Leslie Co. v. Commissioner

64 T.C. 247, 1975 U.S. Tax Ct. LEXIS 147

• Court: United States Tax Court
• Decided: May 19, 1975
• Docket: Docket No. 5964-72
• Status: Published

Opinions

Irwin, Judge:

Respondent determined deficiencies in petitioner’s income tax as follows:

Year Deficiency

1965_ $176,551.77

1966_ 50,700.90

1968_ 155,770.75

The issues presented for our determination are (1) whether the sale and leaseback of property by petitioner in 1968 constituted an exchange of property of a like kind within the meaning of section 1031(a)¹ and, if so, (2) whether petitioner should be entitled to depreciate the property under any of the methods specified in section 167(b) and to avail itself of investment credits pursuant to section 38.

The deficiencies in 1965 and 1966 result from the disallowance of net operating loss carrybacks and investment credit carrybacks based on a claimed net operating loss in 1968 and are completely dependent upon our determination of whether the sale and leaseback comes within the purview of section 1031.

FINDINGS OF FACT

Some of the facts have been stipulated and the stipulation of facts, together with the exhibits attached thereto, are found accordingly.

Petitioner Leslie Co. (hereinafter referred to as Leslie or petitioner) is a New Jersey corporation primarily engaged in the design, manufacture, and industrial distribution of pressure and temperature regulators and automatic instantaneous water heaters. At the time of the filing of its petition with this Court petitioner’s principal place of business was located in Parsippany, N.J. For the taxable years 1965 and 1966 corporate income tax returns were filed with the District Director of Internal Revenue, Newark, N.J. The 1968 corporate income tax return was filed with the Internal Revenue Service Center, Philadelphia, Pa.

For many years prior to 1966 Leslie operated its entire business, plant, and office in Lyndhurst, N.J. In 1966 Leslie determined that the Lyndhurst plant would be inadequate for future use and decided to construct a new facility in Parsippany. Upon completion of the new plant the Lyndhurst property was to be sold. Pursuant to the decision to move, Leslie acquired land in Parsippany in March 1967.

On October 30, 1967, after having explored other financing possibilities without success, Leslie agreed to a sale and leaseback of the land with improvements to the Prudential Insurance Co. of America (hereinafter referred to as Prudential). The agreement provided that Prudential would enter into a contract for the purchase and leaseback of the Parsippany property, subject, inter alia, to the following requirements and conditions:

1. The sale price shall not exceed $2,400,000 or the actual cost of land, building and other improvements erected thereon, whichever is the lower. * * *

2. Leslie Co. shall have erected and completed on the above premises a one story, 100% sprinklered, masonry and steel industrial building containing approximately 185,000 square feet * * *. The building is to be constructed and improvements made according to detailed plans and specifications which have been approved by The Prudential. Any changes to the plans * * * must be approved by Prudential prior to commencement of construction.

[[Image here]]

4. Prudential will be furnished with the following prior to closing:

(a) A lease with Leslie Co. satisfactory in form and substance to Prudential and Leslie Co. for a term of 30 years at an absolute net rental of $190,560, or 7.94% of purchase price if less than $2,400,000, to be paid monthly, in advance, in equal monthly installments. The lease shall include two (2) renewal options of 10 years each with an absolute net annual rental of $72,000,,or 3% of purchase price if less than $2,400,000. The lease shall further include a rejectable offer to purchase at the end of the fifteenth, twentieth, twenty-fifth or thirtieth year based on the following schedule:

at the end of the 15th year_$1,798,000.

at the end of the 20th year_$1,592,000.

at the end of the 25th year- $1,386,000.

at the end of the 30th year_ $1,180,000.

On December 16, 1968, after completion of the plant as approved by Prudential,² Leslie delivered the deed to the Parsippany property to Prudential for $2.4 million. The fair market value of the property at the time of sale was in the neighborhood of $2.4 million. Contemporaneously with the transfer of title to Prudential, Leslie and Prudential entered into the lease as specified in the above agreement. The annual net rental³ of $190,560 was comparable to the fair rental value of similar types of property in the northern New Jersey area. The lease also provided that all condemnation proceeds, net of any damages suffered by Leslie with respect to its trade fixtures and certain structural improvements, would become the property of Prudential without deduction for the leasehold interest of petitioner.

Leslie’s total cost in purchasing the land and constructing the plant was $3,187 million, consisting of the following:

Land_ $255,000

Building-_ 2,410,000

Paving and landscaping- 72,000

Boiler (including special features)_ 140,000

Special electrical wiring_ 138,000

Miscellaneous personal property (including certain special items)_ 140,000

Interim finance costs_ 20,000

Selling costs- 12,000

Total cost_ 3,187,000

Leslie would not have entered into the sales part of the transaction without the guarantee of the leaseback.

