1031 Tax Deferred Exchange and Like-Kind Exchange Agreements

1031 Tax Deferred Exchange and Like-Kind Exchange Agreements

2.1 Taxation Upon Disposition of Real Property. Disposition of a capital asset used for business or investment purposes [IRC § 1221] ordinarily triggers taxes per IRC § 1001. At the federal level, long-term capital gains are taxed at a lower rate than other income, and if you have a loss on the property, you can deduct it. You may have, however, ordinary income as a result of expensing or depreciation. Property held for one year or less is treated as a short-term holding period. Any short-term gain that is not offset by losses or long-term capital gain is taxed at ordinary income tax rates. Property held for more than one year is considered “long-term” property. This gain (after all gains and losses are netted together) will generally be treated at the far more favorable long-term capital gains tax rate, 15% above $37,950 annual income and 20% above $418,401 annual income.

2.1.1 Depreciation and Recapture. Business and investment real property qualifies as IRC §1250 Depreciable Real Property. The IRS permits amortizing the depreciation of improvements of varying depreciation lives. The 2017 Tax Cuts and Jobs Act retains the current Modified Accelerated Cost Recovery System (MACRS) recovery periods of 39 years for nonresidential property and 27.5 years for residential rental property. The 2017 Tax Cuts and Jobs Act simplified treatment for (also qualified leasehold improvements with a general 15-year recovery period.

If you realize a capital gain when you dispose of investment or commercial real estate, you must report all or part of the gain as “recaptured” income to reflect the amount of any depreciation claimed on the asset. Depreciation taken during ownership must be recaptured when property is sold. Depreciation recapture is taxed at twenty-five percent (25%) regardless of one’s tax bracket. The amount that must be recaptured is equal to the lesser of [i] the total depreciation allowable on the asset, or [ii] the total gain realized.

2.2 IRC § 1031 Non-Recognition of Taxes. IRC § 1031 provides an exception to defer the capital gain and recaptured depreciation taxes when real property [the 2017 Tax Cuts and Jobs Act eliminated deferral of taxes for personal property] held for use in a business or for investment is sold and replaced within 180 calendar days of the first closing if the proceeds from the first closing are reinvested in similar ‘like-kind’ property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC §1031 is tax-deferred, but it is not tax-free.

IRC §1031 regulating the exchange of property held for productive use or investment reads:

(a) Nonrecognition of gain or loss from exchanges solely in kind. (1) In general. –– No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

2.2.1 Significance of IRC §1031 for the Taxpayer. The key benefit of a 1031 exchange, and why it is the preferred choice for astute real estate investors to use upon disposing of real estate, is that the taxpayer has much greater investment equity retained from the relinquished/sold property to reinvest in the replacement/purchase property. In other words, the funds that would otherwise have been paid to the IRS can instead be reinvested in replacement property.

2.2.2 1031 Exchange Types

2.2.2.1 Simultaneous 1031 exchange. Permits the simultaneous sale of relinquished property and purchase of replacement property.

2.2.2.2 Delayed exchange. A non-simultaneous 1031 exchange of properties must be completed within 180 days of the closing of the relinquished property. Acceptance by the IRS of delayed exchanges resulted from the famous Starker 1976 case. Today, most exchanges are conducted as “deferred exchanges,” where the relinquished property is sold to one party and the replacement property is subsequently purchased from another party. This requires that the taxpayer employ the services of a qualified intermediary, who must be disinterested in the transaction (this normally disqualifies the taxpayer’s attorney, accountant or real estate agent). The qualified intermediary prepares certain documentation necessary for the exchange transaction and holds the exchange proceeds from the time the relinquished property is sold until a replacement property is purchased.

2.2.2.3 Reverse exchange. In a reverse exchange, the taxpayer buys replacement property before disposing the owned property. The taxpayer may want to improve the replacement property with the sales proceeds from selling the relinquished property, or the replacement property may no longer be available for purchase.

2.2.2.3.1 Example. In a reverse exchange, the taxpayer, through an intermediary and an Exchange Accommodation Titleholder (“EAT”), acquires the replacement property before selling the relinquished property. The taxpayer must have the financial resources available to fund the purchase of the replacement property prior to the sale of the relinquished property. In a “build to suit” or “construction” exchange, the taxpayer sells property and, again using an EAT, acquires replacement property on which he will construct improvements. This type of exchange allows the taxpayer to use the exchange funds to not only buy the property but also to construct improvements. The exchange still must be completed with the 180-day period noted above. In both reverse exchanges and construction exchanges, the intermediary, using an EAT, takes title to the replacement property and eventually conveys it to the taxpayer. In a deferred exchange, the intermediary does not need to take title to either the relinquished or replacement property.

2.3 1031 Exchange Requirements. To properly conduct an exchange, the Code and IRS regulations must be strictly followed.

