Contributed By Thompson & Knight LLP
A real estate lawyer must wear many hats because real estate deals in Texas are increasingly complex in terms of subject matter, debt vehicles and capital stacks.
A broad skillset is very important to address fully the potential risks and pitfalls in any real estate transaction, such as leasing issues, regulatory issues, development issues and structuring a deal from the outset to avoid financing issues. Rarely can an attorney focus solely on development or financing work because the two disciplines are interconnected at many levels.
Likewise, it is important to listen to the aspects of a deal and the client requirements to tailor representation to meet the needs of the client while still adding value to the representation.
Volatility is a trend in the real estate market. Real estate investment is a function derived from many inputs, such as the impact of tax laws and the availability of debt and equity. As debt and equity stacks change from internal (eg, real estate demand and natural disasters) and external (eg, interest rates, stock market returns, bond rates and lending regulations) forces, the velocity of real estate investment and real estate finance changes as well. These forces are ever-changing, which leads to greater volatility in the local marketplace, but, due to strong and diversified underlying economies in the major cities, real estate volatility has seen shorter peaks and shallower valleys in Texas.
Of particular note, the most pressing financing trend appears to be the replacement of LIBOR as a lending index rate. As most US interim loans bear interest based on a LIBOR variable interest rate plus a spread, the announcement that LIBOR will be phased out at the end of 2021 has caused concern from both borrowers and lenders – both want to document certainty with a replacement index rate. As of now, there is no market-accepted replacement for LIBOR and, as a result, replacement rate provisions vary greatly.
The Federal Tax Cuts and Jobs Act is complex legislation that concerns many tax aspects for entities and individuals. While each situation is different, the Act generally decreases the overall tax burden for many who invest in finance real estate. Thus, the Act is generally seen as a positive change, but regulations are still being developed that will fine-tune its effects.
The most common commercial property ownership vehicles are single-asset limited partnerships (typically with a limited liability company as the general partner) and limited liability companies.
Transferring property in Texas is relatively simple. Other than licensing transfer requirements for very specific product types (eg, senior housing), there are no special Texas laws that apply to transfers of real estate.
Real estate title to commercial properties is generally transferred through a special warranty deed (ie, the grantor is only liable for title defects caused by the grantor). Most residential property and foreclosure transfers utilize a general warranty deed (ie, the grantor is liable for all title defects). In cases where title is uncertain, property is transferred with a quitclaim deed (ie, the grantor is not liable for any title defect). The deed is recorded in the county in which the property is located. Many larger counties accept electronic recording. The title company closing the transaction typically records the deed, although anyone can record an original deed at the recorder’s office.
Depending on the size of the buyer, most buyers typically hire third-party consultants to perform non-financial commercial property due diligence. These third-party consultants include an environmental consultant, property condition consultant and other specialty consultants depending on the property (eg, elevator consultant, roof consultant, etc). Since most commercial property is transferred in 'as-is' condition with basic representations contained (and negotiated) in the sale agreement, most buyers will engage in an exhaustive property evaluation during their inspection period as they believe that a good property inspection is more beneficial than an exhaustive list of representations and a potential lawsuit.
The lawyers are typically engaged to review title, survey, and zoning materials for a property and are sometimes engaged for environmental report review and/or lease reviews.
Representations and warranties for commercial property are typically not expansive and cover topics such as seller’s authority, Office of Foreign Assets Control (OFAC), occupancy, rent rolls, no known environmental issues, no known defects, no litigation and no unpaid debts; essentially those representations that a buyer would want to know prior to engaging third-party consultants to review a property. There are very few statutory representations, although it is important to state in the purchase and sale agreement that the seller has not made any other representations except as set forth in the purchase and sale agreement.
The remedies for a representation breach are set forth in the purchase and sale agreement, and are typically: an ability to terminate the contract; return of the earnest money; and, sometimes, reimbursement of third-party costs (which are usually capped at an amount close to the earnest money or the due diligence costs). It is rare to have an uncapped cost recovery remedy against a seller. Buyers usually also have the option to waive any known breach and proceed to closing, but such act will also waive a claim against the seller for the breach.
