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Tax-Free Exchanges: The Fischer Article
(Text p. 957)
#1 Transfer of Unqualified Property
Tax consequences to A?
A
TX
 AA
RE
with a FMV of $11,000
B
with an AB of $10,000
with an AB of [$5,000]
BA
RE with a FMV of $13,000
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 takes the $2,000
portion of BA A
received for the stock
with a basis of $2,000.
 Stock with a FMV of $2,000
A
TX
A’s Basis in Property
Received?
Basic analysis : Bifurcate into two
exchanges
B
A takes the $11,000
portion of BA A
received for the real
estate with a basis of
$10,000.
A’s basis in BA is
$2,000 + $10,000 = $12,000
Continued…
Donald J. Weidner
1
A’s basis in BA is $2,000 + $10,000 = $12,000
First Exchange
Second Exchange
2/13ths interest
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 basis rules postpone the
gain: take $13,000 FMV
property at $12,000 basis.
The loss is recognized
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2
#2 Receipt of Unqualified Property (Recall 1031(b))
The Taxpayer must value the property received
(Situation a. taxpayer actually receives cash)
A
TX
B
Tax consequences to A?
A Transfers RE with AB of
$5,000
Here, A’s realized gain is computed
B Transfers:
AR
= $8,000 [$6,000 FMV of RE + $2,000 cash]
 RE [with FMV of $6,000]
-AB
= $5,000 [basis in RE transferred to B]
 Cash of $2,000
“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.”
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).
A’s basis in the real property received (see 1031(d)) :
AB in property given up
A takes 1. $2,000 cash with $2,000 basis; and
$5,000
2. $6,000 FMV property with $5,000
+ Gain recognized
2,000
basis.
- cash received
2,000
 $1,000 additional gain remains to be
recognized
- any loss recognized
Basis in real property received
n/a
$5,000
3
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Transfer of Property Subject to a Liability and 1031
(Situation b. 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.
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4
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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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.
B
Txpr.
What has B obtained in the exchange?
AB = $500,000
Note: because there is a receipt of unqualified
property, the properties exchanged must be valued.
If §1031(b) applies: The realized gain is not all
recognized. Recognized gain is limited to cash
received and non-like kind property received.
$150,000 “relief”
600,000 value
50,000 cash
Total Consideration
Actual Cash Receipt
$ 800,000
+Deemed Cash Receipt
How much gain did be realize in the exchange?
Total Consideration
-AB (unrecovered cost)
Realized Gain
C
Transfers Apt. House #2: [with a
FMV of $600,000] + 50,000 cash
Tax Consequences to B under 1031?
Consideration received by B:
Transfers Apt. House #1 with $800,000 FMV
Subject to a 150,000 M
Total cash received
$ 50,000
150,000
$200,000
$ 800,000
500,000
$300,000
**Note there is a twin limitation
on recognition: the lesser of
the gain realized or the cash
received.
Continued…
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$ 200,000 realized gain that is recognized
+ 100,000 realized gain not recognized per 1031
$ 300,000 total realized gain
Recognition 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)
- cash received
actual
50,000
constructive 150,000
200,000
$500,000
+ gain recognized on exchange
+200,000
B’s Basis in Aptmt House #2
- 200,000
$500,000
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.
7
Continued…
Donald J. Weidner
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 GAIN
Thus, the remaining $100,000 of gain that was realized but not recognized at the time of the exchange
is finally recognized on the subsequent sale of the property received in the exchange.
The gain thus was recognized in two parts:
First, $200,000 was recognized on the exchange and $100,000 was recognized subsequently. Of
the total $300,000 realized gain, $200,000 was recognized on the exchange and the remaining
$100,000 was not recognized until apartment house #2 number was sold.
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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).
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Day 1
Starker v. United States (9th Cir. 1979)(Text p. 963) (Starker II)
T.J. Starker,
his son and
his son’s W
(“Starkers”)
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
Crown
Zellerbach
Each year, Crown must add a 6%
“growth factor” to the outstanding
balance of the “exchange value
credits” it gave the Starkers
Day 1
+2
months
Starkers
May 31, 1967 [2 mos. later] Crown entered
“exchange value credits” on its books
$1.5 million for T.J.’s timberland
Crown
$73,000 for S, S’s W’s timberland
The Starkers Deeded their timberland
Received their own “exchange value credit’ of
$73,000 for the land they exchanged.
Within
4 mos.
