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Donald J. Weidner
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Tax-Free Exchanges: The Fischer Article (Text p. 957)
#1 Transfer of Unqualified Property
A
TX
AA with a FMV of $11,000
RE with an AB of $10,000
Stock with a FMV of $2,000
with an AB of [$5,000]
B
A
TX
BBA
RE with a FMV of $13,000
A’s Basis in Property Received?
A takes the $2,000 portion of BA A received for the stock with a basis of $2,000.
A takes the $11,000 portion of BA A received for the real estate with a basis of $10,000.
Tax consequences to A?
Basic analysis : Bifurcate into two exchanges
1) “A is deemed to have received a $2,000 portion of the acquired real estate (BA) in exchange for the stock, since $2,000 is the FMV of the stock at the time of the exchange. A $3,000 loss is [realized and] recognized under section 1002 on the exchange of the stock for real estate.”
2) “No gain or loss is recognized on the exchange of the real estate since the property received is of the type permitted to be received without recognition of gain or loss…”
A’s basis in BA is
$2,000 + $10,000 = $12,000
Continued…
Donald J. Weidner
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A’s basis in BA is $2,000 + $10,000 = $12,000
First Exchange
2/13ths interest
Second Exchange
11/13ths interest
Total basis in BA
A’s total basis in BA is the sum of the bases A received in the two exchanges in which he received an 11/13 interest in BA and a 2/13 interest in BA.
Full recognition on two exchanges would have been: $1,000 gain
+ $3,000 loss The loss is recognized
The basis rules postpone the gain: take $13,000 FMV property at $12,000 basis.
Donald J. Weidner
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#2 Receipt of Unqualified Property (Recall 1031(b))(taxpayer actually receives cash)
The Taxpayer must value the property received
A
TX
A Transfers RE with AB of $5,000
B Transfers:
RE [with FMV of $6,000]
Cash of $2,000
B Tax consequences to A?
Here, A’s realized gain is computed
AR = $8,000 [$6,000 FMV of RE + $2,000 cash]
-AB = $5,000 [basis in RE transferred to B]
GAIN = $3,000 Gain Realized
“The gain [realized] from the transaction is $3,000, but is recognized only to the extent of the cash received of $2,000.”
Recognition of the remaining gain is deferred under 1031(a).
“The receipt of cash in partial consideration for the exchange of property is tantamount to a partial sale of the property and will cause the recognition of any gain accordingly.”
A’s basis in the real property received (see 1031(d)) :
AB in property given up $5,000
+ Gain recognized 2,000
- cash received 2,000
- any loss recognized n/a
Basis in real property received $5,000
A takes 1. $2,000 cash with $2,000 basis; and
2. $6,000 FMV property with $5,000 basis.
$1,000 additional gain remains to be recognized
Donald J. Weidner
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Transfer of Property Subject to a Liability and 1031(taxpayer is deemed to receive cash)
• See 1031(d): “For purposes of this section . . . where as part of the consideration to the taxpayer another party to the exchange assumed a liability of the taxpayer or acquired from the taxpayer property subject to a liability, such assumption or acquisition (in the amount of the liability) shall be considered as money received by the taxpayer on the exchange.”
• When one transfers property subject to a liability, the shifting of that liability to another is treated as a receipt of “other property or money” by the transferor under 1031(b)—even if the transferee only takes “subject to” the liability.
Donald J. Weidner
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Transfer of Property Subject to a Liability and 1031 (deemed receipt of cash) (cont’d)
• Recall Tufts: one who transfers property subject to a mortgage is deemed to receive (“constructively receives”) cash in the amount of the unpaid balance of the mortgage. – The amount of the mortgage is treated either as
an “amount realized” or as “discharge of indebtedness income,” depending upon the circumstances.
• The following example shows an exchange of property subject to a mortgage and is from Treas. Reg. 1.1031(d)-2, Example (1).
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B
Txpr.
CTransfers Apt. House #1 with $800,000 FMV
Transfers Apt. House #2: [with a FMV of $600,000] + 50,000 cash
Subject to a 150,000 M
AB = $500,000
House #1 has a FMV of $800,000 and a net equity of $650,000 [equal to the $650,000 value that Tx. B received]. In a taxable exchange, A’s amount realized would be $800,000 ($650,000 cash and property received plus $150,000 mortgage “relief”), producing a $300,000 gain that is both realized and recognized.
Tax Consequences to B under 1031?
What has B obtained in the exchange?
Consideration received by B: $150,000 “relief”
600,000 value
50,000 cash
Total Consideration $ 800,000
How much gain did be realize in the exchange?
Total Consideration $ 800,000
-AB (unrecovered cost) 500,000
Realized Gain $300,000
If §1031(b) applies: The realized gain is not all recognized. Recognized gain is limited to cash received and non-like kind property received.
Actual Cash Receipt $ 50,000
+Deemed Cash Receipt 150,000
Total cash received $200,000
**Note there is a twin limitation on recognition: the lesser of the gain realized or the cash received.
Continued…
Note: because there is a receipt of unqualified property, the properties exchanged must be valued.
Donald J. Weidner
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$ 200,000 realized gain that is recognized
+ 100,000 realized gain not recognized per 1031
$ 300,000 total realized gainRecognition of the realized but unrecognized gain is deferred until the new property is transferred in a subsequent taxable exchange.
What is B’s Basis in Apt. House #2?
B takes apartment house #2 with a basis that is computed
as follows:
AB in property transferred (apt. house #1) $500,000
- cash received
actual 50,000
constructive 150,000
200,000 - 200,000
+ gain recognized on exchange +200,000
B’s Basis in Aptmt House #2 $500,000
Subsequent sale by B of Apt. House #2:
If that house were sold with no other change in value, it would be sold for $600,000 and gain would be:
$600,000 AR
-500,000 AB
$100,000
The remaining $100,000 of gain that was realized but unrecognized on the exchange is finally recognized on the subsequent sale.
Continued…
Granted that you want to allocate basis to the cash you actually receive (up to its face amount), why do you want to allocate basis to the cash you only constructively receive? You must pay back the “advance credit,” the basis, you received in the amount of the mortgage when you acquired the property. Mayerson,Tufts.
Donald J. Weidner
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Section 1031 Recap
• Back to the bigger picture. For §1031 to apply, there must be:
• an exchange– a “reciprocal transfer of property”;
• of qualified properties – held either for:
• use in a trade or business; or
• investment;
• that are of like kind (nature or character matters [real property versus personal property], not “mere” grade or quality).
Donald J. Weidner
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Pays $
Starker v. United States (9th Cir. 1979)(Text p. 963) (Starker II) Day 1
T.J. Starker, his son and his son’s W
(“Starkers”)
Crown
Zellerbach
April 1, 1967 “Land Exchange A’ment”
Starkers agreed to convey all interests in 1,843 acres of timberland in Oregon
Crown agreed “to acquire and deed over” real property in Washington and Oregon
Within 5 years or Crown will pay the Starkers any outstanding balance in cash
Each year, Crown must add a 6% “growth factor” to the outstanding balance of the “exchange value credits” it gave the Starkers
Starkers Crown
Day 1
+ 2 months
May 31, 1967 [2 mos. later] Crown entered “exchange value credits” on its books
$1.5 million for T.J.’s timberland
$73,000 for S, S’s W’s timberland
The Starkers Deeded their timberland
S, S’s W(Bruce & Elizabeth)
Crown SellerS, S’s W found 3 suitable parcels, which Crown purchased and conveyed to S, S’s W pursuant to the contract. The agreed value of the 3 parcels was equal to the exchange value credit.Txprs. and victors
inStarker I
Within 4 mos. Starker I
Conveyed
(sold)
Received their own “exchange value credit’ of $73,000 for the land they exchanged.
