IF A CONTINGENCY CLAUSE DOESN’T FIT; SIMPLY ALTER IT.

Typically, sellers of real property want quick sales with no contingencies; want to sell “as, is”; and want no liability after the sale. Buyers, of course, usually desire the opposite: they want long diligence periods, and accordingly later closing dates; a host of warranties that survive the sale; and a number of contingencies (conditions to their obligation to purchase).

Custom (and positional negotiation) usually dictates closing dates with 30-60 day closings typical in residential deals, and 60-120 day closings typical in most commercial deals. Warranties are much more customary in commercial vs. residential deals, and contingencies are often found in all real estate deals.

Typical buyer contingencies in a residential deal include:

• Financing (the right to terminate if buyer does not receive a commitment from a lender to loan required funds to make the purchase possible);

• Sale of  Existing Property (the right to terminate if buyer’s existing residence or commercial property does not sell prior to the scheduled closing date for their purchase [many buyers of a new home/other property will not be able to qualify for a loan if they still own and owe money on their existing home/property]); and

• Delivery of Good Title.

In addition to the aforementioned, typical contingencies in a commercial real estate contract include: 1) formal approval of the purchase/sale by a governing body; 2) confirmation of zoning conformance or receipt of a zoning variance; 3) all representations and warranties being true and correct in all material respects, as of the date of signing, and the closing date; and 4) there being no material change in the condition or status of the property between the contract date and the closing date.

Many sellers are reluctant to accept offers with contingencies. More often than not, however, sellers take such a hard line risk holding on to their property a lot longer than desired.

Why? Contingencies are easily qualified. In general, contingencies should provide: 1) a specific date or time period (for the occurrence or non-occurrence of the conditional event); and 2) an obligation to use good faith to pursue action likely to lead to satisfaction of the conditional event.  With financing contingencies, for example, the risk of buyers having unreasonable expectations of qualifying for a loan can be minimized by specifying a reasonable percentage of purchase price to be financed (e.g., 80% or less), and maximum interest rate sought by Buyer.

To qualify the “Sale of Existing Property Contingency”, or really, any contingency, consider the following “Right to Market/72 Hour Put” clause:

“Seller and/or its agents may continue to market the Property during the contingency period. If, however, Seller and/or its agent receives a bona fide offer for the purchase of the property (without  a _____________contingency) which Seller is willing to accept, Seller shall give Buyer notice within twenty-four (24) hours of such offer, together with a copy of such offer (“Seller’s Notice”). Within three (3) days of Buyer’s receipt of Seller’s Notice, Buyer may notify Seller in writing of Buyer’s willingness to purchase the property for the price and on the terms set forth in Buyer’s purchase agreement with Seller, except for the ___ contingency (“Buyer’s Notice”). If Buyer issues such Buyer’s Notice to Seller, as and when required, such Buyer’s Notice shall act to nullify the _____ contingency and the parties hereto shall be required to perform their obligations under this Agreement as though the contingency had not been contained therein. If Buyer notifies Seller that it is unwilling to purchase the property without the ____contingency, or fails to respond as and when required herein, Seller may accept such bona fide offer, in which case the earnest money deposit shall be returned to Buyer, and thereafter neither party shall have any liability to the other.”

With the above provision, buyers won’t be locked into a deal without their contingency. Their worst case scenario would be having to walk away from the deal, without penalty. Sellers, on the other hand, won’t need to feel obligated to take a “hard line approach” and refuse a deal with contingencies. A seller’s worst case scenario in this example would be having to wait three (3) days before knowing if it can terminate its contingent deal with its original buyer (if the original buyer does not agree to remove its contingency), and accept a better deal, without contingencies.

What is the moral of this story? Instead of walking away from a contingent deal, if the contingency clause doesn’t fit; simply alter it.

Before Renovating or Demolishing Your Building, Don't Forget To Investigate The Presence Of Asbestos

When you mention the word ‘asbestos’ many people think of the late night commercials run by law firms regarding mesothelioma.  That dreaded disease is typically contracted by a person having breathed a significant amount of asbestos fibers or airborne asbestos dust. Washing a family members’ dirty clothes covered in such fibers or dust can also cause development of this rare form of cancer, lung cancer or other diseases.

Besides all the litigation, which has spawned many headlines over the years, a regulatory environment has developed to address the issue. Anyone who is thinking about construction, particularly renovation or demolition of a structure, whether a home or commercial building, needs to consider whether there is a need to address the abatement of asbestos or not.  This is not just an issue for old buildings and homes, but also, to some degree, new construction, as roofing, ceiling tile and flooring may still contain asbestos, even today, depending on the country from which the material is sourced.

