If you own some commercial or residential real estate, you probably know about Code Section 1031. If you don’t and you finally decide that you are sick of being a landlord, you will almost definitely hear about it. There are a couple of Internal Revenue Code Sections that have worked their way into the language. 401(k) and 501(c)(3) are among them, but among real estate people 1031 is the one you will hear the most. As far as I know, 1031 is the only Code Section that is used as a verb as in “I’m going to 1031 that property”.
Code Section 1031 allows for the deferral of gain on the exchange of property used in a trade or business or held for the production of income if the relinquished and target properties are of like-kind. It has application in areas besides real estate, but the big advantage in real estate is how broadly encompassing “like-kind” is. Swapping cows for bulls will not qualify as like-kind under 1031, but a cow pasture for a strip mall will. Like-kind exchanges are a virtual sub-industry of the real estate industry.
There is even a well developed option for people who want to get out of being a landlord. Retailers like CVS that don’t want to own their stores lease them on very long term triple net leases. For practical economic purposes owning one of those buildings is very much like owning a bond. Deals involving these properties will often involve non-recourse borrowing.
Someone who exchanges into such a deal will often be able to get most of the equity in their relinquished property in cash without recognizing any gain. When I have looked at these deal for people, I have had a couple of concerns – specifically the interest tracing rules and state income taxes. There was something that I hadn’t thought about, though, that one of my real estate friends, Daryl Carter of Maruy L. Carter and Associates explained to me.
The buildings are priced based on the lease. In the event that something happens to the tenant or, as Daryl put it, the building “goes dark”, the cost per square foot is often way out of line with the price that you paid. So you are not just investing in real estate you are, in effect, also investing in CVS. If I really wanted to lose sleep about these deals, I would worry about the IRS arguing that, in substance, the deal should be bifurcated between a piece of real estate and a loan to CVS.
Given how much CVS seems to like these deals, you would not expect CVS to be making that argument. Only they just did. It was not in an income tax case. It was a property tax case in the Indiana Tax Court – Shelby County Assessor v CVS Pharmacy Inc.
CVS and the Assessor actually agreed, in principle, about how to value the property, but they had a little bit of a difference:
During the hearing, both CVS and the Assessor agreed that the income capitalization approach was the most reliable method by which to value the subject property. Accordingly, they presented competing income approach calculations with supporting documentation. While the parties’ income approach calculations were similar in many respects, they differed in one major aspect: CVS used market rents and the Assessor used contractual rent.
I don’t know how many CVS stores there are in the country, but I do know there are a lot. They are not quite as ubiquitous as MacDonalds, but after all, you need to eat every day, while you probably only need to fill prescriptions every couple of weeks or so. I guess you could see how their real estate department would screw up every now and again and pay too much rent. That is not what is going on, though:
CVS believed that the use of the subject property’s contractual rent in the income approach was not appropriate. Indeed, through its expert witnesses, CVS stated that it typically uses sale-leaseback transactions as financing tools; consequently, the lease payments it makes to its lessors pursuant to its leases do not reflect merely the value of the real estate, but rather the broader business value of CVS itself.
Reflect on that for second. There is more.
To demonstrate this point, CVS presented evidence showing that twenty-four vacant CVS, Walgreens, RiteAid, and Eckerd Drug stores (nine in Indiana and fifteen throughout the country) were in the process of being marketed to “second-generation tenants” for rent at approximately $10.00 per square foot. Thus, explained CVS, the $10.00 per square foot figure represented the actual value of the subject property’s real estate. In turn, CVS explained that the “spread” between that figure and the subject property’s contractual rent of $27.20 per square foot represented the investor’s expected return on its investment in CVS.
I added the emphasis. It turned out that both the Indiana Board of Tax Review and the Indiana Tax Court agreed with CVS.
The Indiana Board also rejected the Assessor’s conclusion that the contractual rent of $27.20 per square foot should be used in the income approach because, with respect to sale-leaseback transactions, Indiana law requires “careful consideration to make sure that only the value of the real estate is assessed and not some other business or investment interest.”
The Indiana Board noted that this difference was consistent with CVS’s claim that it used sale-leaseback transactions to sell more than just the ownership rights in its properties; rather, it used those types of transactions as a means to generate additional business capital from investors.
The reason for the structure is that it gives CVS access to the pool of deferred 1031 money that is out there. This explicit acknowledgement that the transactions are about a lot more than the real estate might give people one more thing to lose sleep about when they accept the stores as valid 1031 targets.
I take a little bit of comfort from this section of the 197 regulations:
Section 197 intangibles do not include any interest as a lessor under an existing lease or sublease of tangible real or personal property. In addition, the cost of acquiring an interest as a lessor in connection with the acquisition of tangible property is taken into account as part of the cost of the tangible property. For example, if a taxpayer acquires a shopping center that is leased to tenants operating retail stores, any portion of the purchase price attributable to favorable lease terms is taken into account as part of the basis of the shopping center and in determining the depreciation deduction allowed with respect to the shopping center.
It does not give me a lot of comfort, since 1031 is an entirely different section than 197. It has to make you wonder whether the management people tasked with getting the real estate tax expenses down checked in with the deal meisters chasing the 1031 money before they staked out this position.
You can follow me on twitter @peterreillycpa.