Mechanics Lien Acts

1
Mechanics Lien Acts

• Much of the rhetoric around these laws is
  misleading.
• Much of it is couched in terms of the need to
  give lien protection to those who supply the
  labor and materials to construct building.
• Many of the acts do at least as much, or more, to
  protect
• owners and
• construction lenders.
• Hence, many of these acts are now called
  construction lien acts to avoid the implication
  that they are primarily for the benefit of
  mechanics and materialmen.

2
Guignard Brick Works v. Gantt 159 S.E.2d 850
(S.C. 1968).
Landowner
Guignard Brick
General
Contract to build house for 19,000
22,000 bricks delivered to site
Paid 7,000 on the contract
Used 7,000 bricks and then ABANDONED the project
Used remaining 15,000 bricks to complete
construction, knowing they have not been paid for.
Spent 29,000 to complete construction
Sued Landowner, claiming a lien for only the
brick which has not been used in construction
when the contract was abandoned by General.
Landowner knew before he used these bricks that
Guignard Brick had not been paid.
QUESTIONS What is Guignard Bricks argument on
the basis of the statute at Supp. 83-84? Did
not Guignard Brick furnish the brick with the
consent of the owner?
3
Guignard Brick (contd)

• Bricksupplier claimed a lien under Section 1 set
  out in the Memorandum on Mechanics Liens (Supp.
  P. 83)
• Saying it furnished bricks
• That were actually used in the building
• By virtue of an agreement with, or by consent of,
  the owner.
• Concluding, therefore, that it had a lien on the
  building and upon the interest of the owner in
  the lot to secure the payment of the debt.
• What is the Owners response to Bricksuppliers
  claim under Section 1?
• Bricksupplier is a subcontractor and
  subcontractors do not fall under Section 1.

4
Guignard Brick (contd)

• Section 2 (Supp. P. 83), on the other hand,
  refers to every laborer, mechanic,
  subcontractor or person furnishing material
• when an improvement has been authorized by the
  owner
• gives a lien subject to existing liens of
  which he has actual or constructive notice (Note
  that there is no subject to language under
  Section 1see also Section 7)
• to the value of the labor or material so
  furnished.

5
Guignard Brick (contd)

• Consider the last sentence in Section 4 (Supp. P.
  84)
• It states that the lien given by Section 2
  attaches
• When the laborer or materialman gives written
  notice to the owner of the furnishing of labor or
  material and its value
• But in no event shall the aggregate amount of
  liens set up hereby exceed the amount due by the
  owner on the contract price of the improvement
  made.

6
Guignard Brick (contd)

• Mechanics lien statutes typically provide that
  the lien of all the subcontractors relates back
  to some earlier point prior to the point the
  materials or services were supplied or rendered.
• Can you see why as a matter of policy this should
  be so?
• See Section 7 for the relation-back mechanism
• Such a lien shall not avail or be of force
  against any mortgage actually existing and duly
  recorded prior to the date of the contract under
  which the lien is made.
• Highly atypical provision because it relates the
  lien back to the point of the contract (with the
  general contractor?).
• Statutes more commonly provide that mechanics
  liens relate back to the commencement of
  construction (or to the filing of a notice of
  commencement of construction).

7
More on Supplement pages 83-86

• B CLN M L
• B agrees to loan L
• B Advance 1 L
• B I am not getting paid
  Brick Co.
• B Advance 2 L
• What of the mechanics lien act?
• Section 5 states that no payment by the owner to
  the contractor after notice shall operate to
  lessen the amount recoverable by the person so
  giving the notice.
• Note Is this a payment by the owner?
• What of the optional/obligatory distinction?
• Recall Florida Statute 697.04(1)(a) (Supp. P. 85)
  

8
CASE ON COMMENCEMENT AND PURCHASE MONEY
MORTGAGEMechanics Lien v. 3d Party Purchase
Money Mortgage

• Kloster-Madsen, Inc. v. Tafis Inc., 226 N.W.2d
  603 (Minn. 1975), was an action to foreclose a
  mechanics lien
• Brought by Kloster-Madsen, a general contractor
  that furnished labor and material to remodel a
  3-story building.
• The case involved a priority battle between the
  mechanic lien claimant Kloster-Madsen and lender
  Prudential Life Insurance Company, which had
  closed a loan that was part purchase-money loan
  and part improvement loan.

9
Kloster-Madsen, Inc. v. Tafis Inc., 226 N.W.2d
603 (Minn. 1975).
Purchase Ament for 225,000
July 1970
Seller
Buyer

• Court was faced with 2 issues
• Whether the electricians work on July 30
  constituted an improvement to the premises and
  the actual and visible beginning of the
  improvement on the ground within the meaning of
  the Mechanics Lien Act and
• If yes, whether a purchase money mortgage
  interest filed subsequent to the beginning of
  such improvement is entitled to priority if
  neither the vendor nor the purchase money
  mortgagee authorized the commencement of the work
  constituting the improvement.

anticipating purchase, entered into contract
July 20, 1970
Buyer
General
Sub K
Commenced work on the light fixtures (cut four
holes in ceiling and crawl space without
1)knowledge or authorization of lender or 2)
authorization of seller but, held, seller had
knowledge)
Sub
July 30, 1970
August 3, 1970
Purchase closed
10
Kloster-Madsen (contd)

• First, was the work on the light fixtures an
  improvement?
• Second, was the improvement visible?
• Contractor argued that you could see it.
• Prudential argued, it was not good enough that
  it be visible to the naked eye
• it had to be visible to the minds eye.

