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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 building. Many of the acts do at least as much, or more, to protect owners and

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mechanics lien acts
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 building.
  • 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 the implication that they are primarily for the benefit of mechanics and materialmen.

Donald J. Weidner


Guignard Brick Works v. Gantt

159 S.E.2d 850 (S.C. 1968).



Guignard Brick

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

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.


What is Guignard Brick’s argument on the basis of the statute at Supp. 70-71?

Did not Guignard Brick furnish the brick with the “consent” of the owner?

Donald J. Weidner

guignard brick cont d
Guignard Brick (cont’d)
  • Bricksupplier claimed a lien under Section 1 set out in the Memorandum on Mechanics Liens (Supp. P. 74):
    • 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 interest of the owner in 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. Weidner

guignard brick cont d4
Guignard Brick (cont’d)
  • Section 2 (Supp. P. 74), 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” “subject to existing liens of which he has actual or constructive notice”
    • “to the value of the labor or material so furnished.”
  • Consider the last sentence in Section 4 (Supp. P. 75):
    • 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. Weidner

guignard brick cont d5
Guignard Brick (cont’d)
  • Mechanics lien statutes typically provide that the lien of all the subcontractors relates back to some earlier point prior to the point 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 point 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. Weidner

more on supplement pages 74 77
More on Supplement pages 74-77
  • 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 notice] shall operate to lessen the amount recoverable by the person so giving the notice.”
    • Note: Is this a payment “by the owner?”
  • What of the “optional/obligatory” distinction?
    • Recall Florida Statute 697.04(1)(a) (Supp. P. 76)

Donald J. Weidner

case on commencement and purchase money mortgage mechanics lien v 3d party purchase money mortgage
CASE ON “COMMENCEMENT” AND “PURCHASE MONEY MORTGAGE”Mechanics Lien v. 3d Party Purchase Money Mortgage

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.

The case involved a priority battle between Kloster-Madsen and Prudential Life Insurance Company, which had closed a loan that was part purchase-money loan and part improvement loan.

Donald J. Weidner


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

$PM (+Improvement $)







A’ment for


July 1970



  • Court was faced with 2 issues:
  • 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
  • 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.”

anticipating purchase, enters into contract

July 20, 1970



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


August 3, 1970

Purchase closed

Donald J. Weidner

kloster madsen cont d
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, “not good enough” that it be visible “to the naked eye”
      • it had to be visible “to the mind’s eye.”

Donald J. Weidner

kloster madsen cont d10
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.”

      • The “mind’s eye” must use reasonable care?

Donald J. Weidner

kloster madsen cont d11
Kloster-Madsen (cont’d)
  • Third, is any 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 has been explained in terms of instantaneous transitory seisin
      • This is what Prudential argued

Donald J. Weidner


Kloster-Madsen (cont’d)

Gets judgment lien on all real estate owned by Debtor



Purchase Money Mortgages are special because they often permit the 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 Explanation: Instantaneous transitory seisin.

Pays $

Loans $



Purchase Money Mortgagee




Under the purchase money mortgage rule, the mortgage of the purchase money mortgagee has priority over the prior creditor’s judgment lien.

Donald J. Weidner

kloster madsen cont d13
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. Weidner

kloster madsen cont d14
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 deciding opposite to 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 vendor knew but did not authorize the improvements.

Donald J. Weidner

williams works inc v springfield corp text p 733


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.

Williams & Works, Inc. v. Springfield Corp.(Text p. 733)

Contacts with interest in bldg. Apt. complex




Mechanics Lien Claimant

W & W


Fee Owners

Law Dev. Co.

Kelly M & Inv. Co.

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

June 1972

Formal contract: W&W to perform engineering services


12 holes into ground, 6” diameter “staked”

Phase #1: Feasibility Studies

Actual knowledge of W&W’s work

Phase #2: Finalize all plans

Sells and conveys land




Mortgages land to CNB

City Nat’l Bank


Records the 1st mortgage

Assigns Mortgage (unclear when)

2nd Mortgage



Records 2nd Mortgage

Phase #3: Physical Construction Begins; W & W supervises—sets stakes out



Files action to foreclose its mechanics lien



Donald J. Weidner

williams works cont d
Williams & Works (cont’d)
  • Consider the “much amended” Section 1 of the act, in fn. 5.
    • 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”]
    • 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. Weidner

williams works cont d17
Williams & Works (cont’d)
  • Section 9[3] of the mechanics’ lien act in fn. 1 contains a priority rule.
  • Consider the lien priority 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 FN. 6 to include “designs or engineering plans.”
  • 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.
  • How could the mechanics lien claimants possibly lose this case?
    • “non-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.”

