Contributed By Allen Matkins Leck Gamble Mallory & Natsis LLP
Most real estate is held in a single-purpose entity, which may, in turn, be a fund, a joint venture, a limited partnership operating partner (LPOP) or a publicly traded real estate investment trust (REIT).
The ownership structure above the entity level will be dictated by the needs of the particular investment structure for ultimate ownership. That can be tax-driven, or driven by the operational and investment needs and nature of the parties (whether there are foreign investors, for example) and other factors.
The property-level, single-purpose entity will likely be a Delaware limited liability company that is qualified to do business in California.
Transfer of title in California almost invariably happens through a grant deed. Exceptions would include easements or ancillary rights to real property that are often transferred through a quitclaim deed.
Transfer of full ownership (as opposed to certain partial transfers) triggers city or county transfer taxes. These forms and taxes are typically handled in escrow. The County Recorder collects taxes when the new deed is recorded. This also triggers a tax reassessment of the property.
To avoid state and federal tax withholding, transfers require the seller to disclose its domestic (or non-foreign) status by filing a declaration under the Foreign Investment in Real Property Tax Act (FIRPTA) and California Form 503-C.
There are certain California disclosure requirements in connection with a sale, which can be contractually acknowledged and/or waived, unless there is a public policy reason against it. The buyer acknowledges receipt of all seller disclosures in the purchaser agreement, in order to document satisfaction of the obligation. There are additional obligations in condominium, residential and hospitality transactions.
A notarised grant deed is recorded with the County Recorder’s office, typically co-ordinated through the title company and its escrow services. Due to the timing of the actual filing, which in many counties happens the morning after escrow delivers the documents to the recorder, sellers will sometimes sign a “gap indemnity” to allow the title company to issue a title policy (a condition to the closing) prior to the actual recordation. The gap indemnity protects the title company, through a seller indemnification, against any recordation of an alternate grant deed during such "gap."
Buyers want to validate the income-generating potential of the property and the rents being paid, so will review all leases for anything that could affect that income stream, such as termination rights, free rent periods, abatement conditions, etc. They also look for anything that would limit their ability to eventually re-sell the property. Buyers will also want to review any environmental issues, entitlements and easements, and any zoning changes that might affect how the property can be modified, rebuilt or redeveloped. Additionally, the buyer will want to know if the property is in a district subject to additional taxes for neighborhood improvements, and will want to search for any liens against the property. In sum, they want to ensure the title is free and clear.
Depending on the sophistication and capacity of the client, buyers often rely on their lawyers to conduct much of this diligence. Some experienced clients handle their own lease review, generally limiting lawyer review to key non-economic risk issues relating to the leases. Oftentimes, lawyers perform a detailed review of the largest leases, and the buyer reviews the rest.
Due diligence regarding the physical condition of the building and other inspections are handled by consultants or engineers, typically hired by the buyer, though sometimes hired by the law firm. Lawyers may become involved, depending on the nature of the entitlement and environmental conditions affecting the site.
California is a contract law state. Unless restricted by public policy, all duties and obligations can be written into the contract. Unless the agreement contractually imposes specific representations and warranties, they do not otherwise exist, and the impact of breaches may be limited by maximum exposure limits and time periods. However, public policy prevents a contractual arrangement limiting liability resulting from an established fraud.
Typically, the seller will try to limit its representations and warranties to those items a diligent buyer cannot independently verify. Typical entity-level representations and warranties include that the seller has the authority to sell, and that no third party consents are required (unless otherwise disclosed) in order to effectuate the sale. The seller will also represent that it is not bankrupt or insolvent. Operational representations will relate to validating the income-producing potential of the property, for example, that true and correct copies of any contracts and the leases for all tenants have been shared, and that the seller has turned over all notices from any government agencies. Both seller and buyer will represent that they are in compliance with the Order of Foreign Asset Control (OFAC).
Lastly, a seller will represent that it will notify the buyer if any material changes occur to the representations or warranties during escrow. Typically, the parties will negotiate what constitutes a material change. When the buyer waives contingencies, much of the risk of change shifts from the seller to the buyer, and this shift is typically reflected in the contract.
If there is a breach of one or more of the representations and warranties, the buyer will have several options. It can terminate the contract and recoup some of its costs, such as attorney and consulting fees, pursue specific performance, or elect instead to close over the known breach. Sometimes, the parties will agree to toll the closing for a short period to the extent the breach is curable and the delay may allow time to remedy it. If a buyer discovers a breach after closing, it can choose to pursue a claim against the seller, within certain time limits and caps. There is a window of liability, which is negotiated; typically, this is six to 12 months (most often nine). Additionally, damages are capped, typically at 2-3% of the purchase price (the larger the value of the property, the smaller the percentage and vice versa). This is also negotiated.
There are limitations on ownership and sale if a foreign owner owns a controlling interest in the property. There are also separate tax considerations. To avoid those, many foreign investors will limit their investment to a joint venture interest of no more than 49%.
Once on the chain of title, an owner of real property is a potential defendant to subsequent environmental tort claims, regardless of whether or not they were the polluter or discharger. Owners have exposure to liability for pre-existing conditions and events, even after the sale; this exposure needs to be included in the diligence and underwriting. Environmental disclosures are important, and environmental liability insurance should be considered if there are known or suspected conditions. Options and costs need to be identified in the due diligence phase, if not earlier, as they will effect underwriting. There are statutory disclosure requirements relating to known conditions.
Land use lawyers or consultants will review public zoning information, review the public record for any proposed changes, request the seller to provide any written documentation received from government agencies regarding proposed changes, and investigate applicable uses, such as use or height restrictions.
In certain development situations, an owner may enter into a development agreement, which is a contract between the city and developers, or a disposition development agreement. This will establish parameters for what needs to be developed and any waivers of otherwise imposed zoning requirements. The owners' rights under such agreements are often assignable to a purchaser.
The likelihood of a condemnation or taking in connection with most commercial properties is very remote, with two exceptions, both related to transit. If a commercial property is close to a freeway, there may be plans to create or modify entrance and exit ramps or widen streets. This could affect lot size or setback requirements. In the latter case, the owner may be granted relief, with existing improvements being a “permitted nonconforming use.” Nevertheless, the taking can effect what can be rebuilt on the site, due to lot size reductions. If the property is near a transit-oriented development, the municipality could potentially condemn an older property and take possession to allow for disposition to enable construction of more dense redevelopment with greater public benefit.
California counties and most cities levy a transfer tax whenever 50% or more of the interest in a property is sold. It will almost always apply to a fee-title change of any real property. In most jurisdictions, sellers pay the transfer tax, which ranges from 11 to 56 basis points in most California jurisdictions. While an outlier, the City and County of San Francisco impose transfer taxes of 300 basis points, or 3% of the purchase price.
An exception occurs under an IRC 1031 exchange, which allows an investor to defer revenue recognition and avoid capital gains taxes if the proceeds are invested into replacement, like-kind property within 180 days.
If an investor desires to acquire a replacement property before selling its current investment property, it can engage in a reverse exchange. Essentially, this involves lending funds to an “accommodator,” which purchases the property the investor would like to acquire, holding it until the investor can sell its current property and then using the subsequent sale proceeds to pay off the loan. In that case, to avoid a second set of transfer taxes, the investor then provides documentation to the county tax authorities to establish the reverse exchanges in a single transaction, done in two stages.