126 T.C. No. 14
UNITED STATES TAX COURT
PEABODY NATURAL RESOURCES COMPANY, f.k.a. HANSON NATURAL RESOURCES COMPANY, CAVENHAM FOREST INDUSTRIES, INC., A PARTNER OTHER THAN THE TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 20328-04, 6899-05. Filed May 8, 2006.
A partnership exchanged operating gold mines, including realty, for operating coal mines. The coal mines were subject to two coal supply contracts that obligated the mine owner to provide electric utilities with coal. The benefits and obligations under the contracts were governed by New Mexico law. The gold mines were not subject to supply contracts. The partnership treated the entire exchange as “tax free” under sec. 1031, I.R.C. R determined that the coal supply contracts were not real property and/or like- kind property and constituted “boot” so that the value of the supply contracts would be taxable in the year of the exchange.
Held: The coal supply contracts were covenants running with and appurtenant to the real property under - 2 -
New Mexico law. Held, further, amplifying the holding in Koch v. Commissioner, 71 T.C. 54 (1978), the coal supply contracts are “like-kind” property within the meaning of sec. 1031, I.R.C., and are not taxable as part of the exchange.
Martin D. Ginsburg, Alan S. Kaden, and Richard A. Wolfe, for
petitioner.
Alan M. Jacobson and Donald L. Wells, for respondent.
OPINION
GERBER, Chief Judge: The parties filed motions for summary
judgment1 under Rule 1212 at docket No. 20328-04 with respect to
the issue of whether coal supply contracts that burdened coal
mine property received by a partnership, as part of an exchange
under section 1031, are like-kind property to the gold mining
property transferred by the partnership.
Background
On June 25, 1993, Peabody Natural Resources Co. (a
partnership then known as Hanson Natural Resources Co.) (Peabody)
1 Respondent filed a cross-motion for partial summary judgment, as his position, if correct, would not have resolved all controversy between the parties. However, the partnership’s position, if correct, would be dispositive of all matters in controversy. 2 All Rule references are to the Tax Court Rules of Practice and Procedure, and all section references, unless otherwise indicated, are to the Internal Revenue Code as amended and in effect for the years in issue. - 3 -
transferred the assets of its gold mining business to Santa Fe
Pacific Mining Corp. (Santa Fe), an unrelated corporation, in
exchange for the assets of Santa Fe’s coal mining business. The
parties to the exchange agreed that the mining assets exchanged
by each had a total value of approximately $550 million. Peabody
treated the transaction as a like-kind exchange under section
1031.
The transfer by Peabody to Santa Fe was of gold mines and
other gold mining property (including buildings and other
improvements, machinery and equipment, and mine exploration and
development rights). In exchange, among other things, Peabody
(1) received from Santa Fe the Lee Ranch coal mine in New Mexico
(which included fee simple land and coal leases to other land
giving the leaseholder rights to the coal in place) and (2)
assumed all obligations of Santa Fe under two long-term coal
supply contracts entered into in the early 1980s by Santa Fe with
Tucson Electric Power Co. (TEPCO) and Western Fuels (WEF),
respectively. The Lee Ranch was in a remote part of New Mexico
and consisted of 13,594 acres of fee simple land and 1,800 acres
of leased coal land. During the early 1990s, the annual coal
output of the Lee Ranch mine was approximately 3.2 million to 5.0
million tons. At the time of the June 25, 1993, exchange, the
Lee Ranch mine contained coal reserves of approximately 200 - 4 -
million tons. The gold mines received by Santa Fe were not
burdened by gold supply contracts.
The TEPCO supply contract began during 1983. In connection
with TEPCO’s 1991 bankruptcy, however, the contract was
renegotiated resulting in a coal price reduction from the
original 1983 contract. The renegotiated contract was for a
period ending December 31, 2009. Either party, however, could
extend the contract for additional 5-year periods if the parties
were able to negotiate a good faith price that reflected the
then-current market price for coal. Under the contract, Santa Fe
was the exclusive supplier of the coal required for the operation
of Units 1 and 2 of TEPCO’s Springerville Station power plant,
and TEPCO was obligated to purchase a specified annual minimum
amount of coal. There was no maximum limit on the amount of coal
that Santa Fe could sell to TEPCO under the contract. The
contract, however, did contain estimates that the combined
requirements of Springerville Station Units 1 and 2 would range
from .6 million to 2.34 million tons per year during the term of
the contract. The quality of the coal was defined in the
contract, and the type of coal specified in the contract was the
type of coal produced in the Lee Ranch mine. Under the contract,
Santa Fe committed to use its best efforts to mine the Lee Ranch
mine’s coal reserves and to sell TEPCO the amount of coal needed
for operation of the Springerville Station power plant. - 5 -
The per-ton price of coal under the TEPCO contract was a
base price adjusted by Santa Fe’s actual mining costs. The
contract was to run through December 31, 2009, or until the
retirement of the power station but could be reopened for
contract price renegotiation during July 2008 and at 5-year
intervals after 2010. Specifically, the contract term was to
extend until the earlier of either: (1) The date when
Springerville Station Units 1 and/or 2 were retired from
commercial operation; or (2) sometime after December 31, 2009, if
the parties were unsuccessful in their good faith price
renegotiations for any contract extension period. During the
contract term Santa Fe was not permitted to sell coal to others
if such sales would impair its ability to satisfy the supply
contract obligations to TEPCO.