Donald J. Weidner
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Starker I and Starker II: The Nonsimultaneous Transfers
• The son and his wife were the taxpayers in Starker I—they defeated an IRS attempt to deny them 1031 treatment.
• Having lost against the son and his wife, the IRS went after the father in Starker II.
• The 9th Circuit concluded that Starker I collaterally estopped the IRS from attacking the portion of the exchange dealing with 9 parcels that Crown purchased and conveyed to the father.– Which left with only 3 parcels to discuss in Starker II.
• None of the 3 parcels discussed in Starker II was deeded to the father, T.J. (or to his daughter), at or near the time T.J. conveyed his timberland to Crown.– That is, the common issue as to all three parcels is that the
reciprocal transfers were not simultaneous.
Donald J. Weidner
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Starker II (the first two parcels—conveyance to TJ’s daughter)Timian (Residence) & Bi-Mart (Commercial)
TJ’s Daughter [Jean Roth] [who was not a party to
the “Land Exchange
Agreement”]
Crown Seller
Seller
TJ Transferred possession of residence
Paid rent
# 1. Conveyed Timian, Residence, in 1967, to T.J.’s Daugher
Held: Nonrecognition is Denied to T.J.– NOT “held for investment” under 1031 because used as a personal residence.
Also Held: because TJ never got title, there was no exchange with him.*
[TJ spent substantial time, money, improving and maintaining Bi-Mart in the 3 months before it was conveyed to his daughter. TJ argued he controlled and managed the Bi-Mart property and directed its transfer to her.]
Held: Because TJ never got title, there was no exchange with him.*
$
Residence
$
Commercial Property
# 2. Conveyed Bi-Mart (commercial building) to T.J.’s Daughter in 1968
Donald J. Weidner
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Starker II— IRS Arguments about the Timian (residence) Property Conveyed to T.J.’s Daughter
1. First, There was no “exchange” of property with T.J. because there was no transfer to TJ-- title to the Timian property never went to T.J. – Because there was no identity of economic interests
between T.J. and his daughter, a transfer to her did not constitute a transfer to him.
• The court accepted this argument 2. Second, even if there were transfers of property to TJ,
they were not “reciprocal” because they were not simultaneous (recall, IRS Regs. define an exchange as a “reciprocal transfer of property”)– Instead, there was a sale on credit rather than an
exchange.• Note, this is a plausible argument against all
three transfer involved in “Starker II”
Donald J. Weidner
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Starker II: IRS Arguments About the Timian (residence) property conveyed to T.J.’s Daughter (cont’d)
3. TJ did not receive any 1031 qualified property because he did not receive any “trade or business” or “investment” property. • Rather, he received personal residence property.
4. And so the personal residence property TJ received was not of “like kind” with the investment property he gave up.
Note: The court rejected T.J.’s “substance over form” argument that this was, in economic substance, a transfer of title to him followed by a gift from him to his daughter.
The court was similarly formalistic as to the Bi-Mart (commercial) property transferred to T.J.’s daughter: – it concluded that T.J. never received title to the Bi-Mart
properties because Crown transferred them to his daughter.
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Starker II: Timing of Recognition as to Timian and Bi-Mart
• Because the Timian and Bi-Mart transfers did not qualify for nonrecognition under 1031, T.J. was required to recognize the gain he realized on the exchanges. – When?
• Court: “treat T.J. Starker’s rights in his contract with Crown, insofar as they resulted in the receipt of the Timian and Bi-Mart properties, as ‘boot,’ received in 1967 when the contract was made.” – Note the problem: how does you report in an initial
year (1967) the value of property not identified or transferred to you until a later year (1968) qualifying?
Donald J. Weidner
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Starker II: Timing of Recognition as to Timian and Bi-Mart (cont’d)
• The apparent answer: wait until the later year, say, year 2, to decide whether there was a qualifying LKE. If there was no qualifying LKE, go back to year 1 and treat yourself as having received boot to the extent of the value of the nonqualifying property you received in year 2.
• What if the future year is year 5? Does the statute of limitations run on year 1?
– “We realize that this decision leaves the treatment of an alleged exchange open until the eventual receipt of consideration by the taxpayer. * * * If our holding today adds a degree of uncertainty to this area, Congress can clarify its meaning.”
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Starker II and Section 1031(a)(3)
• Congress added 1031(a)(3) in direct response to Starker II.
• The “identification” requirement. Property will not be treated as like kind unless it is “identified as property to be received in the exchange” within 45 days after the taxpayer has transferred his property.
• The “exchange” requirement. Property will not be treated as like kind unless it is received within 180 days after the transfer – (or after the due date for the tax return for the year of the
transfer).
• The modified 1031 also impacts the Starker II holding with respect to the Booth property (the third, commercial parcel)– as to timing, not as to the philosophy that contract rights to
acquire real property can be a fee equivalent
Donald J. Weidner
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Starker II: The Booth Property (commercial) (the third parcel—contract rights were transferred to TJ)
TJ Crown BuyerAssigned Buyer’s contract rights [1968]
Buyer, 1968, Sells his contract rights to purchase real property subject to the life estate
In 1965, Buyer signed a contract to purchase real property from Seller. The contract was subject to a carved-out life estate.
In 1968 (a year after the “Land Exchange Agreement”), Crown purchased the Buyer’s rights under the contract and assigned them to TJ.
1. Legal title is not to pass until the life estate expires.
2. Until legal title passes, the Buyer is entitled to possession, subject to certain restrictions.
• For example, the Buyer is
prohibited from removing improvements and
required to keep buildings and fences in good repair.
1965, Third Party Contracts to sell subject to a life estate
Donald J. Weidner
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Starker II: The Booth Property
• IRS argued: There was no exchange. – Not only was there a lack of simultaneity to the
conveyances between T.J. and Crown; – there was no conveyance at all to T.J. (there was
a “total lack of deed transfer”)• Even after the expiration of 10 years
• Stated differently, the IRS argued that, because T.J. never received a conveyance of land, he never received property that was of a “like kind” with the land he transferred .
Donald J. Weidner
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Starker II: The Booth Property
• The Court rejected the IRS argument and held instead that T.J. had been transferred the equivalent of a fee:– IRS Regulations say that a lease with 30 years or
more to run is the equivalent of a fee;– T.J.’s rights are at least as great as those of a
long-term lessee; and– the fact that his interest will ripen into a fee prior to
the expiration of 30 years, if the life tenant dies, only makes the equivalence with a fee stronger.
• Once the court said that contract rights are of “like kind” with a fee, it was brought to the basic question: is the exchange disqualified because the transfers were not simultaneous (and hence not “reciprocal”).
Donald J. Weidner
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Nonsimultaneous Transfers
• Recall the basic justifications of 1031– Do non-simultaneous transfers fall within them?
• Liquidity rationale. Doesn’t fully explain 1031. – If you sell, then immediately reinvest the proceeds, the
benefits of 1031 are not available even though the reinvestment leaves the taxpayer illiquid.
– Conversely, the benefits of 1031 seem to be available even if the taxpayer has no liquidity problems.