Donald J. Weidner

summary of major concepts
Summary of Major Concepts
  • When does a lien attach?
    • The three most common possibilities are the date
      • when the general contract is first executed
      • on commencement of construction, 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 the service provided.
  • How much time is allowed to foreclose a perfected lien?
    • Varies from jurisdiction to jurisdiction.

Donald J. Weidner

summary of major concepts cont d
Summary of Major Concepts (cont’d)
  • As of what time does the perfected lien take priority?
    • 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.
      • 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. Weidner

undisbursed or wrongly disbursed funds
Undisbursed or Wrongly Disbursed Funds
  • A subcontractor may not be able to recover if the property is exhausted by liens that have first priority
    • such as a construction loan mortgage or a purchase money mortgage.
  • Equity might help the subcontractor in certain situations by imposing a lien on undisbursed loan proceeds if special circumstances can be shown.
  • Some states provide a “stop notice” remedy that gives a subcontractor priority as to undisbursed loan proceeds if the construction lender continues to disburse money after notice of a subcontractor’s claim.
  • An owner or lender who disburses money after receiving a “Stop Notice” or “Notice to Owner” must comply with local law or run the risk of losing lien priority
    • It may be possible to pay some lienors while getting releases from them

Donald J. Weidner

undisbursed or wrongly disbursed funds cont d
Undisbursed or Wrongly Disbursed Funds (cont’d)
  • Some states say that the Mechanics Lien (Construction Lien) Act preempts the area and precludes courts from fashioning common law or equitable remedies.
  • Wrongful disbursal of funds can result in the lender’s loss of priority as against a construction lien claimant just as it can 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. Weidner

undisbursed or wrongly disbursed funds cont d22
Undisbursed or Wrongly Disbursed Funds (cont’d)
  • Compare Seitz (Text p. 745)
    • “The lien of a deed of trust securing a construction loan has priority over mechanics’ and materialmen’s liens only to the extent that:
      • the funds disbursed actually went into the construction, or
      • to the extent that the construction lender used reasonable diligence in disbursing the construction loan.”

Donald J. Weidner

partial recap
Partial 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 “Stop Notice”)

Minus: Reasonable Cost to Complete (upon “abandonment”)

Equals: Extent of owner’s liability to all non-privity lienors.

Donald J. Weidner

j i kislak mortgage corp v william matthews builder inc text p 679
J.I.Kislak Mortgage Corp. v. William Matthews Builder, Inc.(Text p. 679)
  • Developer and Construction lender entered into a construction loan agreement
    • Developer executed a construction loan note and mortgage
    • Construction lender recorded the mortgage
  • 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
  • Construction lender was not repaid, filed to foreclose on its construction loan mortgage.
  • Masonry subcontractor intervened in the foreclosure, asserting that its mechanics’ lien should be considered prior to the lien of the construction loan mortgage.

Donald J. Weidner

kislak mortgage cont d
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 a construction loan agreement covering a construction mortgage provides for progress payments over a period of time and some of the disbursements are voluntarily made at a time subsequent to the effective date of the mechanics’ lien.”

Donald J. Weidner

kislak mortgage cont d26
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. Weidner

kislak mortgage cont d27
Kislak Mortgage (cont’d)
  • “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. Weidner

florida statute on mortgages for future advances supp p 76
Florida Statute on Mortgages for Future Advances (Supp. P. 76)

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. Weidner

depreciation of tenant constructed improvements the background rules
Depreciation of Tenant-Constructed Improvements: The Background Rules
  • In a tax on income: 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 (See text p. 783).
    • That is, the landlord is not permitted to expense (currently deduct) all of the cost of obtaining a tenant because it will generate receipts for years.
    • The landlord must attribute a portion of the cost to each year’s rent receipts

Donald J. Weidner

depreciation of tenant constructed improvements cont d
Depreciation of Tenant-Constructed Improvements (cont’d)
  • Similarly, bonus payments by a tenant to acquire a lease can not be deducted by the tenant;
    • They are treated as a cost of acquiring the lease and must be capitalized (added to the cost of the asset—the lease) and then amortized over each year of the life of the lease. (See Text p. 784).
  • 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. 784).

