What is a
1031 exchange
and why do I care?
A:
Broadly defined, the term "commercial
real estate" can be used to refer to any
dealing with real property in a business
context. It could involve leasing out office
space, owning an apartment complex, or
selling real property along with and as part
of the sale of a business. It might be
industrial or agricultural property. It
could even involve residential properties
like apartment complexes or rental houses
being held for business or income-producing
purposes. It can even involve working with
the government. Unless the property is a
residence where the homeowner is living, you
are probably dealing with commercial real
estate.
A:
While many of the concepts are the
same, there can be huge differences between
commercial and residential real estate.
Commercial real estate transactions can be
far more diverse and wide-ranging than
selling homes. Any real estate deal has its
share of risks, and problems can arise that
you could never possibly foresee. In
general, however, the risk and potential
liability exposure that you face on a
commercial real estate deal can be much
greater than when you buy a house. Look at
it from this perspective: by and large, we
all have a pretty good idea of what goes on
in a typical family home, but can you say
the same thing about a piece of business
property? Depending on the nature of the
business, commercial property may have all
kinds of liens and title problems. There may
be greater concerns about hazardous
materials or zoning issues. And there will
always be questions about the suitability of
the property's location for your business
needs.
Furthermore, in many
instances, you are not afforded the same
consumer protections on a commercial real
estate deal that may be available when you
purchase a residence. In some states, for
example, residential homebuyers are given
greater protections against abusive lending
practices than are business owners.
Likewise, there are mandatory disclosures
required in residential real estate matters
that may or may not be required in a
commercial transaction.
Q:
What are some of the
common pitfalls
involving a real estate business deal?
A:
Regardless of whether you're buying a
home or a piece of investment property,
there will always be risks involved. Your
goal should be to lessen these risks as much
as you can. Examples of potential problems
that oftentimes lead to legal disputes
include:
- Defects in title
- Debt service and
lender requirements
- Mechanics liens
- Zoning and land use
problems
- Market fluctuations
- Hazardous waste and
environmental contamination
Real property
interests are usually conveyed by a deed.
In order to track how property changes
hands, every state has a public record
system where real property deeds are
recorded, becoming a part of the public
record system for everyone to see. In
theory, this is a great system for keeping
track of who owns what, but deeds are
sometimes not recorded. Sometimes people
sell or transfer partial interests in
property. Lenders make loans against
properties and record mortgages or deeds of
trust that become liens that are of public
record. Easements given to cross over or use
property may or may not be of record. A
judgment against a person can be recorded
and become a lien against any real property
that person owns, even without his consent.
All these things can become a lien against
title. You may not be buying everything you
though you were buying, because someone else
may have a prior claim that you did not know
about.
If you are borrowing
money to acquire a piece of real property,
the lender is no doubt going to want
security for the loan. While a personal
guarantee may work if your net worth is
substantial, a lender will usually want a
mortgage or deed of trust against the
property. This will give the lender the
right to foreclose if you fail to comply
with the terms and conditions of the loan.
Beyond the repayment requirements, these
terms and conditions can give rise to other
concerns that could become a problem. For
example, some lenders prohibit borrowers
from taking out more loans on their
property, which could stop you from getting
more financing that your business may need
down the road.
Oftentimes, a
commercial loan will also require that a
business maintain a certain "net equity."
Pre-payment penalties are also common on
real property loans. Also, many lenders on a
big commercial real estate deal require that
their legal fees and costs be paid by the
borrower(s).
In a business context,
contractors who do work on real property
have a process called a "mechanics lien"
that they can use to make sure that they get
paid. This is a statutory lien that
contractors, laborers and materialmen place
on property when they've performed work or
furnished materials in the erection or
repair of a building or an improvement. They
must generally give advance notice that they
are going to file the lien, and must then
take action to enforce the lien within
strict timelines if they aren't paid.
Ultimately a mechanic's lien could be used
to foreclose on property, so it can be a
very powerful tool for a contractor, a
laborer or a materialman.
A big concern for a
business is to make sure not only that
property used in the business is properly
zoned, but also that the zoning of nearby or
adjacent properties is not going to be a
problem. Believe it or not, many people fail
in new businesses because they don't
investigate the land use and zoning issues
carefully enough. And even if you do your
homework, issues can come up down the road
if governmental agencies or neighbors try to
change the zoning on your property to limit
your use of it.