• Valuation rationale. Doesn’t fully explain 1031. – Whenever the taxpayer receives any cash or non-
qualifying property in an exchange that otherwise qualifies, the property received must be valued to compute the realized gain, a part of which must be recognized.
Donald J. Weidner
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Nonsimultaneous Transfers (cont’d)
• Three aspects of the case make the IRS position appealing (9th Circuit focused only on the last two):– the “exchange agreement” gave the Starkers the
equivalent of a deposit into a checking account, not on a bank but on a major corporation;
– it also gave them the possibility that they might ultimately simply receive cash; and
– the agreement could remain open for a long time.
Donald J. Weidner
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Final Thoughts on Starker II
• 9th Circuit said:
1. if the parties intended to effect a swap of property, 1031 treatment is not denied simply because cash was to be transferred if a swap could not be arranged
• Recall Rev. Rul. 90-34 (Supp. p. 247)
2. elsewhere, in an attempt to deny taxpayers a loss, the IRS has argued that 1031 applies even if there is no strict simultaneity.
Donald J. Weidner
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Final Thoughts on Starker II (cont’d)• IRC 1031(a)(2)(F) says that 1031 does not apply to an
exchange of “choses in action.”• As to the argument that these contract rights were mere
choses in action and not equal to a fee, the 9th Circuit stated: 1. “[T]itle to real property is nothing more than a bundle
of potential causes of action: for trespass, to quiet title, for interference with quiet enjoyment, and so on;” and
2. “The bundle of rights associated with ownership is obviously not excluded from section 1031; a contractual right to assume the rights of ownership should not . . . be treated as any different than the ownership rights themselves.”
• Analyzing the bundle of rights and liabilities that make up an interest is also done in the analysis of leasing arrangements, including sale/leasebacks.
Donald J. Weidner
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The Sale-Leaseback: Advantages to “Buyer”• Starker’s “bundle of rights” discussion is evocative of
Justice Scalia’s approach in Bollinger: “The problem we face here is that two different taxpayers can plausibly be regarded as the owner.”– This is also often the case in the sale-leaseback area.
• For years, most life insurance company investments involved sale-leasebacks with creditworthy corporations.– They received statutory authority in the late 1940s to
make direct investments in income-producing real property
• A life insurance company typically received rent for the property it purchased sufficient to enable it, over the initial term of the lease,– to recover its entire investment,– plus a satisfactory rate of return on that investment.
Donald J. Weidner
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The Sale-Leaseback: Advantages to “Buyer” (cont’d)
• The lease provided that the life insurance company would be made whole by the tenant, even in the event of total condemnation or destruction of the property.– Recall Bolger, in which the tenant’s obligation to
pay rent continued even if the property were destroyed
• Although the insurance company/buyer must include the rent in income, it gets to take depreciation deductions on its investment in the building– assuming the form of the transaction is respected for federal
income tax purposes• As in Leslie (where the seller also claimed a loss on the sale)
Donald J. Weidner
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The Sale-Leaseback: Benefits and Burdens of “Tenant”
• Smith & Lubell, Reflections on the Sale-Leaseback, 7 Real Estate Review
11-13 (Winter 1978) states:
“This lease imposes on the lessee virtually all of the obligations, and gives the lessee substantially all of the benefits, of ownership, subject of course to the lessor’s reversionary rights in the fee.”– Recall, for example, Bolger.
Allocating virtually all the burdens and benefits of ownership to the tenant during the life of the lease, creates the risk that the lessee might be seen as the substantive owner-mortgagor.
Donald J. Weidner
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The Sale-Leaseback: Benefits and Burdens of “Tenant” (cont’d)
• Smith & Lubell state the burdens that fall on the tenant: As in “any ground lease or other absolutely net lease,” “the lessee is obligated to pay rent without off-set or deduction and also to pay– Real estate taxes;– Fire, liability and other insurance premiums;– All costs of operating, maintaining, repairing,
and restoring the premises; and– All other costs relating to the premises that
an owner would normally bear.”
Donald J. Weidner
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The Sale-Leaseback: Other Advantages to “Seller-Tenant”
• Some of the tenant benefits under the lease:
1. Seller-tenant retains the use of the property.
2. Seller-tenant may minimize its equity investment in a property. – Greater financing may be available to a
developer who sells and then leases back than under “conventional mortgage financing.”
– Some corporate tenants may obtain 100% financing.
Donald J. Weidner
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The Sale-Leaseback: Other Advantages to “Seller-Tenant” (cont’d) (and one disadvantage)
3. Seller-tenant may achieve “off-balance sheet” financing – If the Financial Accounting Standards Board (FASB)
classifies the lease as an “operating lease” rather than as a “capital lease.”
4. Seller-tenant gets the right to deduct all rent (while losing the depreciation deduction on its investment in the building)– including the rent for the land, thereby effectively
writing off the land cost.• The loss of the property at the end of the lease term is a
disadvantage—a benefit that passes to the buyer-lessor – unless there are options to renew or to purchase– but that remote “price” may have a low present value.
Donald J. Weidner
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Some Recent Developments• Many other institutional and foreign investors have been
providing financing through sale-leasebacks.• As other forms of 100% financing became available, such
as through real estate subsidiaries, large creditworthy corporations entered into fewer direct sale-leaseback transactions with insurance company investors.
• Accounting rules now make it much more difficult for sale leasebacks to be used to take debt off balance sheets.– There remains more room in the case of leases of
property the tenant did not previously own• Today, many creditworthy corporations obtain financing
through special purpose entities that issue securities – Recall Bolger
Donald J. Weidner
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Sale-Leasebacks as Equitable Mortgages
• FASB has severely limited the use of the sale-leaseback to take financing off the “tenant’s” balance sheet.– FASB says that many leases, especially those arising
from sale/leasebacks, are “capital leases” that must be reported as mortgages on the tenant’s books.
• The off-balance sheet issue most commonly arises if the seller-lessee is unwilling to give up the reversionary interest in the property.
• There can be “significant exposure” because the transaction may be treated, either for state law purposes or for federal income tax purposes, say Smith and Lubell, as “an equitable mortgage, rather than a true conveyance and a true lease.”
Donald J. Weidner
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Consequences if Substance Trumps Form
• If the form of a sale-leaseback is disregarded and it is treated as, in substance, a mortgage:
1.The lessee will be seen as having an equity of redemption such that, if the lessee defaults, the lessor will not be permitted to evict by summary proceedings but will be required to foreclose the lessee’s equity of redemption;
2. If the lessee becomes bankrupt or insolvent, the lessor will have the rights of a secured creditor rather than the rights of a landlord;
3.A deemed mortgage may be subject to substantial mortgage and intangible taxes that were not anticipated;
Consequences if Substance Trumps Form
Donald J. Weidner
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4. The resulting mortgage may be found to be usurious; and
5. The tax consequences of the transaction will change:1. There will be no gain or loss on the sale;2. The rent will be treated as debt service (with
only interest deductible by the tenant and included by the landord);
3. The tenant, and not the landlord, will be entitled to depreciation deductions.
Donald J. Weidner
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Bankruptcy or Insolvency of Tenant
• In general, in bankruptcy, a lease is an executory contract and, as such, is subject to special rules. – An executory contract is both an asset and a liability because there
is still substantial performance required on both sides of the contract.
1. If the lease characterization is upheld:• In the event of a lessee’s bankruptcy (Ch. 11
reorganization), the debtor (in the bankruptcy sense) in possession (“DIP”) has a choice to affirm or reject the lease.– If the lessee’s DIP affirms the lease, it must start making current
payments.– If the lessee’s DIP rejects the lease, the rejection will be treated as
an anticipatory breach of the lease and the landlord will have an unsecured claim for damages.