Starker I
S, S’s W
(Bruce & Elizabeth)
Txprs. and victors
inStarker I
S, 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.
10
Crown
Pays $
Seller
Conveyed
(sold)
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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
Donald J. Weidner
reciprocal transfers were not simultaneous.
11
Starker II (the first two parcels—conveyance to TJ’s
daughter)Timian (Residence) & Bi-Mart (Commercial)
TJ
Transferred
possession
of residence
Paid rent
TJ’s
Daughter
[Jean Roth] [who
was not a party to
the “Land
Exchange
Agreement”]
Crown
# 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.
$
Residence
Seller
$
Commercial
Property
Seller
Also Held: because TJ
never got title, there was
no exchange with him.*
# 2. Conveyed Bi-Mart
(commercial building)
to T.J.’s Daughter in
1968
[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.*
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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, would was a plausible argument against all
three transfers involved in “Starker II”
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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
received personal residence property rather than “trade or
business” or “investment” property.
• Court accepted this argument.
The court also rejected T.J.’s “substance over form” argument
that this was, in economic substance, a transfer of title in the
residence property to him followed by a gift from him to his
daughter. Court said: there was no exchange with him.
The court was similarly formalistic as to the Bi-Mart
(commercial) property transferred to T.J.’s daughter: T.J.
never received title to the Bi-Mart properties because
Crown transferred them to his daughter. Therefore, there
was no exchange with him.
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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 said to “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 do you report in an initial year
(1967) the value of property not identified or
transferred to you until a later year (1968)?
• You won’t know whether the transfer you receive
qualifies until that later year
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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.
1. 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.
2. 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).
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Starker II: The Booth Property (commercial) (the third
parcel—contract rights were transferred to TJ)
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
Buyer’s rights under the contract and assigned them to TJ.
Assigned Buyer’s
contract rights [1968]
TJ
1.
2.
Crown
Buyer, 1968, Sells
his contract rights
to purchase real
property subject to
the life estate
1965, Third
Party
the Contracts to
sell subject
to a life
estate
Buyer
Legal title is not to pass until the life estate expires.
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.
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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 .
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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”).
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Nonsimultaneous Transfers
• Recall the basic justifications of 1031
– Do non-simultaneous transfers fall within those justifications?
• 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 nonqualifying 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.
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21
Nonsimultaneous Transfers (cont’d)
• Three aspects of the case made the IRS position
appealing (9th Circuit focused only on the last two):
– the “exchange agreement” gave the Starkers the
equivalent of an interest-bearing 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.
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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.
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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.”
• The 9th Circuit rejected the argument that these contract
rights were mere choses in action that did not equal a
fee::
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.”
• Identifying the bundles of rights and liabilities is also
done to analyze leasing arrangements, including
sale/leasebacks.
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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.
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25
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)
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26
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.
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27
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.”
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28
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.
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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.”
– Limited in 2016
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.
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30
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 first made it more difficult for sale
leasebacks to be used to take debt off balance sheets.
– There was more room in the case of leases of
property the tenant did not previously own
• Less so after 2016
• Today, many creditworthy corporations obtain financing
through special purpose entities that issue securities
– Recall Bolger
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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.”
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32
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;
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33
Consequences if Substance Trumps Form
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
34
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.
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35
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
36
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
37
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
38
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, Bank’s ground lease to Lyon was 10 years
longer than Lyon’s lease back of the building to Bank.
• 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—Bank
would not then have the right to possess the building.
Donald J. Weidner
39
Maximum Bldg.Price:
Frank Lyon (cont’d)
$ 500,000 Cash
7,140,000 Mortgage
N.Y. Life
$7,640,000
Bank
Bldg.
Note and
Mortgage
Bank “sold” bldg. to Buyer
Bldg.
Buyer
[Lyon Co.]
Bank “leased” bldg. back
from Buyer for:
Bank Sells
Total of 66 years [25 year base
Bldg.
term + 8, 5-year options to
renew] $600,000/yr. rent for the
Then
Lyon Bought
25-year base term, then, rent cut
Becomes a
Building on the land
in half.
Tenant in It
it was leasing
Bank got options to repurchase
Lyon was ground
bldg.
Ground lease
lessee for 76 Years
76 years [$50/yr. rent
.
for first 26 years, then
Bank Retained Title to
rent increases]
Land but Leased It to
the Bldg Buyer
Bank’s Land
Lease of building gave Bank control of bldg. for 65 years. After that, Lyon had the right to keep the
building on 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.