2.3.1 Timing Rules. The most important requirements are the timing rules. Once the relinquished property is sold, the taxpayer must identify potential replacement property within 45 days and acquire the replacement property within 180 days. Accordingly, a prudent strategy for the real estate investor is to place the replacement property or properties [see below] under contract as soon as possible within the 45-day identification period, with closing scheduled on or before the 180-day acquisition period expires. Taxpayers affected by a Presidentially-declared disaster or who are serving in a combat zone are entitled to an extension of these two deadlines. Otherwise, once the closing on your relinquished property has occurred, you cannot qualify for a 1031 exchange. So a 1031 exchange must be set up before the closing of the relinquished property. The directory is full of Accommodators/Qualified Intermediaries.

2.3.2 Like-Kind Exchange. Another requirement of a 1031 exchange is that the relinquished and replacement properties be “like kind.” This was important if someone is exchanging personal property (e.g., yacht, art, airplane). With real estate, however, this requirement is easy to satisfy, since the Code treats most real property interests as like kind with other real property. Thus, residential condominium units can be exchanged for a shopping center, and an apartment building for farmland.

2.3.3 Identifying the Replacement Property or Properties. The two most common identification methods are:

2.3.3.1 Three-Property Rule. Up to three properties may be identified without regard to the fair market value. You may acquire any number of them. one, two, or all three. If acquiring just one property, good practice is to identify two additional properties for safety. You may substitute identified properties via documentation of revocation and replaced identification to the Qualified Intermediary if in the 45-day time period.

2.3.3.2 200% Rule. The 200% rule is used if the taxpayer wants to acquire more than three properties. Any number of properties may be identified so long as their combined fair market value does not exceed 200% of the fair market value of all relinquished property.

2.3.3.3 The 95% Rule. Additionally, if the taxpayer exceeds both the Three-Property Rule and the 200% rule, a valid 1031 exchange if both the Three-Property and 200% Rules are exceeded is to acquire at least 95% in value of all identified properties.

2.3.4 Avoiding Taxable Boot. To fully defer capital gain, there are three rules.

2.3.4.1 The taxpayer should acquire replacement property of equal or greater value than the relinquished property.

2.3.4.2 The taxpayer should not take any cash out of the transaction; all the equity from the relinquished property should be invested in the replacement property. Failure to follow these two rules can result in all or part of the gain being taxed as “boot.”

2.3.4.3 The taxpayer who sells the relinquished property must be the same taxpayer who purchases the replacement property. So a taxpayer holding title to the relinquished property in his own name cannot take title to the replacement property in the name of his corporation.

2.3.5 Holding Period for Relinquished Property. There is no minimum “hold time” with a 1031 exchange, but the IRS typically wants to see that the relinquished property is held for investment, even if used in a trade or business. IRC § 1031 expressly states that property “held primarily for resale” does not qualify for an exchange. An IRS challenge is likely if exchanging a property held less than a year for two reasons: [1] the IRS could reasonably claim that the property was not held for investment but instead for resale, and [ii] the IRS fights taxpayers trying to transmute short-term capital gains into long-term capital gains by doing an exchange. Almost all properties sold in a 1031 exchange are long-term investments and taxed at the long-term capital gains tax rate. Hold the property at least a year to qualify for long-term capital gains treatment.

2.3.6 Assignment Language Requirement. When in a forward exchange, the relinquished property is sold prior to acquiring the replacement property. The contract is assigned to the Qualified Intermediary or Accommodator in both the sale and the purchase.

2.3.6.1 When selling, assignment language is not required, but is suggested so everyone in the transaction is aware of the intent. Sample Relinquished Property Sale Language: “Buyer is aware that Seller has the option to qualify this transaction as an Internal Revenue Code Section 1031 tax deferred exchange. Buyer shall cooperate with Seller in the event of an exchange and hereby agrees to the assignment of this contract to a Qualified Intermediary by the Seller. Seller hereby agrees to hold the Buyer harmless from any and all claims, liabilities, costs, and delays of such an exchange.”

2.3.6.2 When purchasing, assignment language is required because the assignment requires the Seller’s permission. Sample Replacement Property Purchase Language: “Seller is aware that Buyer has the option to qualify this transaction as an Internal Revenue Code Section 1031 tax deferred exchange. Seller shall cooperate with Buyer in the event of an exchange and hereby agrees to the assignment of this contract to a Qualified Intermediary by the Buyer. Buyer agrees to hold the Seller harmless from any and all claims, liabilities, costs, and delays of such an exchange.”

