IRC 1031 and Tenant in Common Ownership Structures

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In the wake of the holidays, it’s the time of year many of us are trying to hold to our resolutions and are thinking about taxes. One resolution of mine was to write more often about interesting legal issues that come up in my practice and since I worked on several deals involving 1031 exchanges last year this quick article seems an appropriate way to kick off a year of active blogging.

Deferring capital gains by proper application of IRC section 1031 is nothing new to real estate investors or real estate attorneys. A twist arises when exchanging sales proceeds into property owned by multiple persons as a tenancy in common (TIC), an ownership structure were multiple owners each acquire an undivided fractional interest in property. In Colorado, TIC is the default ownership when multiple parties own real estate unless the conveyance deed states otherwise (Joint Tenancy is usually preferable for married couples). Most arms-length TIC owners execute a Tenancy In Common Agreement specifying rights and duties of the owners, governing management of the commonly owned property, financial obligations of the owners, establishing transfer restrictions and other rules the owners are bound by. Such an arrangement sounds similar to a limited liability company – so, why not execute an LLC Operating Agreement and invest sales proceeds in an LLC?

To qualify for exchange treatment under section 1031 the property sold and the replacement property must be “like kind” and according to the IRS, membership interests in an LLC (or shares in a corporation) aren’t similar similar enough to real property held for investment. So, rolling proceeds into TIC owned property allows one to invest in a property with multiple co-owners outside of an LLC and qualify for exchange treatment under section 1031. This enables a seller to invest their proceeds into larger and more sophisticated properties with greater potential ROI. Since TIC structures can be similar to partnerships and LLCs, the IRS issued Revenue Procedure 2-2022 outlining requirements TIC structures to qualify for 1031 treatment. The revenue procedure establishes 15 conditions and standards for investments in TIC structures to qualify for exchange treatment. One simple condition is that there may not be more than 35 TIC owners. Another condition is that property management agreements must renew at least annually and while the manager may be a co-owner of the TIC property, they may not be a tenant. Additionally, TIC agreements should require unanimous consent for decisions that will impact the property economically or which result in any other material impact on the property.

When sellers want to roll proceeds into a TIC interest in a property, the TIC Agreement, Property Management Agreement, LLC Operating Agreement (where the TIC interest is to be owned by an LLC) and all other material agreements among TIC owners related to the property bear close scrutiny to confirm the exchange qualifies for section 1031 treatment.

Thanks for reading & happy new year! Good luck with those resolutions…

Avoid Getting Grossed Out: Essential Exclusions to Percentage Rent for Retail Tenants.

     Through the years, it's been my experience that many business owners, while extremely cautious with their commercial real estate purchase agreements, operating agreements and core commercial contracts, give surprisingly little thought to their lease agreements.  This holds true for even the savviest of operators - until they get bitten.  Unfortunately, when clients come in with an executed lease agreement it is usually to late to assist.

     Most businesses that rent space understand the distinction between base rent and CAM (i.e., additional rent comprised of operating expenses, insurance and real estate taxes), however, fewer understand the ins and outs of percentage rent clauses.  In Denver, percentage rent clauses were mostly exclusive to volume restaurant leases once, and even then not all.  In recent years however, they've become something I see in many retail oriented leases, especially for locations in highly desirable locations - which describes most of Denver these days!

     A percentage rent clause entitles the landlord to a cut of a tenant's gross sales revenue in addition to monthly base rent and CAM pass throughs.  While there are several methods of calculating the ratio, the most common ratio is a percentage of gross sales above a natural breakpoint.  For example, "5% of Gross Sales over a Natural Breakpoint."  To the uninitiated this terminology may sound a bit esoteric but in reality it's quite simple: the natural breakpoint is the annual base rent divided by the percentage.  So, if annual base rent is $50,000.00,  and the percentage is 5%, the natural breakpoint is $1,000,000.00.  In addition to base rent and CAM, the tenant must pay 5% of it's annual gross revenues over $1,000,000.00.  So if a site generates $1,750,000.00 of gross revenue, $37,500.00 of percentage rent is due to the landlord.  Simple?