11
Kloster-Madsen (contd)

• The Court upheld the trial courts finding that
  the improvement was visible
• The test for determining visibility is not, as
  Prudential argues, that the improvement, although
  visible to the naked eye, must also be
  discernible to the minds eyes insofar as they
  tell ones mind that an improvement has been
  commenced. Rather, the test is whether the
  person performing the duty of examining the
  premises to ascertain whether an improvement has
  begun is able in the exercise of reasonable
  diligence to see it.
• What the minds eye would see if the naked eye
  had been used with reasonable care?

12
Kloster-Madsen (contd)

• Third, is a pre-existing mortgage or mechanics
  lien defeated by Prudentials purchase money
  mortgage?
• Prudential relied on the special treatment given
  to purchase money mortgages
• In general, purchase money mortgages are special
  because they are preferred to certain
  pre-existing claims against the buyer/purchase
  money mortgagor.
• The purchase money mortgage historically was
  explained in terms of instantaneous transitory
  seisin (which is what Prudential argued)

13
Kloster-Madsen (contd)

• Purchase Money Mortgages are special because they
  often permit the mortgagee to defeat pre-existing
  claims against the buyer/mortgagor. A purchase
  money mortgage takes precedence over
• Judgment liens against the mortgagor
• Liens arising from after-acquired property
  clauses in prior mortgages executed by the
  mortgagor and
• Claims against the mortgagor for dower and
  homestead.
• One Formalistic Explanation Instantaneous
  transitory seisin.

Pays ?
Loans ?
Seller
Debtor
Purchase Money Mortgagee
contemporaneous
conveys fee
Mortgage
Under the purchase money mortgage rule, the
mortgage of the purchase money mortgagee has
priority over the prior creditors judgment lien.
14
Kloster-Madsen (contd)

• Court the purpose of the doctrine of
  instantaneous seisin is to protect mortgagees
  from hidden or undiscoverable liens.
• The mechanics lien here is not hidden or
  undiscoverable
• Prudential is chargeable with constructive
  notice of the attachment of a lien when the
  actual beginning of visible improvements occurs
  prior to the mortgage transaction.
• Further, the court said the mechanics lien act
  does not make any distinction between purchase
  money mortgages and other mortgages.

15
Kloster-Madsen (contd)

• Contrary to Kloster-Madsen, the general rule is
  a purchase money mortgage, whether in favor of
  the grantor or a third party, takes precedence
  over a mechanics lien.
• An additional rationale for deciding opposite to
  Kloster-Madsen
• A mechanics lien statute does not include a
  contracting vendee in possession within the
  meaning of owner of an interest in the property
  to which the lien could attach.
• In short, Kloster-Madsen was an extreme case
  insofar as the mechanics lien was preferred to a
  purchase money mortgagee who neither authorized
  nor knew of the improvements, when the vendor
  knew of but did not authorize the improvements.

16
Williams Works, Inc. v. Springfield Corp.(Text
p. 787)
Contacts with interest in bldg. Apt. complex
Convey
Developer Springfield
Mechanics Lien Claimant W W Engineers
Fee Owners Law Dev. Co. Kelly M Inv. Co.
Developer had the right to terminate the
engineering contract at end of any phase
June 1972 Formal contract WW contracts to
perform engineering services
8/29/72
12 holes into ground, 6 diameter staked
Phase 1 Feasibility Studies
Actual knowledge of WWs work
Phase 2 Finalize all plans
Sells and conveys land
Developer Springfield
1/4/73
Mortgages land to CNB
City Natl Bank
Assigns Mortgage (unclear when)
1/9/73
Records the 1st mortgage
2nd Mortgage
Developer Springfield
Records 2nd Mortgage
Phase 3 Physical Construction Begins W
W supervisessets stakes out
ML
2/10/73
Files action to foreclose its mechanics lien
ML
3/25/74
17
Williams Works (contd)

• The case involves a priority fight between the
  mechanics lien and the mortgage.
• Consider the much amended Section 1 of the act,
  in fn. 5.
• Do you see the language that embraces a general
  contractor?
• Every person who shall, in pursuance of any
  contract . . . existing between himself as
  contractor, and the owner . . . .
• General is called simply contractor for most of
  the statute
• but is also referred to as original or
  principal contractor

18
Williams Works (contd)

• Do you see the language that specifically
  embraces subcontractors? Near the end of Section
  1
• and every person who shall be subcontractor,
  laborer, or material man . . . to such original
  or principal contractor
• Section 1 specifically refers to any engineering
  plan
• Court Section 1 does nothing more than describe
  what is lienable.

19
Williams Works (contd)

• Section 93 of the mechanics lien act in fn. 1
  contains a priority rule.
• Consider the lien priority point
• Mechanics liens shall take priority over other
  liens which shall either be given or recorded
  subsequent to the commencement of said building .
  . . or improvement.
• Improvement is defined in FN. 6 to include
  designs or engineering plans.

20
Williams Works (contd)

• Engineers Williams Worksargue that their
  mechanics lien is superior to the mortgages that
  were both given and recorded after their
  improvement (their engineering plan) was
  begun.
• How could the mechanics lien claimants possibly
  lose this case?
• Non-visible, off-site engineering services . .
  . although lienable under Michigan law, do not
  signal commencement of a building . . . or
  improvement for the purpose of fixing priority
  under Michigans Mechanics Lien Law.
• The improvement was not an improvement for
  lien priority purposes

21
Summary of Major Concepts (Text p. 797)

• When does a lien attach?
• The three most common possibilities are the date
• when the general contract is first executed
• when construction begins, or
• when a claim for payment is first filed.
• What must be done to perfect a lien?
• Typically, a lien must be perfected by filing the
  underlying claim within a certain amount of time
  after the work has been performed or construction
  completed.
• How much time is allowed to foreclose a perfected
  lien?
• Varies from jurisdiction to jurisdiction.