The TEPCO supply contract “[inured] to the benefit of and
[was] binding upon the Parties and their respective successors
and assigns.” The original 1983 contract allowed each party to
assign its rights and duties so long as the assignee or delegatee
“assumes” the rights and duties of the assignor and so long as
the assignee or delegatee is “capable of performing this
Agreement.” The 1983 contract also required any assumption by an
assignee to be accomplished in a written document entered into
with the other parties to the 1983 contract. - 6 -
The WEF supply contract, also entered into in 1983, was
between Santa Fe and WEF, a nonprofit cooperative comprising a
group of relatively small electric utilities. WEF, in turn,
would sell the coal to another cooperative, Plains Electric
Generation & Transmission Cooperative, Inc. (Plains), for use in
its Escalante Power Plant. Although the WEF supply contract is
primarily between Santa Fe, as the seller, and WEF, as the buyer,
that supply contract identified Plains as the guarantor of WEF’s
performance under that contract. That contract contained the
recitation that WEF and Plains “desire to secure a reliable and
reasonably priced supply of coal of the quality and quantities as
set forth herein for use in the generation of electricity in Unit
I, and potentially in an additional Unit II, of the [Escalante]
Station.” That contract also contained a price renegotiation
provision that took effect in 1993 under which WEF could
terminate the contract if a new long-term coal price were not
negotiated.
On account of WEF’s deteriorating financial condition, it
sought to renegotiate its contract. During 1990 the pricing
provisions were modified resulting in coal price reductions and
changes in other contract provisions. The renegotiated WEF
contract ran until December 31, 2004, and could be extended for
up to three 10-year periods by either party. Each 10-year
extension depended on the parties’ ability to renegotiate and - 7 -
agree to a new coal price which, in the parties’ views, reflected
the then market price for coal.
Santa Fe was required to maintain coal reserves adequate to
supply the quantity of coal called for under the WEF contract.
The WEF contract provided that any party subsequently acquiring
an interest in the Lee Ranch mine coal reserves “shall take such
interest subject to the dedication and reservation” of said
reserves. The contract also provided that the “dedication” was
not intended to be construed as a transfer to WEF of an interest
in the coal in place, but that it was “imposed as and * * *
[constituted] both an equitable servitude binding upon * * *
[Santa Fe] and * * * [its] successors and assigns and a covenant
running with * * * [Santa Fe’s] interest”.
The contract price was based on a complex formula that, to
some extent, was based on the variable and fixed costs incurred
by Lee Ranch mine in supplying coal under the contract. Under
the WEF contract, Santa Fe was the exclusive supplier of the
Escalante Station’s coal needs within minimum quantity and
quality standards, on an annual basis, with no limit on the
amount of coal that could be sold to WEF. The contract, however,
did contain an estimate of the Escalante Station’s requirements
as being .5 million to 2.3 million tons per year. Under the WEF
contract, Santa Fe had “the right to supply all of the Usage * *
* for each Year.” Santa Fe could not sell coal from the Lee - 8 -
Ranch mine to others if doing so would impair its ability to
satisfy its coal supply contract obligations to WEF.
The WEF contract terms were to be interpreted under the laws
of New Mexico. Under the WEF contract, Santa Fe would be allowed
to supply coal from mines other than Lee Ranch mine if it were
unable to remove coal from Lee Ranch mine on account of a force
majeure. The WEF supply contract provided that it would “inure
to the benefit of and be binding upon the Parties and their
respective successors and assigns.”
Peabody and Santa Fe determined that the mining assets each
exchanged had a total value of approximately $550 million. In
accordance with section 1.1031(j)-1(a)(2), Income Tax Regs.,
Peabody separated into exchange groups the assets it transferred
and received. Peabody treated the gold mines, coal mine
reserves, and appurtenant supply contracts as real property. It
valued the Lee Ranch mine coal reserves at $272.1 million. On
its income tax returns for the years in issue, Peabody treated
its exchange of the gold mining assets for coal mining assets as
a like-kind exchange under section 1031. - 9 -
In the notices of final partnership administrative
adjustment for Peabody’s taxable years ended March 31, 1994
through 1996, and its short taxable year ended June 30, 1996,
respondent determined that the supply contracts were not like-
kind property as to which Peabody was entitled to nonrecognition
treatment under section 1031.
