San Jose Business Lawyers Blog

Last November, I was working closely with one of our clients and their real estate lender to purchase a large property in the San Francisco Bay Area. I formed two California limited liability companies for the transaction. One LLC was the investment entity that was going to own the property, and the other was the management entity that was going to hold the sponsor interests in the deal. Both entities had to be properly and fully formed so that we could obtain good standing certificates from the Secretary of State and be in position to issue legal opinions for the lender. During the due diligence period, our client discovered something about the property that was not what had been represented to them by the seller of the property. As a result of this information, the purchase fell through.

Fortunately, despite all of the other costs expended on pursuing this property, the client had not yet paid the $800 franchise taxes for each of the two LLCs we formed. In California, if an LLC meets certain requirements it may cancel its Articles of Organization within 12 months of the filing by filing a Short Form Certificate of Cancellation with the Secretary of State, and avoid paying the first year's franchise taxes. These requirements include:

- The California LLC has no debts or other liabilities (other than tax liability);
- The assets, if any, have been distributed to the persons entitled to them;
- The final tax return has been or will be filed with the Franchise Tax Board;
- The California LLC has not conducted any business since filing the Articles of Organization;
- A majority of managers or members, of if there are no managers or members, then the person who signed the Articles of Organization, voted to dissolve the LLC and
- If the LLC has received any payments from investors for LLC interests, those payments have been returned to the investors.

Source: Spidell's California Taxletter, Vol 34.11, Nov. 1, 2012.

Because our client met all of these requirements, we were able to cancel the LLCs without paying the $1600 ($800 x 2) in California franchise taxes. If, on the other hand, the client had already paid the taxes, we would not have been entitled to a refund. With this in mind, sometimes when forming an LLC it may be better to wait until the last minute before the franchise taxes are due before paying them to make sure the business is going forward, as long as you either pay them before late fees would be imposed, or you are willing to incur late fees in the event your LLC does not qualify for the short form cancellation.

Continue reading "Limited Liability Company Short Form Cancellations" »

An investor bought an apartment building in San Jose and the broker wanted to send flowers for the occasion. A large bouquet was delivered to the buyer's office with a note that read, "Rest in Peace."

The buyer was irritated and called the florist to complain. After he had told the florist of the obvious mistake and that he was not pleased, the florist said: "Sir, I'm really sorry for the mistake, but what I'm more concerned about is . . . there is a funeral taking place today, and they have flowers with a note saying, "Congratulations on Your New Apartment!"This amusing joke is a good way of reminding us that both real estate and business deals continue to be closed in the Bay Area. As a banking, real estate and business lawyer representing parties to these transactions, I am very aware, and I expect most readers are as well, that financing continues to be a critical part of making a successful deal. During the robust period prior to 2008, one way parties garnered additional leverage in structuring real estate transactions was to utilize so-called mezzanine financing, in which the collateral securing a junior layer of debt consisted of the ownership interests in the borrower rather than the real estate. When the borrower was a limited liability company, this junior loan collateral could be secured through a pledge of the membership interests the owners held in the borrowing LLC.

The concept of using mezzanine debt to enhance leverage has not gone away. However, recent cases looking at transactions structured several years ago have curtailed the latitude of mezzanine lenders ("Mezz Lender") and improved the position of the senior secured lender ("Mortgage Lender") in the event problems arise after loan closings. If you are a Mortgage Lender holding real estate collateral, this may make it more attractive for you to enter into a transaction involving mezzanine financing. If you are a Mezz Lender or a borrower seeking to obtain and use mezzanine financing, obstacles now exist that were not there - or at least not believed to exist - before the markets collapsed in 2008.

The most significant point to take away from the recent case law is the enormous importance of the intercreditor agreement in multi-party transactions. This includes mezzanine financing discussed here, as well as other arrangements involving multiple creditors. In the cases mentioned below, the courts specifically analyzed the language and terms of the intercreditor agreements executed by the parties in reaching their rulings and, therefore, the exact language drafted into the intercreditor agreement will significantly affect the rights of the parties. If you become involved in a financing using mezzanine debt or a transaction with multiple creditors, close attention should be paid to the intercreditor agreement regardless of your position in the transaction.

