March 03, 2020

Minnesota Supreme Court Rejects Section 1031 Exchange as Evidence of Property’s Value

Property tax assessors often operate under the belief that a property’s sale price represents the best indication of that property’s market value, and thus should form the basis of its next assessment. Generally speaking, however, courts do not share this conviction, and a recent decision out of the Minnesota Supreme Court underscores the fact that when a sale price forms the basis of a property tax assessment, property owners and tax counsel would be wise to take a second look.

Understanding Sale Prices and Market Value

Although such “sales chasing” is rife with uniformity issues, when taxpayers file assessment challenges, it can be hard to look beyond evidence of a recent sale price. Compounding this problem, overzealous assessors occasionally use the sale of a property to retroactively increase earlier assessments of the same property, impacting post-closing considerations for both seller and buyer.

While assessors may rely on recent sale prices, courts have generally confirmed that certain types of sales are not, in themselves, valid indicators of a property’s value. There are a number of factors courts may use to determine that a property’s sale price is not a proper indication of that property’s market value for property tax purposes. For example:

  • Sales of going concerns and sale-leasebacks are laden with non-realty value.
  • Sales might represent non-market considerations, such as foreclosure sales or when a tenant purchases a property it is presently occupying.
  • Portfolio sales can be unreliable because the negotiated price is for a collection of properties, and an allocation of the overall price to an individual property may bear no direct relation to that property’s actual value.
  • Even an otherwise-valid sale may be unreliable because it is too remote in time from the assessment or lien date.

A recent case out of the Minnesota Supreme Court reaffirmed this principle.

Case Background, Initial Assessment and Tax Court Ruling

In Inland Edinburgh Festival, LLC v. County of Hennepin (February 12, 2020), the Minnesota Supreme Court focused specifically on the question of whether the sale of a property pursuant to a Section 1031 like-kind exchange reflected market value for tax assessment purposes.

For the January 2, 2015, assessment, the Hennepin County Assessor assigned an estimated market value of $8,384,300 to the taxpayer’s retail shopping center. The taxpayer appealed, asserting that the market-value estimate was excessive. While the Tax Court proceeding was pending, the taxpayer sold the property in June 2017 for $9,600,000. The sale was structured as a Section 1031 “like-kind” exchange, which allows the equity received from a sale of investment property to be reinvested into “like-kind” property of equal or greater value without payment of capital gains tax.

At the Tax Court hearing, the taxpayer offered an appraisal that relied upon an income approach and sales-comparison approach. In a somewhat unusual move, the Assessor did not solicit an independent appraisal and called no witnesses at the hearing. Instead, the Assessor offered a single exhibit — the taxpayer’s rent rolls.

Due to several computational errors and a lack of explanation regarding methodology, the Tax Court determined the taxpayer’s appraisal lacked probative value and gave it no weight. Instead, the Tax Court relied solely on the sale price from the June 2017 like-kind exchange to determine the January 2015 assessment. Acknowledging that the sale price alone did not reflect the market value as of the date of the value at issue, the Tax Court applied a market-conditions adjustment and an age adjustment to account for the difference in time. No evidence was offered addressing the parties’ motivations underlying the Section 1031 exchange or the potential impact the tax-deferred nature of the transaction had on the transaction price. The Tax Court assigned an adjusted value of $8,461,400, resulting in a slight increase over the county’s original assessed value, and the taxpayer appealed.

Minnesota Supreme Court Opinion

The Minnesota Supreme Court agreed with the Tax Court’s finding that the taxpayer’s appraisal lacked probative value, but took issue with the Tax Court’s sole reliance on the June 2017 sale to arrive at the 2015 market value. The Court was clear that, although the sale of the property being assessed may be “one of the most important elements to be considered,” the Court has never held that the sale of the subject alone is conclusive evidence as to the market value of the property. To the contrary, the Court held that a recent sale of the property being assessed is probative of market value only when it qualifies as an arm’s length transaction. The Court further noted that sales between related parties generally are not indicative of market value.

With that foundation, the Minnesota Supreme Court questioned whether a Section 1031 exchange truly represents an arm’s-length price. The Court noted that this unique type of transaction provides certain tax benefits that enable property owners to defer the recognition of capital gains or losses. But the record evidence lacked any information indicating the motivations of the buyer and to what extent the transaction price was impacted by market forces versus tax-savings motives. Absent evidence indicating that the Section 1031 exchange was at market levels, the Court could not conclude the Tax Court properly relied on the transaction to determine the market value of the property. The Court also found that the Tax Court’s adjustments to the sale price were not supported by record evidence. The Court held that the Tax Court’s value conclusion was clearly erroneous, and it reversed and remanded to the Tax Court to determine the property’s market value.

Because of their income tax benefits, Section 1031 exchanges are a common tool used by REITs and other real estate investors in structuring deals. But such sales can be a convenient target for tax assessors. If an assessor chases the sale price from a Section 1031 exchange or any other type of non-market sale, competent tax counsel should be consulted to determine whether an appeal is warranted. By emphasizing the non-market considerations driving a sale price, diligent owners and property managers can reduce fixed expenses, lower tenant occupancy costs, and ultimately improve the profitability of their investments.

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