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 buildings. • Many of the acts do just as much, or more, to protect • owners and • construction lenders. • Hence, many of these acts are now called “construction lien acts” to avoid any implication that they are primarily for the benefit of mechanics and materialmen. Donald J. Weidner

2. Guignard Brick Works v. Gantt 159 S.E.2d 850 (S.C. 1968). Landowner General Guignard Brick 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 Brick’s argument on the basis of the statute at Supp. 97-98? Did not Guignard Brick furnish the brick with the “consent” of the owner? Donald J. Weidner

3. Guignard Brick (cont’d) • Bricksupplier said that, under Section 1 of the barebones Mechanics Lien Act at Supp. P. 97: • It “furnished” bricks • That were “actually used” in the building • “by virtue of an agreement with, or by consent of, the owner of such building” such that it • “shall have a lien upon such building . . . and upon the interest of the owner . . . of the lot on which it is situated to secure the payment of debt” • What is the Owner’s response to Bricksupplier’s claim under Section 1? • Section 1 is for general contractors only. • Bricksupplier is a subcontractor and subcontractors do not fall under Section 1. Donald J. Weidner

4. Guignard Brick (cont’d) • Section 2 (Supp. P. 97), on the other hand, refers to a lien of “[e]very laborer, mechanic, subcontractor or person furnishing material” • when an “improvement has been authorized by the owner” • “shall have a lien” on the real estate • “to the value of the labor or material so furnished” • “subject to existing liens of which he has actual or constructive notice” • The lien may be enforced “as provided herein.” Donald J. Weidner

5. Guignard Brick (cont’d) • Consider the last sentence in Section 4 of the barebones act (Supp. P. 98): • It states that the lien given by Section 2 (for subcontractors) 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.” Donald J. Weidner

6. Guignard Brick (cont’d) • Mechanics lien statutes typically provide that the liens of all the subcontractors relate back to some earlier point in the development or construction process, that is, prior to the point at which most of the materials were supplied or the services were rendered. • Can you see why as a matter of policy this should be so? • See Barebones Act 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 potentially invisible date of the contract (with the general contractor?). • Statutes more commonly provide that mechanics liens relate back either to the commencement of construction (or to the filing of a notice of commencement of construction). Donald J. Weidner

7. More on Supplement pages 97-98 • 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 does the barebones act provide? • Section 5 states that “no payment by the owner to the contractor [after having been given notice] shall operate to lessen the amount recoverable by the person so giving the notice.” • What about a payment to a subcontractor? • Is Advance #2 a payment “by the owner?” • What of the “optional/obligatory” distinction? • Recall Florida Statute 697.04(1)(a) (Supp. P. 99) Donald J. Weidner

8. “Stop Notice” and Undisbursed Proceeds • A number of states have statutory “stop notice” procedures: “A lender or owner holding construction funds who fails to honor an unpaid supplier’s stop notice demand that it withhold sufficient funds to satisfy the supplier’s claim will be personally liable to the supplier for the amount owed.” Text at 657. • Some courts impose an equitable lien on undisbursed funds. • Others say that equitable liens are not permitted because the mechanics’ lien and stop notice statutes provide the exclusive remedy to subcontractors. Donald J. Weidner

9. “Stop Notice” and Undisbursed Proceeds • “The remedy is statutory, and . . . often the claimant must file a bond to indemnify the lender against damages that might result from a wrongful claim. [Depending upon state law, the Lender might file “a corresponding bond and discharge the stop notice.”] The lender may simply pay the claim and discharge the stop notice, but if the claim is disputed or there are insufficient funds to pay all stop notice claims, litigation may be necessary.” Nelson & Whitmire, Real Estate Finance Law (5th ed. sec. 12.6). Donald J. Weidner

10. Commencement, Mechanics’ Liens and Purchase Money Mortgages Kloster-Madsen, Inc. v. Tafi’s 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 for its New Buyer. A Subcontractor began work prior to the time Buyer acquired either title or the loan to finance it. The case involved a priority battle between the mechanic lien claimant General Contractor and lender Prudential Life Insurance Company, which had closed a loan that was part purchase-money loan and part improvement loan. General Contractor had begun work prior to the time the New Buyer acquired title. Donald J. Weidner

11. Kloster-Madsen, Inc. v. Tafi’s Inc., 226 N.W.2d 603 (Minn. 1975). $PM (+Improvement $) Deed Seller Buyer Pru note Purchase A’ment 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 Pru or 2) authorization of Seller [but, held, Seller had knowledge]) July 30, 1970 Sub August 3, 1970 Purchase closed Donald J. Weidner