Many purchase and sale agreements will also have purchaser representations and warranties on a more basic level, such as purchaser’s authority and OFAC.
Finally, most purchase and sale agreements will limit the duration of all representations to three to 12 months following closing and limit the time period in which a representation breach claim can be made.
An understanding of the US Tax Code and the applicability to the specific foreign investor will best serve an evaluation of Texas real estate. In addition to federal taxes, foreign owners of real property in Texas will be subject to state franchise taxes.
With few exceptions, each owner and operator of a polluted property is liable for the cost to clean up the property, even if that party did not cause the pollution. But the innocent party will have a claim against the responsible party for the cost to clean up the property. However, most commercial property in Texas is owned by single-asset entities that are dissolved soon after a property sale, so these claims are quite complex and costly to litigate. The typical risk allocation between buyers/sellers in a purchase and sale agreement is that the buyer takes the risk that the property is contaminated (unless and to the extent the seller breached an environmental representation in the purchase and sale agreement). It is common in a purchase and sale agreement for the buyer to waive any environmental claims against the seller.
Most parties obtain a third-party zoning report to ascertain zoning compliance (which report is typically reviewed by an attorney). Additionally, most zoning ordinances are available online. Zoning endorsements to a title insurance policy are not available in Texas.
It is possible to enter into a development agreement with relevant governmental authorities concerning property development – typically concerning infrastructure improvements, property restrictions, or annexation into a governmental jurisdiction. In certain situations, governmental entities can also offer tax abatements and other incentives through development agreements. Texas has a strong sovereign immunity law, which makes enforcement of these agreements against a governmental authority cumbersome, but most governmental authorities adhere to their agreements because of potential adverse credit ratings associated with a governmental authority breaching significant agreements.
Taking property by condemnation is possible in Texas (including fairly broad condemnation rights for utility providers). The applicable governmental authority must make a written offer of purchase to the landowner prior to filing a formal court condemnation action. The governmental authority must pay 'market value' for the property, which is the most contested aspect of a condemnation. Typically, the governmental authority and a landowner negotiate a sale transaction prior to a formal court action. Generally, this is not a quick process and most landowners are not surprised by a possible condemnation.
Only usual and customary deed filing and recording fees are required to be paid in connection with the recording of a deed in the county records (ie, Texas does not have a 'transfer tax', 'intangible recording tax', or comparable fee or charge). Texas does not have a transfer tax regarding entity ownership transfers.
Texas generally does not have specific rules regarding foreign investors with respect to acquiring real estate, other than the ownership entity must be registered to do business in Texas. Property ownership is deemed doing business in Texas and requires filing of franchise tax reports, which also requires, in most cases, payment of franchise taxes that vary based on the type of entity and market segment.
Most commercial property acquisitions are financed on a project-by-project basis through asset-based financing consisting of a single-asset owner/borrower granting a deed of trust lien/security interest in all of its property to serve as collateral for the loan.
Portfolio loans are available, but such loans are typically cross-defaulted, cross-collateralized and contain financial covenants applicable to the portfolio as a whole.
A relatively small number of property acquisitions are financed by seller financing (ie, the seller acts as the lender to finance the purchase price).
Generally, any type of security interest that can be created under the Uniform Commercial Code that typically covers any tangible and intangible property right can be entered into by a commercial real estate investor who is borrowing funds to acquire or develop real estate.
Making a loan, taking a deed of trust lien and foreclosing a deed of trust lien are not activities that constitute transacting business in Texas requiring a foreign lender to register in Texas, although owning a property after foreclosure would be considered transacting business that requires registration. The foregoing assumes the lender does not maintain offices or have employees in Texas. Despite the fact that a lender may not be deemed to be transacting business requiring registration in Texas, it may be considered doing business for the purposes of requirements related to the payment of Texas franchise taxes.
Only usual and customary security instrument filing and recording fees are required to be paid in connection with the recording of a deed in the county records (ie, Texas does not have a mortgage tax or comparable fee or charge).
Texas does not have specific requirements prior to granting a security interest.