22
Summary of Major Concepts (contd)

• As of what time does the perfected lien take
  priority?
• A. Commencement of Construction, or
• B. Filing of a Notice of Commencement of
  Construction
• The Uniform Construction Lien Act (similar to
  Florida) requires the owner to file a Notice of
  Commencement prior to the beginning of work.
• If a lien claimant subsequently records a lien,
  the priority of that lien is as of the date of
  the recording of the Notice of Commencement.

23
Undisbursed or Wrongly Disbursed Funds

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

24
Undisbursed or Wrongly Disbursed Funds (contd)

• Some states say that the Mechanics Lien
  (Construction Lien) Act preempts the area and
  precludes courts from fashioning common law or
  equitable remedies.
• Wrongful disbursal of funds can result in the
  lenders loss of priority as against a
  construction lien claimant just as it can as
  against a subordinator
• The same considerations apply as in the case of a
  priority fight between a construction lender and
  a subordinator
• including whether the optional vs. obligatory
  distinction applies

25
Undisbursed or Wrongly Disbursed Funds (contd)

• Compare Guaranty Mortgage Co. of Nashville v.
  Seitz (Text p. 799)
• The lien of a deed of trust securing a
  construction loan has priority over mechanics
  and materialmens liens only to the extent that
• the funds disbursed actually went into the
  construction, or
• to the extent that the construction lender used
  reasonable diligence in disbursing the
  construction loan.

26
Partial Recap

• In many states, the term general contractor is
  not used in the construction lien statute.
  Rather, a contractor is defined as someone in
  privity with the owner
• Florida uses the privity concept
• Lienors in privity can recover on their contract
  with the owner
• The owners liability to lienors who are not in
  privity with it (subcontractors) can often be
  summarized as follows
• Contract Price
• Minus Proper Payments (at least those prior to
  Stop Notice)
• Minus Reasonable Cost to Complete (upon
  abandonment)
• Equals Extent of owners liability to all
  non-privity lienors.

27
J.I.Kislak Mortgage Corp. v. William Matthews
Builder, Inc. (Text p. 733)

• Developer and Construction lender entered into a
  construction loan agreement
• Developer executed a construction loan note and
  mortgage
• Construction lender recorded the mortgage
• Construction subsequently began
• Construction lenders draw inspector fraudulently
  authorized progress payments for work that was
  not done
• Some subcontractors were fully paid
• Masonry subcontractor was paid nothing
• Developer defaulted on the loan and Construction
  lender filed to foreclose.
• Masonry subcontractor intervened in the
  foreclosure, asserting that it had a mechanics
  lien that should take priority over the lien of
  the construction loan mortgage.

28
Kislak Mortgage (contd)

• In the usual case it is apparent that a mortgage
  lien would take priority over a mechanics lien
  that was filed after the effective date of the
  mortgage provided none of the work covered by the
  mechanics lien was done prior to the recording
  of the mortgage.
• However, there is an exception to the rule which
  applies when a construction loan agreement
  covering a construction mortgage provides for
  progress payments over a period of time and some
  of the disbursements are voluntarily made at a
  time subsequent to the effective date of the
  mechanics lien.

29
Kislak Mortgage (contd)

• Where a mortgage is recorded prior to the time
  that a mechanics lien attaches to the property
  and it is optional with the mortgagee as to
  whether a further advance is to be made, and
  where the mortgagee has made an advance with
  knowledge of the fact that the mechanics lien
  has already attached, to the extent of such later
  advances, the mortgage is inferior to the
  mechanics lien.
• Even though the lender did not have actual
  notice of attachment at the time that the
  advancements were made
• The lender was charged with knowledge of the law
  that mechanics liens relate back

30
Kislak Mortgage (contd)

• As between a subcontractor which did not have
  the protection of a construction loan agreement
  and a mortgage lender which did not avail itself
  of the protection it had under the agreement it
  is not inappropriate . . . that the mortgage
  lender bear the loss.
• Note, in this case, the lender did not even ask
  for receipts when it made the voluntary payments.

31
Florida Statute on Mortgages for Future Advances
(Supp. P. 85)

• 697.04  Future advances may be secured. --
• (1)(a)  Any mortgage or other instrument given
  for the purpose of creating a lien on real
  property, or on any interest in a leasehold upon
  real property, may, and when so expressed therein
  shall, secure not only existing indebtedness, but
  also such future advances, whether such advances
  are obligatory or to be made at the option of the
  lender, or otherwise, as are made within 20 years
  from the date thereof, to the same extent as if
  such future advances were made on the date of the
  execution of such mortgage or other instrument .
  . . . Such lien, as to third persons without
  actual notice thereof, shall be valid as to all
  such indebtedness and future advances from the
  time the mortgage or other instrument is filed
  for record as provided by law.

32
Depreciation of Tenant-Constructed Improvements
The Background Rules

• Because we have a tax on income, the tax law
  attempts to match receipts with the cost of
  generating those receipts.
• A landlord must capitalize the cost of obtaining
  a tenant and amortize that cost over the life of
  the lease (See text p. 837).
• That is, the landlord is not permitted to expense
  (currently deduct) all of the cost of obtaining a
  tenant because it will generate receipts for
  years.
• The landlord must attribute a portion of the cost
  to each years rent receipts

33
Depreciation of Tenant-Constructed Improvements
(contd)

• Similarly, a bonus payment by a tenant to acquire
  a lease can not be deducted by the tenant
• The bonus payment is treated as a cost of
  acquiring the lease and must be capitalized
  (added to the cost of the assetthe lease) and
  then amortized over each year of the life of the
  lease. (See Text p. 838).
• However, a tenants payment of advance rent to a
  landlord at the acquisition of the lease is
  taxable to the landlord when the landlord
  receives it. (See Text p. 837).