Discussion
The focus of this case concerns a section 1031 like-kind
exchange of gold mines for coal mines. Respondent acknowledges
that the coal mines and gold mines are like-kind property as to
which Peabody is entitled to nonrecognition treatment under
section 1031(a). In petitioner’s motion for summary judgment and
respondent’s cross-motion for partial summary judgment, the
parties disagree about whether two coal supply contracts are real
property and/or like-kind property within the meaning of section
1031 (i.e., whether the coal supply contracts are boot).
Initially, we must decide whether the coal supply contracts
are considered or treated as real property under New Mexico law.
We must also decide whether those contracts, in the setting of
this case, constitute “like-kind” property within the meaning of
section 1031.
Summary judgment is intended to expedite litigation and
avoid unnecessary and expensive trial. Fla. Peach Corp. v.
Commissioner, 90 T.C. 678, 681 (1988). Summary judgment may be - 10 -
granted with respect to a legal issue, if there is “no genuine
issue as to any material fact and * * * a decision may be
rendered as a matter of law.” Rule 121(a) and (b); Craig v.
Commissioner, 119 T.C. 252, 259-260 (2002); Sundstrand Corp. v.
Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 (7th
Cir. 1994). There is no disagreement between the parties as to a
material fact, and therefore this matter is ripe for summary
judgment.
I. New Mexico Law: Are the Supply Contracts Real Property?
Petitioner argues that the supply contracts are real property
under New Mexico law, whereas respondent argues the contracts are
not real property but some type of intangible right.
A. Petitioner’s Arguments
Petitioner contends that the supply contracts are real
property under New Mexico law. Petitioner asserts that each
contract established a servitude under which Santa Fe and
successive owners of the Lee Ranch mine land have the obligation
to mine and supply the coal needed pursuant to that contract to
operate the utility’s power plant. This servitude, petitioner
maintains, is a real property interest under New Mexico law.
B. Respondent’s Arguments
Respondent contends that the supply contracts are not real
property under New Mexico law, relying on the fact that the
contracts did not result in a transfer of ownership of the coal - 11 -
to the buyer/utility. Respondent also points out that under
neither contract did the utility have the right to go onto the
Lee Ranch land and extract coal. Instead, respondent contends
Peabody had to mine and supply the coal required by the utility’s
power plant. Accordingly, respondent concludes that the supply
contracts are not real property but contracts to sell personal
property. See Townsend v. State ex rel. State Highway Dept., 871
P.2d 958, 959 (N.M. 1994) (observing that though mineral-in-place
interests constitute real property, the underlying minerals are
transformed into personal property when the mineral or physical
substance is severed from the land).
C. Analysis of Coal Supply Contracts Under New Mexico Law
We begin our analysis by noting that the supply contracts
are contracts for the sale of goods under New Mexico law. In
addition, each contract created a servitude obligating Santa Fe
and subsequent owners of the Lee Ranch mine to extract and supply
coal to the power plant. We conclude that under New Mexico law,
the supply contract servitudes constitute real property
interests, for reasons we will discuss.
1. Status as Contracts for the Sale of Goods
Minerals in place (i.e., minerals lying unworked beneath or
on the surface of the land) are considered part of that land, and
an interest in minerals in place is real property for purposes of
New Mexico law. Interests in minerals in place can be separately - 12 -
conveyed to and held by someone other than the owner of the
surface estate. After the minerals are severed and removed from
the land, they become personal property. See generally id. at
959; 58 C.J.S., Mines and Minerals, sec. 141 (1998).
As pertinent to this case, New Mexico has adopted section 2-
107 of the Uniform Commercial Code, which addresses minerals to
be severed from realty by the seller. In pertinent part, N.M.
Stat. Ann. section 55-2-107 (Michie 1993) provides:
Sec. 55-2-107. Goods to be Severed from Realty; Recording
(1) A contract for the sale of minerals or the like (including oil and gas) * * * to be removed from realty is a contract for the sale of goods within this article if they are to be severed by the seller but until severance a purported present sale thereof which is not effective as a transfer of an interest in land is effective only as a contract to sell.
* * * * * * *
(3) The provisions of this section are subject to any third party rights provided by the law relating to realty records, and the contract for sale may be executed and recorded as a document transferring an interest in land and shall then constitute notice to third parties of the buyer’s rights under the contract for sale.
Accordingly, the TEPCO and WEF coal supply contracts are
contracts for the sale of goods under New Mexico law.3
3 N.M. Stat. Ann. sec. 55-2-106(1) (Michie 1993) and sec. 2-106(1) of the Uniform Commercial Code each define a “contract for sale” to include both a present sale of goods and a contract to sell goods in the future. - 13 -
Even though coal supply contracts are contracts for the sale
of goods covered by article 2 of the Uniform Commercial Code, the
obligation of Santa Fe or its successors to sell unsevered coal
in the future may also qualify to be treated as the transfer of
an interest in land. See N.M. Stat. Ann. sec. 55-2-107(1). In
other words, classification of the two supply contracts as
contracts for the sale of goods in the future by N.M. Stat. Ann.
section 55-2-107(1), does not preclude those contracts from also
effecting a transfer of an interest in real property under New
Mexico law. See also 1 Restatement, Contracts 2d, sec. 127, cmt.
b & c (1981).