Donald J. Weidner
40
Frank Lyon (further facts)
•
•
•
•
•
1.
2.
3.
4.
•
•
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:
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.”
Bank also gave New York Life a mortgage on an adjoining parking
deck.
Lyon assigned to New York Life its rights as Landlord under the
building lease with Bank (Bank agreed to the assignment);
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
Donald J. Weidner
Bank on a “subsequent unrelated loan.”
41
Lyon’s Net Cash Flow on its investment in the building (if
Bank keeps exercising its options to renew the lease)
Frank Lyon’s NCF
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 as
ground rent keeps
going UP.
1-26 (1968-1994)
$
26-31 (1994-1999)
-DS
(To N.Y. Life)
-Ground Rent
(Lyon Owes To Bank)
$600,000
- $600,000
- $
$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 (ground rent
escalates further)
36-41 (2004-2009)
$100,000 (5 years)
$300,000
-
-0-
- $200,000 (ground rent
escalates further)
41-66 (2009-2034)
$50,000 (25 years)
$300,000
-
-0-
- $250,000 (ground rent
escalates again)
?
-
-0-
- $ 10,000 (rent to Bank
slashed during this last
ten years)
66-76 (2034-2044)
- 50
= RR
(From Bank)
?
(10 years)
50
Ground lease from Bank to Lyon is 10 years longer than Lyon’s lease
back of the building to Bank (Bank did not have an optionDonald
to lease
the
J. Weidner
bldg. back
for the last 10 years of its ground lease to Lyon).
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
Donald J. Weidner
hands of a “mere” tenant.
43
Bank Had Four Options to “repurchase” the
building
•
After 11 years for $6,325,169
–
in fact, Bank 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
44
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?
Donald J. Weidner
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
Donald J. Weidner
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
47
Basic Possibilities Summarized
1. Bank Exercises Its Options to Renew Its Lease of Bldg.
•
Lyon gets a return of its investment, plus approximately 6%,
counting the use of the land and building for years 66-76
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
48
Donald J. Weidner
District Court Upheld Lyon’s Claim to the 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 market rent for possession and not to build equity).
• Concluded that the Banks’s option prices, negotiated at armslength, represented fair estimates of fair market value on the
option exercise dates
– rejecting any negative inference from the fact the option prices was the
amount 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.
• Lyon was true owner even though it had mixed motives,
including the desire for the benefits of a “tax shelter.”
Donald J. Weidner
49
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
Donald J. Weidner
50
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 that had been created through
amortization and/or appreciation
4. The building rent during the base term was equal to the
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.
Donald J. Weidner
51
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.
Donald J. Weidner
52
•
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.”
Donald J. Weidner
53
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.”
Donald J. Weidner
54
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?
Donald J. Weidner
55
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.”
Donald J. Weidner
56
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.
Donald J. Weidner
57
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.”
In response, it could be argued that Bank make a greater
commitment of capital than Lyon. The 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.
Donald J. Weidner
58
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.”
Donald J. Weidner
59
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
Donald J. Weidner
60
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.”
Donald J. Weidner
61
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.”
Donald J. Weidner
62
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.”
Donald J. Weidner
63
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 [now
probably LLC].
3. The limited partnership typically uses nonrecourse
financing such that there will not be any personal liability to
the institutional lender [harder to get since 2009].
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.
64
Donald J. Weidner
Hilton (Part I) (Supp. p. 248)
Formed as the
shopping center
store was being
completed
5 Insurance Companies [agreed to lend (purchase
notes) on completion of construction]
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
D
E
E
D
“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%
Fourth Cavendish conveyed land year was determined by Broadway’s credit rating.]
and bldg. “subject to”
Options to Broadway to renew lease for additional 68
a)
The lease
years
b)
The mortgage indenture
@ 1.5% of purchase price for first 23-year renewal
term [rent slashed 75% after notes are paid ].
c)
The assignment of lease
d)
Encumbrances of record
No consideration or
assumption of M
Medway (GPP)
Formed to receive the interest
from Fourth Cavendish
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.
@ 1% of purchase price for 2nd and 3rd renewal
terms (23 yrs. and 22 yrs.)
Original Ps in Medway were
65
14th P.A. LPP (49% int.) (TXs were Ps)
MacGill (1% int.) (P in Inv. firm) Donald J. Weidner
Cushman (50% int.) (P in Inv.firm)
Hilton (Part II)
Fourth Cavendish
Single Purpose
Financing Corp.