Of bigger concern are renovation and demolition projects where the presence of asbestos needs to be determined by the project commences. This is because of the likely potential that asbestos could be disturbed. In the course of demolishing or renovating a home or commercial building, it is wise to first determine whether any ACM are present, what type and how much.  There are many competent environmental consultants in Ohio that are licensed to conduct a review and test for the presence of asbestos.

[Note: For the sake of space, I’m over-simplifying this, so to any environmental consultant reading this who is cringing about all the nuances I’m glossing over, please feel free to submit an article to me covering the issue in more detail.]

Two factors that can affect what property owners and their contractors must do are the amount of asbestos that is present and the type of asbestos, i.e., whether the ACM is friable or non-friable. When dry, ACM will be categorized as “friable” if it can be easily crumbled, pulverized or otherwise reduced to powder. If the material cannot, then it is considered “non-friable.”  Non-friable ACM can be turned into friable under certain conditions such as removing it during demolition or renovation, or by fire. Non-friable ACM are also placed into two categories based upon how resistant the materials are to crumbled or pulverized.

Left undisturbed, asbestos-containing materials  (ACM) are not a risk. However, anyone considering the renovation or demolition of a building should first hire an appropriately licensed asbestos contractor who can test for the presence of asbestos in the building, or portion of building, that is being demolished or renovated.

Depending on the type and category of ACM found, if any, and the amount of ACM present, the removal or encapsulation of ACM may be necessary.

Two Ohio agencies/departments are significantly involved in the regulation and oversight of this process: The Ohio Environmental Protection Agency and the Ohio Department of Health. Data regarding their respective roles in oversight, regulations and licensure  and other useful information can be found on their web sites.

Environmental consultants are worth their weight in gold when addressing what to do and how prior to commencing and during construction or demolition. A good consultant can advise on an approach that minimizes the costs of abatement and help convince the appropriate regulators to permit it.  Should the asbestos regulations be ignored and the state regulators get initiate an adversarial process, then retaining specialized environmental legal counsel will also become necessary. .

Property owners considering renovation or demolition would be wise to consult real estate counsel ahead of time. Most real estate attorneys have worked with  environmental consultants and attorneys that are environmental law specialists and can advise on who to call and when.

Lease Option or Installment Sale; what is the Economic Reality of your Transaction?

By: Donald J. Valachi, CCIM, CPA

Editor’s notes:

Reprinted with permission from Commercial Investment Real Estate, The Magazine of the CCIM Institute, May/June 2015, Vol. XXXIV, No. 3

(This article, which originally appeared in Commercial Investment Real Estate, July/August 1996, is one of the most popular articles downloaded from the CIRE archive. Here is a condensed version of the original article).

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A lease with an option to purchase is a common real estate arrangement. The important income tax question in lease-option transactions is whether the tenant is leasing the property or, as an economic reality, an installment sale has occurred prior to the tenant exercising the purchase option.

The answer to this question depends upon an analysis of all the surrounding factors. As Gerald J. Robinson observed in the Federal Income Taxation of Real Estate: “A collection of telltale signs leads to the conclusion that exercise of the option was virtually certain from the outset, so that treating the entire transaction as a sale is warranted.”

If a lease option is treated as a sale, there are two important tax implications:

•           The timing of the property’s transfer of ownership is changed. With a “true” lease option, ownership transfers when the option is exercised. If the transaction is treated as a sale, then ownership transfers when the parties execute the original agreement.

•           The nature of the option payment and the rent payments during the lease period are changed.

Because the tax treatment of a purchase transaction is so different from a lease transaction, it is important to understand the factors that may lead the Internal Revenue Service to characterize a lease-option transaction as a sale.

            LEASE TERMS

The basic tax question is whether or not the IRS will assume a sale occurred before the tenant actually exercises the option to purchase. If, at the time the lease option agreement is executed, all economic circumstances indicate a high probability that the tenant will execute the option, the IRS will very likely characterize the lease option as a sale. If the tenant acquires equity in the property during the period of the lease, it increases the likelihood that the tenant will exercise the option to purchase, because this is the only way to protect the investment.