12. Kloster-Madsen (cont’d) • 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 mind’s eye.” Donald J. Weidner

13. Kloster-Madsen (cont’d) • The Court upheld the trial court’s 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 mind’s eyes insofar as they tell one’s 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.” • Is the court saying that the test is what the “mind’s eye” would see if the naked eye had been used with reasonable care in looking for a commencement of construction? Donald J. Weidner

14. Kloster-Madsen (cont’d) • Third, is a pre-existing mortgage or mechanics lien defeated by Prudential’s 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. • Historically, the priority of a purchase money mortgage was explained in terms of instantaneous transitory seisin (which is what Prudential argued) • The argument was that seisin passed so quickly from the buyer to the purchase money mortgagee that the buyer’s pre-existing liens never had sufficient time to attach to it Donald J. Weidner

15. Kloster-Madsen (cont’d) Gets judgment lien on all real estate owned by Debtor CR Debtor Purchase Money Mortgages are special because they often permit the purchase-money 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 and Archaic Explanation: Instantaneous transit of seisin. Pays $ Loans $ Seller Debtor Purchase Money Mortgagee contemporaneous conveys fee Mortgage Under the purchase money mortgage rule, the purchase money mortgage has priority over the prior creditor’s judgment lien against Debtor. Classically, seisin passed so quickly the prior judgment never had a chance to take hold of it. Donald J. Weidner

16. Kloster-Madsen (cont’d) • Court: the purpose of the doctrine of instantaneous seisin is “to protect mortgagees from hidden or undiscoverable liens.” • The mechanic’s 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. Donald J. Weidner

17. General Rule: Purchase Money Mortgage Defeats Prior Mechanic’s Lien • 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. • Purchase Money Mortgagee’s contribution supplied the asset • Giving it to prior creditor would be a windfall • An additional rationale for rejecting the outcome in 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 Seller knew of but did not authorize the improvements. Donald J. Weidner

18. Kelly Kelly holds the 1st Mortgage and is the 2nd Mortgagee, both mortgages Kelly acquired after actual knowledge of the work W & W had previously performed. Williams & Works, Inc. v. Springfield Corp.(Text p. 646) Contacts with interest in bldg. Apt. complex Convey Developer Springfield Mechanics Lien Claimant W & W Engineers Fee Owners Law Dev. Co. Kelly Mortgage & Inv. Co. Developer had the right to terminate the engineering contract at end of any phase June 1972 Formal contract: W&W contracts to perform engineering services 8/29/72 12 holes into ground, 6” diameter “staked” Phase #1: Feasibility Studies Actual knowledge of W&W’s work Phase #2: Finalize all plans Sells and conveys land Developer Springfield 1/4/73 Mortgages land to CNB City Nat’l Bank Assigns Mortgage (unclear when) 1/9/73 Records the 1st mortgage 2nd Mortgage Developer Springfield Records 2nd Mortgage Phase #3: PhysicalConstruction Begins; W&W supervises—sets stakes out ML 2/10/73 ML Files action to foreclose its mechanics lien 3/25/74 Donald J. Weidner

19. Williams & Works (cont’d) • Like Kloster-Madsen, this is a lien priority dispute between the mortgagee and a mechanics lien claimant who started work for the Developer before the Developer acquired title. • FN. 5, p. 647, has the “much amended” Section 1. • Do you see the language in Section 1 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” in other parts] Donald J. Weidner

20. Williams & Works (cont’d) • 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” • However, the court held that Section 1 does nothing more than describe what is “lienable.” Donald J. Weidner

21. Williams & Works (cont’d) • Section 9[3] of the mechanics’ lien act in fn. 1 contains a priority rule. • Consider the lien priority (relation-back) 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 statute at FN. 6 to include “designs or engineering plans.” Donald J. Weidner

22. Williams & Works (cont’d) • Engineers Williams & Works—argue that their mechanics lien is superior to the mortgages that were both given and recorded after their “improvement” (their “engineering plan”) was begun. • Given the statute, how could the mechanics lien claimant engineers possibly lose this case? • Held: “[N]on-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 Michigan’s Mechanics’ Lien Law.” • The “improvement” was not an “improvement” for lien priority purposes • Michigan legislature subsequently specifically embraced the Williams v. Works result (p. 655) Donald J. Weidner

