– Not if you insist on finding an “exchange” of properties

that have “capital value” (See Jordan Marsh)

Donald J. Weidner86

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) to and between the factory and the land and 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 basis in the factory immediately prior to the transaction, $531,700, minus the reduction in basis caused by the $150,000 cash Century Electric received in the transaction, $381,700.

Donald J. Weidner87

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 required to

amortize its investment in “the leasehold”• Over its 95 year life

– And was not permitted to depreciate the building• Over its shorter life

• Is this inconsistent with the first holding: that nothing of consequence happened?

Donald J. Weidner88

Jordan Marsh v. Commissioner (Supplement p. 221)

1944JM “Sold” 2 parcels and building

$2.3 million cash “concededly,” the FMV

30 year, 3 day lease back“full and normal rentals”

Additional 30-year extension if JM erects new building

JM does not get an option to repurchase

Vee

Contemporaneous in 1944

Jordan Marsh reported a “loss” on the sale. IRS said that 1031 requires nonrecognition of the loss.

There are two issues, according to the court:

1. Was there a sale as opposed to an exchange?

2. If there was an exchange, were the properties of like kind as to their “nature or character?”

Donald J. Weidner89

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– So that Section 1031 prevents the recognition of loss.

• If Section 1031 applies, no loss may be recognized even if the taxpayer receives money as part of the exchange

• 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 Regulation stating that a leasehold of more than 30 years to run is the equivalent of a fee.

Donald J. Weidner90

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.

Donald J. Weidner91

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.

Donald J. Weidner92

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.”

Donald J. Weidner93

Jordan Marsh (Statutory Intent)• Jordan Marsh was concerned with a taxpayer

whose money is tied up with a continuing investment of the same sort (rather than Century Electric’s concern for the need to avoid difficult valuations):– “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 . . . .”

Jordan Marsh (Statutory Intent)• A purpose to avoid valuation would have

suggested nonrecognition for all exchanges, 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)

Donald J. Weidner94

Donald J. Weidner95

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?

Donald J. Weidner96


• 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?

Donald J. Weidner97


• 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.”

Donald J. Weidner98


• 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

Donald J. Weidner99

Leslie v. Commissioner (Supplement p. 227)

March 1967 Leslie bought land for new factory in Parsippany

October 1967

Leslie Pru

Contract to sell land and building 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.

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.

Donald J. Weidner100

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)


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


Leslie (Tax Court)

The Tax Court’s approach:• 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.


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



• 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.



• 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.”

• 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



• 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.”


• 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:

Leslie (Tannenwald Dissent)


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, self-

amortizing 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.


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.


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.”


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.


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)


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.

donald j. weidner1 mechanics lien acts much of the rhetoric around these laws is misleading. –much...

Documents

construction lien acts

guignard brick works

lien protection

weidner5 guignard brick

guignard bricks argument

weidner1 mechanics lien

mechanics liens

general slide