Donald J. Weidner
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Bankruptcy or Insolvency of Tenant (cont’d)
2. If the lease is recharacterized as a mortgage:• The “Lessor’s” claim against the tenant is treated as
a secured claim (rather than a landlord’s claim for breach of a lease) and the tenant’s DIP will be excused from paying debt service during the bankruptcy proceeding.– Then, if a “plan” is confirmed, debt service
payments from the tenant to the lessor will resume (although the plan may restructure the loan agreement).
Donald J. Weidner
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Bankruptcy or Insolvency of Tenant (cont’d)
• G. Nelson and D. Whitman Real Estate Finance Law 73 (5th ed. 2007):
• “[I]f the lessee-seller goes into bankruptcy, he or she usually finds it much more advantageous to be a mortgagee than a lessee. This is because a lessee who files a bankruptcy petition must either assume or reject the lease within a short period of time or the lease will be deemed rejected. In the latter situation, the lessee will be required to surrender the property immediately to the lessor. On the other hand, if the transaction is characterized as a mortgage, the seller-mortgagor often will be able to retain possession of the real estate and restructure the mortgage obligation as part of a bankruptcy reorganization plan. Finally, on rare occasions, a lessor-purchaser rather than the lessee-seller will seek to recharacterize a sale-leaseback transaction as an equitable mortgage.”
Donald J. Weidner
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Frank Lyon Company v. United States(Text p. 981)
• Worthen Bank owned a parcel of land and was constructing a building on it. – There was an office building construction race in
downtown Little Rock– The Bank wanted to hold title to the building and finance
it through a wholly-owned real estate subsidiary.– Bank regulators would not approve this approach.
• Frank Lyon Company (“Lyon”) was a distributor of home appliances. – The Chairman of the Board of Lyon, Frank Lyon, was
also on Worthen Bank’s Board of Directors.• The construction lender and the permanent lender
approved Lyon as an acceptable borrower.
Donald J. Weidner
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Frank Lyon (cont’d)
• Worthen Bank:– Retained title to the land;– Net leased the land to Lyon for 76 years;– Sold the building, piece by piece, as it was
constructed, to Lyon; and– Leased back the building from Lyon for 66 years.
• In short, Worthen conveyed to Lyon the right to possess the land for 10 years longer than Worthen retained the right to possess the building.
• For Lyon’s last 10 years as tenant under the ground lease, Lyon could do what it wanted with the building—occupy it itself or lease it to someone else-- Worthen no longer had a right to lease back the building.
Donald J. Weidner
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Frank Lyon (cont’d)
Bank Bldg.
Bank Sells Bldg.
Then Becomes a Tenant in It
LandBank Retained Title to Land but Leased It to
the Bldg Buyer
Bldg. Buyer
[Lyon Co.]Lyon Bought
Building on the land it was leasing
Lyon was ground lessee for 76 Years
Bank “sold” bldg. to Buyer
Bank “leased” bldg. back from Buyer for:
Total of 66 years [25 year base term + 8, 5-year options to renew] $600,000/yr. rent for the 25-year base term, then, rent cut in half.
Bank got options to repurchase bldg.
.
Ground lease76 years [$50/yr. rent for first 26 years, then rent increases]
N.Y. Life
Maximum Bldg.Price:
$ 500,000 Cash
7,140,000 Mortgage
$7,640,000
Lease of building gave Bank control of bldg. for 65 years. After that, Lyon had the right to keep the building on the bank’s land for 10 more years. Stated differently, Lyon had a leasehold estate in the land that lasted for 10 years after it owned the building free and clear of any lease to the Bank.
Note and Mortgage
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Frank Lyon (further facts)
• Lyon agreed to buy the building from Worthen Bank at price not to exceed $7,640,000
• Payable: $ 500,000 cash 7,140,000 N.Y. Life Mortgage $ 7,640,000• The “permanent lender” participated by a “Note Purchase
Agreement.”• Lyon’s note to New York Life was the promise to pay. • To secure repayment of the note, New York Life received: 1. Lyon gave New York Life a 1st deed of trust on the building and Bank
“joined in the deed of trust as the owner of the fee.”2. Bank also gave New York Life a mortgage on an adjoining parking
deck.3. Lyon assigned to New York Life its rights as Landlord under the
building lease with Bank (Bank agreed to the assignment);4. Lyon assigned to New York Life its rights as Tenant under the ground
lease with Bank.• Actual cost of complex (excluding land) was $10,000,000.• Lyon’s offer to pay lower rent for the first five years was first accepted
and later changed into an agreement to pay higher interest to the Bank on a “subsequent unrelated loan.”
Donald J. Weidner
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Lyon’s Net Cash Flow on its investment in the building (if Bank keeps exercising its options to renew the lease)
Years Frank Lyon’s NCF = RR
(From Bank)
-DS
(To N.Y. Life)
-Ground Rent
(Lyon Owes To Bank)
1-26 (1968-1994) $ - 50 $600,000 - $600,000 - $ 50
26-31 (1994-1999) $200,000 (5 years) $300,000 (rent from Bank cut in half)
- -0- - $100,000 (rent to Bank goes up dramatically—other increases to follow)
31-36 (1999-2004) $150,000 (5 years) $300,000 - -0- - $150,000 (escalates further)
36-41 (2004-2009) $100,000 (5 years) $300,000 - -0- - $200,000 (escalates further)
41-66 (2009-2034) $50,000 (25 years) $300,000 - -0- - $250,000 (escalates again)
66-76 (2034-2044) ? (10 years) ? - -0- - $ 10,000 (rent to Bank slashed during this last ten years)
These are 8 additional 5-year terms available to Bank under building lease. That is, the rent Lyon RECEIVES from the bank does not change once these 5-year lease renewal terms begin. BUT the rent Lyon must PAY the bank for as ground rent keeps going UP.
Ground lease from bank 10 years longer than building lease to Bank (Bank did not have an option to lease the bldg. for the last 10 years of its ground lease to Lyon).
Donald J. Weidner
42
Condemnation or Destruction
• Bank’s obligation to pay rent to Lyon was not affected by any damage or destruction to the building.– That is, Bank had greater obligations than those of a normal tenant
• But not greater obligations than those of tenants in sale-leasebacks.
• Any (a) condemnation award, and (b) any insurance proceeds resulting from a total destruction of the building, would be applied in the following order:1. to New York Life in an amount sufficient to fully prepay the mortgage;
2. the next tranche to Lyon up to the amount of Lyon’s $500,000 down payment plus 6%; then
3. any excess to Bank.
• Thus: condemnation awards were allocated as if New York Life and Lyon were both lenders and Bank was the owner.
• Bank had the option to either replace the building or to purchase it in the event of a partial condemnation or total destruction on or after December 1, 1980 (after about 12 years).– Here again, Bank had more of the bundle of sticks than is usually in the
hands of a “mere” tenant.
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43
Bank Had Four Options to “repurchase” the building
• After 11 years for $6,325,169– in fact, Worthen purchased at this point, when its tax shelter
would have collapsed
• After 15 years for $5,432,607• After 20 years for $4,187,328• After 25 years for $2,145,935
The option price at each date equaled:
1. The unpaid balance of the N.Y.Life Note; plus
2. Lyon’s $500,000 down payment plus 6% compound interest
Donald J. Weidner
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Bank’s options to “repurchase” the building (cont’d)
The prices on the options to purchase were the same as if Lyon had a 6% passbook account with the Bank.
