Leslie Co. v. Commissioner of Internal Revenue
38 A.F.T.R.2d (RIA) 5458, 1976 U.S. App. LEXIS 8095, 539 F.2d 943 (1976)
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Rule of Law:
A sale and leaseback transaction qualifies as a sale, allowing for the recognition of loss under Int.Rev.Code § 1002, when the property is conveyed for its fair market value in cash and the leaseback is acquired at a fair market rental, indicating the leasehold has no separate capital value.
Facts:
- Leslie Company (Leslie), a New Jersey corporation, engaged in the manufacture and distribution of pressure and temperature regulators and instantaneous water heaters.
- Leslie's Lyndhurst, New Jersey plant became inadequate for its needs, prompting a decision to move to a new facility.
- In March 1967, Leslie purchased land in Parsippany, New Jersey, for the construction of a new manufacturing plant.
- Leslie was unable to acquire the necessary $2,400,000 financing for the plant's construction.
- On October 30, 1967, Leslie entered into an agreement with Prudential Life Insurance Company of America (Prudential) whereby Leslie would erect a plant to Prudential's specifications, Prudential would then purchase the Parsippany property and building from Leslie, and immediately lease back the facility to Leslie.
- The property and improvements were to be conveyed to Prudential for $2,400,000 or Leslie's actual cost, whichever was less, and the lease term was set at 30 years with two 10-year renewal options at an annual net rental of $190,560 (7.94% of the purchase price).
- Construction was completed in December 1968, at a total cost to Leslie (including land) of $3,187,414.
- On December 16, 1968, Leslie unconditionally conveyed the property to Prudential for $2,400,000, and simultaneously executed a 30-year lease agreement with Prudential.
Procedural Posture:
- Leslie Company, on its 1968 corporate income tax return, reported and deducted a loss of $787,414 from the sale of the property.
- The Commissioner of Internal Revenue disallowed the claimed loss, asserting the transaction constituted a like-kind exchange under Int.Rev.Code § 1031, and treated the $787,414 as Leslie's cost in obtaining the lease, amortized over 30 years.
- The Commissioner assessed tax deficiencies of $383,023.52 against Leslie for the years 1965, 1966, and 1968.
- Leslie petitioned the Tax Court for a redetermination of the deficiencies, arguing the conveyance was a sale on which loss is recognized.
- The Tax Court agreed with Leslie, holding that the fee conveyance was a sale entitled to recognition and the leaseback was merely a condition precedent.
- The Commissioner of Internal Revenue (appellant) appealed the decision of the Tax Court to the United States Court of Appeals for the Third Circuit.
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Issue:
Does a transaction involving the sale of real property for its fair market value, immediately followed by a leaseback of the same property at fair market rental rates, constitute a "sale" allowing for the recognition of loss under Int.Rev.Code § 1002, or a "like-kind exchange" under Int.Rev.Code § 1031, precluding loss recognition?
Opinions:
Majority - Garth, Circuit Judge
Yes, a transaction involving the sale of real property for its fair market value, immediately followed by a leaseback of the same property at fair market rental rates, constitutes a "sale" allowing for the recognition of loss under Int.Rev.Code § 1002, and not a "like-kind exchange" under Int.Rev.Code § 1031. The court affirmed the Tax Court's decision, finding that the transaction was a sale because the consideration received by Leslie was solely money. The court adopted the reasoning of the Second Circuit in Jordan Marsh Co. v. Commissioner, which dictates that to determine if a transaction is an "exchange" under § 1031, the fair market value of the properties involved must be ascertained to ensure that the transfer was not solely for money consideration. The Tax Court's findings that Leslie sold the property for cash equal to its fair market value ($2,400,000) and acquired a leasehold for which it paid fair rental value led to the conclusion that the leasehold had no separate capital value. This established that the conveyance was "solely for a money consideration" and thus a sale under Treas.Reg. § 1.1002-1(d). The court rejected the Commissioner's reliance on Century Electric Co. v. Commissioner, which disregarded property valuation, preferring Jordan Marsh's view that Congress intended § 1031 to prevent recognition of "paper gains" where an investment remains tied up in property of the same sort, which was not the case here where Leslie liquidated its investment for cash.
Dissenting - Tannenwald, Judge
No, while the conveyance was a sale, the loss deduction should be disallowed because the leasehold had a premium value to Leslie. Judge Tannenwald argued that the $787,414 difference between Leslie's actual cost and the sales price should be treated as a bonus Leslie paid to obtain the leasehold. He reasoned that Leslie would not have willingly incurred this financial difference but for the guaranteed lease. Therefore, this amount should be treated as a capital expenditure for the acquisition of the leasehold interest and amortized over the lease's 30-year term, rather than being deducted as an immediate loss.
Dissenting - Wilbur, Judge
The dissent by Judge Wilbur, joined by Judges Tannenwald and Hall, declined to decide whether the conveyance was a sale or an exchange, but stated that the loss should not be recognized as a current deduction. Judge Wilbur expressed concern that the majority was permitting the taxpayer to "write off 25 per cent of the costs of acquiring the right to use a building for one-half a century that was constructed for its [Leslie’s] own special purposes." He contended that the loss incurred was more properly attributable to the acquisition of the leasehold interest rather than to the construction of the building, and thus, like Judge Tannenwald, believed it should be capitalized and amortized.
Analysis:
This case provides crucial guidance on distinguishing a sale from a like-kind exchange in sale-leaseback transactions for federal tax purposes. By endorsing the Jordan Marsh approach, the Third Circuit establishes that market value and the nature of the consideration received are paramount. This decision clarifies that if a taxpayer truly liquidates an investment for cash at fair market value and leases back the property at fair market rental, the economic reality points to a sale, allowing for immediate loss recognition, rather than a tax-deferred exchange. This approach ensures that the non-recognition provisions of § 1031 are applied strictly to reciprocal transfers where the investment remains substantially unchanged in kind, and not to transactions that are economically equivalent to a sale and subsequent new lease.