Now, we discuss some basics about mezzanine financing and then assess the recent case law. Mezzanine financing provides an opportunity to apply an additional layer of secured debt to a real estate transaction by using the equity in the borrower itself, which are held by the owners. This debt is in addition to the Mortgage Lender's loan, which is secured by a first deed of trust against the subject property. For example, assume an entity acquiring real estate is an LLC, and the Mortgage Lender will loan 65% of appraised value based on its underwriting policies. This amount, however, is insufficient to close the transaction. A layer of mezzanine financing might be obtained by having the owners of the LLC, i.e., its members, pledge their interests in the borrowing LLC to secure additional loans. This financing, secured by entirely separate collateral and often provided by an entirely different lender - the Mezz Lender, reduces the owner/investor funds required to complete the purchase.

The Mortgage Lender, holding real property collateral, and the Mezz Lender typically enter into an intercreditor agreement as well, whereby the mezzanine financing is, among other things, subordinated to the loan held by the Mortgage Lender. But other terms and conditions are also rounded up and placed in the intercreditor agreement, including provisions limiting the remedies of the Mezz Lender while the senior secured loan is in default. One common term in many intercreditor agreements requires the Mezz Lender to cure defaults in the senior secured loan prior to transferring its interest in the borrower through a UCC foreclosure sale of its collateral to a "qualified transferee."

In the event problems develop with the project and defaults occur in the senior secured loan, the ultimate remedy for the Mortgage Lender, at some point, is to commence foreclosure proceedings. When this occurs, and particularly if values have declined, the junior Mezz Lender's strategy for protecting its interest frequently involves taking control of the borrower through a foreclosure sale of the ownership interests, and then placing the borrower in bankruptcy to maintain control and buy time to work out a liquidation that, to the extent possible, increases value at sale and protects the Mezz Lender's interests.

Recent court decisions, including Bank of America, N.A. v. PSW NYC LLC, 918 N.Y.S.2d 396, 2010 N.Y Slip O-p. 51848(U) (N.Y. Sup. Ct. Sept. 16, 2010), and U.S. Bank National Association v. RFC CDO 2006-1 Ltd., Case No. 4:11-cv-664, Doc. No. 41 (D.Ariz Dec. 6, 2011), changed the playing field for these strategies by reaching the conclusion that the Mezz Lender is required to cure all defaults, including repaying the entire senior secured loan if that loan has been accelerated or matured, prior to conducting its UCC foreclosure sale. The Mezz Lender also may have to replace guarantors supporting recourse carve outs prior to a foreclosure. The bottom line is that these court decisions, which seem to be generating persuasive force, shift negotiating power in a workout or problem situation to the Mortgage Lender at the expense of the Mezz Lender.

As mentioned, these cases carefully scrutinized the intercreditor agreements, and therefore it will be worthwhile for a party to the transaction to pay close attention to that agreement.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

As 2012 is coming to an end, corporations and individuals alike are already thinking about taxes that they will need to pay at year-end. Every meeting I have with business owners lately somehow comes around to talking about taxes and how much I expect taxes to increase next year. The passage of Assembly Bill 1492 added yet another tax to the mix - the wood and lumber tax. This tax may affect homeowners, contractors and real estate developers.

We have all heard that ordinary federal income tax rates, currently maxing out at 35%, are scheduled to increase to 39.6%. Dividends could lose their special tax treatment and be taxed at this ordinary income tax rate as well. Federal long term capital gains rates will go from 15% back up to 20%. Payroll taxes may go back up from 4.2% to 6.2%. The AMT exemption amount may go back to 2010 levels. And high income earners will have an additional 3.8% Medicare tax. But on top of all that, starting January 1, 2013, those of us in California will also have to pay an additional 1% tax on the sales price of engineered wood and lumber products. (Assembly Bill 1492 (Ch. 12-289)).

Normally I would write this off as minor, but this year my husband and I are actually right in the middle of planning a huge fencing and deck project for our new house. (Did you know there was still residential land in the Silicon Valley that has not been fenced?) So, it was quite annoying to read about how this tax is going to be instituted on lumber, decking, railings and fencing as well as particle board, plywood and other wood building products, and even non-wood but wood-like products such as plastic lumber and decking. Even more so because it is already the middle of October and I'm pretty sure our project won't be completed until early 2013. So, if I buy all the wood before the end of the year, I save 1%... but probably end up with more than I need and the inability to return it. But, if I wait until January to buy it just in time to install it, I am going to hate paying that extra 1%.