2.4 The 2017 Tax Cuts and Jobs Act. Investment property owners will continue to be able to defer capital gains and depreciation recapture taxes using 1031 tax-deferred exchanges which have been in the tax code since 1921. No new restrictions on 1031 exchanges of real property were made in the tax law. However, the tax law repeals 1031 exchanges for all other types of property that are not real property. This means 1031 exchanges of personal property, collectibles, aircraft, franchise rights, rental cars, trucks, heavy equipment and machinery, etc. will no longer be permitted.

Reference: National Business Institute, Inc. Real Estate Transactions: Buying and Selling Commercial Real Estate [78952] Pages: 95-99 (2018)

Choice of Entity & Tax Considerations

Choice of Entity & Tax Considerations

Choice of Entity & Tax Considerations. In Arizona, the types of entities used to hold real estate are:

  1. the general partnership,
  2. the limited partnership,
  3. the trust,
  4. the corporation, and
  5. the limited liability company.

1.1 General Partnership. In a general partnership, all partners are fully, completely, totally liable for the debts and obligations of the general partnership. Unless formed specifically as a limited partnership, a partnership defaults to a general partnership, and the statutory authority for general partnerships is at Chapter 5 of Title 29, of the Arizona Revised Statutes, Revised Uniform Partnership Act, ARS § 29-1001 et seq.

1.2 Limited Partnership. Chapter 3 of Title 29, ARS § 29-301 et seq. controls limited partnerships in Arizona. Limited partnerships were the favored entity of choice in Arizona and throughout the country until the widespread of acceptance of limited liability companies. Before Arizona adopted its LLC statute in 1992, the limited partnership (“LP”) was the entity of choice to hold real estate and the corporation was the entity of choice to operate a business. The primary reason of the demise of limited partnerships was that the general partner of a limited partnership–and there had to be at least one general partner–had general liability. Weighing the value of control versus the general liability exposure as a general partner in limited partnerships, syndicators and other general partners in the business of real estate opted instead for the ease and limited liability of limited liability companies.

1.3 Trust.

1.3.1 Formation. In Arizona, the Trust Code is at ARS § 14-1101 et seq. and trust administration is set forth at ARS § 14-7401. An Arizona trust need not file any formation documents with any Arizona governmental agency, pay any formation filing fees or publish any documents in a newspaper. To form a trust, the trust creator (also called trustor or settlor) names a trustee to hold legal title to property conveyed by the trustor to the trustee for the benefit of one or more beneficiaries designated by the trustor. The trustor may be the trustee and a beneficiary. A trustee of a trust owes fiduciary duties to all the beneficiaries of the trust. Property must be conveyed or assigned to the trustee of the trust before the trustee can manage the property according to the trustor’s instructions. While trusts may be created by an oral agreement, but if a trust involves assets with more than nominal value, the trust should be in writing. Trusts may be revocable, irrevocable, simple or complex, but most trusts are revocable when first created. A revocable trust is a trust that can be amended or terminated at any time by the trustor. Every trust involving valuable property should be evidenced by a good written trust agreement that instructs the trustee on exactly what to do with the trust property.

1.3.2 Land Trust. A “land trust” or “Illinois land trust” is a special type of trust used by some owners of real property owners to hide the owner’s identity or owners’ identities. A land trust is usually revocable, so the trustee exerts power and control over the trust assets and, if distinct from the trustee, the beneficiaries. Arizona does not have any land trust statutes or court cases.

In some states, the identity of the beneficiaries of the land trust can be hidden from the public. ARS § 33-404, however, requires that every deed post-June 22, 1976 that conveys an interest in Arizona real property: (i) identify the trust that is a grantor or a grantee, and (ii) disclose the names and addresses of the beneficiaries of the trust. If the deed does not satisfy these requirements, the deed is voidable by the other party to the conveyance within a 2-year statute of limitations. ARS § 33-404 [E]. Therefore, a person who acquires an interest in Arizona real estate and places the property in a land trust of which the person is a beneficiary using a deed that does not disclose the name and address of the person/beneficiary has created a situation where the grantor/seller has the legal right and power to void the deed. This statute is the reason title insurance companies will not insure title obtained by a deed that has a trust as a grantor or a grantee unless the deed satisfies the requirements of the statute. A typical purpose of a ‘land trust’ or a ‘business trust’ is to hide assets owned by the beneficiaries. But every asset protection plan must have a business purpose. This does not include the ability to hide bona fide debts from creditors. So these types of trusts are not well-recognized for use in Arizona. That one cannot create a trust to defeat creditors is codified in ARS § 14-10505[A][1] that states, “During the lifetime of the settlor, the property of a revocable trust is subject to claims of the settlor’s creditors.” ARS § 14-10505 [A][2] states, “…with respect to an irrevocable trust, a creditor or assignee of the settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit.” So a creditor may claim satisfaction against the trust’s assets unless the debtor can show the business purpose behind the plan. Violating ARS § 33-404 to create a land trust to hide ownership of Arizona real estate to prevent creditors from being paid the amount owed on a lawful debt is not a qualified business purpose.