However, the District Court said that the option price: “also represents the negotiated estimate of [Lyon] and [Bank] as to the fair market value of the building on the option dates, which the court finds to be reasonable. The [IRS] produced no witnesses to contest the reasonableness of the option prices.”
Was the District Court too credulous?
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45
Bank’s Options to Repurchase the Building (cont’d)
• The District Court concluded that the Bank was unlikely to exercise these options to purchase, given:– The Bank’s future capital requirements;– The substantial amount of the option price; and – The reasonableness of the net rent the Bank
would pay if it remained a Tenant.• Bank also had a right to purchase the building at fair
market value if– Lyon became insolvent or– control of Lyon changed hands
• Presumably, the value of Bank’s right to purchase at fair market value was limited by the price of Bank’s Options to Repurchase
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46
Possibilities if Bank Does Not Exercise Its Options to Purchase
1. If Bank does not exercise its options to renew the building lease:
1. Lyon would remain liable for the substantial rents required by the ground lease; and
2. Lyon would still control the building.• “This possibility brings into very sharp focus the fact that
Lyon, in a very practical sense, is at least the ultimate owner of the building. If [Bank] does not extend, the building lease expires and Lyon may do with the building as it chooses.”– That is, in this situation, there is no promise that Lyon will
be repaid its $500,000, with or without interest.
2. If Bank extends the building lease by exercising all the lease renewal options: says the IRS, “the net amounts payable . . . would approximate the amount required to repay Lyon’s $500,000 investment at 6% compound interest.”
Donald J. Weidner
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Basic Possibilities Summarized
1. Bank Exercises Its Options to Renew Its Lease of Bldg.• Lyon gets a return of its investment, plus approximately 6%, no
more
2. Bank Walks Away at the End of the Base Lease Term• At that point, Lyon has not gotten back any of its investment,
much less a 6% return, and could get less or more
3. Bank Exercises one of its Options to Purchase• Lyon gets a return of its investment plus 6%, no more
4. Bank Exercises its Right to Purchase if Lyon becomes insolvent or has a change of control• Although formally at fair market value, the price presumably is
informed by Bank’s Options to Purchase, in which event Lyon gets a return of its investment plus 6%, no more
5. The Property Is Condemned• Lyon gets return of investment plus 6%, no more
Donald J. Weidner
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District Court Permitted Lyon to Claim Depreciation Deductions
• District Court rejected the argument that Bank was acquiring an equity through its rental payments– Even though the rent payments reduced the balance owed to N.Y. Life
and hence the cost of the Bank’s option to purchase – Concluded that rents were unchallenged and reasonable throughout
the period (fair value for possession and not to purchase an equity).
• Concluded that the option prices, negotiated at arms-length, represented fair estimates of fair market value on the option exercise dates– rejecting any negative inference from the fact the option prices were the
amounts needed to (a) pay off N.Y.Life Loan + (b) pay $500,000 + 6%.
• Concluded that Bank would acquire an equity only if it exercised an option to purchase– which it found highly unlikely.
• Concluded that Lyon had mixed motives, including the desire for the benefits of a “tax shelter.”
Donald J. Weidner
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Eighth Circuit Reversed the District Court
• Eight Circuit held: Lyon was not the true owner – Therefore, Lyon was not entitled to depreciation deductions.
• Property rights are analogous to a “bundle of sticks,” and “Lyon ‘totes an empty bundle’ of ownership sticks:”
1. Lyon’s right to profit from its investment was circumscribed by Bank’s option to purchase at a price equal to Lyon’s investment, plus 6% thereon, plus the unpaid balance on the N.Y.Life mortgage;– That is, Bank had the option to get title to the building
back by treating Lyon as a second mortgagee @ 6%
2. The prices of Bank’s options to purchase did not take into account any appreciation in the value of the building, even from inflation;– Hence, Lyon had fewer rights than the normal owner
of a commercial building
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Eighth Circuit Reversal (cont’d)
• Lyon’s “empty bundle” (cont’d)3. Any amount realized from destruction or condemnation
in excess of the NY Life mortgage and return of Lyon’s $500,000 plus 6% would go to Bank rather than to Lyon; and– That is, Bank got all of any equity through amortization and/or
appreciation
4. The building rent during the base term was equal to debt service and hence gave Lyon zero cash flow; and
5. Bank retained control over the building through its:– a) options to purchase the building, – b) options to renew its lease of the building, and – c) ownership of the site.
• In summary, Bank had virtually all of the benefits and burdens of ownership of the building and Lyon merely got a tax shelter for 11 years.
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Supreme Court reversed Eighth Circuit and Allowed Lyon the Depreciation Deductions
Consider the significance of each of the following points made by the Supreme Court:
• Supreme Court distinguished Lazarus (which treated a sale-leaseback as a mortgage) by saying it involved only two parties: – “The present case, in contrast, involves three parties, [Bank],
Lyon and the finance agency.”
• The Court also noted that the transaction was compelled:– “Despite Frank Lyon’s presence on [Bank’s] board of directors,
the transaction, as it ultimately developed, was not a familial one arranged by [Bank], but one compelled by the realities of the restrictions imposed upon the bank. Had Lyon not appeared, another interested investor would have been selected.”
• This last part is what troubles the IRS—someone was going to get a pretty naked tax shelter, at least for the first 11 years.
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Supreme Court’s Points to Reverse the Eighth Circuit
• Lyon had more risk than the typical second mortgagee.
1. Lyon alone was liable on the New York Life Loan:– “Here . . . most significantly, it was Lyon alone,
and not [Bank], who was liable on the notes, first to City Bank, and then to New York Life.”» However, Bank was obligated to pay “rent” equal
to the debt service on the notes
2. Lyon was an ongoing business entity that placed the rest of its business at risk by undertaking this liability– “Lyon, an ongoing enterprise, exposed its very
business well-being to this real and substantial risk.”
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Supreme Court Emphasized Risk
• Lyon’s Risk beyond that of a second mortgagee (cont’d):
3. “The effect of this liability on Lyon is not just the abstract possibility that something will go wrong and that [Bank] will not be able to make its payments. Lyon has disclosed this liability on its balance sheet for all the world to see. Its financial position is affected substantially by the presence of this long-term debt, despite the offsetting presence of the building as an asset.”
• “To the extent that Lyon has used its capital in this transaction, it is less able to obtain financing for other business needs.”
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Some Other Factors
• “[T]he characterization of a transaction for financial accounting purposes, on the one hand, and for tax purposes, on the other, need not necessarily be the same.” – Recall Leslie said the same thing
• Here, the regulators would not permit a direct mortgage.– Can Lyon be limited to transactions that are
compelled?• Could Bank also be attempting a Leslie?
– And claiming a tax loss on the “sale” of the building?
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Blackmun on 2d Mortgages and Ownership• Blackmun says there was no second mortgage from Lyon to
Bank because Bank did not promise to repay Lyon: – “There is no legal obligation between Lyon and [Bank]
representing the $500,000 ‘loan’ extended under the Government’s theory.”
– “And the assumed 6% return on this putative loan . . . will be realized only when and if [Bank] exercises its options.”