The good news is that the tax will not be imposed on furniture or firewood, so at least I can wait to buy the new outdoor table and chairs and fill up the new fire pit.

[Source: Spidell's California Taxletter, Volume 34.10, October 1, 2012.]

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

As a business and real estate lawyer in San Jose, I have been paying special attention to the recovering real estate market. I have noticed an increase in residential and commercial properties transactions in San Jose, Sunnyvale, and Santa Clara. As much as the real estate market has improved, lenders are still cautious when it comes to providing financing, which has affected some of my business and real estate clients.

When the credit market is tight and financing is harder to obtain, sellers of real property may be more willing to provide seller financing to a buyer in order to sell a property. This is even more common when the seller and the buyer have some pre-existing relationship. When representing the seller, I will protect the seller by securing the loan with a deed of trust against the property so that if the buyer does not make the loan payments, the seller can take back the property. This sounds like a low risk proposition for the seller. However, taking back the property may be worse than it sounds. If the value has gone up since the seller bought it, which is usually the case, there is no way to reinstate the seller's former base-year value for property tax assessment purposes. When the seller sells the property to the buyer, the property is reassessed. When the seller repossesses the property, the property will be reassessed again. Since there is no sales price to determine the value when the property is repossessed, an appraisal must be done. Seller, as the new owner, must report the fair market value of the property to the County. Penalties of up to $20,000 apply for failing to report a change in ownership. In my blog, "New Rules for Business Entities Change of Ownership Reporting for Real Property," I talked about the need to report a change of ownership of an entity that owns real property as well.

So, if you are considering providing financing to a buyer on the sale of your property, you may want to think twice about whether you are comfortable with the remedy of repossessing the property with a new property tax value. It may be worthwhile waiting for a buyer who does not require you to assist with financing.

Continue reading "Property Taxes: Sellers Providing Financing Should Beware of Reassessment on Repossession" »

As a business and real estate attorney in Santa Clara County, I have often heard our Tax Assessor, Larry Stone, talk about how hard his office is working to reappraise properties to make sure the property tax assessment roll is correct. However, I just spoke with a California homeowner who is close to losing her home and is being forced to list it for sale. As we spoke, I looked up her address online and found that her property taxes were based on a value far in excess of the amount her real estate agent has told her she should be able to sell for. This is costing her thousands of dollars per year in extra property taxes.

This conversation came at a time that my own property tax assessments from Santa Clara County have just arrived in the mail, reminding me that I need to reconsider the comparable sales in my area and decide whether it is time to contact the Assessor's Office with the information. When you get that yellow notice in the mail, do not ignore it. Take a close look at the information on the card and see if it is in line with what you think your property is worth. If it is not, you should call the Assessor's Office, provide them with any supporting documentation, and see if you can get the staff to agree with you. If they do not, in Santa Clara County you have until September 17, 2012 to file an appeal. Under Proposition 13, your base-year value (the value when you bought your property) can be increased by no more than 2% per year. However, if the market value has fallen below the adjusted base-year value as of a January 1st lien date, you can get a Proposition 8 assessment which is the lesser of the Prop. 13 adjusted base-year value or the market value. Keep in mind that once you get a Prop. 8 assessment, you are no longer limited to a 2% increase per year. If the value jumps up, your assessment can recover up to the Prop. 13 level at any time. For example, if you buy a home for fair market value of $1 million and the value goes up $50,000 immediately after you buy it, the assessment is limited to a 2% increase over the base-year value, or $1,020,000 (instead of $1,050,000). However, if the value of your property falls to $900,000 the following year, you can get a Prop. 8 assessment of $900,000. The following year, your assessment is not limited to $900,000 plus 2%, but can recover all the way up to the base-year plus 2% per year for each year since the purchase year.

During the appeal process, you must pay the assessed property taxes. Then, if you get the value reduced, you must actually call and ask for your refund check.

Santa Clara County includes the cities of Santa Clara, San Jose, Sunnyvale, Cupertino, Milpitas, Monte Sereno, Palo Alto, Mountain View, Los Altos, Los Altos Hills, Saratoga, Campbell, Los Gatos, Morgan Hill, and Gilroy.