1.4 Corporation. Chapter 3 of Title 29, ARS § 10-120 et seq. controls corporations in Arizona.

1.4.1 Corporation Types to Hold Real Estate. All for-profit corporations created under Arizona law have the same legal structure, rights and powers. Arizona recognizes that corporations may be formed for profit or not for profit, but not as C or S corporations. A corporation is called a C corporation if it is taxed under Subchapter C of the Internal Revenue Code of 1986 or an S corporation if it is taxed under Subchapter S of the Internal Revenue Code. C corporations and S corporations are taxed differently for federal income tax purposes [discussed below], but structurally and for most other purposes, they are the same.

1.4.2 Formation and Operation. Forming and operating a corporation under Arizona law is the most complex and costly of the real estate entity alternatives. Articles of Incorporation are filed with the Arizona Corporation Commission [“ACC”] and the shareholders will be subject also to its by-laws, as well as any shareholder agreements and other binding instruments. After forming the corporation, the directors named in the Articles prudently should have an organizational meeting to adopt resolutions approving the corporation’s bylaws, naming the officers of the corporation, and authorizing the the issuance of stock to the stockholders, the form of the stock certificate, and the opening of corporate bank accounts. Filing the Articles of Incorporation with the ACC is relatively nominal, but still more than that for a partnership or limited liability company. Arizona corporations must have a statutory agent, file an annual report with the ACC and pay a $45 fee to the ACC annually. The annual report, available on the ACC’s website, must disclose the names and addresses of all: (i) stockholders that own 20% or more of the stock, (ii) the directors, and (iii) the officers.

If the annual report is not filed timely, the ACC assesses a penalty and will eventually revoke the charter of a corporation that does not timely file its annual report. A single person may form an Arizona corporation and be its sole shareholder, officer and director. There are no limits on the number of stockholders or the types of entities that can own stock of a C corporation.

1.4.3 Control & Management. While the shareholders own a corporation, the Board of Directors is responsible for managing the corporation, with the assistance of the corporation’s officers. The shareholders elect the members of the Board of Directors at the annual meeting of shareholders. A corporation is operated day-to-day by its officers, and they report to and serve under the guidance of the Board of Directors. Arizona law requires that the shareholders hold an annual meeting, but directors should meet as often as necessary to manage the corporation and oversee the officers, [but not less than once a year]. Meetings of shareholders and directors must be called by giving proper notice as set forth in the Bylaws of the corporation. Each meeting requires a quorum to be able to conduct a meeting and to approve any action. All meetings of directors and officers should be documented with written minutes duly signed by the authorized managers.

1.4.4 Limited Liability. The engine for the growth of corporations, and arguably for the growth economically of the United States, is that a corporation will afford ordinarily its shareholders and managers limited liability. That is, shareholders, officers and directors of a corporation are not liable for the corporation’s obligations and liabilities. There are exceptions to this general rule; for example, directors and officers may be liable for improper or illegal conduct. The legal concept “piercing the corporate veil” occurs when a court permits creditors to penetrate this corporate shield of limited liability and imposes general liability. Piercing the corporate veil may result from something as seemingly innocuous as not observing the formalities of operating in the corporate form. The risk of having the corporate veil pierced is why it is very important that corporations hold properly called and documented annual and special meetings of stockholders and directors and that they file their annual reports and pay the filing fee timely.

1.4.5 Different Federal Income Taxation Treatment for C and S Corporations. A corporation is a distinct taxpayer under federal income tax law that files its own federal income tax return [Form 1120]. A C corporation must pay at its corporate tax rate on taxable income, and its losses can only be offset by the corporation’s income. Profits, losses and other tax items of a C corporation are not passed through to its shareholders for them to use on their personal income tax returns.

1.4.5.1 Because a C corporation is subject to double taxation on income—at the corporate level and again at the individual [shareholder] level—Subchapter S corporations are an attractive alternative for corporate ownership of real estate and other purposes. For qualifying S corporations, there is ordinarily no tax at the corporate level, i.e., distributions are ‘passed through’ to the individual level and taxed at the shareholder’s marginal tax rate.

An S corporation must file an in informational tax return on IRS Form 1120S to notify the IRS
of its profits, losses and other tax significant items, despite not being a taxpaying entity for
federal income tax purposes, it. See IRS Publication 542, Corporations.