34
Depreciation of Tenant-Constructed Improvements
(contd)

• Tenants often construct buildings on land that
  they lease (recall Penthouse, Cambridge).
• If a tenant invests in a building that is
• used in its trade of business or
• held for the production of income,
• it is allowed to recover its investment in
  the building through depreciation (cost
  recovery) deductions. (See Text p. 838).

35
Write-offs Available to Tenants Who Construct
Improvements

• In short, a tenant may be doing all of the
  following
• amortizing its investment in a lease
• deducting the rent it is paying under the lease
  and
• depreciating its investment in the building it
  constructs on the leased land.

36
Chirelstein Are Tenant-Constructed Improvements
Rent to Landlord?
NFO LL
FO
MFG T
20 year ground lease
T to pay relatively low annual rent
T to construct factory at minimum cost of
1,000,000
Factory to become property of LL on termination
of the lease thusapparently a form of rent
in kind.
Constructs building
T
With 25 year U.L. (5 years longer than the lease)
That has an expected depreciated value of
200,000 at the time the 20-year lease expires
Pays relatively low annual Cash Rentals
T
LL
37
General Considerations

• In defining income, Glenshaw Glass emphasized a
  realized disposable increase in wealth
• Here we have instances of undeniable accessions
  to wealth, clearly realized, and over which the
  taxpayers have complete dominion.
• Is the factory building income to the Landlord?
  Is it an
• accession to wealth,
• clearly realized,
• over which the taxpayer has complete dominion?
• If it is income, when are these criteria met?
• If it is income, in what amount?

38
The Realization Requirement

• Chirelstein because the realization
  requirement exists, the income tax is a tax on
  transactions instead of being a tax on income in
  the economic sense.
• There are four possible answers to the question
  of when a tenant-constructed building is income
  to the landlord. It can be taxed as either
• prepaid rent
• prorated rent
• postpaid rent or
• no rent at all

39
Possibility 1 Prepaid Rent

• Possibility 1 The Landlord receives Prepaid
  Rent in the year in which the building is
  constructed.
• How much rent?
• The present value of the right to get the
  building at the end of the lease term.
• Assume the building is expected to be worth
  200,000 at the end of 20 years.
• reduce that 200,000 payment at the end of year
  20 to its present value.
• Using an 8 discount rate, the present value is
  about 50,000.
• If you report the present value of the future
  payment in income at the beginning of the lease,
  you could consider the transaction closed at this
  point, with no further income to report when the
  lease ends.

40
Possibility 1 Prepaid Rent (contd)

• As soon as the landlord reports the building in
  income, the landlord receives a 50,000 basis in
  it.
• Sometimes referred to as a tax cost basis
• Landlords basis in the building at the
  termination of the lease at the end of year 20
  would be 50,000, the amount previously included
  in income.
• Landlords depreciation deductions for the last
  five years of the buildings useful life (after
  the lease expires), on a straight-line method,
  would be
• 50,000/5 10,000 per year.
• Note To implement this prepaid rent approach,
  there must be a prediction of the value the
  building will have at the end of 20 years.

41
Possibility 2 Prorated Rent

• 2. Possibility 2 The Landlord receives rent
  that is prorated over the life of the lease.
• How much rent?
• The anticipated value of the building at the end
  of the lease term, 200,000.
• When?
• Include some of the buildings value in income
  for each year of the lease.
• Ex., 10,000 for each of 20 years. 10,000 X
  20 200,000.
• Landlords basis in the building on termination
  of the lease would be 200,000the amount
  previously included in income (a tax cost
  basis).
• Landlords depreciation for the remaining 5 years
  of useful life after the lease expires
  200,000/5 40,000 per year (using a
  straight-line method of computing depreciation).
• The Prorated Rent approach requires, as did the
  Prepaid Rent approach, a prediction of the value
  of the building at the end of the 20 year lease
  term.

42
Possibility 3 Postpaid Rent

• 3. Possibility 3 The Landlord receives
  Postpaid Rent.
• When is the income realized?
• At the end of the 20 year lease, when the
  Landlords reversion in the building becomes
  possessory.
• How much rent?
• The fair market value of the building when the
  lease terminates.
• If the buildings actual value turns out to equal
  the anticipated value, that amount is 200,000 in
  this hypothetical.
• Landlords basis in the building would be
  200,000, the amount included in income.
• Again, a tax cost basis
• Landlords depreciation deduction for each of the
  remaining 5 years of the buildings useful life
  200,000/5 40,000 per year.

43
Postpaid Rent (contd)

• The Postpaid Rent alternative has the advantage
  in that it does not require an initial estimate
  of the value at the end of 20 years.
• But it still requires an appraisal of the
  property at the end of the lease.
• The Postpaid Rent alternative is the approach the
  first IRS regulations took that the expiration
  of the lease was the landlords realization
  event.
• When the landlords reversion in the building
  became possessory.
• The courts initially rejected this approach.

44
Pre-Helvering v. Bruun

• Cases prior to Bruun held that there was no
  taxable realization to the lessor either
• when the leasehold improvements were installed by
  the tenant or
• when the improvements vested in the lessor at the
  expiration of the lease.
• The idea was that the building could not be
  severed and disposed of separately from the land,
  and thus was not portable and detachable
  unless it was torn down and scrapped.
• Another way of stating the notion is that
  profit must be severed from capital to be
  taxed.
• The realization requirement turns what might have
  been a tax on economic enhancement in wealth into
  a tax on transactions.