For information on how to file an appeal, see the Board of Equalization website, there is a video to assist you available at www.boe.ca.gov/info/AssessmentVideo/AppealAssessmentIndex.html. To contact the Santa Clara County Assessor's Office, go to http://www.sccgov.org/sites/scc/Contacts/Pages/default.aspx.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

As a Silicon Valley business lawyer, I have many clients that are limited liability companies, partnerships, and corporations which own real property in California. It is common knowledge that when property changes hands in California, the property will be reassessed (unless an exception applies). However, people often forget that similar rules apply for business entities like corporations, partnerships and LLCs that own real property, when interests in the business entity change hands. As of January 1, 2012 there are some new rules and some higher penalties regarding reporting a change of ownership or control of real property in California. The required period for reporting has been extended from 45 to 90 days. The maximum penalty is now $5,000 for property eligible for the homeowners' exemption and $20,000 for property not eligible for the homeowners' exemption.

A change of ownership can happen in one of two ways:

1. Change in Control of a Legal Entity: If real property is owned by an entity and any person or entity gains control of that entity through direct or indirect ownership of more than 50% of the voting stock of a corporation or a majority interest in a partnership or LLC, the real property owned by that entity is considered to have undergone a change in ownership and must be reappraised.

2. Cumulative Transfers by Original Co-Owners: If real property is owned by an entity and over time voting stock or ownership interests representing more than 50% of the total interests are transferred by the original co-owners (in one or more transactions), the real property owned by that entity is considered to have undergone a change in ownership and must be reappraised.

There is no change of ownership when the direct or indirect proportional interests of the transferors and transferees do not change.

For legal entity transfers, the Form BOE-100-B Statement of Change in Control and Ownership of Legal Entities must be filed with the Board of Equalization in three circumstances. The personal or legal entity acquiring control of an entity must file when there is a change in control and the legal entity owned California real property on the date of the change. The entity must file when there is a change in control and it owns California real property. An entity must file upon request by the Board of Equalization. Source: Spidell's California Taxletter, Volume 34.2, February 1, 2012

Continue reading "New Rules for Business Entities Change of Ownership Reporting for Real Property" »

This year has brought some significant changes to the rights of lenders participating in short sales. In January 2011, a new California law was passed (SB 931) which required residential (1-4 units) lenders in first position who agree to accept a short sale, to accept the amount received in the short sale as payment in full on the loan. Now, effective July 15, 2011, that rule applies to junior lien holders as well (SB 458).

This is great news for short-sellers, but may not be such great news for potential short-sellers who have more than one lender on the property. Unless the loans were purchase money loans that provide protection against deficiency judgments, the new law could act as a disincentive for junior lenders to agree to a short sale.

I was recently asked by a Cupertino real estate investor whether he should form his limited liability company in Nevada or some other state in order to avoid California taxes. I had to tell him that if anything, this would just increase his overall costs and taxes.

California franchise taxes can be much higher than taxes in other states, and include a minimum tax of $800 per year. As a result, companies often do not want to be classified as doing business in California. One way to avoid this classification used to be to form your entity in another state, and not register it in California. Some of my clients have numerous Delaware LLCs or Nevada LLCs. Often, those LLCs own other LLCs, which own property in California. In order to avoid the California minimum franchise tax for multiple entities, they just register the entity that actually owns the property in California.

However, a new ruling says that if the entity is doing business in California, owns property in California, or is managed by people in California, this exemption is no longer available at the parent LLC level.

The California Franchise Tax Board just issued FTB Legal Ruling 2011-01, stating that activities of a disregarded entity will be attributed to the entity's sole owner. A disregarded entity is a single member LLC or a Qualified Subchapter S subsidiary ("QSub") which is disregarded for income tax purposes so that its income passes through to its parent for tax reporting purposes. Therefore, if the disregarded entity is doing business in California, the 100% owner will be considered to be doing business in California and, if it is an entity, will have to register with the Secretary of State in California. This is true even if that owner entity has no other activities in the state, other than owning the disregarded entity.

This ruling is in addition to a previous California Franchise Tax Board ruling that an entity will be considered to be doing business in California if its managing person(s) are in California, even if all of its other activities are out of state.