23. Summary of Construction Lien Concepts (Text p. 655) • 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? • Also varies from jurisdiction to jurisdiction. Donald J. Weidner

24. Construction Lien: Concept Summary (cont’d) • As of what time does the perfected lien take priority? Depends upon the state. Typically, as of: • 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. • In Florida, the subcontractors, in turn, must file a “Notice to Owner” (and lender) that they are about to begin 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. Donald J. Weidner

25. Construction Lien: Owner v. Subcontractor 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 owner’s liability to lienors who are not in privity with it (subcontractors) can often be summarized as follows: Contract Price Owner Agreed to Pay Minus: Proper Payments (at least those prior to any notice) Minus: Reasonable Cost to Complete (upon “abandonment”) Equals: Extent of owner’s liability to all non-privity lienors. Donald J. Weidner

26. Wrongly Disbursed Funds • Wrongful disbursal of funds by lender can result in the lender’s loss of lien priority as against a mechanics’ lien claimant • just as wrongful disbursal might cause a lender to lose its lien priority 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 Donald J. Weidner

27. J.I.Kislak Mortgage Corp. v. William Matthews Builder, Inc. (Text p. 595) Developer and Construction lender entered into a construction loan agreement • Developer executed a construction loan note and mortgage to construction lender • Construction lender recorded the mortgage • Construction subsequently began • Construction lender’s 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. Donald J. Weidner

28. Kislak Mortgage (cont’d) • “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.” • That is, from the lender’s point of view, everything started out as it should to give the lender first lien priority. • “However, there is an exception to the rule which applies when . . . some of the disbursements are voluntarily made at a time subsequent to the effective date of the mechanics’ lien.” Donald J. Weidner

29. Kislak Mortgage (cont’d) • “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 court appears to be saying that, even though there is “no actual notice,” there is “constructive knowledge” • The lender was “charged with knowledge of the law that mechanics’ liens relate back” Donald J. Weidner

30. Kislak Mortgage (cont’d) • Essentially the mechanics’ lien took priority to the extent the lender made voluntary payments with knowledge that mechanics liens could subsequently be filed that would relate back to the commencement of work. • “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. • So Lender bore the risk of loss when its draw inspector took a bribe? Donald J. Weidner

31. Wrongly Disbursed Funds (cont’d) • Compare Guaranty Mortgage Co. of Nashville v. Seitz (Text p. 657): “The lien of a deed of trust securing a construction loan has priority over mechanics’ and materialmen’s 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.” • Can the lender use reasonable diligence and still have money stolen by an employee? Donald J. Weidner

32. Recall: Florida Statute on Mortgages for Future Advances (Supp. P. 99) 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.” Donald J. Weidner

33. Landlords Must Capitalize the Cost of Obtaining Tenants • We have a tax on income, rather than, for example, a tax on gross receipts. The basic idea behind income is an enhancement in wealth during a particular year. Therefore, the tax law attempts to tax receipts for the year minus the cost incurred during the year to generate those receipts. • A landlord must capitalize the cost of obtaining a tenant and amortize that cost over the years that rent will be generated (See text p. 693). • That is, the landlord is not permitted to expense (currently deduct) all of the cost of obtaining a lease from a tenant because the lease is an asset that will generate receipts for years. • The landlord must attribute a portion of the cost of the lease to the rent receipts it will receive each year. Donald J. Weidner

34. Landlord Must Capitalize Cost it Incurs to Obtain Tenant (cont’d) • The Landlord must capitalize the cost it incurs to acquire a tenant (cont’d). • For example, at the beginning of year 1, Landlord Pays Tenant $10 to enter into a 10-year lease • Landlord may not deduct the full $10 payment in year one. • Rather, Landlord must “capitalize” the $10 payment (the landlord gets basis in the lease asset) • Landlord then deducts the payment $1 at a time--$1 per year for each of the 10 years of the lease • Thus matching and offsetting the rent receipts with the cost of generating those receipts Donald J. Weidner

35. Tenant Must Capitalize Cost it Incurs to Obtain Favorable Leases • Similarly, a tenant may not immediately deduct a bonus it pays to acquire a lease ; • The bonus payment is treated as a cost of acquiring the lease and must be capitalized (treated as the cost (basis) of the asset—the leasehold estate) and then amortized a little bit each year of the life of the lease. (See Text p. 693). • However, a tenant’s 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. 693). Donald J. Weidner