The Parsippany plant was not in operation on December 16, 1968, the date of closing, and did not become fully operational until mid-January 1969. The useful life of the new plant was stipulated to be 30 years. Leslie sold the Lyndhurst plant for $600,000 when it moved into the Parsippany facilities.

Leslie is not a dealer in real estate.

On its 1968 corporate income tax return Leslie reported the disposition of the Parsippany property as a sale with a gross sale price of $2.4 million and a cost of $3,187,414 with a loss thereon of $787,414. The claimed loss resulted in a net operating loss of $366,907, which was carried back to 1965. In addition, an investment credit of $436.41, not utilizable in 1968 on account of the claimed net operating loss, was carried back to 1965. An investment credit of $50,700, likewise not utilizable in 1968 on account of the claimed net operating loss, was carried back to 1966. Respondent, in disallowing the claimed loss, thereby disallowed all of the claimed carrybacks. Respondent would allow the loss as a cost of obtaining the 30-year lease and permit it to be amortized over the period of the lease.

Leslie treated the claimed loss as an unrecovered cost of plant construction on its books to be amortized over 30 years.

Prudential treated the rental receipts as rental income and depreciated the property on its corporate income tax returns.

OPINION

Respondent, relying upon section 1.1031(a)-1(c), Income Tax Regs.,⁴ and Century Electric Co., 15 T.C. 581 (1950), affd. 192 F. 2d 155 (8th Cir. 1951), cert. denied 342 U.S. 954 (1952), submits that the sale and leaseback between petitioner and Prudential falls within the nonrecognition provisions of section 1031,⁵ and that, therefore, petitioner’s claimed loss is not allowable. In the same breath, respondent would allow the claimed loss as a “cost” of acquiring the leasehold and amortize it over the 30-year term. Petitioner, on the other hand, submits that there was no “exchange” within the meaning of section 1031, and that, therefore, the claimed loss must be recognized. We agree with petitioner that section 1031 is inapplicable and that the loss must be recognized. The amount is not in dispute.

As an exception to the general rule requiring the recognition of all gains and losses, section 1031 must be strictly construed. See sec. 1002 and the regulations thereunder, particularly sec. 1.1002-1(b), Income Tax Regs.⁶ In order for this nonrecognition provision to come into play it must first be established that an exchange occurred. An exchange is defined in the regulations as a transaction involving the reciprocal transfer of property, as distinguished from a transfer of property for a money consideration. Sec. 1.1002-1(d), Income Tax Regs. See also Vernon Molbreak, 61 T.C. 382, 390-392 (1973), affd. per curiam 509 F. 2d 616 (7th Cir. 1975).

In the instant situation petitioner executed a sale and leaseback agreement with respect to the Parsippany property. It is clear that the sale and leaseback were merely successive steps of a single integrated transaction. It is also equally clear that petitioner, unable to obtain financing to construct a new plant, employed the sale and leaseback mechanism to obtain the needed new facilities. These factors, however, do not dispose of the issue.

While the leaseback arrangement was a necessary condition to the sale, we are of the opinion that, based on the record before us, the leasehold herein did not have any separate capital value which could be properly viewed as a portion of the consideration paid or exchanged. Petitioner received $2.4 million on the sale of the property. The sale and leaseback agreement, executed prior to construction of the new facility, provided that the sale price was to be actual cost to petitioner or $2.4 million, whichever was less. This was based on Prudential’s appraisal of the worth of the property after improvements. As it turned out, the actual cost to construct the new facilities (including purchase of the land) totaled $3,187 million. Although we are troubled by the disparity between $2.4 million and $3,187 million, the only evidence in the record (and this presented by respondent) indicated that the fair market value of the property as improved at the date of sale was in the neighborhood of $2.4 million, not $3,187 million. Respondent has also not objected to petitioner’s proposed finding of fact that the property as improved had a fair market value of $2.4 million at the date of sale.⁷ We also note that the evidence presented indicated that this valuation was comparable to the fair market value of similar types of property in the area. The annual net rental was also comparable to the fair rental value of similar types of property in the area. Based on the record before us, we have no choice but to find that the fair market value of the property was within the $2.4 million range. In our judgment, therefore, the sole consideration paid for the property was the $2.4 million in cash. The leasehold, while integral to the transaction, had no separate capital value and was not a part of the consideration. See City Investing Co., 38 T.C. 1, 9 (1962). In support of our finding that the leasehold had no capital value in and of itself at the time of the sale, we also note that in addition to the fact of the sale price and net rentals being for fair value, the condemnation clause in the lease agreement provided (with certain exceptions not material herein) that in the event of condemnation all proceeds would be paid to Prudential without deduction for the leasehold interest. This clause, while clearly not conclusive on the issue, is further evidence of a lack of capital value.