• The rents alone, due after the primary term of the lease (Lyon had negative NCF during the primary term), do not provide Lyon the simple 6% return the IRS alleges. – “Thus, if [Bank] chooses not to exercise its options [to
purchase], Lyon is gambling that the rental value of the building during the last 10 years of the ground lease, during which the ground rent is minimal, will be sufficient to recoup its investment.”
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More Blackmun Points
• “It is not inappropriate to note that the Government is likely to loose little revenue, if any, as a result of the shape given the transaction by the parties.”– Such language is not often seen in tax cases
• “Lyon is not a corporation with no purpose other than to hold title to the bank building. It was not created by [Bank] or even financed to any degree by [Bank].”– This can be an important limiting factor in the case
• “[N]one of the parties to this sale-and-leaseback was the owner of the building in any simple sense.”– Recall Scalia in Bollinger said the same thing.– Recall the “bundle of potential causes of action” that
was the equivalent of a fee in Starker.
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More Blackmun• “But it is equally clear that the facts focus upon Lyon as
the one whose capital was committed to the building and as the party, therefore, that was entitled to claim depreciation for the consumption of that capital.”
• Did Bank make a greater commitment of capital than Lyon? Bank:
1. Promised to pay rent equal to the debt service for the first 25 years and in the process repay the debt.
2. Also promised to pay all operating expenses for those 25 years
3. Also paid the difference between the purchase price and the $10 million actual cost
4. Also mortgaged the adjoining parking garage• In a footnote, Justice Blackmun cited World Publishing.
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The “Black Letter” Law of Frank Lyon
• There are two statements of the Frank Lyon test.
1. The long form: “In short, we hold that where . . . there is [1] a genuine multiple-party transaction [2] with economic substance which is [3] compelled or encouraged by business or regulatory realities, [4] is imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.”
2. The short form: “Expressed another way, so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.”
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Justice Stevens’ Dissent
• Justice Stevens said some of Justice Blackmun’s factors are “largely irrelevant:” – the number of parties; – the reasons for structuring the transaction; and– the tax benefits that may result.
• The “controlling issue” is “the economic relationship between” lessor and lessee.
• “The question whether a leasehold has been created should be answered by examining the character and value of the purported lessor’s reversionary estate.”– How many of the benefits were retained by Frank Lyon Co. as
nominal owner-lessor?
• Stevens’ opinion emphasized benefits of investment– Whereas Blackmun’s opinion emphasized risk
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Stevens’ Dissent (cont’d)• “For a 25-year period [when Bank can acquire full
ownership by repaying the amounts advanced by N.Y.Life and Lyon, plus interest] the economic relationship among the parties parallels exactly the normal relationship between an owner and two lenders, one secured by a first mortgage and the other by a second mortgage.”
• The options to purchase give Bank all equity buildup during the base lease term:– “All rental payments made during the original 25-year term
are credited against the option repurchase price, which is exactly equal to the unamortized cost of the financing.”
• Bank can exercise its repurchase option cost-free, and Lyon, “the nominal owner of the reversionary estate, is not entitled to receive any value for the surrender of its supposed rights of ownership.”
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Stevens’ Dissent (cont’d)
• Justices Stevens quoted Estate of Franklin: 1. “’[D]epreciation is not predicated upon ownership of
property but rather upon an investment in property.’”2. “No such investment exists when payments of the
purchase price in accordance with the design of the parties yield no equity to the purchaser.”
• But Franklin involved nonrecourse financing.– Stevens would apparently extend the Franklin analysis to a
recourse financing situation.
• More Justice Stevens: “Here, [Lyon] has, in effect, been guaranteed that it will receive its original $500,000 plus accrued interest. But that is all. It incurs neither the risk of depreciation nor the benefit of possible appreciation.”– “[Bank], on the other hand, does bear the risk of depreciation,
since its opportunity to make a profit from the exercise of its repurchase option hinges on the value of the building at the time.”
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Stevens’ Dissent (conclusion)
• Lyon “has assumed only two significant risks.” – “First, like any other lender, it assumed the risk of [Bank’s]
insolvency.” – “Second, it assumed the risk that [Bank] might not
exercise its option to purchase at or before the end of the original 25-year term.”
• “If [Bank] should exercise that right not to repay, perhaps it would then be appropriate to characterize [Lyon] as the owner and [Bank] as the lessee.”
– Reminiscent of Geneva Drive-In?• “At present, since [Bank] has the unrestricted right to control
the residual value of the property for a price which does not exceed the cost of its unamortized financing, I would hold, as a matter of law, that it is the owner.”
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Idiosyncratic Facts• Text at 993 states that Frank Lyon offers little guide
to planning because it is idiosyncratic in several ways:1. The barriers imposed by regulators are rarely present.
2. A limited partnership is the modal investment vehicle.
3. The limited partnership typically uses nonrecourse financing such that there will not be any personal liability to the institutional lender.
4. The limited partnership is likely to be a thinly-capitalized, single-purpose entity, with no business apart from the transaction at issue.
• Compare Hilton, next slide, which involves limited partnerships that receive a conveyance from a nominally capitalized single-purpose entity that obtained financing that was nonrecourse as to the partnerships.
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Options to Broadway to renew lease for additional 68 years
Hilton (Part I) (Supp. p. 248)
Fourth Cavendish [single purpose financing Cp.] owned by investment firm that “served as the intermediary in negotiating the transaction between Broadway and the insurance companies”. Capitalization: $1,000
5 Insurance Companies [agreed to lend (purchase notes) on completion of construction]
Broadway intended to build new store, to internally finance construction but get external “take-out.”
The Bakersfield land cost $198,000. Total land and construction cost $3.3 million.
Formed as the shopping center store was being completed
Sells
its
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es
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.Pai
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s.
Sold land and bldg.
Paid $ purchase price ($3.15M: building cost, not land cost) with proceeds from sale of Fourth Cavendish M notes.
Leased back land and bldg. (net lease)
Broadway’s annual rent for 30-yr. base term = DS on the 30-yr. M notes (not fully SAM:10% balloon at end of 30 yrs.) @ 6.33% of $ purchase price [Interest @ 5.5% year was determined by Broadway’s credit rating.]
@ 1.5% of purchase price for first 23-year renewal term [rent slashed 75% after notes are paid ].@ 1% of purchase price for 2nd and 3rd renewal terms (23 yrs. and 22 yrs.)
Medway (GPP)
Formed to receive the interest from Fourth Cavendish
Fourth Cavendish conveyed land and bldg. “subject to”
a) The lease
b) The mortgage indenture
c) The assignment of lease
d) Encumbrances of record
DEED
No consideration or assumption of M Original Ps in Medway were
14th P.A. LPP (49% int.) (TXs were Ps)
MacGill (1% int.) (P in Inv. firm)
Cushman (50% int.) (P in Inv.firm)
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Hilton (Part II)Fourth Cavendish
Single Purpose Financing Corp. Broadway“Sold” (see previous slide)
MEDWAY
(GPP with 3Ps)
1) 14th P.A., LPP 49%
2) MacGill 1%
3) Cushman 50%
Conveyed in 1967
MacGill, Cushman, were both Ps in the investment firm
Just formed
14th Prop. Assoc., LPP
GP: JRYA
(Frequent syndicate participator)
Zero cap. contribution
LPs: Individuals 1) contributed $180,000
2) were allocated 100% of profits and losses
Just formed, acquired interest in Medway
$180,000 traced as follows:
1) $70,000 to GP (JRYA) for “SERVICES”
2) $110,000 to Medway as 14th PA LPP’s contribution to the capital of Medway (Medway paid the $110,000 to Cushman for “services”)
Table 1 in opinion: Forecast of operations for Medway for part of 1967 thru 1980: $922,923 tax losses.
