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Gross Lease vs. Net Lease

July 6, 2014,

lease.jpgWhether you're starting a business or looking to expand, chances are you'll encounter some kind of lease. The most common are the gross lease and the net lease. In this blog post we'll take a look at the differences between the two and the benefits of each.

Gross Lease

In this scenario, the tenant pays a fixed amount each month. The landlord is responsible for the costs associated with property taxes, insurance and maintenance. A gross lease offers some flexibility because these properties are generally deemed as either Class B or Class C. They're less desirable so the landlord may be willing to negotiate over things like who pays the utility bill.

Net Lease

You'll likely see a net lease in properties deemed Class A. These are typically high value structures in a popular part of town. As such, tenants can expect to pay a fixed amount along with maintenance charges, insurance and taxes. The benefit to you as a business owner is exposure and the possibility of working in a new, less problem prone building.

Letter of Intent

Before you sign a gross lease or net lease, it's a good idea to craft a letter of intent. This document typically addresses issues like length of the rental, when the space is available and whether or not expansion is possible. You'll want to have a lawyer look over any lease documents. The professionals at Structure Law Group can help you craft a suitable letter of intent that protects your interests.

There is plenty more to consider when crafting a lease. At least now you understand the key differences between the two main types of commercial leases. This information will help you when you're coming up with a budget for your business. Knowing these costs up front eases some stress and makes it easier to get started.

About Structure Law Group

Structure Law Group is a San Jose based firm that specializes in business issues including business formations, commercial contracts and litigation.

Common Pitfalls in Real Estate Loan Documents: A Top Ten List - Part 2

January 28, 2014,

At a recent conference with San Jose and Silicon Valley real estate owners and lenders, Attorneys Jack Easterbrook and Tamara Pow presented their "Top 10 List" of issues that commonly arise in commercial real estate loan transactions. Having been involved in countless real estate and commercial loan transactions, Tamara and Jack developed the list to share with the participants key points to be attentive to when entering into a real estate transaction. The Top 10 List assumed that the basic business terms of the transaction had been decided, so the focus was on items that can arise in the documentation phase and create issues or obstacles in getting a deal to closing.

A previous blog presented three items from this Top 10 List, including: (1) inconsistency between a borrower's state of registration and a lender's requirement; (2) the special purpose entity and the independent direct/manager requirements of the lender; and (3) the personal guaranty. Here are three more items to keep in mind when negotiating a commercial real estate loan:

No. 4: Treatment of Other Creditors, Including Any Mezzanine Lender.

Comment: Are other creditors or lienholders involved, and will intercreditor or subordination agreements be necessary? If the answer is "yes," these agreements will need careful scrutiny. The recent trend in the case law continues on the path of strictly construing the terms of such agreements. This includes Bank of America v. PSW NYC LLC, in which it was held that an agreement between a senior secured lender and a mezzanine lender prevented a foreclosure by the mezz lender until it cured payment defaults in the senior secured lender's loan. The bottom line: other creditors of the owner/purchaser, whether new or existing when the deal is done, can significantly affect getting a transaction to closing. It is very worthwhile to have a strategy concerning them worked out early.

No. 5: Prohibition on Transfers, Including Transfers of Fractional Interests in a Borrowing Entity.

Comment: Standard loan documents often contain language that says that the borrower is in default if the property securing the loan, or any interest in the property, is transferred. However, an owner or borrower should not think it is safe from this provision if the title to the property is held in an entity, such as an LLC, just because the title is not changing. Many loan documents also provide that if an interest - perhaps even a small interest - in the ownership entity changes, a default is triggered. An owner or borrower is wise to not ignore these provisions. Borrowers should carefully consider whether they will need to (or want to) transfer partial ownership interests in the future and lenders should consider the magnitude of such changes that may be acceptable. A transfer of an ownership interest could occur as a result of estate planning needs, in connection with a management transfer, or perhaps the unforeseen death of someone in an ownership group, such as an LLC member. If the parties don't address these provisions before loan documents are finalized, subsequent events may trigger an unexpected and immediate default with unknown future implications.

No. 6: Prohibition on Changes in Management of the Borrower.

Comment: Are the borrower's short-and medium-term management plans prohibited by the loan agreement? Make sure the loan documents accommodate planned future changes in managers of the owner. For example, a family owned LLC may be intending to pass management to the next generation or a key employee long before the maturity date of the loan. Like prohibited transfers of ownership interests, loan documents may prohibit transfers of management power. Pay attention to these provisions and make sure intended changes are not prohibited by the loan documents. It may also be prudent to have potential future managers pre-approved by the lender.

Watch for our next blog for the remaining items addressed in the presentation.

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.

California Has a New Rule for Tracking Deferred Taxes from Section 1031 Exchanges

December 4, 2013,

As a business and real estate attorney in California, I often assist clients in real estate transactions using Internal Revenue Code Section 1031 to defer the tax on the sale of their real estate by transferring the tax attributes of that property into a new, like-kind, property. IRC Section 1031 is a federal statute, but we can also take advantage of the tax deferral on the exchange of like-kind property for California income taxes.