    One clause warranting close attention is the definition of "Gross Sales."  Like the definition of "operating expenses" with respect to CAM provisions, the initiated tenant should negotiate for both customary and fair carve outs from gross sales.  One obvious example is revenue derived from vending machines used by employees only.  A less obvious but important example is credit charges due by the tenant to third parties attributable to credit sales; this can add up to a substantial amount for most businesses in today's economy where point hoarders (I know I am one!) use credit cards for a large portion of their monthly consumer spending.  Discount sales to employees is another example. In a recent negotiation for a restauranteur I received pushback from the landlord on this request - in the end the landlord agreed to the exclusion so long as that amount was capped at "3% of total gross sales to employees in a Lease Year."  The list of gross revenue exclusions that are warranted in lease negotiations are informed by the specific business a tenant is engaged in, what is common in a given center's lease negotiations, industry custom and of course, a given landlord's willingness to negotiate. 

    Summit 6 Legal represents a wide range of local and national retailers and restauranteurs and is adept at helping our clients negotiate fair terms in their LOIs and Lease Agreements.

    Contract Wisely!

    David C. Uhlig
 

Arbitration and Majority Rules: Resuscitating Stagnant Colorado Condominium Development?

Earlier this month, the Colorado Supreme Court ruled in a 5-2 decision that binding arbitration agreements are valid in condominium construction defects cases and binding on homeowners’ associations that do not receive written consent to remove the arbitration provisions.  The case, Vallegio at Inverness Residential Condo Association vs. Metropolitan Homes Inc., is the most recent in a series of pro-condo-developer developments in Colorado law.  House Bill 1279 also passed this session.  The Bill requires the majority of homeowners, instead of a homeowners’ association board, to decide whether the raise a claim against a condominium developer for construction defects.  Backers of the bill said that it is more fair to homeowners to give them a voice in a dispute that could affect their homes’ resale value.

 

Colorado law has one of the most permissive statutes of limitations on construction defect cases on the books—only two years within the time the claimant or claimant’s predecessor in interest discovers, or should have discovered, the physical manifestations of a defect in the construction improvement that causes an injury.  C.R.S. § 13-80-104. Taken together, it seems as though the current climate in Colorado is shining warmly on encouraging condominium development, which has dropped from 20% of new development in Colorado in 2007 to about 3% today. 

 

This attitude only makes sense because of the increasing number of transplants to Colorado in recent years—almost 101,000 new residents between 2014 and 2015 alone.  Current numbers show the population influx evening out somewhat but it takes one glance at the property market in Denver alone to see what a challenge these newcomers present to a market so hot, the inventory of existing homes for sale is at historic lows.  The demand for affordable housing in Denver continues to go up but supply is down, which drives prices up. 

 

Condominiums and multifamily developments are an obvious solution to the problem.  If we can build up instead of out, residents in Denver will be able to stay in desirable areas without breaking the bank and possibly realize the American Dream of property ownership.  But is the best way to encourage condo development to deregulate and make it more difficult for homeowners to sue their developers?

 

Those in favor of the decision in Vallegio and HB 1279 would argue that these decisions put more power in the hands of homeowners.  The Bill makes it impossible for an HOA board to decide to bring a case without the consent of homeowners.  While the obvious consequence of this rule makes it more difficult to sue developers (majority of 100 unit owners is much more difficult to receive and calculate than a majority of a 10-person HOA board), it also purports to be in the interest of condo owners.  After all, why should they have to worry about changes in their property value based on a lawsuit brought by a sue-friendly HOA?  Then again, a well-settled rule of property law is predicated on sellers disclosing material defects as an exception to the general rule of caveat emptor.  So, if a homeowner wishes to avoid litigation to keep property value up, he or she would still have to disclose known issues with the property at the time of sale.  It is anyone’s guess whether making it more difficult to sue developers for condominium construction defects will be better or worse for homeowners in the long run but hopefully it will serve its purpose of encouraging development of much-needed multifamily housing in highly-populated areas of Colorado.