45
Helvering v. Bruun309 U.S. 461 (1940)
LL
T
Leased lot building for 99 years
1915
T may, on giving bond to secure 2 years rent,
remove or tear down any bldg.
On termination of the lease, T to surrender all
land, buildings, and improvements
T
Removed existing buildings and constructed a new
bldg with a UL of 50 years. 85 years left on
the lease
1929
nonpayment of rent taxes
LL
1933
LL regained possession of land and building

FMV building constructed by T is
64,000 LLs unamortized cost of old bldg. is
13,000 Net FMV net gain
51,000 as at 7/1/33, says IRS
stipulation
46
Bruun and Its Aftermath From Possiblility 3
to Possibility 4

• Bruun agreed with the IRS and held that there was
  income to the landlord when the tenant defaulted
  and the landlords reversion became possessory
  (Possibility 3).
• One might ask what would happen if, upon the
  tenants default, the value of the land had
  decreased.
• Would the landlord have been allowed a deduction?
  
• Congress reversed Bruun by enacting sections 109
  and 1019
• thus adopting Possibility 4.

47
Possibility 4 No Rent

• 4. Possibility 4 The Landlord has No Rent At
  All from the Building Constructed by the Tenant.
• The building is treated as unrealized
  appreciation that is not taxed as rent at any
  time.
• With nothing included in income, the landlords
  basis in the building at the expiration of the
  lease is zero.
• Because the landlords basis in the building is
  zero, the landlord gets no depreciation
  deductions during the remaining useful life of
  the building.

48
Sections 61, 109 and 1019 in A Nutshell

• Sec. 61 regulations provide that, if a tenant
  pays any of the landlords expenses, the payments
  are additional rental income to the landlord.
• Further, if a tenant places an improvement on the
  real estate that is a substitute for rent, the
  improvement is additional rental income to the
  Landlord.
• The test for whether it is rent is the intent of
  the parties.

49
Sections 61, 109 and 1019 (contd)

• Sec. 109 states that, on termination of a lease,
  the landlord does not have income on account of
  the value of an improvement erected by a tenant
  (See Text p. 838, Supp. P. 153).
• The regulations provide
• However, where the facts disclose that such
  buildings or improvements represent in whole or
  in part a liquidation in kind of lease rentals,
  the exclusion shall not apply to the extent that
  such buildings or improvements represent such
  liquidation.
• This regulation has never been vigorously
  enforced.

50
Sections 61, 109 and 1019 (contd)

• Sec. 1019 is a basis rule that is consistent with
  the Section 109 exclusion of what could otherwise
  be seen as income.
• Section 109 states that there is no income and
  Section 1019 states that, as a consequence, there
  is no basis increase (no tax cost incurred, hence
  no tax cost basis). (Supp. P. 153).

51
World Publishing Co. v. Commissioner
(Supplement p. 151)
Net lease for 50 years
T
OFO
1928
Annual rental averaged 28,500
Tenant must construct a 6 story building costing
at least 250,000
Building to become part of the realty on
construction. Tenant agrees to subordinate to a
mortgage up to a stated percentage of ground
value.
1950
Sold all its interest
Taxpayer WORLD PUBLISHING NFO
700,000, subject to the lease to T, which had 28
more years to run
ACCEPTED The FMV of the land alone was
400,000. QUESTION What did TX, the New Fee
Owner, buy for the extra 300,000? STIPULATED
When the NFO, World Publishing Co., purchased
whatever it purchased, the remaining useful life
of the building was not greater than the
unexpired term of the lease. That is, the
remaining useful life of the building was equal
to, or shorter than, the remaining term of the
lease.
52
World Publishing (contd)

• Is there anything facially confusing about NFOs
  claim for Depreciation and Amortization?
• Recall, a depreciation deduction is only
  available if the property is
• used in a trade or business, or
• held for the production of income.
• IRS position is NFO has merely a reversionary
  interest, which may not be depreciated.
• The person claiming a depreciation deduction must
  have something akin to a substantial present
  possessory interest.
• The IRS argued this in Bolger

53
World Publishing (contd)

• Blackmun rejected the argument that NFO did not
  have a sufficient possessory interest.
• Consider the analogy of a building constructed by
  a landlord and then leased
• Where an owner of land erects a building on it
  and then leases it, he is still entitled to
  recover the cost of the improvement by
  depreciation deductions.
• Even though the present possessory interest in
  the building is in the tenant.
• Thus, the normal landowner/building owner is not
  required to have a present possessory interest in
  a building to depreciate the landdowner/ building
  owners investment in it.
• The facts of the particular tenant constructed
  improvement matter
• Here, taxpayer clearly owned the building in
  more than a bare-legal-title sense.

54
Then-Judge Blackmuns Factors

• Judge Blackmun the NFO had invested in an ample
  bundle of sticks to claim a depreciable interest
• The building became a part of the land and thus
  the Lessors on construction.
• Lessor had the right to inspect, reject and amend
  plans for the building.
• Lessor was a named insured of the building.
• Lessor had a right to subject the building, and
  not just the fee, to a mortgage.
• Lessor could prevent lessee from making major
  (10,000 or more cost) changes to the building
  without Lessors consent.
• State law provided that a building permanently
  affixed to the realty becomes a part of the
  realty.

55
World Publishing (contd)

• IRS also argued New Fee Owner can not purchase
  more of an interest than its seller had to sell.
  
• Here, the seller (OFO) did not have a depreciable
  interest in the building.
• IRS also argued The tenant has a depreciable
  interest in the building (the tenant paid to have
  it built), and it would be anomalous to have both
  the tenant and the new landlord (NFO)
  depreciating the same building.
• Blackmun fails to see the anomaly each
  taxpayer has made a separate wasting investment
  which meets the statutory requirements for
  depreciation.
• Each is recovering his own investment.
• That each is concerned with the same building is
  of no relevance.
• Analogy two taxpayers who own separate,
  undivided interests in real estate.