If you are in the real
estate business, changes in property values
and other market fluctuations can have a
profound effect on your operations. Rents
can go up or down; tenancy rates can
increase and decrease. Changing property
values and market fluctuations can also
affect any other type of business that owns
property. With retail space, for example, a
company that owns rather than leases a store
location may decide to change locations to
follow their customer base, only to find out
that they can't afford to move because of
property values having dropped to the point
that their business premises can't be sold
at the price they need. (In contrast, a
lease may provide more flexibility because,
at the end of the term, the business could
simply pack up and move without having to
worry about selling the premises.)
The biggest potential
concerns to owning business property,
though, are hazardous waste or environmental
cleanup problems. Property owners are the
ones who have primary responsibility for
fixing such problems, even if the current
property owner did not cause them. These
problems may not be obvious or apparent to
the naked eye, and could arise from anything
ranging from an underground storage tank to
an old garbage dump. If you're in the chain
of title to contaminated property (meaning
that a some point you held an ownership
interest in that property), you're
potentially responsible for paying for the
clean up. The costs for an environmental
cleanup operation can run into the millions
of dollars.
A:
The goal of every seller is to
maximize profits, and every prospective
buyer wants to get property as cheaply as
possible. Having to pay a real estate
commission or other professional fees as
part of a real estate deal only works at
odds with these goals. Consequently, many
business people who are sophisticated when
it comes to negotiating real estate deals
may feel comfortable with doing a lot of the
work themselves on commercial real estate
deals. However, even sophisticated business
people will still rely on professional
advice when comes down to actually closing a
deal, as the potential pitfalls can be so
significant. The bottom line is that you
should seriously consider hiring real estate
professionals, and professional fees should
be factored in as a cost to doing any
commercial real estate deal.
There are many reasons
why you should hire your own real estate
broker (or an agent who may work for a
broker). The broker or agent should have
specific expertise in commercial real
estate, and particularly in the area where
you need it (for example, office space,
retail space, industrial warehouse space,
apartment complexes, agricultural land).
Even if you're just leasing property, a real
estate broker may be invaluable. If he or
she is good, an agent will go out and find
property for you. The agent will also serve
as an arm's-length intermediary to negotiate
on your behalf, which can be much more
effective than you trying to negotiate the
deal yourself. (Wouldn't you love to have an
agent representing your interests when you
go buy a new car? It would help you to avoid
high-pressure sales tactics, prevent you
from making rash decisions and make it
easier for you to say "no." The same
considerations apply here.)
Keep in mind, too,
that real estate agents work on similar
deals all the time, so presumably know what
they are doing. Their knowledge and contacts
can well be worth the cost of a commission.
They can also help you with the paperwork,
to make sure you don't do something stupid
when submitting an offer.
If you are a buyer, it
may really make no sense not to hire a
broker when it would usually be at no extra
cost to you. The seller usually pays the
commission in most real estate deals. Most
real estate agents agree to split the
commissions on listed properties, though, so
an agent has a real incentive to be involved
in a deal even if he or she is not the
listing agent. But a buyer can simply chose
to work with the seller's agent to close a
deal. The seller's agent usually won't
object if a written consent is signed.
(Incredibly, this happens all the time and
it only makes sense from the standpoint of
the seller's agent, who then gets to keep
the whole commission!)
A multiple-listing
arrangement is a "you scratch my back,
I'll scratch yours" sharing mechanism for
real estate agents. They are mutually
beneficial to buyers and sellers, as well,
since the multiple listing of all properties
on the market will inevitably help to bring
buyers and sellers together. One of the
conditions to an agent participating in such
an arrangement is that commissions are
shared when more than one agent is involved
in a transaction.
Any reputable real
estate agent would be more than happy to
explain the process at greater length. The
agent should also be willing to work with
you as long as you understand that he or she
would have to look to the seller's agent for
payment of a commission, if any is to be
paid. This helps protect the buyer in the
rare instances where there is no seller's
agent (for instance, a "property for sale by
owner") where the seller's agent does not
participate in a multiple-listing
arrangement.
You shouldn't hire a
broker just because he or she is a relative,
or because he or she is your best friend's
spouse. Instead, hire the best person you
can find who has expertise in representing
parties on real estate sales in the segment
of the market where you are looking. Ask
lots of people who they would recommend and
why. Ask disinterested parties who are more
likely to give you an informed answer (for
example, escrow agents, lenders,
contractors, real estate attorneys, and
people who have recently bought or sold
commercial property). Look in the newspaper
advertisements to see who have been the
highest producers in your segment of the
real estate market. When somebody's name
comes up more than a few times, that person
would be someone who you would want to
contact.