The linking of inflated rents and a below-market option price tends to corroborate that the tenant is acquiring an equity interest in the property. For example, assume that Adams agrees to lease an industrial building from Baker for two years at an annual rent of $120,000. At the same time, Adams pays Baker $20,000 for an option to purchase the property at the end of two years for $240,000. At the time the lease option agreement is executed, the fair market value of the property is $500,000 and the annual fair rental is $50,000.

Adams acquires $70,000 of equity per year over the two-year lease period ($120,000 annual rent payment - $50,000 fair market rent). In addition, the total payments made by Adams equal the value of the property ($20,000 option payment + $120,000 rent payment [year #1] + $120,000 rent payment [year #2] + $240,000 option price = $500,000 fair market value). Thus, the economic circumstances at the time the agreement is executed indicate that the lease option is, in economic reality, a sale and that the $20,000 option payment is the down payment.

This lease-option transaction example will be treated as a sale for tax purposes, because the rental amounts are so great that the tenant is economically compelled to exercise the option, and, even more compelling, the inflated rents and the low option price add up to the approximate fair market value of the property.

However, a “bargain” option price will not, by itself, result in the lease-option transaction being characterized as a sale. If the option price represents a substantial portion of the fair market value of the property, the rent approximates the actual fair market rental value, and the rent payments are not applied to the purchase price, the lease-option will not be characterized as a sale.

The IRS may come to the same conclusion in that example if the option price of the property is set at market value, but the rent and the option payments are applied to the option price. For example, assume the same facts as in the previous example, except that the option price is $500,000 and the $20,000 option payment and the two annual $120,000 rent payments are to be applied to the option price. When Adams exercises the purchase option, he pays Baker $240,000 ($500,000 option price - $20,000 option payment - $120,000 rent payment [year #1] - $120,000 rent payment [year #2] = $240,000).

            OTHER ECONOMIC CIRCUMSTANCES

In addition to the rental value and option price, other economic factors may be considered in determining whether a lease option should be characterized as a sale for tax purposes. In analyzing lease option transactions, each of the following factors has been considered evidence that indicates a sale:

•           The lease requires that the tenant make substantial improvements to the property and the tenant can recoup his investment only by exercising the option.

•           A portion of the rent payments can be identified as a substitute for loan interest.

•           The agreement calls for the crediting of rent payments against the option price. This is true even when both the rental value and the option price are set at fair market value.

Regarding the situation in the third point, the tenant is paying no more in rent than would be the case in the absence of the option. Thus, the tenant is not acquiring equity during the lease period. However, if the rent may be applied to the option price, the lease option transaction has the appearance of an installment sale with a balloon payment. This is especially true when the rent payments approximate the amount of installment payments the tenant would make, given a loan amortization schedule with a market rate of interest.

But there is no certainty that the tenant will exercise the option. Thus, if the tenant can demonstrate to the IRS that the reason for the lease option is that a sale was not possible because of economic conditions, the lease option will likely be upheld. As Michael P. Sampson says in Tax Guide for Residential Real Estate: “...if you can demonstrate that the reason for the lease option is the impossibility of a cash sale because of economic conditions, the form of the transaction as a lease option will probably stand. This would be the case, for instance, where your purpose is to tie down the property during a tight money market, with the expectation that within the option period you can get institutional financing.”

            INTENTION OF THE PARTIES

In some cases, the court has ruled that the intentions of the parties determine whether a lease-option transaction is to be treated as a sale, instead of relying on strictly economic tests. If the parties believed when they entered the transaction that the rent charged reflected fair market rents and that the option price reflected a good faith estimate of the future value of the property, the lease option will very likely be upheld.

Because the party’s intention is subjective, an IRS agent or a judge would need to corroborate these intentions in the economic circumstances surrounding the transaction.

Although the lease option is a valuable strategy, it should be used with great care. Both the rental payments and the option price should be set by the parties with reference to going market values and rents for similar properties. And the parties should be prepared to justify their estimates of rent and purchase price if the transaction is later challenged by the IRS. Rental value and property value are best established through independent appraisal by experts.

            TAX CONSEQUENCES TO TENANT AND LANDLORD

If the IRS characterizes the lease option as an installment sale for income tax purposes, the ownership of the property is assumed to transfer at the time the tenant gave the landlord the option payment and the lease commenced. This timing alters the tax consequences considerably for both the tenant and the landlord.

Tenant as Buyer

•           The tenant will not be allowed to deduct his rental payments as such.

•           The tenant will be allowed to deduct depreciation, based on the portion of the presumed purchase price allocated to depreciable improvements. In addition, the tenant may also deduct other expenses associated with operating the property.