1.4.5.2 An S corporation may not have more than 100 shareholders [spouses (and their estates) are treated as a single shareholder. Shareholders may only be individuals, estates, exempt organizations described in Internal Revenue Code Sections 401(a) or 501(c)(3) or certain trusts described in Section 1361(c)(2)(A). The corporation must not have more than one class of stock. The corporation must have a tax year end based on the calendar year unless a different year end was approved by the IRS. A shareholder may not be a nonresident alien. All shareholders of an S corporation must have agreed on Form 2553, the form to elect subchapter S tax treatment within 75 days from the date of formation, to adopt S corporation status.

1.4.5.3 Except in limited instances [e.g., taxable recapture if the corporation used the LIFO inventory method the year before converting to S status, taxable recapture for any investment credit, tax net recognized built-in gain, taxable excess net passive income], the profits and losses of the S corporation are passed through pro rata to its shareholders based on each shareholder’s percentage ownership of stock for them to report tax on their personal returns.

1.5 Limited Liability Company [LLC]. LLCs in Arizona are governed pursuant to Chapter 4 of Title 29, ARS § 29-601 et seq. under the Arizona Limited Liability Company Act.

1.5.1 General Benefits of the LLC Entity. The LLC form of entity enjoys advantages over the other types of entities. Overall, it has few legal formalities [no requirement for annual meetings and minutes]; it is cheap to form; it is cheap to operate [unlike Arizona corporations, no annual report accompanied by an annual fee is due the State of Arizona]; it is good asset protection vehicle [see below]; and it offers multiple ways to be taxed at the federal level. ; )

1.5.2 LLCs Are Simpler to Form and Operate. An Arizona LLC ordinarily is the preferred choice of entity to hold real estate because there are fewer legal formalities. In contrast, Arizona for-profit corporations, the most preferable alternative to an LLC for holding real estate in Arizona, must satisfy the following corporate requirements:

1.5.2.1 hold meetings of shareholders and of the board of directors at least annually;

1.5.2.2 document the meetings of shareholders and the board of directors with minutes or resolutions; and 1.5.2.3 file annually a report with the Arizona Corporation Commission [‘ACC’], together with a $45 annual fee to the ACC.

The significance of this distinction of formalities between an LLC and a corporation should not be lost; a corporation may be dissolved involuntarily by the ACC or a creditor may ‘pierce the corporate veil’ and attach personal assets of the corporate shareholder[s] to satisfy the corporation’s liabilities and obligations. The ACC will revoke the charter of the corporation if the annual meetings are not held and documented, or even if the corporation changes its place of business without notice to the ACC. Revocation of a corporation’s charter in Arizona, without reinstatement within the 6-year time period per ARS § 10-1422, results in punitive consequences for the corporation’s shareholders: [1] The shareholders receive a taxable distribution of their proportionate share of the corporation’s assets; and [2] the shareholders lose the “corporate shield” to protect them from the corporation’s debts and liabilities. They effectively become common law general partners, with each liable for all the debts and obligations of the unincorporated business activity. If an Arizona LLC is found delinquent and dissolved by the ACC, filing for reinstatement must also be made within six years from the dissolution date, which is roughly five months after the ACC discovers any delinquency. This may be accomplished by filing with the ACC the delinquent documents, all filing fees that are due, and the proper reinstatement fee.

1.5.3 LLCs Provide Asset Protection. An Arizona LLC is preferable, ceteris paribus, to an Arizona corporation. A judgment against the stockholder of an Arizona corporation gives the creditor greater collection power to enforce than a judgment against the member of an Arizona LLC. A judgment creditor may compel the debtor to dispose of his entire shareholder interest in a corporation, even if the value of the shares exceeds the amount of the debt. In contrast, a judgment creditor is limited to serving a charging order on the LLC–a court order that when and if any property including cash is distributed to the judgment debtor, the LLC instead must distribute the property to the judgment creditor. ARS §29-655 [A] provides: On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the member’s interest in the limited liability company with payment of the unsatisfied amount of the judgment plus interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the member’s interest.” The judgment debtor’s membership interest in the LLC otherwise is undisturbed. Further, ARS § 29-655 [C] provides: “This section provides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the judgment debtor’s interest in the limited liability company. Absent a court order compelling the distribution of property from the LLC, the judgment debtor in a sole member LLC may refrain from distributing property indefinitely.

1.5.4 LLCs Permitted Four Alternatives for Federal Income Taxation. An LLC may be taxed at the federal level as [1] a sole proprietorship [single-member LLC or two-members who are a husband and wife who own their interest as community property]; [2] a partnership [if there are at least two members] under subchapter K of the IRC; as a C corporation under subchapter C of the IRC; or as an S corporation [if in compliance with subchapter S of the IRC]. As with a corporation, an LLCs can be taxed under subchapter S or subchapter C of the Internal Revenue Code, but the selection of the method of taxation does not transmute the LLC into a corporation. The LLC remains an LLC.