 

Vallegio seems at first blush to be more protective of developers than warranted but really, the decision simply upholds another well-settled rule of Contracts—that parties can and often do contract around any number of rights in their agreements.  After all, the court did not say that binding arbitration clauses are the norm in construction defects litigation for condos—merely that, since the HOA in the case agreed to a binding arbitration clause, it cannot sidestep the agreement and sue anyway, regardless of the injuries suffered. 

 

As litigation costs rise and the process is a dice roll in terms of favorable decisions, there is a trend in real estate and business law matters toward requiring arbitration in lieu of trial.  Deciding whether to acquiesce to arbitration over court is a decision to make at the start of a deal, not in the middle.  This is the heart of the Colorado Supreme Court decision in Vallegio, and a good rule to remember when embarking on any kind of project.  Because courts in Colorado hold parties to their word and require all parties to have a seat at the table if renegotiation is on the menu.  Regardless of the policy considerations or arguments about protectivism toward questionable real estate construction, the purpose of a contract is to keep deals consistent regardless of the direction in which they go.  And that, at the end of the day, is a strong reassurance for anyone engaged in construction or contract in Colorado. 

 

Sources and Additional Resources: http://www.cpr.org/news/story/why-is-denvers-housing-market-still-on-fire-supply-and-demand; http://www.denverpost.com/2016/07/07/colorado-second-population-growth-2015/; C.R.S. 13-80-104; http://www.denverpost.com/2017/06/05/colorado-supreme-court-construction-defects-battle/.

Commercial Leasing; Tenant's, Operating Expenses & The Simple NNN Lease.

     During my day to day, I draft and negotiate my fair share of commercial lease agreements.  They range from office leases, to retail leases and industrial leases but in almost every case, especially with new clients leasing their first space, the conversation begins the same; they say "I am going to send you a simple lease that my Landlord drew up, take a quick look and let me know it all looks good"; and I respond, "Send me the lease and I'll take a look."

     Most real estate lawyers are familiar with this elusive document, the simple lease, so often described by clients eager get their business up and running and turning a profit.  Unfortunately, Landlord leases are typically one sided at best and the clauses invariably tilt to the Landlord's advantage.  

     One example of a lease clause that can be surprisingly expensive for tenants is the clause governing operating expenses.  Most tenants understand the difference between a triple net lease and a gross lease; the former is structured so that in addition to base rent, tenants are responsible for a share of operating expenses (the landlord's real estate taxes, insurance and costs to operate the building in which the premises are located) and the latter is structured so that tenants pay a single rental payment that includes everything.  In the commercial setting, triple net lease forms are very common and tenants often sign these leases without legal review and counseling.  Operating expense provisions seem simple - the tenant pays its share of the operating costs, but, oftentimes the lease language is overly generous with what may be included in the operating costs.  An example of expenses that should be excluded or at least carefully limited are capital expenses.  Furthermore, its ordinary for tenants to ask for a cap on annual operating cost increases so they can budget for the worst case scenario during each lease year.  If there is no cap on operating expenses then they can expand and increase without limit and Landlords have little motivation to keep their costs down when they can be passed through to tenants without question.  Another important concept when it comes to operating expenses is language providing the tenant a right to audit the Landlord's books.  A good audit provision should provide that if the audit reveals overcharges exceeding a certain percentage, the Landlord will be responsible for paying the audit costs. A skilled real estate attorney understands which expense categories are inappropriate to pass through their clients and can help their clients limit ballooning expenses and excess expense pass throughs.

     The key to providing useful legal counsel to tenants in commercial lease negotiations involves picking one's battles.  A typical commercial lease agreement contains upwards of 50 clauses and its possible to negotiate each one, however sending proposed revisions to all or nearly all of the lease clauses is sure to cause delays (which neither side wants) and sometimes, it can blow a deal.  Evaluating which clauses will be most important to a client begins with understanding the nature of their business very well and then focusing on the clauses that relate to their business and those which may cost them additional money above and beyond rental payments.  The expense clauses in triple net leases certainly qualify there!  