2. Creation of Servitudes
The TEPCO and WEF coal supply contracts created servitudes
under New Mexico law. The modern view is that servitudes may be
created by contract. See Cafeteria Operators, L.P. v. Coronado-
Santa Fe Associates, L.P., 952 P.2d 435, 441 (N.M. Ct. App.
1997); 1 Restatement, Property 3d (Servitudes), sec. 2.1(1)(a),
reporter’s note (2000).
Although he disputes that the supply contracts created
servitudes under New Mexico law, respondent acknowledges that the
servitudes (stemming from the seller’s obligation to mine and
supply coal from the Lee Ranch mine property to the
buyer/utility) involve affirmative covenants. See 1 Restatement, - 14 -
Property 3d (Servitudes), sec. 1.3(1) & (2), cmt. d, illus. 1 &
2.4
New Mexico law recognizes both “real covenants” and
“equitable servitudes”.5 E.g., Pollock v. Ramirez, 870 P.2d 149,
153 (N.M. Ct. App. 1994). In Pollock, a restrictive covenant was
not enforceable because the instrument creating it did not meet
the requirements for recordation in real property records. The
court in Pollock, however, noted that the restriction could still
be enforced as an equitable servitude assuming the requirements
for establishing and enforcing such an equitable servitude were
met. See id. at 153.
Under New Mexico law, there are three requirements for a
covenant to be an equitable servitude: (1) The covenant must
touch and concern the land; (2) the original “covenanting”
4 Vol. 1 Restatement, Property 3d (Servitudes), sec. 1.1 (2000) defines a “servitude” as a legal device that creates a right or an obligation that runs with land or an interest in land. “Running with land” means that the right or obligation passes automatically to successive owners or occupiers of the land or the interest in land with which the right or obligation runs. Id. sec. 1.1(1)(a). Servitudes covered by the Restatement include easements, profits, and covenants. Id. sec. 1.1(2). As defined by the Restatement, an “easement” creates a nonpossessory right to enter and use land in the possession of another and obligates the possessor not to interfere with the uses authorized by the easement, whereas a “profit” is an easement that confers the right to enter and remove timber, minerals, oil, gas, game, or other substances from land in possession of another. Id. sec. 1.2(1) & (2). 5 Vol. 1 Restatement, supra sec. 1.4 has dropped the terms “real covenant” and “equitable servitude” to describe servitudes encompassed within covenants that run with the land. - 15 -
parties must intend that covenant to run with the land; and (3)
any successor against whom enforcement is sought must have
actual, constructive, or inquiry notice of that covenant. Lex
Pro Corp. v. Snyder Enters., Inc., 671 P.2d 637, 639 (N.M. 1983);
Pollock v. Ramirez, supra at 153.
In Lex Pro Corp. v. Snyder Enters., Inc., 100 N.M. at 391,
the New Mexico Supreme Court observed that a covenant touches and
concerns the land if either (1) the burden of that covenant
renders the covenantor’s interest in land less valuable or (2)
the benefit of that covenant renders the covenantee’s interest in
land more valuable. The New Mexico courts have also held that a
covenant meets the “touch and concern” requirement if it calls
for either doing physical things to the land such as building a
wall, or refraining from doing physical things to the land.
Cypress Gardens, Ltd. v. Platt, 952 P.2d 467, 470 (N.M. Ct. App.
1997). The TEPCO and WEF supply contract obligations of Santa Fe
and its successors to mine and supply coal from the Lee Ranch
mine property do touch and concern that land.6
As to the second requirement that the original covenanting
parties intend that the covenant run with the land, the WEF
supply contract specifically expresses an intent to effect a
6 Although 1 Restatement, supra sec. 3.2, now requires neither the benefit nor the burden of a covenant to touch and concern land in order for the covenant to be valid as a servitude, we need not here decide whether this requirement has been superseded under New Mexico law. - 16 -
dedication of the Lee Ranch mine coal reserves to fulfilling that
contract and to establish a servitude upon Santa Fe and its
successors running with the Lee Ranch mine property. Although
the TEPCO supply contract contains no specific provision, it
provides that the agreement is to inure to the benefit of and be
binding upon respective successors to and assigns of the original
parties to the TEPCO contract. Where the original instrument
creating a covenant involving land provided that successors
should be bound by the covenant and where only successive owners
of the land were capable of performing the obligation pertaining
to that covenant, that covenant has been held to run with the
land. Murphy v. Kerr, 5 F.2d 908, 910 (8th Cir. 1925); Bolles v.
Pecos Irr. Co., 167 P. 280, 282-283 (N.M. 1917).7
As to the requirement that the successor against whom
enforcement of that covenant is sought have actual, constructive,
or inquiry notice, Peabody had actual notice of the TEPCO and WEF
coal supply contract obligations, as it assumed those contracts.