Non-judicial foreclosures are conducted under a power of sale conferred by a deed of trust. The sale must be a public sale at auction held generally on the first Tuesday of a month. Notice of the sale must be posted, filed and mailed 21 days before the sale date in accordance with statutory procedures. The notice of sale must state the county and location in which the sale will be conducted (typically designated by the county's commissioner's court) and the time of the sale. The sale must begin within three hours of the time designated in the notice. No formal notice is required not to foreclose on a particular date – the trustee simply does not conduct the sale. If a sale is not conducted in a particular month, the posting and notice procedure must be repeated for any future foreclosure.
It is possible to foreclose on a property non-judicially through the court system, but those actions are extremely rare.
A lender must perfect its lien/security interest to have priority over subsequently perfected private party security interests. A lien/security interest will not have priority over a private party security interest that has already been perfected. Prior to any foreclosure, a lender typically obtains lien and security interest search reports to determine if other creditors exist.
Generally, parties can subordinate debt between themselves.
Generally, holding a lien on a property will not subject an independent third-party lender to environmental liability unless the lender owns or operates the property.
A properly created and perfected security interest will afford the lender secured creditor status in a subsequent borrower bankruptcy and will be superior to the interests of unsecured creditors in such bankruptcy. The specifics of such treatment will be subject to the bankruptcy plan.
Municipalities typically adopt ordinance construction codes (such as building codes and fire codes). These codes do not apply to the areas outside of a general law municipality’s boundaries and may not apply outside the boundaries of a home rule municipality. Usually construction cannot occur until an application with detailed plans and specifications has been approved as consistent with applicable codes and a permit is issued.
Counties may engage in limited regulation outside of a municipality’s boundaries. They may adopt (but are not required to have) a fire code that all non-residential construction must meet before a permit to proceed is issued. For residential construction, counties may choose to require that homes be built in conformance with the International Residential Code. Compliance with that code is not determined by the county. Instead, a builder must hire a professional to inspect as construction occurs to determine compliance. The county must receive the results of the inspections.
Municipalities are authorized to adopt zoning ordinances that specify, among other controls, what types of uses are allowed, the size and number of structures, and the required parking. Almost all municipalities in Texas have adopted zoning ordinances. A notable exception is the City of Houston. The city does, however, have a development code that governs how property can be subdivided and acts somewhat like a zoning ordinance and also aggressively enforces private deed restrictions.
Counties, with a few very limited exceptions, have no authority to adopt zoning ordinances.
Municipalities and counties have the authority to require that plats be submitted and approved to subdivide land. Typically, the municipality or county will require dedication of land for streets and utilities to obtain approval. Who approves plats of property in the extraterritorial jurisdiction of a municipality (limited areas adjacent to the city limits) depends on what agreement, if any, has been worked out between a municipality and a county.
Municipalities and counties generally have ordinances regulating development in flood plains, meaning that – whether or not property is subject to the jurisdiction of a municipality – local approval will be necessary before development can occur in the flood plain.
If the zoning on a tract does not need to be amended to allow a project to proceed then it is only necessary to obtain a building permit and possibly pay impact fees.
Obtaining a change to a municipal zoning ordinance is typically a three-step process, initiated with an application that is reviewed by staff, who then develop a report that is presented to a planning and zoning commission. A public hearing is held by the zoning commission and at the conclusion a vote is taken on whether to recommend the city council approve or deny. The city council, after another public hearing, acts on the recommendation and approves, approves with conditions or denies.
In some cases, a project may require exceptions or variances. In that case, a request is made to the Zoning Board of Adjustment. These cases are heard by five members in a trial-type proceeding that has limited public involvement. A favorable vote of four of the five board members is necessary to obtain the exception or variance.
Platting in a municipality and a county is typically a two-step process. An application is filed, reviewed by staff, a recommendation provided, and then approved or denied by: (i) a planning commission or a city council (if the planning commission has not been given final authority) for property subject to the jurisdiction of a municipality; or (ii) by the commissioners' court (the governing body of a county) for property not subject to the jurisdiction of a municipality.