•           A portion of the rental payments that the tenant makes will be recharacterized as interest payments and will be treated as deductible interest for income tax purposes. The amount of the interest deduction will be calculated under the “imputed interest rules.” The portion of the rental payments treated as loan principal payments is considered part of the purchase price and, thus, is added to the tenant-buyer’s tax basis for the property.

Landlord as Seller

•           The option payment is treated as a down payment. Since the landlord did not receive all cash for his equity, the installment method of reporting would be applicable to the transaction. Thus, the option payment will be treated as an initial payment received in the year of “sale” under the installment method.

•           The rental payments received by the landlord-seller under the lease agreement are treated as part of the selling price, and part of each installment payment is taxable gain. Since no interest is stated in the rent payments, it must be imputed.

•           The recharacterized rental payments will result in either long-term capital gain or ordinary loss. This assumes that the property was held for more than one year at the time the lease-option agreement was signed, and that the landlord-seller was not a “dealer” in real estate with respect to the property in question.

•           Ordinary income (rental income) converts into capital gain (sale proceeds). As a result, the applicable tax rate could be lower. In addition, the amount of reportable income would be limited to the gain, if any, on the sale.

•           The landlord would not be allowed to deduct an allowance for depreciation or other rental expenses.

Donald J. Valachi, CCIM, CPA, is a retired clinical professor of real estate at California State University in Fullerton.

The CCIM Institute is a 501(c)(6) trade association that trains and certifies commercial real estate professionals as CCIMs (Certified Commercial Investment Members) after successfully completing a designation process that ensures CCIMs are proficient in theory and practice. Their members are brokers, leasing professionals, investment counselors, asset managers, appraisers, corporate real estate executives, property managers, developers, institutional investors, commercial lenders, attorneys, bankers, and other allied professionals. Among the Institute’s services are: online and in-class education, conferences, networking events, industry-recognized certification.  For more information on the Institute, log on to: www.ccim.com

County Land Banks in Ohio: Tackling Abandoned Property One Parcel At A Time

Here’s a scenario that’s all too common in cities across Ohio:  A structure, often a house in a struggling residential neighborhood, stands empty, abandoned by its titled owners and steadily deteriorating year by year. The lender could foreclose and take title to the property through a credit bid if there are no higher bidders at the sheriff’s sale. However, this often does not happen if the mortgaged property is in a blighted or other struggling neighborhood. The lender does not want to be stuck with the property.

 

A property can hang in this legal limbo indefinitely, dragging down a neighborhood by suppressing property values and attracting crime.

 

One option for combating this property is a land bank. A “land bank” is a nonprofit entity, often governmental, that is established primarily to take title or control of vacant or abandoned property, manage it and then dispose of the property.  As stated by the Western Reserve Land Conservancy, based in Cleveland, Ohio, “… land banks can safely hold a distressed property, clean its title and prepare it for a better day.”

 

According to Jessica de Wit, in her article for the University of Michigan/economic development titled Revitalizing Blighted Communities with Land Banks,

“When property owners neglect and abandon their properties, the local municipality must use its own resources to clean and maintain the properties as part of their nuisance abatement responsibilities to protect the public health, safety and welfare of its community. … Abandoned and vacant properties drive down the surrounding property values, which lowers the property taxes that most municipalities rely on as a primary source of revenue.

Property abandonment can destabilize a neighborhood by causing an out-migration of property owners, who are worried about losing value on their properties due to surrounding vacant and abandoned land. A Temple University study suggests that, all things being equal, the presence of an abandoned house on a block reduces the value of all the other property by an average of $6,720.”

There are quite a few land banks in the state of Ohio.  The Western Reserve Land Conservancy lists 24 Ohio county land banks on its web site. The first county land bank in Ohio was created in 2008 when legislation was passed in the state to allow the creation of a land bank in Cuyahoga County. The formation of 23 additional county land banks in the past 7 years is testimony to the growing need to deal with vacant blighted properties in the state.

 

There are those who believe a strong, all powerful government is the solution for all that ails us. On the other end of the spectrum of those who what no government led or backed solution to anything.  I tend to fall somewhere in the middle. While I don’t much care for a large, intrusive, over-regulating government at any level, there are some problems out there that cannot be solved without governmental, or quasi-governmental involvement. The problem of abandoned property in our urban areas is one of them. Land banks are one of the few options I’ve seen that can clear title so these properties can be put back into service and help our cities get back on their feet.

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