These 14th PA limited partners were the taxpayers
1969 conveyed all but .5% (2 years later) of his interest
Grenada Assoc., LPP
GP: Cushman
1% interest in Grenada
LP: 37th Prop.Assoc., LPP (formed by JRYA)
99% interest in Grenada
GP: JRYA
LPs: Individuals LPs Contributed $155,000
$155,000 traced as follows:
1) $60,000 to GP JRYA for “services”
2) $95,000 to Grenada as 37th PA LPP’s contribution to the capital of Grenada, which paid the $95,000 to Cushman for “services”
37th PA limited partners were also taxpayers
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Hilton (cont’d)
• Principal issue: are the partners “entitled to deduct their distributive shares of partnership losses.”
• Notwithstanding the “tiered partnership labyrinth, the central issue . . . is the bona fides of the sale-leaseback. This is essentially an exercise in substance versus form.”
• “The terms of this sale and leaseback transaction are fairly traditional.”
• IRS made 3 basic arguments:1. The transactions were “sham” transactions, contrived for tax
purposes, and should be disregarded.2. Tax consequences should be determined by substance, not form,
and, in substance, this was not a sale but a financing transaction with a note and a mortgage by Broadway.
3. The partnerships were not engaged in purposive economic activity and therefore are not entitled to deductions that are premised on purposive economic activity.
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Hilton and Frank Lyon• On the “financing transaction” challenge, the
transaction must be tested, under Frank Lyon, to determine whether it is:
1. Genuinely multi-party;
2. With economic substance;
3. Compelled or encouraged by business or regulatory realities – [business but not “regulatory” realities are claimed here];
and
4. Imbued with tax-independent considerations that are not shaped solely by tax-avoidance features.
Lyon says, if these factors are present, the IRS should defer to the taxpayer’s choice of form.
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68
Hilton and Frank Lyon
• Frank Lyon’s lesson is not “that we are to accept every putative sale-leaseback transaction at face value.”
• Although “the seller-lessee’s financing requirements may be a valid business purpose to support a sale-leaseback transaction for tax purposes,” – the transaction “will not stand or fall merely
because it involved a sale-leaseback mandated by Broadway’s financing requirements.”
• To Emphasize: Even if the transaction was economically compelled, its form can still be disregarded – as has always been the case under the state law of mortgages
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Genuinely Multi-Party?
1. From Broadway’s point of view, “the transaction had economic substance and was encouraged by business realities:”– conventional financing from insurance companies
would have been only 75% of value (vs. the 100% of building cost obtained through this sale/leaseback);
– Broadway had limitations in its loan and credit agreements with banks that put• a ceiling on the total debt it could incur; and• limits on the total value of its property that could be
mortgaged.– Also, Broadway, in effect, got to deduct 90% of
principal and 100% of interest.
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Genuinely Multi-Party? (cont’d)
2. From the point of view of the insurance companies, “the transaction had economic substance and was encouraged by business realities:”– the insurance companies had limits on the
amounts and proportions of their funds that could be committed to direct real estate “mortgages”; and
– the note purchase, secured by a lease with a well-rated tenant, allowed the insurance companies to avoid other lending restrictions.
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71
Genuinely Multi-Party? (cont’d)
• “In this context, we do not deem the existence of [1] a net lease, [2] a nonrecourse mortgage or [3] rent during the initial lease term geared to the cost of interest and mortgage amortization to be, in and of themselves, much more than neutral commercial realities.”
• “Furthermore, the fact that the transaction was put together by an ‘orchestrator’ . . . would not alone prove fatal to the buyer-lessor’s cause – provided the result is economically meaningful on
both sides of the equation.”
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Genuinely Multi-Party? (cont’d)
• Judge Nims said: Frank Lyon looked at the substance of the interest of both seller-lessee and the buyer-lessor and the legal and economic substance of the contractual relationship between the two.
• The focus here must be on the buyer-lessor:
“[D]oes the buyer-lessor’s interest have substantial legal and economic significance aside from tax considerations, or is that interest simply the purchased tax byproduct of Broadway’s economically impelled arrangement with the insurance companies?”
--Nice statement
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73
With Economic Substance?
• The facts are like the “paradigmatic facts” of Bolger, however, here, the Commissioner “does not so blithely abandon ship and it is the efficaciousness of the lease, itself, which he now frontally attacks.”
• Frank Lyon says that the taxpayers “must show not only that their participation in the sale-leaseback was [1] not motivated or shaped solely by tax avoidance features that have meaningless labels attached, but also
• [2] that there is economic substance to the transaction independent of the apparent tax shelter potential.”– Is that the lesson you got from Frank Lyon?
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With Economic Substance?
• Recall: Depreciation is predicated upon investment, not ownership. Mayerson.
• Hilton says that another way of stating the Frank Lyon test “is suggested by” Estate of Franklin, to wit: “Could the buyer-lessor’s method of payment for the property be expected at the outset to rather quickly yield an equity which the buyer-lessor could not prudently abandon?” – If it can not be expected to yield an equity, the
buyer-lessor has not made an investment in property.
– This sounds like Stevens’ dissent in Frank Lyon rather than Blackmun’s majority opinion.
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75
The “Fatally Defective” Analysis of the Taxpayer’s Expert on Economic Substance
• Taxpayer’s expert based most of his analysis on assumptions about the value of the property.– He assumed that, on whatever date that Broadway
decided not to exercise its options to renew its lease (whether at year 30, 53 or 76), the value of the property would be equal to its purchase price
• this is known as the “100% residual value theory”• which he conceded might be “slightly positive”
– He also made certain assumptions about how much it would cost to refinance the balloon
• He did not consider many of the factors that would be considered by a qualified appraiser.
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The Taxpayer’s Defective Expert on Economic Substance (cont’d)
• Even based on the Taxpayer’s assumptions, “the present value of the property determined on a conservative actuarial basis would not be indicative of economic substance.” (see FN. 23)
• Those Taxpayer assumptions were:1. for the first 30 years, there was no pre-tax cash flow.2. beginning at the end of 30 years and ending 23 years
thereafter, the pre-tax net income will be $23,000 per year (net cash flow after estimated debt service to refinance the balloon @ 5 1/8% interest);
3. the property could always be sold for its original cost: $3.15 million; and
4. the property will be free and clear of financing at the end of 53 years.
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The Taxpayers’ Expert on Economic Substance (cont’d)
• In short, the court in FN. 23 calculated the present value of the interest the SPE purchased by adding:
1. the $49,271 Present Value of the $23,000 per year NCF that begins in year 31 with the start of the first lease renewal term and continues through year 53 (rent from Broadway minus estimated DS to refinance the balloon) ; and
2. the $143,640 Present Value of the right to receive property worth $3.15 million at the end of 53 years; for a
• Total Present Value of $192,911• Roughly 6% of the sale price
• The court then found a “deficit” between this total Present Value of $192,911 and the $334,000 cost of the partners’ interests.
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The “Generally Persuasive” IRS Expert
• The IRS Expert:
1. Made a thorough investigation of – the property (including the neighborhood) and – the details of the transaction.
2. Determined that the life expectancy of the housing stock followed the “general rule” and would have a life span somewhere between 50-60 years with little change in the characteristics of the inhabitants. See FN 24.