In addition, a memorandum of dedication concerning the WEF
contract was recorded in 1985 with the County Clerk for McKinley
County, New Mexico, the county in which the Lee Ranch mine is
7 See also 1 Restatement, supra sec. 2.2, cmt. i (“If the contract calls for a performance that can only be rendered by someone who owns or occupies a particular parcel of land, and if it would have little value to the other party if it could be terminated by a conveyance of that land, the burden was probably intended to run with the land of the promisor.”). - 17 -
located.
We hold that the TEPCO and WEF coal supply contracts created
servitudes obligating Santa Fe and successive owners of the Lee
Ranch mine to mine and supply coal to the buyer/utility and that
those servitudes are real property interests under New Mexico
law. See 1 Restatement, Property 3d (Servitudes), sec. 2.1 cmt.
b, illus. 4.
II. Like-Kind Status of the Supply Contracts Under Section 1031
Petitioner contends that the real property status of the
supply contracts under New Mexico law should be determinative of
the like-kind issue; i.e., should automatically qualify the
contracts as like-kind property to the gold mining property under
section 1031(a). In support of this argument, petitioner, among
other things, relies on this Court’s holding in Or. Lumber Co. v.
Commissioner, 20 T.C. 192, 196-197 (1953). Petitioner notes that
this Court held in Or. Lumber Co. that the rights to harvest
standing timber were personal property under Oregon law and
therefore were not like-kind property to land (real property)
received in exchange.
If the status of the supply contracts as real property is
held not in and of itself to be dispositive, petitioner
alternatively argues the supply contracts are like-kind property
to the gold mining property because the contracts (including - 18 -
potential renewals) could have a duration or term lasting 30 or
more years. Petitioner’s argument is based on section 1.1031(a)-
1(c), Income Tax Regs., which provides a safe harbor for a 30-
year or greater leasehold of a fee to qualify as “like kind” to a
fee interest in real property.
Finally, petitioner places reliance in Koch v. Commissioner,
71 T.C. 54, 65-70 (1978), a case which petitioner contends is
indistinguishable from the circumstances we consider here. In
that case, this Court held that two parcels of fee simple real
property were like kind, under section 1031(a), even though one
parcel was subject to 99-year condominium leases. In Koch, it
was reasoned that the leases did not constitute boot because they
were not separable from the fee simple real property interest.
Conversely, respondent contends that the fact that the
supply contracts are treated as real property interests under New
Mexico law does not conclusively establish that they are like
kind to the gold mining property Peabody transferred. Respondent
argues that like kind status of the supply contracts, for
purposes of section 1031, is a question of Federal tax law.
Respondent also notes that section 1031 case precedent does not
support the axiom that exchanges of real property are ipso facto
like kind. On this point, see Koch v. Commissioner, supra at 64-
65 (citing Fleming v. Commissioner, 24 T.C. 818, 823-824 (1955), - 19 -
affd. in part and revd. in part 241 F.2d 78 (5th Cir. 1957),
affd. sub nom. Commissioner v. P.G. Lake, Inc., 356 U.S. 260
(1958)). Respondent contends that the supply contracts
constitute property of a different kind and class and are not
like-kind property to the gold mining property Peabody
transferred, because the contracts are of an intrinsically
different nature and character from gold mining property. See
sec. 1.1031(a)-1(b), Income Tax Regs.
Finally, respondent argues that Koch is distinguishable from
and inapplicable to this case because the condominium leases in
Koch were 99-year (long-term) land leases, whereas the coal
supply contracts we consider are only interests in coal to be
removed from the ground.8 Respondent also attempts to
distinguish Koch, where condominium leaseholders had the primary
right directly to use the land, from this case, where the coal
buyers have no direct and substantially similar right to use the
Lee Ranch mine land.
C. Analysis
We agree with respondent that exchanges of real property
interests are not, ipso facto, like-kind exchanges under section
1031. Koch v. Commissioner, supra at 64-65; see also Smalley v.
8 We note that respondent does not carry this reasoning into the question of whether the Lee Ranch mine (land in fee and coal leases) is like-kind property to the two gold mine properties received in exchange. - 20 -
Commissioner, 116 T.C. 450, 463-464 (2001). For example, carved-
out oil payments, although characterized as real property under
State law, were found not to be like kind to a fee interest in
real estate. Fleming v. Commissioner, supra at 823-824. See
also Wiechens v. United States, 228 F. Supp. 2d 1080, 1085 (D.
Ariz. 2002), where 50-year water rights were not like kind to a
fee interest in real estate, and Clemente, Inc. v. Commissioner,
T.C. Memo. 1985-367, where an 8-acre parcel of land was not like
kind to gravel extraction rights in another parcel of land.