     Before signing that next "simple lease" have an attorney take a look and help you try to balance the important terms.  Its very difficult to help a tenant after they've signed the document!

LLC Operations: Shielding Owners from Personal Liability

     This is the last of a series of three posts covering LLC basics.  In two prior posts (March 21st and May 19) we discussed the necessity of a good operating agreement and taxation basics for LLCs.  In addition to pass-through taxation, most LLC owners form LLCs intent on insulating their personal assets from exposure to liabilities incurred by the business.  In a lawsuit against an LLC, a plaintiff's attorney may ask the court to hold LLC members personally responsible for the debts, obligations or liabilities of the LLC; this is referred to as "piercing the corporate veil."  Colorado law concerning this topic, and the grounds for disregarding the liability shield afforded to business owners by LLC is somewhat befuddled.  Many owners are exposed to personal liability for the debts and obligations of their LLCs because they make a common mistake; after creating the LLC and opening for business, they quickly forget all about the entity and operate their companies informally and inconsistently.  Their perception is that registering the entity with the Colorado Secretary of State and paying the annual fees is all they have to do to enjoy the limited liability of operating under the guise of an LLC.  That perception is wrong.  Their LLC is form over substance and as such is susceptible to being viewed as the alter ego if its owners rather than a truly separate entity.

     In deciding whether to pierce the corporate veil and impose personal liability on LLC owners, Colorado courts apply what is known as the alter ego test.  As the name implies, the initial analysis centers around whether the business entity is truly a separate "entity" or is in fact the alter ego of the owner.  In Colorado this involves an 8 point balancing test.  Factors courts consider include: whether the the LLC is operated as a distinct business entity; whether assets and funds are commingled; whether adequate corporate records are maintained; whether misuse by an insider is likely due to the nature and form of the LLC's ownership and control structure; whether the LLC is marginally capitalized; whether the LLC is a mere shell with no real assets; whether owners disregard legal formalities such as meetings, minutes, approval resolutions and consents in accordance with the LLC's operating agreement and whether corporate funds or assets are used for non business purposes.  No single factor is determinative or holds more weight than another.  That is reflected by the Colorado statute on point, C.R.S. 7-80-107(2) (2016) which states, "the failure of a limited liability company to observe the formalities or requirements related to the management of its business and affairs is not, in itself, a ground for imposing personal liability on members for liabilities of the limited liability company.    

     In Colorado, traditionally, in addition to proving an LLC fails the alter ego test, plaintiff had to establish that the LLC was used to carry out a fraud or overcome an otherwise rightful claim.  However, in recent years, Colorado courts seem to have adopted a looser standard for piercing the corporate veil and done away with this second requirement.  In Martin v. Freeman (Colo. App. 2012), the Colorado Court of Appeals reasoned that "neither wrongful intent or bad faith" are not necessary to satisfy the second part of the piercing test.  The practical effect of this is that by being a party to litigation where the plaintiff seeks to pierce the corporate veil, an LLC is exposed to liability if it fails the alter ego test.  In 2009, in Sheffield Services Company v. Trowbridge (Colo.App. 200), the Colorado Court of Appeals extended personal liability of an LLC to an LLC's managers in addition to the LLC's owners.  It should be noted that the Martin case concerned a single member LLC but logic dictates that it should apply to all manner of LLC's.  The Sheffield case was a clear extension of the applicable law as the relevant statute, cited above, is expressly limited to members.  