However, historically, when the exchange was made into property in another state, it was difficult for California to track these exchanges and make sure the state eventually got its share of deferred taxes. For example, if a real estate investor were to sell a shopping center in Sunnyvale, California and buy a shopping center in Incline Village, Nevada, and the real estate investor satisfied all of the IRC 1031 requirements, both federal and California taxes could be deferred until the later taxable sale of the Nevada property (or any other property into which it had been exchanged). The problem was that part of those deferred taxes were California income taxes, and California had no system in place to make sure the FTB was aware of the eventual tax recognition event. A new rule now provides the Franchise Tax Board with the information it needs to keep track of these transactions and the deferred taxes so that it can collect them when the time is right.

Starting January 1, 2014, if you exchange California property for out-of-state property you will be required to file an information return with the FTB for the year of the exchange and every subsequent year that the gain is deferred. Regardless of your state of residency at the time of the exchange, if you are a California resident when the out-of-state property is later sold, all of the gain is taxable in California. But don't think that moving to Nevada can get you out of theses deferred taxes. If you were a California resident at the time of the exchange but you are a nonresident when it is sold, the previously untaxed California gain is still taxable to California. Also, if you exchange out-of-state property for California property you must reduce the California basis on the property by the amount deferred, even if you were a nonresident at the time of the exchange. [Source: Spidell's California Taxletter, Vol. 35.7, July 1, 2013]. The new filing requirements will help the FTB track these exchanges.

For more information on California Taxation of Nonresidents and Individuals Who Change Residency, see FTB Publication 1100.

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.

Limited Personal Guarantees: It Pays to be Precise!

September 27, 2013,

The personal guarantee has long been used to bolster the quality of a commercial loan, real estate loan or business loan. Often the personal guarantee is a full guarantee, extending to all obligations of the borrower and giving a lender potential recourse to all property of the guarantor in an enforcement action. Sometimes, however, the lender and guarantor agree that the guaranty will be more limited. A recent case out of the Bay Area, Series AGI West Linn of Appian Group Investors DE LLC v. Eves, 217 Cal. App.4th 156 (2013), dealt with such a limited guarantee , which carved-out the guarantor's home and exempted it from the lender's reach under the guarantee. The personal guarantee was very broad, but for the specific exclusion for the house. After the guarantee was signed, but before the loan soured and the lender demanded payment, the guarantor sold the exempted house for cash and put the proceeds of the sale in segregated accounts. Once defaults occurred under the loan, the question at issue was whether the carve-out under the guarantee exempted only the asset named, a house in Como, Italy (but for our purposes it could have been a home in San Jose or Palo Alto as well!) or extended to the proceeds from the cash sale of the house.

In the AGI West Linn case, the lender sued the guarantor and also asked the court to enter a right to attach order and writ of attachment to lock up the cash from the sale of the house. The guarantor opposed this, arguing that the money was simply proceeds of the excluded residence and, as the house itself was excluded from lender's recourse, the direct proceeds of the sale of the house should be excluded as well. The lender countered that the guarantee did not say anything about "proceeds" being excluded, only the house.

The court held for the lender, taking a strict reading of the guarantee.

So what is the take-away? Careful drafting is a must if parties wish to exclude certain specific assets from the otherwise broad scope of a personal guarantee. The court here read the plain language of the guarantee and stated that if the guarantor intended to include proceeds of the sale of the asset as part of the exclusion, he should have expressly put this in the guarantee , and it was not the court's job to save a party from the ugly implications of the plain language of a contract. One gleans from the court opinion that the strategy of strictly construing the guarantee would also likely apply if other limitations, such as a limitation on the scope of the guaranteed obligations, existed and required analysis.

Another point is to be aware that when analyzing the guarantee, this court rejected the approach of applying the UCC formula for treatment of proceeds of collateral, which extends a lien on an asset to a lien on proceeds of the asset if it is liquidated (subject to certain tests). If the UCC's formula was being followed, segregated proceeds of the sale of the exempted house would have naturally been included with the carve-out of the house. The court in the AGI West Linn case dismissed this avenue of analysis and instead applied principles of strict contract interpretation.

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.

Limited Liability Company Short Form Cancellations

March 4, 2013,

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.

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Real Estate Loans, Mezzanine Financing and Intercreditor Agreements: Sometimes Words Mean Something

January 16, 2013,

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.

Higher Taxes in 2013: The California Wood and Lumber Tax

October 24, 2012,

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.

Property Taxes: Sellers Providing Financing Should Beware of Reassessment on Repossession

September 11, 2012,

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" »

Property Taxes: California Property Owners Should Consider an Appeal

August 29, 2012,

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.

New Rules for Business Entities Change of Ownership Reporting for Real Property

April 27, 2012,

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

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Short Sales - Can the Bank Still Come After You for the Deficiency?

August 22, 2011,

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.

Owners of Single Member LLCs Doing Business in California Must Also Be Registered in California

May 2, 2011,

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.

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Are You A Real Estate Professional?

April 18, 2011,

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.

California is Focusing on Cancellation of Debt Income

March 28, 2011,

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.