A:
The benefit of competent legal advice
on a real estate deal stands on its own.
There are so many things that can go wrong
on a real estate deal that you may very well
end up kicking yourself mightily if you
don't hire an attorney to help you with the
transaction. You may even end up hiring a
lawyer on a lawsuit, which could end up be a
lot more expensive. Real estate agents don't
usually get paid unless the deal closes (or
unless you somehow become obligated to pay a
commission by, for example, backing out of a
deal or otherwise breaching your listing
agreement). And listing agreements will
clearly state that real estate agents are
not providing legal advice. So real estate
agents are typically not going to worry
about the "what if's" of the legal details
and are inclined to do whatever they can to
push a deal to closure. This is not the case
with an attorney working on an hourly basis,
who is going to get paid one way or the
other. An attorney will be in a better
position to provide you with essential legal
advice and to do so with more impartiality
than may be the case with your real estate
agent.
A:
Strictly speaking, no. Unless the
parties contractually agree to it as part of
their deal, there is seldom a legal
requirement that there be an escrow.
Inevitably, though, an escrow is almost
always a good idea. The escrow company ends
up being an intermediary and a facilitator
to the transaction. They can also handle
most of the details and the paperwork,
including escrow instructions, title
reports, title insurance, recording deeds
and other instruments, and disbursing funds.
A:
In some states, there are lawyers who
specialize in researching public records to
determine the status of title to property.
They will issues opinions or reports as to
the condition to title. In other states, the
job of researching title to property has
become something that is almost universally
done by title insurance companies. These
companies have developed tools that they use
to track public records and other resources
to develop extensive databases on title to
real property. They're able to prepare title
reports on property that are used to
determine the status of title on real
property transactions, and that are used as
a basis for issuing title insurance.
Q:
What is a preliminary title report and how
much attention should I pay to it?
A:
A preliminary title report is a
document prepared on real property once an
escrow is opened, but prior to closing. It
provides all kinds of information about the
property that is essential for a buyer to
see, such as how title is currently held and
what kind of exceptions to title are
currently of record (for example, easements,
liens and encumbrances). The preliminary
title report then becomes the final title
report, on which title insurance is based.
In addition to specific exceptions to title
that will be listed on a title report, it
will also list standard exclusions from
coverage.
In virtually every
real estate transaction, the buyer has the
right to approve or object to the
preliminary title report and back out of the
deal unless the seller can provide clean
title by eliminating certain exceptions to
title prior to closing. But a buyer will
only have a short period of time during
which to act on the preliminary title
report. So it's extremely important for a
buyer to carefully review a preliminary
title report immediately and to take
appropriate action if there are any
unacceptable exceptions to title.
Q:
What is title insurance and why is it
necessary?
A:
Title insurance is nothing more than
an insurance policy that provides assurance
to interested parties that there is good and
marketable title to the property being
insured. However, this never means that
title insurance guarantees perfect title. As
with all insurance, there are a number of
different types of policies and
endorsements. There are also many exceptions
to title, which all tie back into
information in the preliminary title report.
These include specific exceptions listed on
the property to be insured, as well as
standard exceptions.
One standard
exception, for example, is that the
insurance will only be provided for
exceptions to title that are reflected by
the public records. Unless a special
endorsement is obtained (which costs more
money), there is no obligation on the
insurance company to insure against defects
in title that would have been apparent from
surveying or otherwise physically inspecting
the property.
There are also
different types of policies. For example,
it's customary in most states for a seller
to pay for standard coverage for the buyer
that insures that the deed from the seller
is conveying title that it purports to
convey, subject to exceptions in the title
report. If a buyer wants additional
protection against third party claims such
as mechanic's liens, the buyer can purchase
an owner's policy. If a loan is involved, a
lender's policy can be issued that
specifically insures the lender against
title defects.
It is not always
necessary to get title insurance. In a
transaction between related parties, for
example, they may decide not to pay for it
and take the risk of transferring property
interests without purchasing title
insurance. In a typical arm's-length deal,
though, it almost always makes sense to
purchase title insurance. If a commercial
loan is involved, the lender will require
title insurance to protect its interest.
Q: Are
there different types of deeds, and why
should I care?
A:
The type of deed can make a big
difference. In some states, the typical
conveyance is a grant deed, which
basically says the seller has an interest in
the property and that it is being conveyed
to the buyer, but not necessarily with any
representations or warranties as to title.
Other states have warranty deeds that
go a step further to provide a warranty that
the seller has good title to the interest
being conveyed. All states have something
like a quitclaim deed where a party
is only signing over whatever interest that
party has in the property, if any.