“Sold” (see previous slide)
Broadway
Conveyed in 1967
MEDWAY
(GPP with 3Ps)
1) 14th P.A.,
LPP 49%
2) MacGill 1%
3) Cushman
50%
Just formed
14th Prop. Assoc., LPP
Just formed, acquired
interest in Medway
GP: JRYA
These 14th PA limited partners were the taxpayers
(Frequent syndicate
participator)
Zero cap. contribution
The $180,000 LPs’ contribution traced as follows:
LPs: Individuals
1)
contributed $180,000
2) were allocated 100%
of profits and losses
MacGill,
Cushman, were
both Ps in the
investment firm
Table 1 in opinion: Forecast
of operations for Medway for
part of 1967 thru 1980:
$922,923 tax losses.
1969 conveyed
Grenada Assoc., LPP
all but .5% (2
years later) of GP: Cushman
his interest
1% interest in Grenada
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”)
37th PA limited partners were also taxpayers
LP: 37th Prop.Assoc.,
LPP (formed by JRYA)
99% interest in Grenada
GP: JRYA
LPs: Individuals LPs
Contributed $155,000
The $155,000 LPs contribution 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”
Donald J. Weidner
66
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.
Donald J. Weidner
67
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
– [Taxpayer claims business realities but not “regulatory”
realities 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.
Donald J. Weidner
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
Donald J. Weidner
69
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, it the “rent” label sticks, Broadway, in effect, gets
to deduct 90% of principal and 100% of interest.
Donald J. Weidner
70
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.
Donald J. Weidner
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.”
Donald J. Weidner
72
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
Donald J. Weidner
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?
Donald J. Weidner
74
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 buyerlessor has not made an investment in property.
– This sounds like Stevens’ dissent in Frank Lyon rather
than Blackmun’s majority opinion.
– Lyon won even though it was not building up an equity for the first
25 years (and here, Broadway has no options to repurchase).
Donald J. Weidner
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.
Donald J. Weidner
76
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
because the rent was all applied to service the debt.
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 [slightly lower
than the current rate]);
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.
Donald J. Weidner
77
The Taxpayers’ Expert on Economic Substance
(cont’d)
•
•
•
The court in FN. 23 calculated the present value of the interest the
Buyer/Lessor acquired. It added:
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 of
23 years and continues through year 53 (rent from Broadway for
the 23-year renewal period 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 (assuming the final 2,
23 year renewal options would not be exercised); 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.
Donald J. Weidner
78
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.”
Donald J. Weidner
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.
Donald J. Weidner
80
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.
Donald J. Weidner
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 10% 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.
Donald J. Weidner
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.”
Donald J. Weidner
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, the 98-year total lease period gave
Broadway the economic equivalent of an option
to repurchase
Donald J. Weidner
84
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 Buyer/Lessor 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 Buyer/Lessor rejects the lessee’s offer to purchase, the
Buyer/Lessor keeps the condemnation proceeds
– That is, the Buyer/Lessor has the right to “put” the property
to the lessee for the amount needed to pay the mortgage
• The Buyer/Lessor would reject the lessee’s offer to purchase
if there were equity in the property.
Donald J. Weidner
85
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.
Donald J. Weidner
86
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.”
Donald J. Weidner
87
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.”
– Sounds like Estate of Franklin.
• “Furthermore, Broadway made substantial
expenditures related to the property prior to its transfer
to Medway which were not reimbursed.”
– Sounds 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.”
Donald J. Weidner
88
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?
Donald J. Weidner
89
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?
Donald J. Weidner
90
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.”
Donald J. Weidner
91
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.”
– Was 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?
Donald J. Weidner
92
SYNTHETIC LEASE VARIANT
SPE Acquires Title from A Third Party
Pay $x
Sells property
SELLER
$x
NOTEPURCHASERS
Lease
SPE
Pay $Y per year rent
USER
Donald J. Weidner
93
FASB Approaches Generally
1. Historically, required that only some leases be
treated as mortgages for financial accounting
purposes.
• Those leases that were “capital” leases rather
than mere “operating” leases
2. Historically, declared sale-leasebacks as especially
vulnerable to being treated as mortgages.
3. Historically, required 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.
4. As of 2016, all leases must be reflected as
mortgages on the balance sheet.
Donald J. Weidner
94