     From a practical standpoint, all of this means that in Colorado its easier than ever for the liability shield afforded by LLCs to be disregarded if the LLC's owners treat the entity as a mere alter ego and fail to operate it as a truly separate and independent entity from themselves.  As lawyers, its imperative for us to advise our clients that creating an LLC is merely the beginning and proper operation as truly separate entity is essential to maintain the liability shield that they assume is in place by virtue of operating their business as an LLC.  In addition to creating the LLC and drafting an operating agreement, clients need sound advice on proper procedures, safeguards and formalities in the day to day operation of their business so that they do not unintentionally expose their personal assets to the liabilities and debts of the LLC.

Restaurant Leases; Exclusive Use Clauses

Photo by fazon1/iStock / Getty Images
Photo by fazon1/iStock / Getty Images

     Earlier in my legal career I worked with a large law firm representing a popular and rapidly expanding restaurant chain; those years afforded me a baptism by fire in the negotiation of restaurant leases.  It may be related to those early years fighting for the big chain tenant, or maybe its because I spend so much time enjoying and relaxing in restaurants around Denver, but, I've always enjoyed working on restaurant leases.  In the universe of lease agreements, they are almost always the most interesting.  Since I just finished one up, this seems like a great opportunity to kick off a series of blog posts focusing on restaurant leases and issues tenants need to know about, especially new owners and entrepreneurs without a lot of leasing experiences.

     The issue of exclusivity is often at the center of restaurant lease negotiations.  In shopping centers or other multi-tenant environments,  tenants should try to lock down assurances they will not face harmful competition from other tenants.  The easiest way to do that is to include an exclusive use clause in the lease.  Its best if the broker helping a tenant find a space sets the expectation that exclusivity is a part of the deal by including the concept in the letter of intent (LOI).  In most cases, landlords and tenants agree on a non-binding LOI laying out the basic terms of the deal before proceeding to draft and negotiate the lease document. So, what level of competition is actually "harmful?"  In shopping centers or other retail settings with multiple buildings, tenants should consider whether an exclusive within the building their space is located in is sufficient, or is an exclusive covering the entire retail center appropriate? Further, many retail centers are governed by CC&Rs or Declarations and in such cases, its important to confirm nothing in those documents limits the new tenant's plans for its space or grants another tenant an exclusive use pre-empting the tenant's planned use.  Restaurant tenants should also carefully consider the nature and scope of the exclusive rights they desire; does the tenant want to be the only restaurant in the building/center or, is it acceptable (or even better) for them to allow other restaurants users so long as they have exclusivity based on certain food types (for example, Mexican food) and/or operational type (for example, fast-casual versus a sit down, full service restaurant with table service)?  Does the tenant want to be the only fast casual restaurant in the building serving alcoholic beverages?  A properly drafted exclusivity clause is very specific and leaves no room for argument or interpretation.  With respect to restaurants and bars, different types of operators can often co-exist and feed off of one another (no pun intended!) quite nicely, so it might not necessarily behoove one to be the "only" restaurant in a particular setting.  While thinking about exclusivity clauses for restaurants in multi-tenant settings, one frequently overlooked point is signage on the exterior of the premises; depending on the situation, it may be important for tenants to lock down the exclusive right to display their signage on the exterior of the space. 

     Another important consideration for restaurant tenants negotiating exclusive use clauses is the practical effectiveness of these clauses.  Often tenants focus on obtaining the exclusivity language they need but neglect addressing how they'll actually enforce that language if the landlord disregards it, or if another tenant disregards it and assigns or sublets their space to a competing business.  In addition to the exclusivity clause, its a good idea for tenants to try to push for language discouraging landlords from ignoring the exclusivity restrictions and also requiring them to take action in the instance of renegade tenants.  There are several ways to do that, including expressly providing that a tenant may pursue equitable remedies such as an injunction or even granting the wronged tenant a substantial rental reduction or abatement during the period their exclusive use protection is compromised.  If unaddressed, a tenant may be left with no recourse except for an expensive lawsuit against a landlord who may have deep pockets.  A tenant's ability to obtain adequate exclusivity protection is often proportionate to their bargaining power with respect to the landlord (is the tenant a highly desirable addition to the center?) and other tenants, and is also related to how the desired protective language relates to the overall negotiation of the lease.