If a rezoning request is first heard by a zoning commission, the applicant, if the recommendation is denial, and any one opposed, if the recommendation is approval, can appeal to the city council. If there is no opposition and the recommendation is approval the matter is automatically presented to the city council for final action. If more than 20% of the owners within 200 feet of the rezoning request oppose rezoning or the zoning commission recommends denial, city council approval requires a three-quarters vote.
A denial of a rezoning request by a city council can be challenged by filing a lawsuit in a district court, which is a trial court in Texas. Challenges can be based on procedural irregularity or the substantive decision. As substantive decisions are considered a legislative act, these lawsuits can be difficult to win.
Denial of a variance or special exception can also be judicially challenged. Such appeals are to a district court and have to be made within ten days of the decision by the Board of Adjustment. Typically, these challenges are reviewed based on the record established in front of the Board of Adjustment.
Denials of plats can be judicially challenged. Approval of a plat is considered a ministerial action. If the plat conditions specified by ordinance or statute are met, yet approval has been denied, a court will overturn the denial.
A practice commonly employed for large developments needing a rezoning is a 'planned development district'. A PD, as they are known, is a zoning ordinance within the general zoning ordinance that is tailored to a particular project. They usually involve a situation in which a municipality is willing to remove or substantially modify land use restrictions in exchange for certainty about what will be constructed. There is not a practice in Texas of transferring development rights from one property owner to another.
Many municipalities, but not counties, impose impact fees memorialized in written agreements. These agreements are intended to impose on the developer the marginal costs of providing infrastructure (roads, water, sewer, parks and other city services) for the development. It is also quite common for developers to enter agreements specifying what infrastructure they will construct in connection with a development.
The platting process also involves specifying on the plat land that will be dedicated for infrastructure purposes. Without a plat, utilities will not provide service to a development.
For property that is being added to a municipality, it is common for the landowner and the municipality to enter into a development agreement, which provides for the timing of the annexation, the uses that will be allowed when the land becomes part of the municipality, and the sequencing of services.
The primary mechanism used by municipalities for ensuring enforcement is the building permit process and platting approval. Applications are reviewed not only for compliance with the construction codes, but with the zoning ordinance. Plats are reviewed for compliance with subdivision ordinances. If a project does not satisfy zoning requirements, no building permit will be issued, and if subdivision requirements are not met a plat will not be approved.
If violations occur after construction, a municipality will typically issue a notice of violation, which is a warning to correct a non-compliant situation. If not corrected, a municipality will issue criminal citations for violating the law. If compliance is still not achieved, the municipality can go to district court to enjoin illegal activity.
Counties’ enforcement authority is limited to plat approval and seeking monetary penalties or injunctive relief for non-compliance where a fire code or a residential building code has been adopted.
Generally, property ownership is held in a limited partnership or limited liability company. Most of these entities are formed in Texas or Delaware.
Limited partnerships and limited liability companies offer similar limited liability for the owners (other than the general partner of a limited partnership) and are otherwise very similar. Most sponsors that own a property through a limited partnership form a special general partner with limited liability as well, which requires additional filing fees and franchise tax reports; both are subject to franchise taxes, with an extra exemption being available to a limited partnership.
In a limited circumstance in which 90% of a limited partnership’s income for a given year is derived from 'passive' income (property rents are not passive income, but property sales proceeds are passive income), a limited partnership can be exempt from Texas franchise taxes for that year. Generally, this situation could occur with a sale of the property very early in the tax year, but this exemption has proven difficult for property owners to achieve. This exemption does not exist for limited liability companies. An entity can convert from a limited liability company to a limited partnership; however, in order to take advantage of the franchise tax exemption, the conversation must take place at least one year in advance.
Texas has very basic statutory governance provisions, which will apply to each entity type unless the governing documents provide alternate provisions. Most real estate investors do not utilize the statutory governance provisions and provide their own governance provisions, which can vary widely depending on the complexity of the deal and the parties involved.
The two most common arrangements used in Texas for a temporary use of real estate are leases and licenses. The latter are generally for much shorter terms and provide the occupant with fewer rights than leases.
The most common types of commercial leases in Texas are ground, office, industrial and retail. With each type of lease, the tenant is expected to pay, normally on a monthly basis, a predetermined amount of 'base rent' plus a certain amount for taxes, insurance and other expenses associated with the property.