To decide whether an exchange is like kind within the
meaning of section 1031(a), we must compare the exchanged
properties to ascertain whether the nature and character of the
transferred rights in and to the respective properties are
substantially alike. Koch v. Commissioner, supra at 64-65; sec.
1.1031(a)-1(b), Income Tax Regs. See generally the discussion in
Smalley v. Commissioner, supra at 461-464. We conclude that the
real property interest status under New Mexico law of the TEPCO
and WEF supply contracts is not determinative of whether those
supply contracts constitute like-kind property as opposed to boot
under section 1031. See Koch v. Commissioner, supra at 64-65.
In making this comparison, consideration is to be given to the
respective interests in the physical properties, the nature of
the title conveyed, the rights of the parties, the duration of
the interests, and any other factor bearing on the nature or - 21 -
character of the properties as distinguished from their grade or
quality. Id.; sec. 1.1031(a)-1(b), Income Tax Regs.
In Commissioner v. Crichton, 122 F.2d 181, 182 (5th Cir.
1941), affg. 42 B.T.A. 490 (1940), the Court of Appeals for the
Fifth Circuit held that the exchange of an overriding royalty
interest in minerals for a city lot qualified as a like-kind
exchange. See also Rev. Rul 68-331, 1968-1 C.B. 352, in which it
was ruled that the exchange of an oil producing lease for a fee
simple title to a ranch qualified as a like-kind exchange.
Conversely, in Fleming v. Commissioner, 24 T.C. at 823-824,
we held that the exchange of an assignment of carved-out oil
payment rights for a fee interest in real estate failed to
qualify because they were not like-kind properties, even though
applicable State law characterized the oil payment rights as an
interest in real estate.
In Koch v. Commissioner, 71 T.C. at 65, we reconciled the
difference in the holdings of Crichton and Fleming as follows:
The main distinction between the two transactions is the duration of the interests--an overriding royalty interest continues until the mineral deposit is exhausted whereas a carved-out oil payment right terminates usually when a specified quantity of minerals has been produced or a stated amount of proceeds from the sale of minerals has been received.
Petitioner attempts to distinguish the coal supply contracts
here from the carved-out production payment rights in Fleming, on
the basis that the supply contracts are more extensive in scope - 22 -
and duration. Petitioner argues that the contracts involve
“essentially perpetual and unlimited rights” and meet the 30-
year-leasehold safe harbor of section 1.1031(a)-1(c), Income Tax
Regs., because each contract, with renewals, had 30 or more years
to run at the time of the exchange.
Peabody’s right to mine and extract coal from the Lee Ranch
mine land derives solely from its ownership of the land in fee
and the coal leases making up that coal mine property, not from
the TEPCO and WEF contracts. As previously discussed, the supply
contracts created servitudes obligating Peabody to mine and
supply coal from the Lee Ranch mine to the utility/buyers
pursuant to those contracts. Those contracts themselves,
however, did not give Peabody the right to mine coal from the Lee
Ranch land.
The supply contracts obligate each utility/buyer to pay a
specified price for Lee Ranch mine coal. In other words, the
contracts afford Peabody specified payment rights with respect to
the coal supplied. In that respect, Peabody’s supply contract
payment rights are incident to, derive almost exclusively from,
and cannot be separated from its ownership of the Lee Ranch mine
land. It is Peabody’s ownership of that mine’s coal reserves
that gives Peabody the right to mine and extract coal from the - 23 -
Lee Ranch mine land.9 In addition, unlike the overriding royalty
interests in Crichton, Peabody’s supply contract payment rights
do not necessarily last until coal on the Lee Ranch mine land has
been exhausted. Without optional renewals, the TEPCO supply
contract lasts until December 31, 2009, and the WEF supply
contract lasts until December 31, 2004. See, e.g., Clemente v.
Commissioner, T.C. Memo. 1985-367, where exchanged properties
were held not to be like kind because the gravel extraction right
the taxpayer received did not give that taxpayer the right to an
unlimited quantity of gravel. By contrast, in Rev. Rul. 55-749,
1955-2 C.B. 295, the exchange of fee land for perpetual water
rights was ruled to be qualified as like kind.10
9 In his declaration, the Lee Ranch mine’s controller stated that, to the best of his knowledge, all coal ever supplied under the TEPCO and WEF supply contracts has come from the Lee Ranch mine. In certain limited and/or remote circumstances, each contract would permit the seller to furnish substitute coal from a source other than the Lee Ranch mine. For instance, the seller under the TEPCO contract commits to use its best efforts to mine and supply to TEPCO such coal as is needed for operation of the Springerville Station from the Lee Ranch mine’s coal reserves. The TEPCO contract, however, provides that from “time to time”, the seller may substitute coal from other mines owned by the seller so long as the substituted coal delivered satisfies prescribed quality requirements and does not cost more than coal then being delivered to the Springerville Station from the Lee Ranch mine. Similarly, during an event of force majeure, the WEF supply contract would permit the seller, with the buyer’s consent, to deliver substitute coal (i.e., coal obtained from a source other than the Lee Ranch mine) to the Escalante Station. 10 In Rev. Rul. 55-749, 1955-2 C.B. 295, 296, the rationale for the ruling included the following:
(continued...) - 24 -
However, Peabody seeks to come within the safe harbor of
section 1.1031(a)-1(c), Income Tax Regs., by relying on the
renewal terms of the supply contract that might cause the
contracts to last 30 years or more.11 In Century Elec. Co. v.