Respondent, however, in the body of his reply brief, argues that since petitioner’s cost exceeded the contract price, the difference must be equal to the capital value of the lease. We find this unsupported by the evidence presented. In essence, it would appear that respondent is arguing that although the leasehold had no capital value, it had a premium value to petitioner. The excess expenditures over $2.4 million would not be a loss as such to petitioner since it would be able to utilize the improvements as lessee and thus would be willing to spend more than $2.4 million. Although this argument seems to comport to economic realities, it does not give the leasehold value. The difference between $2.4 million and $3,187 million is clearly attributable to the cost of building the plant (including the purchase of land); it is not attributable to the leasehold. While it may be true that it was only because of the leasehold that petitioner was willing to spend $3,187 million, it does not follow that the leasehold had a value equal to the difference between $2.4 million and $3,187 million. To reach such a result, it must be shown that the fair market value of the improved property was $3,187 million, not $2.4 million. This was not done.

From an accounting standpoint it is true that the loss, being an extraordinary item, may cause a distortion of income. That is probably why petitioner amortized the unrecovered costs over the 30-year term in its financial statements. Petitioner’s treatment of the item on the books, however, is not dispositive of the issue for tax purposes. It is not at all uncommon to find that the book and tax treatment of a given transaction differ. Although losses may be amortized for book purposes, nothing in the Code permits such amortization for tax purposes.

When all the cards are on the table, the fact remains that petitioner had a cost basis of $3,187 million in the improved property and realized $2.4 million on the sale. The bonafideness of the sale was not questioned by respondent. As stated previously, since the evidence indicates that petitioner would be paying a net rent comparable to the fair rental value, the leasehold could have no value at the time of sale, and thus could not be a part of the consideration paid. It was merely a condition precedent to the sale; no more and no less. The fact that petitioner was willing to sell the property “only with some kind of leaseback arrangement included does not of itself detract from the reality of the sale.” Cf. City Investing Co., supra.

We, therefore, conclude that there was a bona fide sale of the property and not an “exchange” within the meaning of section 1031. See Jordan Marsh Co. v. Commissioner, 269 F.2d 453 (2d Cir. 1959), nonacq. Rev. Rul. 60-43, 1960-1 C.B. 687, revg. a Memorandum Opinion of this Court. We need not consider Century Electric Co., supra, and its possible conflict with Jordan Marsh Co. since we have found that there was no “exchange” within the meaning of section 1031. We do note, though, that if an “exchange” had been found, then, assuming “like kind” property, the fair market value of such property would appear not to be relevant.

Since the nonrecognition provisions of section 1031 are not applicable, the general rule of recognition under 1002 applies.

Because of our holding in the above issue we need not consider the other issue presented.

Reviewed by the Court.

Decision will be entered for the petitioner.

1 All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.

2 We note that Prudential did not approve the original plans. There was also a misunderstanding on the part of Leslie with respect to the square footage requirements.

3 The term “net rental,” as employed by the parties, indicates that the lessee will pay all taxes, maintenance, and other charges on the property.

4 (c) No gain or loss is recognized if (1) a taxpayer exchanges property held for productive use in his trade or business, together with cash, for other property of like kind for the same use, such as a truck for a new truck or a passenger automobile for a new passenger automobile to be used for a like purpose; or (2) a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate; or (3) a taxpayer exchanges investment property and cash for investment property of a like kind.

5 SEC. 1031. EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OR INVESTMENT.

(a) Nonrecognition of Gain or Loss From Exchanges Solely in Kind. — No gain or loss shall be recognized if property held for productive use in trade or business or for investment (not including stock in trade or other property held primarily for sale, nor stocks, bonds, notes, dioses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest) is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment.

(b) Gain From Exchanges Not Solely in Kind. — If an exchange would be within the provisions of subsection (a), * * * if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to he received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

(c) Loss From Exchanges Not Solely in Kind — If an exchange would be within the provisions of subsection (a), * * * if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.

6 (b) Strict construction of exceptions from general rule. The exceptions from the general rule requiring the recognition of all gains and losses, like other exceptions from a rule of taxation of general and uniform application, are strictly construed and do not extend either beyond the words or the underlying assumptions and purposes of the exception. Nonrecognition is accorded by the Code only if the exchange is one which satsifies both (1) the specific description in the Code of an excepted exchange, and (2) the underlying purpose for which such exchange is excepted from the general rule. The exchange must be germane to, and a necessary incident of, the investment or enterprise in hand. The relationship of the exchange to the venture or enterprise is always material, and the surrounding facts and circumstances must be shown. As elsewhere, the taxpayer claiming the benefit of the exception must show himself within the exception.

7 We hypothesize that respondent’s willingness to accept petitioner’s proposed finding of fair market value was due to his desire to ensure that the transaction would not be characterized as merely financial with title in substance remaining with petitioner. At the same time, relying upon Century Electric Co., 15 T.C. 581 (1950), he must have assumed that this Court would disregard the fair market values in finding sec. 1031 applicable. What he has failed to take into account is that it must first be determined that an “exchange” occurred for sec. 1031 to apply.