36. Tenants Depreciate their Investments in Buildings on Land they Lease • Tenants often construct buildings on land that they lease (recall Penthouse, Cambridge). • A tenant who invests in a building that is • used in its trade of business or • held for the production of income, is allowed to recover its investment in the building (basis) through depreciation (“cost recovery”) deductions. (See Text p. 693). Donald J. Weidner

37. Write-offs Available to Tenants Who Construct Improvements on Leased Land • In short, a tenant who leases land and constructs a building on it may be doing all of the following: • amortizing its investment in the ground lease • deducting the rent it is paying under the ground lease and • depreciating its investment in the building it constructs on the leased land. Donald J. Weidner

38. Pays $800,000 Conveys tract of land Are Tenant-Constructed Improvements Rent the Landlord Must Include in Income? The Chirelstein Hypo NFO LL FO 20 year ground lease MFG T T to pay relatively low annual rent T to construct factory to cost at least $1,000,000 Factory to become property of LL on termination of the lease [“thus…apparently… 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 LL T Donald J. Weidner

39. 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 constructed by the tenant “income” to the Landlord? Is it an • “accession to wealth,” • “clearly realized,” • “over which the taxpayer has complete dominion”? • What is the “right result?” • If it is income, when are these criteria met? • If it is income, in what amount? Donald J. Weidner

40. The Realization Requirement • Chirelstein: “because the realization requirement exists, the income tax is a tax on transactionsinstead 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 Donald J. Weidner

41. 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 the landlord reports the present value of the future payment in income at the beginning of the lease, you could consider the transaction closed at this point, and not require the landlord to report any further income when the lease ends. Donald J. Weidner

42. Possibility # 1: Prepaid Rent (cont’d) • As soon as the landlord reports the present value of the right to receive the building in income, the landlord receives a $50,000 basis in it. • Sometimes referred to as a “tax cost basis” • Landlord’s basis in the building at the termination of the lease at the end of year 20 would remain $50,000, the amount previously included in income. • Landlord’s depreciation deductions for the last five years of the building’s useful life (after the lease expires and the landlord’s interest in it becomes possessory), on a straight-line method, would be: $50,000 (basis) /5 = $10,000 per year. • Note: To implement this prepaid rent approach, there must be a prediction of the value of the building at the end of 20 years. Donald J. Weidner

43. 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? • Require the landlord to include some of the building’s value in income for each year of the lease. Ex., $10,000 for each of 20 years ($10,000 X 20 = $200,000). • Landlord’s basis in the building on termination of the lease would be $200,000—the amount previously included in income (a “tax cost basis”). • Landlord’s depreciation for the remaining 5 years of useful life after the lease expires: $200,000 (basis) /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. Donald J. Weidner

44. 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 Landlord’s reversion in the building becomes possessory. • How much rent? • The fair market value of the building when the lease terminates. • If the building’s actual value turns out to equal the anticipated value, that amount is $200,000 in this hypothetical. • Landlord’s basis in the building would be $200,000, the amount included in income. • Again, a “tax cost basis” • Landlord’s depreciation deduction for each of the remaining 5 years of the building’s useful life: $200,000/5 = $40,000 per year. Donald J. Weidner

45. Postpaid Rent (cont’d) • 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 landlord’s realization event. • When the landlord’s reversion in the building became possessory. • The courts initially rejected this approach. Donald J. Weidner

46. 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. Donald J. Weidner

47. T defaulted Helvering v. Bruun309 U.S. 461 (1940) LL Leased lot & building for 99 years T 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 LL’s “unamortized cost” of old bldg. is 13,000 “Net FMV” [net “gain” $51,000 as at 7/1/33, says IRS] stipulation Donald J. Weidner

48. Bruun and Its Aftermath: From Possiblility # 3 to Possibility # 4 • Bruun held for the IRS, concluding that the landlord had incomewhen the tenant defaulted and the landlord’s reversion became possessory (Possibility #3). • One might ask what would happen if, upon the tenant’s 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. Donald J. Weidner

49. 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 landlord’s basis in the building at the expiration of the lease is zero. • Because the landlord’s basis in the building is zero, the landlord gets no depreciation deductions during the remaining useful life of the building. Donald J. Weidner

50. Sections 61, 109 and 1019 in A Nutshell • Sec. 61 regulations provide that, if a tenant pays any of the landlord’s 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. Donald J. Weidner