Commissioner, 15 T.C. 581, 591-592 (1950), affd. 192 F.2d 155
(8th Cir. 1951), we indicated that subsequent 10-year periods
were added to the initial term of a 25-year lease to meet the
requirements of a leasehold for 30 years or more under the
Treasury regulation safe harbor. See also Rev. Rul. 78-72, 1978-
1 C.B. 258, which would allow the addition of optional renewal
periods to determine if a leasehold interest was for 30 years or
more.
10 (...continued) where the water right, whatever its size, is in perpetuity, as distinguished from a right to a specific total amount of water or to a specific amount of water for a limited period, the water rights and the land involved are regarded as sufficiently similar to constitute property of a like kind within the meaning of section 1031(a) of the Code. * * * 11 We previously have indicated that a short-term leasehold of real property is not equivalent to a fee interest for purposes of sec. 1031. Capri, Inc. v. Commissioner, 65 T.C. 162, 181-182 (1975); May Dept. Stores Co. v. Commissioner, 16 T.C. 547, 556 (1951); Standard Envelope Manufacturing Co. v. Commissioner, 15 T.C. 41, 48 (1950). As we observed in Smalley v. Commissioner, 116 T.C. 450, 464 n.11 (2001), this characterization of short- term leasehold interests derives not from any particular State law characterization but from negative implication of longstanding regulations which provide that an exchange of a 30- year lease for a fee interest qualifies as a like-kind exchange under sec. 1031. - 25 -
Contrary to petitioner’s argument, the supply contract
payment rights are not a leasehold interest in a fee property.
As previously held, Peabody’s right to mine and extract coal from
that land comes solely from ownership of the coal mine. We
therefore conclude that the 30-year safe harbor provisions of
section 1.1031(a)-1(c), Income Tax Regs., do not apply. See
Wiechens v. United States, 228 F. Supp. 2d at 1085 (where it was
held that a taxpayer’s 50-year water rights were not equivalent
to a leasehold of a fee for 30 years or more so as to qualify for
the regulation safe harbor).
The underlying rationale for allowing nonrecognition of gain
or loss under section 1031 is the concept that a taxpayer’s
economic situation following the exchange is essentially the same
as it had been before the transaction. This is expressed in the
following quote from the committee report underlying the
predecessor statute to section 1031: “if the taxpayer’s money is
still tied up in the same kind of property as that in which it
was originally invested, he is not allowed to compute and deduct
his theoretical loss on the exchange, nor is he charged with a
tax upon his theoretical profit”. H. Rept. 704, 73d Cong., 2d
Sess. (1934), 1939-1 C.B. (Part 2) 554, 564; see also Biggs v.
Commissioner, 69 T.C. 905, 913 (1978), affd. 632 F.2d 1171 (5th
Cir. 1980). The underpinning supporting section 1031(a) is that
the new property is substantially a continuation of the old - 26 -
investment which remains unliquidated. Commissioner v. P.G.
Lake, Inc., 356 U.S. at 268.
In determining whether the like-kind requirement of section
1031 had been met, we found it significant in Koch v.
Commissioner, 71 T.C. at 65, that section 1031(a) refers to
property of a like, not an identical, kind. The required
comparison of the old and new exchanged properties, we reasoned,
should be directed to whether the taxpayer, in making the
exchange, has used its property to acquire a new kind of asset or
has merely exchanged its property for an asset of like nature or
character. Id. Examining the exchanged properties in Koch with
those principles in mind, we held the taxpayer’s exchange of fee
simple land for other fee simple land subject to 99-year
condominium leases qualified for nonrecognition treatment under
section 1031(a) because those exchanged properties were property
of a like kind. Id. at 65-70.
In Koch, we rejected the Commissioner’s contention that the
taxpayer/lessor’s interests (primarily the right to condominium
rental payments) could be separated from the taxpayer’s fee
simple interest in that land. We observed that: (1) The
taxpayer’s right to rent was not a separate and distinct item of
property but part of the bundle of rights incident to ownership
of the fee; (2) the bundle of rights and its related obligations
were inextricably bound up with the fee simple interest; (3) the - 27 -
condominium leases contained numerous provisions (some of which
we briefly summarized in our findings in Koch) not only securing
the payment of rent but also protecting the value of the
taxpayer’s reversionary interest; and (4) the right to rent was
merely an incident of ownership of the fee simple interest. Id.
at 66-68. We also acknowledged that the 99-year condominium
leases prevented the taxpayer from taking physical possession of
the land received and using it for other purposes. We viewed
that leasehold restriction on the taxpayer’s use of the new land
as a distinction in the grade or quality of the exchanged old and
new properties as opposed to a difference in their kind or class.