56
M. DeMatteo Constr. Co. v. United
States(Supplement p. 160)

• Same essential facts as World Publishing.
• The tenant-constructed building has a useful life
  no greater than the unexpired term of the lease.
• The New Fee Owner argued it was entitled to
  depreciation
• The court rejected World Publishing, saying the
  selling lessor has nothing to sell except bare
  legal title and the purchaser buys nothing more.
• The New Fee Owner might have argued it could
  amortize a premium paid for a favorable lease
• It is the lease which produces the income, not a
  building which the lessee constructed and which
  is going to reach the end of its useful life
  before the taxpayer obtains possession.
• However, the court said the NFO could not on
  appeal raise the new argument of a premium lease
  amortization theory

57
Geneva Drive-In Theater, Inc.(Supplement p. 162)

• Here, the tenant-constructed improvements have a
  useful life that is 5 years longer than the
  remaining (4-year) term of the lease.
• 1950 OFO 20-year lease
  T
• Pursuant to lease, builds
  T
• OFO sells for 200,000 above
  NFO
• price for land alone.
• What did the NFO buy for the extra 200,000?
• NFO claimed It purchased the improvements and
  could immediately depreciate its investment in
  them.
• IRS claimed NFO purchased a future interest
  the right to acquire the depreciable assets at
  the end of the lease. The investment is not
  depreciable until the interest becomes possessory
  at the end of the lease.

58
Geneva Drive-In (Tax Court)

• First statement of the court To qualify for
  the depreciation deduction the taxpayer has the
  burden of proving that he has a depreciable
  interest in the property in the sense that he has
  made an investment in it and will suffer the
  economic loss resulting from its deterioration
  through obsolescence.
• Focus on the word the
• It could mean whatever economic loss there is
• It could mean that the taxpayer must suffer an
  economic loss
• The latter meaning is hard to square with prior
  case law
• Did the taxpayer in Geneva Drive-In have more or
  less of an economic investment in the asset than
  the taxpayers in Mayerson, Bolger and Tufts?

59
Geneva Drive-In (Tax Court)(contd)

• Second statement of the court The
  improvements were not 1 used in his trade or
  business or 2 held for the production of
  income.
• The rent which he received compensated him only
  for the use of the land, a nondepreciable asset.
• Since the tenant constructed the building, the
  tenant would not have paid rent for it.
• Third statement of the court NFO purchased only
  so much of an interest as the OFO had.
• And the OFO did not have a depreciable interest

60
Geneva Drive-In (Tax Court)(contd)

• Recall why we do not see the OFO as having a
  depreciable interest?
• Is it because, under our tax law, we fail to see
  OFO as having realized income with respect to the
  tenant-constructed improvement?
• Thus the court said Other than this
  reversionary interest, NFO acquired no present
  interest in the theatre improvements.
• Compare World Publishing, in which Blackmun said
  that many fee owners get to depreciate buildings
  that are long-term leased to tenants
• Nor did NFO show that they paid any premium for
  the assignment of the lease which would entitle
  them to amortization deductions for the remainder
  of its term.

61
Geneva Drive-In (Tax Court)(contd)

• In explaining why this was neither 1 trade or
  business nor 2 production of income property,
  the Tax Court stated
• The improvements could produce no income for
  the NFOs until the lease terminated and their
  interest ripened into ownership of the
  improvements. Their interest in the improvements
  did not diminish in value as a result of the
  passage of time but, instead, the NFOs interest
  in them increased in value as the time for the
  actual enjoyment of the improvements approached.
• However, the same is not generally said in cases
  of lessor-constructed improvements

62
Geneva Drive-In (Tax Court)(contd)

• In the alternative even if the improvements
  deteriorated in value prior to the expiration of
  the lease, the NFOs did not suffer any economic
  loss because of that deterioration.
• Because the purchase price no doubt took into
  account that they would not receive the property
  until the end of their lease, and that it would
  then be in a deteriorated state.
• The NFO acquired none other than the
  reversionary interest, which was not a
  depreciable one.

63
Geneva Drive-In (Tax Court)(contd)

• The court said the lessee bore the risk of
  economic depreciation during the unexpired lease
  term because the lessee was required to surrender
  the building in as good a condition as when it
  was constructed.
• therefore, whatever depreciation occurred
  during the unexpired term of the lease was
  suffered by the lessee.

64
Geneva Drive-In (Tax Court)(contd)

• There may be situations where lessee-constructed
  improvements enhance the value of real property
  acquired subject to a lease. Such improvements,
  for example, may provide added assurance that the
  land rent to which the purchaser becomes entitled
  will be collectible. In the final analysis,
  however, the existence of improvements in such
  circumstances adds value to the lease which
  produces income to the purchaser, and in
  appropriate cases the courts have indicated that
  the premium value of the lease is amortizable.
• On the other hand, in other cases, where the
  purchaser may be required to remove or rebuild
  deteriorated or obsolete structures, their
  existence may be a negative factor in their
  purchase.

65
Geneva Drive-In (Tax Court and 9th Circuit)

• Tax Court said, and 9th Circuit agreed World
  Publishing allowed amortization, not
  depreciation.
• Tax Court added even if World Publishing
  allowed depreciation, it is distinguishable
  because the NFO in World Publishing purchased a
  larger bundle of sticks
• the lessor in World Publishing could borrow money
  and secure it by a mortgage to which the tenant
  was subordinated and
• the lessor in World Publishing could attach
  whatever clauses its mortgagee would require to
  the lessees insurance policies.

66
Geneva Drive-In (conclusion)

• Apparently, the court concluded that the NFO in
  World Publishing had more of a present possessory
  interest than the NFO in Geneva.
• Ninth Circuit affirmed, with one correction
• The Tax Court said The taxpayers
  interest in the improvements did not diminish in
  value as a result of the passage of time but,
  instead, increased in value as the time for the
  actual enjoyment of the improvements
  approached.
• Insofar as the Tax Court opinion makes
  entitlement to depreciation depend upon actual
  changes in market value, it is erroneous.