Reference: National Business Institute, Inc. Real Estate Transactions: Buying and Selling Commercial Real Estate [78952] Pages: 89-100 (2018)

Sale-Leaseback Transactions

Sale-Leaseback Transactions

1. What Is a Sale-Leaseback? A sale-leaseback transaction is one in which the owner of a property sells it to a third party and then leases it back from the buyer. These transactions are very common in corporate real estate. Most real estate decisions by corporations are really financial decisions. If a corporation determines that certain real estate is necessary for its business operations—the real estate decision—the corporation then makes a financial decision—how should the corporation pay for/finance the cost of the property. There are four basic alternatives: own the property for all cash; own the property partially financed via mortgage debt [often 50%+ of market value]; lease the property from a third party; or lease the property via a sale-leaseback. In the typical sale-leaseback, a property owner sells real estate used in its business or acquired for the specific purpose of the sale-leaseback transaction, to an unrelated private investor or to an institutional investor. Simultaneously with the sale, the property is leased back to the seller for a mutually agreed-upon lease term, usually 10 to 30 years. The sale-leaseback may include either or both the land and the improvements. Lease payments typically are fixed to provide for amortization of the purchase price over the term of the lease plus a specified investment rate of return for the buyer’s investment. Typically, the sale-leaseback transaction is a “triple-net-lease.” Sale-leasebacks generally also include an option for the seller-tenant to renew its lease, and on occasion, repurchase the property.

2. Purpose of Sale-Leaseback Transaction.

2.1 Seller-Tenant Advantages.

2.1.1 With a sale-leaseback, the seller can free up ‘frozen’ capital held as ‘equity’ tied up in property ownership; at the same time, the seller retains possession and continued use of the property for the lease term.

2.1.2 The seller-tenant can typically raise more cash with a sale-leaseback than through a conventional mortgage financing. For example, if the company seeks to liquidate the value of both land and improvements, conventional mortgage financing normally funds no more than 70 percent to 80 percent of a property’s value. By comparison, in a sale-leaseback the seller receives 100 percent of the property’s market value (less any capital gains tax).

2.1.3 The seller-tenant can pre-negotiate many of the sale-leaseback terms according to what best serves its financial interests, depending on its bargaining power, which in turn is based on its prior and anticipated financial success. So the seller-tenant usually can structure the initial lease term for a desired time period without the burden of balloon payments, call provisions, refinancing, or the other conventional financing difficulties. Further, the seller-tenant avoids conventional financing’ additional costs such as points, appraisal fees, and legal fees, which may be the substantial costs. The seller-tenant may also include in the sale-leaseback renewal options, while conventional mortgage financing has no guarantee for refinancing.

2.1.4 In a sale-leaseback, the seller can remove from its balance sheet the property’s value and the debt burden incurred by it and replace them with net sales proceeds obtained from liquidating the property, while not needing to report the lease on the balance sheet. The seller replaces a fixed asset (the real estate) with a current asset (the cash proceeds from the sale). If the lease is classified as an operating lease, the seller’s rent obligation usually is disclosed in a footnote to the balance sheet rather than as a liability. This results in an increase in the seller’s current ratio, or the ratio of current assets to current liabilities – which often serves as an indicator of a borrower’s ability to service its short-term debt obligations. Thus, an increased current ratio improves the seller’s position for borrowing future additional funds. [However, if the lease is classified as a capital lease, or a financial lease that does not constitute a real sale, the advantages of the sale-leaseback arrangement from an accounting perspective are altered considerably. Statement of Financial Accounting Standards No. 13 on accounting for leases requires that a capital lease be recorded as an asset and capitalized and requires the obligation to make future lease payments to be shown as a liability.]

2.1.5 Undervalued real estate on a company’s books often serves as a target for corporate raiders—a time-worn technique in the leveraged buyout. Having structured one or more sale-leaseback transactions could assist management in two ways—additional funds available to fend off the takeover, and the financial obligation of a long-term lease [not as inviting to raiders as undervalued real estate].

2.1.6 Because a sale-leaseback is not considered a loan, state usury laws do not apply, so a seller-tenant can offer the buyer in a sale-leaseback a higher rate of return on its investment than if the buyer instead merely financed the property still owned by the seller.

2.1.7 A company subject to debt financing limitations by prior loan/bond agreements may circumvent these limits via a sale-leaseback. Generally, rent payments under a sale-leaseback are not treated as indebtedness.

2.2 Seller-Tenant Disadvantages.

2.2.1 Perhaps the major disadvantage of the sale-leaseback is that the seller-tenant transfers title to the buyer-landlord. Owners can minimize this disadvantage by including a repurchase option in the leaseback. However, a repurchase option changes how the sale-leaseback arrangement is reported for accounting purposes–the lease will be recorded as an asset and capitalized, and the obligation to make the future lease payments will be reported as a liability.