We observed that section 1031(a) “‘was not intended to draw any
distinction between parcels of real property however dissimilar
they may be in location, in attributes, and in capacities for
profitable use.’” Koch v. Commissioner, 71 T.C. at 68 (quoting
Commissioner v. Crichton, 122 F.2d at 182).12 Finally, in Koch
v. Commissioner, supra at 70, we held that the value of the
taxpayer’s condominium lease interests did not constitute taxable
12 Sec. 1.1031(a)-1(b), Income Tax Regs., contains the explanation that the “like-kind” requirement concerns the nature or character of property and not its grade or quality. As we observed in Commissioner v. Crichton, 42 B.T.A. 490, 492 (1940), affd. 122 F.2d 181 (5th Cir. 1941), substantially similar interpretations of the term “like kind” have appeared in all applicable regulations beginning with those issued under the Revenue Act of 1921. - 28 -
other property or boot under section 1031(b), because the
“lessor’s fee simple interest cannot be so fragmented.”
In return for the gold mining property Peabody, among other
things, received the Lee Ranch coal mine, which was subject to
two coal supply contracts. Respondent acknowledges that the Lee
Ranch mine (consisting of fee simple land and coal leases) is
like kind to the gold mining property and qualifies for
nonrecognition treatment under section 1031(a).13 Respondent,
however, contends this case is distinguishable from Koch.
Respondent argues that the coal supply contracts are separable
from the Lee Ranch mine and constitute taxable other property or
boot under section 1031(b). In other words, respondent argues
those two supply contracts can be fragmented and are not
inextricably bound up with Peabody’s ownership of the Lee Ranch
mine’s coal reserves. We disagree.
Although each supply contract is also a contract for the
sale of goods under New Mexico law and does not give the
utility/buyer a right to extract coal from the Lee Ranch mine
land, in the context of this case we do not find those
distinctions to be significant nor to sufficiently distinguish
this case from Koch. Peabody’s right to mine and extract coal
13 Apparently, respondent does not dispute that the exchange of leasehold for fee interest here is all right. In addition Peabody’s right to mine and extract coal from the Lee Ranch mine is obviously substantially alike to the right to mine and extract gold from the two gold mines. - 29 -
from the Lee Ranch mine land and its supply contracts payment
rights for the coal cannot be separated from its ownership of the
Lee Ranch mine coal reserves. Those rights are part of the
bundle of rights incident to Peabody’s ownership of the Lee Ranch
mine land coal reserves. Indeed, those supply contracts give
Peabody no right to mine and extract coal from that land.
Instead, Peabody’s right to mine and extract coal from that land
comes solely from its ownership of that land and coal reserves.
As to the right to payment under the contracts for coal
furnished, those rights are ancillary to Peabody’s ownership of
the coal reserves. Accordingly, the question of whether the
supply contracts afford an advantageous or detrimental coal price
to Peabody is immaterial in that setting. See Koch v.
Commissioner, 71 T.C. at 68. Because we hold that the right to
receive income from the tenant is part of the bundle of rights
ancillary to and inherent in the ownership of the realty, the
question of whether the lease was advantageous or detrimental to
the fee owner is immaterial.
It is true Peabody is obligated to mine and supply coal to
meet the operating needs of power stations and that Peabody is
prohibited from impairing the contracted-for supply by selling
coal to other buyers. In our view those contract obligations and
restrictions constitute a distinction in the grade or quality of
the old and new mining properties rather than a difference in - 30 -
their kind or class. The new coal mine property is of a like
nature or character to the gold mining property Peabody
exchanged. By exchanging the gold mining property for the coal
mining property subject to the supply contracts, Peabody is
essentially continuing the original investment which remains
fully unliquidated. See Commissioner v. P.G. Lake, Inc., 356
U.S. at 268. Respondent, contrary to our holding in Koch, is
attempting to fragment and currently tax Peabody on the supply
contracts before their actual realization.
We hold that the coal mine subject to the TEPCO and WEF
supply contracts Peabody received is like kind to the gold mining
property transferred and that Peabody’s exchange qualifies for
nonrecognition treatment under section 1031(a). See Koch v.
Commissioner, 71 T.C. 54 (1978). In the light of that holding
and because the supply contracts cannot be separated from
Peabody’s ownership of the Lee Ranch mine coal reserves, it
follows that those contracts are not taxable as other property or
boot under section 1031(b). See id. - 31 -
D. Conclusion
On the basis of the forgoing, we conclude, as a matter of
law, that petitioner is entitled to summary judgment and
respondent is not so entitled.
An appropriate order will be issued
at docket Nos. 20328-04 and 6899-05.
[Reporter’s Note: This Opinion was modified by Order dated July 13,
2006.]