Ground leases typically have longer lease terms (20-plus years) and generally allow the tenant to construct and maintain the improvements as if owned by the tenant. During the term of a ground lease, the tenant should expect to be responsible for all taxes, insurance, maintenance and other expenses incurred for the leased property. Upon the termination of the ground lease, the improvements are typically either removed by the tenant or conveyed to the landlord with no additional compensation.
Industrial leases cover general warehouse and industrial uses, with lease terms typically ranging from five to ten years. Industrial leases in Texas are normally 'triple net', meaning that tenants pay their proportionate share of taxes, insurance, maintenance and other expenses incurred by a landlord in connection with the property, with limited exclusions for capital repairs and replacements to the structure of the building. Industrial tenants should expect to be responsible for maintaining everything within their own premises and those systems exclusively serving their premises – including heating, ventilation and air-conditioning (HVAC) – with the landlord only responsible for maintaining the structural portions of the building, common building systems and common areas of the property, with the maintenance costs passed through to the tenants.
Office leases typically have a lease term of five years, although it is not uncommon for larger office leases to have terms of up to ten years. The expense reimbursements for office leases vary, depending on what is customary for the specific geographic area. The basic categories for expense reimbursements in office leases are:
In office leases, tenants are generally responsible for maintaining the interior, non-structural portions of their premises, with the landlord responsible for maintaining the building’s structure, common areas and those systems serving the building in general (building HVAC, elevators, etc), with the maintenance costs passed through to the tenants (depending on the reimbursement structure).
Retail leases cover general retail uses ranging from food service to toy store to nail salon, with lease terms typically ranging from five to ten years. Retail leases in Texas are normally triple net (similar to industrial leases as discussed above). Some landlords will take a percentage of gross receipts from the premises as rent. The rate is usually in the 3% to 5% range and usually only applies to the amount by which gross receipts exceed a certain threshold. Retail tenants should expect to be responsible for maintaining everything within their own premises, the store front and those systems exclusively serving their premises (including HVAC), with the landlord only responsible for maintaining the structural portions of the building, common building systems and common areas of the property, with the maintenance costs passed through to the tenants. Retail leases usually have more provisions regarding the 'tenant mix' of the retail center. Retail tenants may want remedies such as rent abatement or termination rights if a certain percentage of the center is vacant or if a particular anchor tenant leaves. They may also want restrictions on competing business leasing space in the same center. Visibility and signage are also more important in a retail setting than in industrial or office projects.
Rents and length of lease terms are generally not regulated in Texas. However, a lease for real estate for a term of longer than one year is not enforceable unless it is in a signed writing.
See above, 6.2 Types of Commercial Leases.
Texas commercial leases almost always provide for annual escalations of base rent.
Increases in base rent are negotiated by the parties prior to lease execution. Office lease rent most often increases by a set amount per square foot per year (typically USD0.25 to USD0.75); industrial lease rent typically increases at the rate of 2.5% or 3% per year; and retail leases normally provide for annual increases ranging from USD0.50 to USD1.00. Base rent increases under ground leases are less standard and it is not uncommon to have increases only occur every five or ten years, based on a certain percentage or the consumer price index.
Texas does not impose a tax directly on rent. However, Texas does impose a franchise tax (often referred to as a 'margin tax') that will apply to most commercial landlords. Landlords typically expect to include the margin tax as part of the taxes and expenses to be reimbursed by tenants, but this can be negotiated by the parties.
Upon the execution of a Texas commercial lease, tenants should expect to pay any security deposit and the first month’s gross rent payable under the lease. In addition, if the cost of the tenant’s improvements to be performed by the landlord will exceed the construction allowance provided by the landlord, most landlords will require tenants to pay the excess prior to commencing construction.
Common area maintenance is customarily performed by the landlord, with the costs incurred passed through to tenants on a pro-rata basis.
In industrial leases, landlords typically provide electricity and, if applicable, gas service connections to the premise. Tenants are responsible for contracting directly with the utility provider for these and any other desired services. Unless it is a single-tenant facility, water and sewer service are most often jointly metered for the entire building, with the cost shared by the tenants on a pro-rata basis.