Donald J. Weidner

depreciation of tenant constructed improvements cont d31
Depreciation of Tenant-Constructed Improvements (cont’d)
  • Tenants often construct buildings on land that they lease.
  • If a tenant invests in a building that is
    • used in its trade of business or
    • held for the production of income,

it is allowed to recover its investment in the building through depreciation (“cost recovery”) deductions. (See Text p. 784).

Donald J. Weidner

write offs available to tenants who construct improvements
Write-offs Available to Tenants Who Construct Improvements
  • In short, a tenant may be doing all of the following:
    • amortizing its investment in a lease
    • deducting the rent it is paying under the lease and
    • depreciating its investment in the building it constructs on the leased land.

Donald J. Weidner

chirelstein tenant constructed improvements as rent

Pays $800,000

Conveys tract of land

Chirelstein: Tenant-Constructed Improvements as Rent




20 year ground lease


T to pay relatively low annual rent

T to construct factory at minimum cost of $1,000,000

Factory to become property of LL on termination of the lease [“thus…apparently… a form of ‘rent in kind’.”]

Constructs 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

Pays relatively low annual Cash Rentals



Donald J. Weidner

general considerations
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 “income” to the Landlord? Is it an
    • “accession to wealth,”
    • “clearly realized,”
    • “over which the taxpayer has complete dominion”?
  • If it is income, when are these criteria met?
  • If it is income, in what amount?

Donald J. Weidner

the realization requirement
The Realization Requirement
  • Chirelstein: “because the realization requirement exists, the income tax is a tax on transactionsinstead 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
    • prepaid rent
    • prorated rent
    • postpaid rent or
    • no rent at all

Donald J. Weidner

possibility 1 prepaid rent
Possibility # 1: Prepaid Rent
  • 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 nothing further to report when the lease ends.
      • That is, report $50,000 income now, no further income later.

Donald J. Weidner

possibility 1 prepaid rent cont d
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. Weidner

possibility 2 prorated rent
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?
      • 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. Weidner

possibility 3 postpaid rent
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. Weidner

postpaid rent cont d
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. Weidner

pre helvering v bruun
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. Weidner

helvering v bruun 309 u s 461 1940



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


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]


[nonpayment of rent & taxes]



LL regained possession of land and building


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]


Donald J. Weidner

bruun and its aftermath from possiblility 3 to possibility 4
Bruun and Its Aftermath: From Possiblility # 3 to Possibility # 4
  • Bruun agreed with the IRS and held that there was income to the landlord 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. Weidner

possibility 4 no rent
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. Weidner

sections 61 109 and 1019 in a nutshell
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. Weidner

sections 61 109 and 1019 cont d
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. 784, Supp. P. 144).
  • 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. Weidner

sections 61 109 and 1019 cont d47
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. 144).

Donald J. Weidner


World Publishing Co. v. Commissioner(Supplement p. 145)

Net lease for 50 years




Tenant to pay annual rental averaging $28,500

Tenant required to construct a 6 story or more building of cost of 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.


Sold all its interest



$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, buy for 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.

Donald J. Weidner

world publishing cont d
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
    • used in a trade or business, or
    • held for the production of income.
  • IRS position is: NFO has merely a reversionary interest, which may not be depreciated.
    • The person claiming a depreciation deduction must have something akin to a substantial present possessory interest.
      • The IRS argued this in Bolger

Donald J. Weidner

world publishing cont d50
World Publishing (cont’d)
  • Blackmun rejected the argument that NFO did not have a sufficient possessory interest.
  • 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 landdowner/ building owner’s investment in it.
  • 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. Weidner

then judge blackmun s factors
Then-Judge Blackmun’s Factors

Judge Blackmun: the NFO had invested in an ample bundle of sticks to claim a depreciable interest:

  • The building became a part of the land and thus the Lessor’s on construction.
  • Lessor had the right to inspect, reject and amend plans for the building.
  • Lessor was a named insured of the building.
  • Lessor had a right to subject the building, and not just the fee, to a mortgage.
  • Lessor could prevent lessee from making major ($10,000 or more cost) changes to the building without Lessor’s consent.
  • State law provided that a building permanently affixed to the realty becomes a part of the realty.