    Next time this series of posts will address building out restaurant lease spaces and common issues surrounding landlord and tenant construction obligations.  Until then, contract safely and remember, everything is negotiable.

 

Real Estate 101 - Helping Residential Buyers and Sellers

     Most residential real estate transactions are handled by real estate brokers.  Traditionally, sellers execute a listing contract with a seller's broker who, in return for a commission of around 6% of the sales price, markets the seller's property on a multiple listing service (MLS).  Brokers representing buyers then show their clients properties of interest.  When a sale closes the brokers split the commission. One common exception to the standard process described above is when a "transaction broker" represents both parties. Today, to stay competitive, many brokerage firms are starting to offer flat fees for facilitating transactions.  Most straight-forward residential deals don't necessitate an attorney being involved on either side.  My opinion is that in most instances, competent brokers are more than capable of facilitating real estate transfers using the form contracts produced by the Colorado Real Estate Commission (CREC) for that purpose.  Also, brokers have access to resources such as the MLS, their own property databases and word of mouth intel on properties coming to market that real estate attorney can't provide.  The best brokers also bring marketing expertise and property staging expertise to their clients.   Therefore, until recently, my involvement in residential deals has typically been limited to helping buyers and sellers and their brokers in transfers involving high value, luxury class properties that involve significant changes to the CREC contracts, or in sales that have become contentious or involve some problem or extraordinary circumstance.  So far this year has been different noticeably different.

When parties use a broker, the higher the sales price, the larger the commission due from the seller

     While the bulk of my law practice remains focused on commercial real estate deals, finance and leasing, lately more buyers and sellers are asking me to get involved with their straight forward residential deals on the front end.  While I'm happy to help; I've also been curious why the volume of this work has increased so noticeably.  I perceive several reasons for this increase in residential deal work.  obviously, since leaving big firm life in January, I'm closer to the ground (both literally and figuratively) with office space in a building dominated by younger, dynamic entrepreneurs and tech oriented tenants so, I find myself talking to a variety of people and fielding questions about real estate throughout the days rather than talking to the same old people every day, and some of these conversations lead to residential work as these folks are looking for homes in a tight market.    Its no secret its a seller's market around Denver these days, with quality properties going under contract very quickly (often 24 hours or less) and commonly escalating into bidding wars.  Ready buyers abound and the higher the sales price, the larger the commission due from the seller at closing; consider that 6% of $400,000.00 is $24,000.00.  With buyers easier to find than ever and the supply of available properties at an all time low, I see sellers foregoing the MLS and coming together with buyers on their own through alternative means such as Zillow or most often, through word of mouth.  These sellers and buyers need someone to draft the contracts, deeds and other paperwork necessary to transfer the property and to coordinate closings with a title company - that is where I come in.  

these days I find myself drafting residential sales contracts between landlords selling condos or townhomes to tenants; and in seller-carryback deals.

     One fact that many people outside the real estate world don't realize is that brokers don't actually draft contracts.  While they offer many services a lawyer can't (see above), when it comes to drafting they simply fill in the blanks on CREC form contracts.  They are actually forbidden by law to make changes to these forms other than filling in the blanks and their forms are locked.  I use the same CREC form contracts as the brokers but, as a licensed attorney I have access to alterable MS Word versions.  That makes these deals  fun for me since I can make some changes to these contracts that benefit my clients!   Since I can draft contracts and coordinate a straightforward residential closing for in between 4 to 8 hours of total attorney time, regardless of the purchase price, the sellers I work with are usually very happy that my legal fees are substantially less than the brokerage commission would have been!  Buyers can also benefit from that fact and sometimes use it to bargain for a price reduction.  The two most common situations where I find myself drafting residential contracts for sellers and buyers these days are: when a landlord wants to sell their condo or town-home to their tenant; and when a seller is providing the financing for the buyer and taking back a note and deed of trust at closing.  I'm always happy to help sellers and buyers close residential property sales.