2.2.2 A potentially large risk is that if the buyer files for bankruptcy, the trustee in bankruptcy may reject any agreement to renew the leaseback or the seller’s option to purchase the property.

2.2.3 The seller-tenant loses the flexibility associated with property ownership, such as remodeling improvements or changing or discontinuing the use of the property, which may be mitigated to a certain extent via protective lease provisions. The sale-leaseback often restricts the seller-tenant’s right to transfer the leasehold interest, and even if possible, generally it is more difficult to dispose of a leasehold interest than a fee-ownership interest.

2.2.4 A poorly drafted sale-leaseback may leave the seller-tenant foundering for a lease extension or relocation at then-current market rents.

2.2.5 If the rental market softens, the seller will likely be locked into the higher rental rate negotiated at the time of the sale-leaseback. Rental payments under the lease cannot be adjusted without the buyer-landlord’s consent—the seller-tenant is tied to the interest rate implicit in the sale-leaseback for the full lease term.

2.2.6 The cost of capital for a seller-tenant seeking to improve the leased property will likely be higher because financing will only be secured by a leasehold interest. Moreover, the leasehold may contain provisions that prohibit the seller-tenant from mortgaging the leasehold interest.

2.2.7 The interest rate, i.e., the rent, in a sale-leaseback arrangement generally is higher than what the seller-tenant would pay through conventional mortgage financing. The economic rationale for this is that the buyer-landlord’s investment in the leased property may be less liquid or marketable than a loan. Moreover, the buyer-landlord assumes additional risks by ‘financing’ the property’s entire fair market value.

2.3. Buyer-Landlord Advantages.

2.3.1 In a sale-leaseback, the buyer-landlord typically receives a higher rate of return in a sale-leaseback than in a conventional loan arrangement. Also, the buyer-landlord should circumvent state usury laws that limit the rate of interest charged with conventional financing. At the expiration of the lease term, the buyer-landlord also receives the benefit of any appreciation in the value of the property. Finally, the buyer-landlord can leverage the purchase with mortgage financing, further amplifying the return rate on the cash invested.

2.3.2 The buyer-landlord has a built-in tenant, i.e., the seller-tenant, which is a cost and time savings.

2.3.3 The long-term net lease enables the buyer-landlord to estimate accurately the expected future rate of return. Also, the extended term of the lease provides the buyer-landlord with protection from downturns in the real estate market and, assuming the property’s value appreciates over time, a hedge against inflation.

2.3.4 If the seller-tenant defaults under the lease, the buyer-landlord can simply terminate the lease and have the seller-tenant evicted. The buyer-landlord’s greatest risk then may have trouble finding another tenant, particular if the property is a special use. 2.3.5 The buyer-landlord owns the reversionary interest in the property, possibly whipsawed if the seller-tenant has an option to purchase or an option to renew the lease, this may limit or postpone the time that the buyer-landlord actually realizes the profit potential. The buyer-landlord, of course, also bears the risk that the property’s value might decline over the lease

2.4 Buyer-Landlord Disadvantages.

2.4.1 Perhaps the biggest risk for the buyer-landlord isa lease default by the seller-tenant, probably leaving leave the buyer-landlord without a tenant, as lest for a time. If the seller-tenant files for bankruptcy, the buyer-landlord is considered a general creditor. If the arrangement were a conventional mortgage, the buyer-landlord would be considered a secured creditor. If the seller-tenant files bankruptcy in a soft real estate market, the buyer-landlord may have a difficult time finding a new tenant.

2.4.2 Because the typical sale-leaseback usually must be structured to meet the specific needs and requirements of both parties, it may require more time and thus higher expenses, e.g., legal, appraisal, financial costs, than a conventional loan transaction. 2.4.3 The seller-tenant typically assumes in a sale-leaseback responsibility and expense for day-to-day property management matters during the lease term, aka a triple-net lease. The buyer-landlord must therefore verify that the seller-tenant pays the property taxes on time and that tax assessments are reviewed and challenged when appropriate. The buyer-landlord also must periodically review the insurance coverage on the property and inspect the property periodically for proper maintenance.

2.5 Tax Considerations for the Seller-Tenant.

2.5.1 Tax Benefits for the Seller-Tenant. A seller-tenant’s decision to raise funds through a sale-leaseback is typically derived from the substantial income-tax advantages that flow from the transaction, savings producing cash for the seller-tenant to use more productively.

2.5.1.1 The key tax advantage of a valid sale-leaseback is that rental payments under the lease are fully deductible. With conventional mortgage financing, a borrower deducts interest and depreciation only. The rental deduction may exceed the depreciation if: [1] the property consists primarily of a non-depreciable asset, such as land (although land is not depreciable, rental payments for the lease of land may be deducted); [2] the property has appreciated in value (while depreciation deductions are limited by the cost of the property, rental deductions may equal the fair market value of the property); or [3] the property has been fully depreciated.