The bottom line is
that you could take a deed from someone that
means nothing. While this may amount to
fraud on the part of the seller, who wants
to have to sue someone to try to enforce
your rights? And you may not even have a
good case if, for example, you accepted a
quit claim deed that says that you got only
whatever interest the other party had, which
may have been nothing. You can see the need
to get competent legal advice.
A:
There are many issues that can arise
with respect to how you take title to
property, and especially so in a commercial
context. If you take title as an individual,
you may be exposing yourself to potential
liability exposure that you might want to
try to avoid or at least minimize. You take
title through a business corporation, but
doing this could be disaster from a tax
standpoint point. Sometimes, there may be
other alternatives such as forming a limited
liability company that you would own and
control that, in turn, could lease the
property to your business entity.
If joint ownership is
involved, you should clearly understand the
differences between taking title as joint
tenants, as tenants in common, as a
partnership, or as community property. You
should also clearly understand your rights
versus the rights of your co-owners. Each
and all of these types of ownership have
significant ownership implications and
rights of survivorship.
It short, there are no
universal rules of thumb with respect to how
to take title. It's always advisable to seek
professional advice, including your lawyer
and CPA, to assist you in making a smart
decision.
Q:
What should be in a real estate
purchase
contract?
A:
Real estate purchase contracts can be
extraordinarily simple but usually end up
being very complex and lengthy documents, in
order to try to address all the "what if's"
that are typically involved in a commercial
real estate transaction. Points that would
typically be covered include:
- Parties
- Recitals
(background facts as to why the parties
are doing the deal)
- Description of the
property
- Sales price and
terms of payment
- Title and title
insurance
- Closing date
- Escrow provisions
- Conditions to
closing
- Representations and
warranties
- Environmental and
hazardous waste provisions
- Zoning and land use
issues
- Rights to
inspection
- 1031 exchange
provisions, if applicable
- Liability insurance
requirements
- Indemnification and
hold harmless provisions
- Remedies if a party
breaches
- Rights to amend and
modify
- Term and
termination
- Rights to
assignment or delegation of rights
- Attorneys' fees and
costs
- Arbitration rights,
if any
- Governing laws
- Other standard
provisions
In many instances,
it's possible to use standard form documents
prepared by realtor associations that help
to facilitate the drafting process. At a
minimum, these standard form agreements can
serve as effective checklists of issues you
may want to address.
Q:
Does "as is" mean "as is"?
A:
As between the parties, it may be.
Even here, though, there may be laws that
preclude a seller from completely passing
the buck on certain issues such as
environmental clean up and hazardous waste.
And the law sometimes requires mandatory
disclosure of defective conditions or other
problems with property.
Q: If
I am buying real property for my business,
do I need to get an environmental
site
assessment?
A:
Some lenders may require an
environmental site assessment, and there are
certain situations where only makes sense to
get one (such as when you're buying a
service station or a manufacturing
business). Otherwise, though, the chance of
there being any problem may seem remote and
it may be tempting to pass on doing an
expensive assessment. But you're probably
doing yourself a disservice if you don't get
one, as any problem that arises could result
in catastrophic liability exposure for you
even if you didn't cause the problem.
There are also
different types of environmental site
assessments. A "Phase I," for example,
generally involves an inspection of the
property and review of various records, but
it doesn't actually involve any boring or
drilling, or the testing of soil or water
samples. These activities are usually done
during the course of a Phase II assessment,
which can be quite expensive. It's usually
an option for a buyer to do a Phase I
assessment and consider the results and
recommendations of that process before
deciding on whether to proceed further.
A:
A "1031 exchange" refers to a method
of deferring tax on the sale of an interest
in real property allowed under section 1031
of the Internal Revenue Code. In brief, it
allows a seller to defer tax on a gain that
would otherwise be realized on a sale of
property if the proceeds from the sale were
reinvested in like-kind property. It's quite
common for a 1031 exchange to be involved in
some manner in a commercial real estate
transaction.
A seller must
contractually arrange to convey his or her
interest in the property being sold in
exchange for receiving an interest in
another piece of commercial property. If
cash is involved, an escrow company or
facilitator usually it, because treatment
under section 1031 won't be possible if the
proceeds are paid to the seller even for an
instant. In practice, however, the rules for
a 1031 exchange can be quite complex and it
is easy for a seller to run afoul with them.
It's always advisable to have competent
legal counsel involved in the transaction.
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