3. Determined that Broadway would expect to occupy for more than 30 years and, hence, was likely to exercise “its right to extend the lease through the first option period of 23 years.”
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79
The “Generally Persuasive” IRS Expert (cont’d)
• Beyond 50-60 years, properties tend to become, “if not physically deteriorated, at least marked by obsolescence and, therefore, are no longer attractive to the persons who originally inhabited them.”– Therefore, no prediction can be made that Broadway
would renew the lease past the first 23-year renewal option period.
– Also, the cost of removing the store would have to be a factor (noting a single-purpose structure designed to serve the needs of a specific type of tenant).
• Returns in years after the first lease renewal term, in addition to being too speculative, would also have to be deeply discounted, so were not counted.
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IRS Expert on Sources of Profit to the Partners
• The IRS expert summarized the “potential sources of economic gain” (the benefits in the bundle of sticks) of the partnership-owners under the following categories:
1. net income or loss;
2. net proceeds from sale;
3. net proceeds from condemnation; and
4. net proceeds from mortgage refinancing.
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81
Sources of Profit to the Partners (cont’d)
1. Net income or loss (net cash flow):– There will be no net cash flow for the 30-year base term of
the lease because all the rent is dedicated to debt service;– The net cash flow during the first 23 lease renewal term is
quite low. • First, because the rent is substantially reduced during
the lease renewal periods.• Second, the rent receipts from Broadway will be reduced
by the debt service the partnerships must pay to refinance the balloon due at the end of the 30-year base term. – to pay the balloon, the partners must either
» make new capital contributions to pay off the balloon or
» refinance the balloon.
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82
Sources of Profit to the Partners (cont’d)
2. Net Proceeds from Sale:– Net proceeds from sale will be significantly limited
by the lease and lease renewal options.– More specifically, the partners’ opportunity for
gain on sale “will be limited to any then-present value of the rental income flow and the residual, the combined total of which . . . is minimal and in any event less than [the partners’] investment.”• “The reason . . . is that . . . the lease . . . gives
Broadway carte blanche to sublet the property or assign its leasehold interest after the original term of the lease.”
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83
Sources of Profit to the Partners (cont’d)
2. Net Proceeds from Sale (cont’d)– “Since Broadway will continue to have virtually total
control of the property for an additional 68-plus years after the expiration of the original term, and since [the partners’] interests will be strictly limited for all those years, Broadway, and not [the partners], will be in a position to realize the true economic value of the property by the simple expedient of using the property, itself, at nominal cost or subletting or assigning it to another for the then-going rate”
• Thus, Broadway had the economic equivalent of an option to repurchase
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Sources of Profit to Partners (cont’d)3. Net Proceeds from Condemnation:• In one situation, a total taking, there is a potential for gain
by the partners:– If there is a total (or substantial) taking such that
Broadway considers the property unsuitable for use or not feasible to rebuild, “the lease will terminate and the lessee must . . . offer to purchase the property at a price equal to the unpaid principal of the notes outstanding together with unpaid interest thereon.”• If the lessor rejects the lessee’s offer to purchase, the lessor
keeps the condemnation proceeds
– That is, the Lessor has the right to “put” the property to the lessee for the amount needed to pay the mortgage• The lessor would decline to exercise the put (reject the
lessee’s offer to purchase) if there were equity in the property.
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Sources of Profit to Partners (cont’d)
3. Net Proceeds from Condemnation (cont’d)– However, a prospective investor would not
ordinarily look to condemnation as a likely source of economic gain:• the act of condemnation is beyond the control
of either lessor or lessee; and• the amounts of the award cannot be
speculated in advance.
– Not even “incorrigible gamblers” would be attracted to this chance.
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Sources of Profit to Partners (cont’d)
4. Net Proceeds from Mortgage Refinancing:• The considerations that limit the proceeds on sale from
being a source of significant economic return also apply to the possibility of significant proceeds from mortgage refinancing.
• In light of “the premium to be paid for prepayment and the fixed rental terms which generate no net cash flow during the initial lease term, the only opportunity for economic gain [from mortgage refinancing] would occur in the event of a substantial decrease in interest rates below the 5 1/8 percent provided for in the financing.”– Given the interest on the notes was below prevailing
rates, and given that there was evidence of upward pressure on rates, “the likelihood of a substantial reduction in interest payments which would lead to an economic gain through mortgage refinancing was quite remote.”
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Tax Court Wrap-up
• “Finally, in considering whether [the partners] made an investment in the property, we consider it to be significant that none of the [partners’] cash outlays went to Broadway.”– Sound like Estate of Franklin?
• “Furthermore, Broadway made substantial expenditures related to the property prior to its transfer to Medway which were not reimbursed.”– Sound like Estate of Franklin?
• But the same could have been said of the Bank in Frank Lyon
• “Broadway dealt with the transaction in this respect in the same manner as it would have done as the true owner of the property; – it financed as much of the cost as possible and – paid the balance from its own funds.”
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Tax Court Wrap-up (cont’d)
• “[A]part from tax benefits, the value of the interest acquired by the [partners] is substantially less than the amount they paid for it. . . [T]he buyer-lessor would not at any time find it imprudent to abandon the property.”– Imprudent abandonment is from Estate of
Franklin • Is it not appropriate to consider tax benefits in
pricing an investment?
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Tax Court Wrap-up (cont’d)
• Tax Court distinguished Lyon on the ground that the buyer in Lyon was a substantial corporate entity that negotiated the transaction and became personally liable on the mortgage:– “Frank Lyon, the purchaser, was a substantial
corporate entity which participated actively in negotiating the terms and conditions of the sale and leaseback, was personally liable for the payment of the principal and paid, in addition to the mortgage financing, $500,000 out of its own funds to Worthen.”
• Is Lyon’s basic lesson that risk matters?
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9th Circuit Affirms Tax Court with “Two specific caveats”
Begins by agreeing that Estate of Franklin applies. Then, the two caveats:
1.As To The Suggestion That There Must Be A Minimum Rate of Return
FN 23: “Using a six percent rate of return, the court calculated that the taxpayers were facing a net loss from the transaction. We deem the six percent rate to be for illustrative purposes only. No suggestion of a minimum required rate of return is made. Taxpayers are allowed to make speculative investments without forfeiting the normal tax applications to their actions.”
9th Circuit Affirms with “Two specific caveats” (cont’d)
2. As To The Suggestion That The Balloon Was Problematic
“Balloon payments have a legitimate place in many kinds of financial arrangements. Simply because one was used in this sham transaction should not reflect negatively on the practice as a whole.”
– Is the transaction a “sham” simply because the substance of the transaction was different from its form?
– Or because it was designed to strip away the depreciation deductions to compensate the orchestrator?
– Or simply because the “owner” was not building up an equity?
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SYNTHETIC LEASE VARIANTSPE Acquires Title from A Third Party
SPESELLER USER
NOTEPURCHASERS
Sells property
$x
Lease
Pay $Y per year rent
Pay $x
Issu
e Not
es
Pay $
y pe
r yea
r DS
Mor
tgag
e pr
oper
ty
Assig
n Le
ase
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FASB Approaches Generally
1. Require that some leases be treated as mortgages for financial accounting purposes.• As “capital” leases rather than “operating”
leases
2. Declare sale-leasebacks as especially vulnerable to being treated as mortgages.
3. Require some lessees to file consolidated financial statements with their SPE/lessors• Indirectly bringing an SPE’s assets, and
the debts that encumber them, on to the Lessee’s books