Donald J. Weidner

world publishing cont d52
World Publishing (cont’d)
  • IRS also argued: New Fee Owner can not purchase more of an interest than its seller had to sell.
    • Here, the seller (OFO) did not have a depreciable interest in the building.
  • IRS also argued: The tenant has a depreciable interest in the building (the tenant paid to have it built), and it would be anomalous to have both the tenant and the new landlord (NFO) depreciating the same building.
  • 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. Weidner

m dematteo constr co v united states supplement p 154
M. DeMatteo Constr. Co. v. United States(Supplement p. 154)
  • 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. Weidner

geneva drive in theater inc supplement p 156
Geneva Drive-In Theater, Inc.(Supplement p. 156)
  • 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

  • OFO sells for $200,000 above NFO

price for land alone.

What did the $200,000 pay for?

NFO claimed: It purchased the improvements and could depreciate its investment in them, by the composite method, over a 9-year useful life.

IRS claimed: The NFO spent $200,000 for a future interest: the right to acquire the depreciable assets at the end of the lease. The investment is not depreciable until the interest becomes possessory at the end of the lease.

Donald J. Weidner

geneva drive in tax court
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 itandwill 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. Weidner

geneva drive in tax court cont d
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.”
  • 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. Weidner

geneva drive in tax court cont d57
Geneva Drive-In (Tax Court)(cont’d)
  • Why do we not see the OFO as having a depreciable interest?
  • Is it because, under our tax law, we fail to see OFO as experiencing a realization event 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. Weidner

geneva drive in tax court cont d58
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

Donald J. Weidner

geneva drive in tax court cont d59
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.”

Donald J. Weidner

geneva drive in tax court cont d60
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.”

Donald J. Weidner

geneva drive in tax court cont d61
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.”

Donald J. Weidner

geneva drive in tax court and 9 th circuit
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. Weidner

geneva drive in conclusion
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. Weidner

section 1031 and sale leasebacks supplement p 169
Section 1031 and Sale-Leasebacks (Supplement p. 169)
  • 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 is 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. Leslie sided with Jordan Marsh.
  • Consider first the basic rules in section 1031(a)-(d) and then consider a series of hypotheticals.

Donald J. Weidner

section 1031
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 find “income” (or loss) because the transaction satisfies the realization requirement, section 1031(a) states that the income (or loss) that has been realized will not be recognized.

Donald J. Weidner

section 1031 cont d
Section 1031 (cont’d)
  • A quick read of section 1031(a) suggests that 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. Weidner

mixed exchanges
Mixed Exchanges
  • What if the exchanges are not solely of like kind properties?
  • Section 1031(b) states that there will be somerecognition of gain if some “other property or money” is received as part of the mix.
  • Section 1031(c) states that there will be norecognition of any loss if any “other propertyor money” is received.
    • Jordan Marsh states: “even the receipt of cash . . . is not enough to permit the taxpayer to recognize loss.”

Donald J. Weidner

mixed exchanges cont d
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. 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, which is also worth $3,000.




$3,000 FMV

$1,000 AB

FMV $3,000


$3,000 Amount Realized

-1,000 Adjusted Basis

$2,000 Realized Gain

A’s gain?

Is the realized gain recognized?

Donald J. Weidner


Ex. 1 (Cont’d)

The realized gain is notrecognized 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 but is not recognized at the time of the exchange.

  • It is postponed.
  • A’s basis in the property A received from B, Bakeracre, is $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.

Donald J. Weidner


Ex. #2

$3,000 Amount Realized

-2,000 Adjusted Basis

$1,000 Realized Gain



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

$1,000 cash


Ableacre + $1,000 cash

$2,000 FMV

$1,000 AB

Property Ableacre

Because A had to pay an additional $1,000, A’s gain on the exchange of Ableacre is now only $1,000. It is realized but not recognized. However, because A also paid the $1,000 cash, 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:

Donald J. Weidner


Ex. #3

Basis of property given up

- money received

+ any gain recognized

- any loss recognized

Basis in property received




+ $500 cash

$3,500 FMV

$1,000 AB

$3,000 FMV


500 CASH


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

A has a realized gain of $2,500. How much is recognized?

The exchange is no longersolelyin 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:


- 500

+ 500


Donald J. Weidner


Ex. #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.