67
Section 1031 and Sale-Leasebacks (Supplement p.
175)

• Century Electric, Jordan Marsh and Leslie involve
  attempts by the IRS to disallow losses claimed
  by taxpayers who sell property and lease it
  back.
• The IRS weapon of choice in each of these three
  cases was the Codes best known nonrecognition
  provision Section 1031.
• Century Electric and Jordan Marsh represent the
  classic split in the Circuits on how to interpret
  Section 1031. The most recent of the three cases,
  Leslie, sided with Jordan Marsh.
• Consider first the basic rules in section
  1031(a)-(d) and then consider a series of
  hypotheticals.

68
Section 1031

• Section 1031(a) states that there shall be no
  recognition of gain or loss if property held for
  productive use in a trade or business or for
  investment is exchanged solely for like-kind
  property that will itself be held for use in a
  trade or business or for investment.
• That is, even though we can perceive income (or
  loss) because there has been an exchange that
  satisfies the realization requirement, section
  1031(a) states that the income (or loss) that has
  been realized will not be recognized (at least
  not at the time of the exchange).

69
Section 1031 (contd)

• A quick read of section 1031(a) suggests that,
  for it to apply, there must be
• 1) an exchange
• 2) of qualified properties
• 3) that are of like kind.
• The exchange of real estate held for investment
  with real estate held for productive use in a
  trade or business may be a like kind exchange if
  the transaction is otherwise qualified.

70
Mixed Exchanges

• What if the exchanges are not solely of like kind
  properties?
• Section 1031(b) states that the taxpayer will
  recognize some gain if it receives some other
  property or money as part of the mix.
• Section 1031(c) states that the taxpayer may not
  recognize any loss if it receives any other
  property or money.
• Jordan Marsh states even the receipt of cash .
  . . is not enough to permit the taxpayer to
  recognize loss.

71
Mixed Exchanges (contd)

• To recap if the taxpayer receives some
  unqualified property as part of the mix in the
  exchange
• There can be some recognition of gain
• There can be no recognition of loss

72
A owns Ableacre, property with a FMV of 3,000 in
which A has an Adjusted Basis of 1,000. A
exchanges it for Bs like-kind property,
Bakeracre, which is also worth 3,000.
Ex. 1.
As gain?
How much, if any, of the realized gain is
recognized?
73
Ex. 1 (Contd)

• The realized gain is not recognized if
  1031(a)(1) applies. 1031 provides
  nonrecognition of gain or loss to an exchange of
  properties held for productive use in a trade or
  business or for investment.
• As gain is realized but is not recognized at
  the time of the exchange.
• It is postponed.
• As basis in the property A received from B,
  Bakeracre, becomes 1,000. See 1031 (d).
• It is substituted basis property (7701(a)(42))
  that is exchanged basis property
  (7701(a)(44))(basis is determined by reference
  to other property held . . . by the person for
  whom basis is to be determined ).
• If A later sells Bakeracre for 3,000 cash, the
  postponed 2,000 gain would be recognized on that
  subsequent sale.

74
Ex. 2

• Assume As property, Ableacre, was worth only
  2,000 so that A also had to give 1,000 cash
  (referred to as boot) to get Bakeracre, Bs
  property with a FMV of 3,000.

A
B
Bakeracre
FMV 3,000
1,000 cash
Ableacre 1,000 cash

2,000 FMV 1,000 AB
Property Ableacre
Because A had to pay an additional 1,000, As
gain on the exchange of Ableacre is now only
1,000. It is realized but not recognized.
However, because A also paid the 1,000 cash, As
basis in Bakeracre is increased by 1,000, to
2,000. Thus, if A subsequently sold Bakeracre
for 3,000 cash, A would recognize a 1,000 gain
at the time of that sale
75
Ex. 3

• Assume, now, that As property, Ableacre, is
  worth 3,500, so that B gives A 500 cash as boot

A
B
Bakeracre
500 cash
3,500 FMV 1,000 AB
3,000 FMV 500 CASH
Ableacre
A has a realized gain of 2,500. How much is
recognized? The exchange is no longer solely in
kind as required by 1031(a). 1031(b) says that
the 2,500 realized gain is recognized to the
extent of the 500 boot received. What is As
basis in the property A received? 1031(d) says
that the basis of the property A received
(Bakeracre) is
1,000 - 500 500 1,000
76
Ex. 3 (Contd)

• Thus, if A later sells Bakeracre for 3,000 the
  value it had when A took it in the exchange from
  B, A will recognize the additional 2,000 gain.
• 3,000 Amount Realized on sale of Bakeracre
• 1,000 Adjusted Basis in Bakeracre
• 2,000 Gain Recognized on sale of Bakeracre
• Thus, the realized gain on the exchange was
  recognized in two installments
• 500 at the time of the exchange
• 2,000 at the time of the eventual sale of
  the property received
• The end result of the exchange followed by the
  sale is that A has 3,500 cash with 3,500 basis
  in it.