In office leases, landlords typically provide some base level of electricity, water and sewer service, with the cost passed through as additional rent. Tenants remain responsible for contracting for their own telecommunication services.
In retail leases, landlords typically retain broad rights to control how utilities are provided and paid for. Typically, a landlord will have the option to provide utilities and charge the tenant directly or to require the tenant to contract directly for the utilities. Tenants remain responsible for contracting for their own telecommunication services.
In ground leases, the tenant is normally solely responsible for contracting directly for its desired utilities.
Landlords will typically maintain property insurance on the building, which normally covers most improvements, but may exclude tenant-specific alterations or above-standard improvements made by a tenant. The cost of the landlord’s insurance is passed through to tenants as additional rent. However, for ground leases, the tenant will normally be solely responsible for its own insurance. Coverage will depend on the actual policy, but landlords are typically expected to cover those perils customarily covered by standard causes of loss – special form property insurance policy in an amount equal to the full replacement value of the building.
Texas commercial leases normally restrict the tenant’s use to specific permitted uses, such as general office, general warehouse and distribution, or a specific type of retail use. Local zoning ordinances and restrictions filed of public record may further restrict the use of the premises.
Texas commercial leases almost always require the tenant to obtain the landlord’s prior approval for any alterations or improvements. Small, purely cosmetic alterations that will have no effect on the remaining portions of the building are often exempted from this requirement. Landlords will typically require approval of plans, contractors and insurance coverages maintained by the contractors, and landlords often require a construction management fee based on the cost of the improvements. If alterations affect the systems or structure of the building, the landlord will want the plans to be reviewed by the building’s architect and engineer at the tenant’s cost. Landlords normally reserve the right to require tenant alterations to be removed and tenants should request that the landlord provide notice as to which alterations may be required to be removed at the time of approval of the plans.
The Texas Property Code has provisions covering leases in general (Chapter 91), residential tenancies (Chapter 92) and commercial tenancies (Chapter 93). The detailed requirements of these statutes are beyond the scope of this summary discussion.
Bankruptcy law will govern the landlord’s and tenant’s respective rights and obligations with respect to a tenant’s insolvency, despite provisions in a lease to the contrary. At the most basic level, a tenant in bankruptcy will have a period to assume or reject the lease. The landlord’s claims for damages will be calculated pursuant to the Bankruptcy Code.
The most common forms of security in Texas commercial leases are (i) a security deposit, (ii) a guaranty by an entity or individual affiliated with the tenant, and (iii) a letter of credit.
Absent contractual provisions to the contrary, a holdover tenant will be treated as a month-to-month tenancy, on the same terms in effect upon the termination of the lease, which may be terminated by either party upon 30 days' notice to the other. Most Texas commercial leases will provide for increased rent during any holdover equal to 150% of the rent in effect upon termination. In addition to the increased rent, landlords should require tenants to be responsible for any damages the landlord may suffer as a result of the holdover and make it clear that any holdover does not serve to extend the lease term or create a month-to-month tenancy.
Texas law generally recognises the right of landlords and tenants to negotiate the terms by which each party would be entitled to terminate the lease. Casualty and condemnation are the primary events triggering the rights of the landlord or tenant to terminate a lease and the conditions giving rise to a termination right should be detailed in the lease. In addition, landlords normally have the right to terminate the lease (or the tenant’s right of possession) as a result of an event of default by a tenant, but tenants should not expect the reciprocal right to terminate as a result of a landlord default.
If a commercial tenant is in default for failure to pay rent (absent lease terms to the contrary), Texas law permits the landlord to evict the tenant by changing the locks to the premises and posting a statutory notice. Texas law also provides for a streamlined judicial process for evicting a tenant that is in default, which is commonly referred to as a 'forcible detainer'. A forcible detainer action, if successful, should normally be expected to take approximately 30 to 40 days.