Donald J. Weidner

century electric co v commissioner supplement p 172
Century Electric Co. v. Commissioner(Supplement p. 172)
  • CE “Sells” Mfg. facility for $150,000 College

Pays $150,000 cash College

95-year lease back College

CE Reported

$ 150,000 Amount Realized on Sale of Mfg. facility

- 531,700 Adjusted Basis

$(381,700) Loss

  • 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
  • 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 other property.
    • Basis does not just disappear

Donald J. Weidner

century electric further facts
Century Electric (further facts)

Century involved:

  • A custom-designed building.
  • That was essential to the operation of the taxpayer’s profitable business.
  • Taxpayer’s sine qua non was to retain the use of the building.
  • The sale of the real estate improved its ratio of current assets to current liabilities.
  • The sale also generated a tax loss.
  • The building was never publicly offered for sale.
  • Taxpayer sought a “friendly landlord.”
  • The “sale” price was 30% below assessed value.

Donald J. Weidner

century electric issue 1 sale versus like kind exchange
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. Weidner

sale versus exchange cont d
Sale versus Exchange (cont’d)

The Eighth Circuit’s approach (cont’d):

  • The excepted securities category [under 1031(a)(2)][Supp. p. 169] 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. Weidner

sale versus exchange cont d78
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. Weidner

the section 1031 regulations
The Section 1031 Regulations

The basic Section 1031 regulations are the same today as they were at the time of Century Electric. They provide:

  • “[T]he words ‘like kind’ [refer] to the nature or character of the property and not to its grade or quality.”
  • “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 for a vacant lot qualifies!
    • Note the great breadth of the section.

Donald J. Weidner

the section 1031 regulations concerning a 30 year leasehold
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?

Donald J. Weidner

century electric issue 2 given the loss was disallowed where did the basis go
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, or a total of $381,700.

Donald J. Weidner

century electric allocating the remaining basis cont d
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. Weidner


Jordan Marsh v. Commissioner

(Supplement p. 177)



“Sold” 2 parcels and building


$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.
  • There are two issues, according to the court:
  • Was there a sale as opposed to an exchange?
  • If there was an exchange, were the properties of like kind as to their “nature or character?”

Donald J. Weidner

jordan marsh sale versus exchange
Jordan Marsh: Sale versus Exchange
  • The IRS said that, in substance, the transaction was an exchange of a fee for a long term lease
    • And that they were trade or business properties
    • Of like kind
    • Such that Section 1031 prevents the recognition of loss.
  • If Section 1031 applies, losses may not be recognized even if the taxpayer receives money as part of the exchange
    • Jordan Marsh received a large amount of money
    • 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.
  • The IRS emphasized the Regulation stating that a leasehold of more than 30 years to run is the equivalent of a fee.

Donald J. Weidner

jordan marsh sale versus exchange85
Jordan Marsh: Sale versus Exchange

The Second Circuit first considered statutory intent:

  • Section 1031 is an exception to the general rule that the entire amount of gain or loss realized on a sale or exchange will 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. Weidner

jordan marsh more sale versus exchange
Jordan Marsh (more sale versus exchange)
  • Current Section 1031 requires recognitionif the property receivedis 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. Weidner

jordan marsh more sale versus exchange87
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.”
    • Conversely, do the calculation if profit is realized in cash.

Donald J. Weidner

jordan marsh statutory intent
Jordan Marsh (Statutory Intent)
  • The Second Circuit rejected the Century Electric conclusion that Section 1031 was enacted to avoid administrative problems of valuation:
    • “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 . . . .”
  • 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
    • For example, a taxpayer who receives any nonqualifying property must value the properties to compute the gain, part of which will be recognized and part of which will be deferred

Donald J. Weidner

jordan marsh cont d
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. Weidner

jordan marsh cont d90
Jordan Marsh (cont’d)
  • The court concluded that Jordan Marsh’s investment was completely liquidated for cash
    • In other words, value matters
  • Because the lease back was at “full and normal” rental, the leasehold interests that “devolved upon” the taxpayer “were of no capital value.”
    • Does that follow from the fair market value sale price?

Donald J. Weidner

jordan marsh cont d91
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 rent for upwards of thirty years.”

Donald J. Weidner

jordan marsh cont d92
Jordan Marsh (cont’d)
  • The statute includes the word “exchange” for its meaning
  • An exchange is a reciprocal transfer of properties
  • An exchange isnot “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. Weidner

leslie v commissioner supplement p 182

October 1967

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.”)

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].

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.