For real estate investors, lenders often require a special purpose entity ("SPE") to hold the property, which is structured as a single member Delaware LLC. Under these new Franchise Tax Board rulings, the single member LLC holding the property must be registered in California, and its 100% owner parent company must be registered in California as well. The bad news is that both entities are required to pay the $800 minimum franchise tax to California. However, the LLC gross receipts tax is not incurred twice on income that flows through from one LLC to another.

Continue reading "Owners of Single Member LLCs Doing Business in California Must Also Be Registered in California" »

Over many years of working with real estate investors, one question has come up over and over again: "Can I qualify as a real estate professional so I can deduct my passive losses against my ordinary income?" The last time was from a San Jose full-time professional who has rental property in Sunnyvale. I almost always have to disappoint my clients with the answer that they do not qualify. Several times I have had my Silicon Valley clients and their advisors disagree with me, despite explaining the rules to them. Many of them go on to report it the way they want to, and take the risk.

The United States Tax Court just answered the same old question again. In Yusufu Yerodin Anyika et ux. (TC Memo. 2011-69, March 24, 2011), the taxpayers were a married couple that had been buying, renovating, managing and selling rental real estate for years. He worked 37.5 hours per week, 48 weeks per year as an engineer and she worked 24 hours per week as a nurse. During 2005 and 2006 they had two rental properties, which Mr. Anyika considered to be his second job as well as their investment property. They filed their tax returns themselves with TurboTax, claimed he worked 800 hours per year managing the real estate, and deducted their rental real estate losses. The Tax Court held that for them to be able to deduct their rental real estate losses he must have worked more than 750 hours and over half of his working hours on their real estate investments. Mr. Anyika then re-estimated his real estate hours to be 1920, just over the 1800 he spent in his day job. Unfortunately for Mr. Anyika, the Tax Court did not believe his new, unsubstantiated re-estimate and held that he did not qualify as a real estate professional. The Tax Court did hold that Mr. Anyika qualified for a $25,000 deduction for materially participating in real estate, but this deduction was not available to him because his adjusted gross income was too high.

Something to note, which was not an issue in the Anyika case, is that the rules are even worse for short term rentals. Time spent on properties with average rental periods of seven days or less does not count towards the 750 hour test, and losses on those properties are also ineligible for the $25,000 deduction for actively managed real estate. (Source: Kiplinger Tax Letter, March 18, 2011, Vol. 86, No. 6)

So - if you think you should qualify as a real estate professional, create a log of every hour you work on the real estate and, at the end of the year, compare those hours to the hours you work in your regular job. If the real estate hours exceed 750 hours and also exceed the hours you worked in your regular job and you can prove it, you qualify as a real estate professional. If they do not, try for the material participation test to get the $25,000 deduction (unless your income is too high). And no matter what you choose to do... don't blame TurboTax. The Tax Court has heard that one before.

Over the last two years I have often been asked to answer the question of what the consequences will be if a client walks away from a property, letting the bank take it back. The previous decade of incredible real estate appreciation resulted in many people without previous real estate investment experience becoming real estate investors. The most common situation I see is the condo owner who had enough income to keep his condo as a rental and still buy himself a single family residence. Then the recession hit and both properties are now underwater. Now, he thinks he can walk away from the property thanks to the Mortgage Debt Relief Act. Unfortunately, that Act was put into place to help people who were losing their homes, not to help people with investment properties. Even more unfortunate is that a lot of these beginner real estate investors thought that they could handle their taxes themselves without an accountant.

California is now focusing on finding those people and making them pay tax on the cancellation of debt income they should have recognized on giving up their underwater investment property to the bank. According to Spidell's California Taxletter, (March 1, 2011, Volume 33.3), California is mailing letters for tax years 2007 and 2008 to taxpayers who had debt relief on properties that were reported on Schedule E and therefore, probably do not qualify for the principal residence exclusion. The letter calculates the potential additional tax owed as well as a 20% accuracy related penalty and interest on the unreported income.

If it is too late and you have already been given notice of an audit on cancellation of debt income, there are still some other exclusions that you may qualify for, such as business and farm indebtedness. If you are thinking of giving an investment property back to the bank, be sure to bring in a good accountant to analyze the tax situation for you first.