Judge Laro calls Section 1031 appraisal ‘tainted’ and ‘useless’

BVWireIssue #171-2
December 14, 2016

Attendees of the 2015 AICPA conference may remember a session in which David Laro, senior judge of the U.S Tax Court, cautioned against attorneys who seek to steer the valuation. If discovery reveals the attorney’s undue involvement in the valuation, the appraisal and the expert’s reputation may be damaged. A recent Section 1031 case that Judge Laro adjudicated shows he had a specific situation in mind.

Sale-leaseback strategy: The taxpayer wanted to minimize the tax consequences of a $1.6 billion gain resulting from the sale of two fossil fuel power plants. It decided to pursue a Section 1031 exchange that allows for the deferral of gain where the relinquished property is exchanged “solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

In a nutshell, the taxpayer used the untaxed proceeds from the sale to lease a number of like-kind replacement properties from tax-exempt third parties, in different states, for a term exceeding the plants’ useful life and then subleased them to the plants’ original owners. At the end of the subleases, the sub-lessees had a cancellation/purchase option.

A Chicago law firm provided tax advice, and a nationally known financial firm appraised the relinquished properties and the replacement properties. Because of its work on the sold properties, the appraiser knew how much gain the taxpayer wanted to defer.

The crux of the appraisal was that the fair market value of the replacement properties at the end of the leaseback term would be less than the cancellation or purchase-back option price. The replacement property owners would not be economically compelled to exercise the cancellation/purchase options. As such, the transactions represented a genuine equity investment on the taxpayer’s part rather than a financial arrangement.

The Internal Revenue Service disputed that the transactions met the Section 1031 requirements, and the taxpayer petitioned the Tax Court for review.

Flagrant letter: Discovery revealed that, as the appraiser worked on the appraisal reports, the lawyers provided continuous feedback. A flagrant attorney letter to the appraiser included a list of “appraisal conclusions we anticipate will be necessary to support our tax opinion issued in connection with any leasing transaction.” As Judge Laro noted, the list appeared “almost verbatim” in the appraisal reports.

The court agreed with the IRS expert who contended the appraisal had serious technical flaws. But the court seemed most disturbed by the attorneys’ conduct, which it said compromised “the integrity and independence of the appraisal process.” The law firm provided the conclusions “it expected to see in the appraisals to be able to issue tax opinions at the ‘will’ and ‘should’ level.” This degree of interference “improperly tainted the … appraisal, rendering it useless,” the court said. Moreover, it tainted the attorneys’ tax opinions.

The court decided the transactions failed to qualify as Section 1031 exchanges and the taxpayer was not entitled to the various deductions it had claimed related to the transactions. The court also ruled in favor of accuracy-related penalties. The taxpayer was sophisticated and claimed to have read the law firm’s tax opinions in their entirety, the court noted. Accordingly, it knew or should have known that the opinions were based on flawed appraisal reports. Relying on the opinions was “misguided,” the court said.

The case is Exelon Corp. v. Commissioner, 2016 U.S. Tax Ct. LEXIS 26, Sept. 19, 2016. A digest of the decision and the court’s opinion are available at BVLaw.

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