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 v. Commissioner(Supplement p. 182)

March 1967 Leslie bought land for new factory

Donald J. Weidner

leslie co v commissioner cont d
Leslie Co. v. Commissioner (cont’d)
  • Leslie first explored other financing sources, without success.
  • Today’s right to receive $1,180,000 at the end of 30 yrs., assuming a 7% discount rate, has a present value of $154,580.
  • Leslie reported: AR = $2.4 million

-AB = 3.2 million (cost)

Loss = ( .8 million)

  • IRS denied the loss. It 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.”
    • It allocated the unrecovered basis to the lease, as in Century Electric (only the lease here is shorter)

Donald J. Weidner

leslie cont d
Leslie (cont’d)
  • Stipulated: the useful life of the building was 30 years
    • although Prudential reported depreciation over a 50-year useful life.
  • On its books: Leslie amortized $800,000 of unrecovered cost of plant construction over 30 years.
    • In effect, what the IRS wanted it to do for tax purposes by treating 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

Donald J. Weidner

leslie tax court
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.
    • Because Section 1031 is an exception to this general rule, it must be strictly construed.
  • In order for Section 1031 to apply, there must be an exchange,
    • which the IRS regulations define as “a reciprocal transfer of property.”
  • A transfer of property for money does not qualify as an exchange.

Donald J. Weidner

leslie tax court cont d
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 a sine qua non of the transaction), it did not have the right kind of value—it did not have capital value

Donald J. Weidner

leslie tax court cont d98
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 comparables.

Donald J. Weidner

leslie tax court cont d99
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.”
  • The Tax Court said the $ 800,000 was “clearly attributable” to the land and building, not to the leasehold.
    • Concluding there was a genuine sale at a loss.
    • Thus rejecting the IRS position that there was an exchange of a fee for a lease

Donald J. Weidner

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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.”

Donald J. Weidner


Leslie (Tannenwald Dissent)

  • 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 can not be the vehicle for denying Leslie’s claim of a loss:

Donald J. Weidner

leslie tannenwald dissent
Leslie (Tannenwald Dissent)
  • Tannenwald’s FN 4 states two alternative grounds for holding that Leslie may not claim a “loss” on a “sale”:
    • That 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.
      • Recall, in FN 7, Judge Irwin speculated that the IRS accepted the stipulation of FMV to avoid having the transaction characterized as “financial” (a mortgage).
    • That Leslie acted as Prudential’s agent in constructing the bldg.

Donald J. Weidner

leslie tannenwald dissent103
Leslie (Tannenwald Dissent)
  • Tannenwald’s 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.

Donald J. Weidner

leslie tax court dissents cont d
Leslie: Tax Court dissents (cont’d)
  • Judge Wilbur, dissenting in FN 4, rejects 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.”

Donald J. Weidner

leslie cont d105
Leslie (cont’d)
  • An additional argument that could be made to disallow the loss: Under IRC 446(b), if “the [accounting] method used [by the Taxpayer] does not clearly reflect income, the computation . . . shall be made under such method as . . . does clearly reflect income.”
  • Finally: will Prudential ever do business with Leslie again? See 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 the “mortgage” issue.

Donald J. Weidner

revenue ruling 90 34 supplement p 202
Revenue Ruling 90-34(Supplement p. 202)
  • X and Y enter into a contract that requires X to transfer Blackacre to Y.
    • Blackacre has a Fair Market Value of $1Million and has been used by X in X’s trade or business.
  • The contract also requires Y to transfer to X, property, that is not yet identified, that is of like kind and that has the same Fair Market Value.
  • The contract requires X to locate and identify property with a $1million Fair Market Value that is of like kind within 45 days of X’s transfer of Blackacre.
    • section 1031(a)’s 45-day “identification period”
  • The contract requires Y to purchase and transfer the identified property to X before the earlier of 180 days from the date of the transfer of Blackacre or the due date for X’s tax return for the year in which X transfers Blackacre.
    • section 1031(a)’s 180-day “exchange period”

Donald J. Weidner

rev rul 90 34 cont d
Rev. Rul. 90-34 (cont’d)
  • If X fails to identify the property or Y fails to purchase and transfer that property, Y must pay $1M in cash.
  • Neither X nor Y contracts to exchange Blackacre with any other party.
  • Within the appropriate time periods:
    • X identifies Whiteacre, owned by Z, as property for Y to buy.
    • Y pays Z and directs Z to transfer Whiteacre to X before the end of the exchange period.
    • Z transfers Whiteacre to X.
  • X holds Whiteacre for use in its trade or business.
  • The “exchange” is good, and not a direct purchase by X, even though:
    • Y never held title to Whiteacre.
    • Y paid Z for Whiteacre pursuant to X’s instruction.
    • Z transferred Whiteacre directly to X.

Donald J. Weidner