77
Century Electric Co. v. Commissioner (Supplement
p. 178)

• CE Sold Mfg. facility for 150,000
  College
• Paid 150,000 cash
  College
• Got a 95-year lease back
  College
• CE Reported
• 150,000 Amount Realized on Sale of the
  Mfg. facility
• - 531,700 Adjusted Basis in that Mfg.
  facility
• (381,700) Loss on Sale
• To say there was a 381,000 loss is to say the
  entire property was sold for only 150,000,
  leaving the seller with 381,000 in unrecovered
  cost/investment/basis
• Recall basis is unrecovered investment for tax
  purposesthe loss was the unrecovered basis
• Presumably, if the IRS disallowed the claim of a
  loss, the 381,000 in unrecovered basis would
  have to be accounted for in some other
  way--allocated to some property.
• The taxpayers basis would not simply disappear

78
Century Electric (further facts)

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

79
Century Electric Issue 1 Sale versus Like-kind
exchange

• The Eighth Circuits approach
• Congress was not defining sales and
  exchanges.
• It was concerned with the administrative problem
  involved in the computation of gain or loss in
  transactions of the character with which the
  section deals.
• The controlling policy of 1031 is the
  non-recognition of gain or loss in transactions
  where neither is readily measured in terms of
  money, where in theory the taxpayer may have
  realized gain or loss but where in fact his
  economic situation is the same after as it was
  before the transaction.

80
Sale versus Exchange (contd)

• The Eighth Circuits approach (contd)
• The excepted securities category under
  1031(a)(2)Supp. p. 175 indicates that 1031
  does not apply if the gain or loss is readily
  measured in terms of money.
• In the computation of gain or loss on a
  transfer of property held for productive use in
  trade or business for property of a like kind to
  be held for the same use, the market value of the
  properties of like kind involved in the transfer
  does not enter into the equation.
• Dont separate the transaction into its component
  parts.
• Rather, look at what actually was intended and
  accomplished.

81
Sale versus Exchange (contd)

• The Eighth Circuit said that Century Electric
  both intended and accomplished
• an exchange of a fee for a) a long-term lease
  back plus b) 150,000,
• with no change in possession or control.
• of property that, both before and after the
  transfer, was necessary to continue its business.
• The only change was in Century Electrics
  estate or interest in the factory.

82
The Section 1031 Regulations

• The basic Section 1031 regulations are the same
  today as they were at the time of Century
  Electric. They provide
• The words like kind refer to the nature or
  character of the property and not to its grade or
  quality.
• The fact that any real estate involved is
  improved or unimproved is not material, for such
  fact relates only to the grade or quality of the
  property and not to its kind or class.
• Thus, a building exchanged for a vacant lot
  qualifies!
• Note the great breadth of the section.

83
The Section 1031 Regulations Concerning A 30-year
Leasehold

• 3. No gain or loss is recognized if . . . a
  taxpayer who is not a dealer in real estate
  exchanges
• city real estate for a ranch or farm, or
• a leasehold of a fee with 30 years or more to run
  for real estate, or
• improved real estate for unimproved real estate.
• 4. Under the Treasury interpretation a lease
  with 30 years or more to run and real estate are
  properties of like kind.
• Does this regulation dispose of Century Electric?

84
Century Electric Issue 2 Given the Loss Was
Disallowed Where Did the Basis Go?

• Century Electric wanted to allocate the 381,700
  loss that was disallowed (its unrecovered basis)
  to and between the factory and the land and
  depreciate the portion allocated to the factory.
• Note it is awkward to talk of allocating the
  loss.
• First, the court said there was no loss.
• Second, the court was really allocating Century
  Electrics basis in the factory immediately prior
  to the transaction, 531,700, minus the reduction
  in basis caused by the 150,000 cash Century
  Electric received in the transaction, or a total
  of 381,700.

85
Century Electric Allocating the Remaining Basis
(contd)

• Court said Century Electric no longer has an
  identifiable capital investment in the
  improvements on the land covered by the lease.
• Its capital investment is in the leasehold and
  not its constituent properties.
• Accordingly, the taxpayer was required to
  amortize its investment in the leasehold
• Over its 95 year life
• And was not permitted to depreciate the building
• Over its shorter life
• Is this inconsistent with the first holding
  that nothing of consequence happened?

86
Jordan Marsh v. Commissioner (Supplement p. 183)
1944
JM
Sold 2 parcels and building
Vee
2.3 million cash concededly, the FMV
30 year, 3 day lease back
Contemporaneous in 1944
full and normal rentals
Additional 30-year extension if JM erects new
building
JM does not get an option to repurchase

• Jordan Marsh reported a loss on the sale.
• There are two issues, according to the court
• Was there a sale as opposed to an exchange?
• If there was an exchange, were the properties of
  like kind as to their nature or character?

87
Jordan Marsh Sale versus Exchange

• The IRS said that, in substance, the transaction
  was
• an exchange of a fee for a long term lease
• The two were trade or business properties
• Of like kind
• Such that Section 1031 prevents the recognition
  of loss.
• If Section 1031 applies, no loss may be
  recognized even if the taxpayer receives money as
  part of the exchange
• Recall, Section 1031(c), which applies to
  exchanges not solely in kind, states that no loss
  may be recognized if other property or money is
  received.
• Jordan Marsh received a large amount of money
• The IRS emphasized the Regulation stating that a
  leasehold of more than 30 years to run is the
  equivalent of a fee.

88
Jordan Marsh Sale versus Exchange

• The Second Circuit first considered statutory
  intent
• Section 1031 is an exception to the general rule,
  which is the entire amount of gain or loss
  realized on a sale or exchange is to be
  recognized.
• Section 1031 originally required recognition
  whenever the property received in exchange had a
  readily realizable market value.
• The readily realizable market value test was
  stricken from the statute because its application
  was too indefinite.

89
Jordan Marsh (more sale versus exchange)

• Current Section 1031 requires recognition if the
  property received is notes or securities that are
  essentially like money.
• See Section 1031(a)(2), stating that Section 1031
  shall not apply, for example, to any exchange of
  stocks, bonds, other securities or evidence of
  indebtedness.
• Section 1031 also requires recognition if the
  property received represents a different kind of
  investment.

90
Jordan Marsh (more sale versus exchange)

• But if the taxpayers money is still tied up
  in the same kind