A governmental action, such as a condemnation, can lead to a termination of a lease, but Texas commercial leases are not generally terminated by governmental authorities. If a lease is terminated as a result of a condemnation, landlords typically expect to receive the entire condemnation proceeds, including any value for the leasehold interest, but tenants are often allowed to pursue their own claim against the condemning authority to the extent it does not reduce the landlord’s award, such as for the tenant’s moving expenses. If the lease is actually a sublease (pursuant to an underlying prime lease or ground lease) then the termination of the underlying superior lease will terminate the sublease, absent an agreement to the contrary.
The most common structures for construction contracts involve (i) a stipulated sum or fixed-price contract and (ii) a cost plus a percentage fee or fixed-fee, usually with a guaranteed maximum price (GMP). Open-ended cost plus contracts without a GMP, including unit price contracts, are not that common. Construction manager at risk (CMAR) contracts involve hiring a contractor early in the process who will provide pre-construction services, including expertise with regard to constructability, budgeting and scheduling. They also usually estimate an initial GMP, but an amendment establishes the final GMP.
Responsibility for the design and construction of a project depends on whether the project is a traditional design-bid-build project or a design-build project, or some combination of the two. While design-build projects are becoming more common, the design-bid-build model is dominant.
Prior to the owner contracting with an architect or engineer for design of the project, the owner often engages one or more design professionals with respect to advice on general site development and utility issues. The design professional team can consist of the architect and various consultants, such as landscape architects, interior designers, lighting and acoustical, Leadership in Energy and Environmental Design consultants, code consultants, structural engineers, civil engineers and mechanical, electrical and plumbing engineers, among other consultants. The owner must decide which of the consultants it will retain and which of the consultants will be retained by the architect.
Additionally, on standard commercial projects, the contractor often retains the mechanical subcontractor to provide the mechanical design.
Owners and contractors aim to manage risk on construction projects by incorporating favorable language into the contract to shift risks to the other party. This occurs through indemnification, insurance, limitation of liability, waivers (including mutual waivers of consequential damages), warranties and contingency provisions. Since indemnification provisions are generally subject to statutory limitations prohibiting the indemnitor from indemnifying the indemnitee against the indemnitee’s own negligence, they are based on comparative fault. Contractors expressly warrant that the work will be free from defects for a specified period of time following substantial completion of the project, generally 12 months, and attempt to exclude the implied warranties of habitability, sound workmanship and proper construction. The statute of repose in Texas is ten years with respect to defective design and defective construction. Contingency provisions benefit owners and contractors by permitting the contractor to use the contingency (included in the cost of the work and GMP) to cover certain unanticipated costs.
Most contracts contain 'time is of the essence' provisions. Schedules are agreed upon subject to extension for certain specified events beyond the control of the contractor, including adverse weather and certain acts or omissions of the owner and the owner’s agents. If, however, the delay is not the fault of the contractor, the contractor may be entitled to an extension of the schedule and additional compensation for increased costs. Owners attempt to limit exposure for delay damages and only provide an extension of time. If the contractor is responsible for failing to achieve milestone/completion dates in a timely fashion, the contractor is usually subject to liquidated damages, which accrue on a daily basis until the milestone is achieved. In such circumstance, the contractor also may be required to recapture the schedule at the contractor’s expense. Owners also may have the contractual right to require the contractor to accelerate the work even when the contractor is not at fault, at the expense of the owner, to try to bring the project back on schedule.
While owners should check a contractor’s references, including bank references, and select contractors with favorable reputations, owners often seek to obtain additional forms of security to attempt to guarantee the contractor’s timely performance of the project on larger projects. The most common are performance and payment bonds, followed by parent guarantees. Lenders will require dual obligee riders to be a beneficiary of such bonds. Another form of security recently introduced often provided to protect against subcontractor default is subguard insurance, which may obviate the need for bonds from the contractor under certain circumstances. Letters of credit and escrow account arrangements to provide the owner with security are less likely to be used for this purpose. Finally, incentive clauses are often used to reward timely completion.
In Texas, contractors, subcontractors, suppliers and design professionals are entitled to file statutory mechanic’s liens against the owner’s property in the event of non-payment. Most states have adopted mechanic’s lien statutes (similar to the Texas Property Code) outlining the procedure for filing, foreclosing and releasing liens. In Texas and many other states, the owner can file a bond to indemnify against a lien or equivalent bond, which requires the lien claimant to release its lien and pursue its claim against the bond. Construction lenders may require these parties to subordinate their liens to the lender’s liens expressly, although if the deed of trust is recorded prior to the commencement of construction, the lender’s lien should have priority.
The municipal building code or applicable regulations govern the issuance of a certificate of occupancy or its equivalent. In Houston, once the owner/contractor obtains final inspections approving the foundation, structural elements, mechanical, electrical and plumbing, and other specified building systems, the fire department makes a final inspection. If approved by the fire department, a certificate of occupancy may be issued. This practice is similar throughout the United States. Additionally, in Houston and other jurisdictions, it is possible to obtain a temporary certificate of occupancy permitting occupancy of the building by the owner-occupier and tenants while the contractor continues to work on punch-list items and other non-material items or other portions of the building.
Generally, the sale of US real estate results in long-term capital gain (or loss) for federal tax purposes, although part of such gain may be taxed at higher rates due to recapture of prior depreciation deductions. Typically, for individual taxpayers, the bulk of such gain is taxed at the long-term capital gain rate of 20%, although portions may be taxed at 25% or even 37%. Corporate taxpayers pay a single rate at 21%. The seller is responsible for paying the applicable income tax, although the tax may be deferred using a 1031 exchange or qualified opportunity zone investment structure. If the seller is a business entity, the gain may also be subject to Texas franchise tax. However, under certain circumstances, a properly structured limited partnership may be able to avoid the Texas franchise tax resulting from gain on the sale of real estate. In addition, other methods may be available to restructure sales in order for any gain to be sourced outside of Texas.
Texas does not have a real estate transfer tax. However, to the extent personal property is involved, such property generally triggers Texas sales tax. Certain exemptions from sales tax, however, are available for sales of an entire operating business or transactions that can be restructured as sales of intangibles, including interests in business entities.
Texas imposes a franchise tax on the taxable margin (which includes gross rental income) of all business entities doing business in Texas. Owning real estate in Texas creates sufficient nexus to subject a foreign business entity to Texas tax jurisdiction. City-level taxes on real estate operations in Texas are typically not encountered.
Rental income of foreign investors in US real property is typically subject to a 30% US withholding tax, although this tax may be reduced under an applicable income tax treaty. In addition, a foreign person’s sale of US real estate generally is subject to US income tax and typically results in a 15% withholding tax on the gross sales proceeds under the US Foreign Investment in Real Property Tax Act (FIRPTA) provisions, although the rate of withholding may be reduced by following certain Internal Revenue Service procedures. A common structure to avoid these taxes is to impose a US corporation (either a state law corporation or a limited liability company that 'checks the box' to be taxed as a corporation) between the foreign owner and the property. This way, the corporate 'blocker' bears the US taxes and files the US tax returns instead of imposing these concerns on the foreign owner. In addition, other US estate tax and FIRPTA advantages may be gained if a second foreign corporation is inserted to own the stock of the US blocker corporation. In some situations, reduced rates of US tax may be realized by using a real estate investment trust (REIT) as the blocker instead of a normal corporation. REITs, though, tend to have higher formation and operation costs, and greater tax-compliance burdens, so they may not be ideal for every situation.
Improved real estate investments generate depreciation deductions and, under the recent US tax act, certain aspects of a real estate acquisition may be eligible for immediate expensing deductions. In addition, interest on debt incurred to purchase real estate generally is deductible, subject to certain recently enacted limitations, although a real estate trade or business is typically eligible to elect out of such limitations. For individuals, gain on the sale of real estate is typically eligible for the reduced long-term capital gain rate of 20% (subject to the previously noted exceptions). Also, certain types of real estate (such as historic buildings and low-income housing developments) may be eligible for additional state and federal tax credits, depending on the specific facts. Moreover, real estate investors in disregarded or pass-through entities may benefit from a 20% deduction applicable to qualified business income, including income from a real estate trade or business, under the recent US tax act. Finally, real estate investments generally qualify under the new qualified opportunity zone deferral regime.
The following are the key changes in the tax reform legislation that impact real estate:
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