2.5.1.2 A seller-tenant can use the sale-leaseback transaction affirmatively to time recognition of gains or losses while retaining the use of a property. A business may want to recognize gains, for example, to use business credits or net operating loss carryovers. If the business owns appreciated property, a sale of assets will produce a gain that could be offset by the credits or net operating loss carryovers. If the adjusted basis of the assets exceeds its fair market value, however, a recognized loss will reduce tax liability.

2.5.1.3 Because the property involved in a sale-leaseback generally is held for use in the seller-tenant’s trade or business, it qualifies for capital gain-ordinary loss treatment under IRC § 1231. If the property is held for the long-term holding period, then ordinarily gain on the sale will be taxable as long-term capital gain to the extent that the gain exceeds the losses in the same year from the sale of other Section 1231 property. [But to the extent of recapture income, the gain will be taxable as ordinary income. If the sale instead results in a loss, it will be deductible in full as an ordinary loss to the extent the loss exceeds Section 1231 gains from the sale of other property in the same year.

2.5.1 Tax Disadvantages for the Seller-Tenant.

2.5.1.1 The ordinary loss deduction ordinarily allowable on a sale-leaseback transaction might be barred if the lease term is for 30 years or more, on the theory that it is a nontaxable exchange of like-kind property under IRC Section 1031. Still, the seller-tenant would be entitled to depreciation on its basis for the leasehold over the lease term.

2.5.1.2 If the sale-leaseback transaction gives the seller-tenant an option to repurchase the property or if the seller-tenant retains substantial ownership rights, the Internal Revenue Service may view the transaction as a mortgage. In that case, the seller-tenant would not be allowed a deduction for rent but could deduct depreciation and a portion of the rent payments as interest.

2.5.1.3 Recapture on a sale-leaseback transaction may be onerous, because the sale of the property under a sale-leaseback may trigger depreciation, investment tax credit, and other types of recapture.

2.6 Tax Considerations for the Buyer-Landlord.

2.6.1 The buyer-landlord in a sale-leaseback reports rental payments entirely as ordinary income as they are received over the lease term. If instead the transaction were structured as a loan transaction, the lender is taxed only on the interest portion of the payment and not on the amount that represents the repayment of principal.

2.6.2 The buyer-landlord in a sale-leaseback as a real property owner still derives beneficial tax treatment. Rental income may be offset, in part, with available deductions and credits. Interest on mortgage debt, subject to certain limitations, also would be deductible. The buyer-landlord may also claim depreciation deductions for eligible property, and available tax credits.

Reference: National Business Institute, Inc. Real Estate Transactions: Buying and Selling Commercial Real Estate [78952] Pages: 87-105 (2018)

Should You ‘Short Sale’ Your Home?

Should You ‘Short Sale’ Your Home?

Consider First All Alternatives
For many homeowners with their homes ‘underwater,’ i.e., the loan[s] against the home exceed the value of the home, the knee-jerk reaction is to short sale the property. While a short sale may indeed be the best solution for a particular homeowner, the homeowner is ill-advised to proceed without first considering all alternatives, in order to make an informed decision. Consulting legal counsel experienced in residential real estate matters will greatly assist the homeowner in assessing options and choosing the best course of action. Following are options other than a short sale:

  • Loan Workout: The lender may agree to loan reinstatement, a repayment plan, or forbearance, or the homeowner may be eligible for a claim advance.
  • Loan Modification: The lender may agree to change the original loan’s terms to make the payments more affordable for the homeowner.
  • Deed-in-Lieu of Foreclosure: The lender may permit a homeowner to convey the home to the lender in exchange for full relief.
  • Work-Out Sale: The lender may permit the home to be sold and the loan to be paid off within a specified time period.
  • Refinance: The homeowner may be able to refinance the loan with another lender.
  • Bankruptcy: Filing for bankruptcy protection may be the homeowner’s best option to protect the homeowner’s total financial situation.
  • Foreclosure: Allowing the lender to foreclose [or conduct a trustee sale] on the property may be the homeowner’s best option.

 

Short Sale Considerations
 If, after reviewing all alternatives, the homeowner concludes that a short sale is the best option, following are some issues related to  the process:

  • Qualified Real Estate Professional: Like the real estate mantra—location, location, location—the choice of a competent, experienced real estate broker is critical, especially in handling short sales. And, best of all, the lender and not the homeowner generally pays the real estate commission.
  • Short Sale Documentation: The real estate broker can assist the homeowner in assembling the extensive documentation required by the lender. Each lender has its own criteria.
  • Property Fair Market Value and Total Debt: The seller must show the lender[s] that the unpaid loan balance exceeds the estimated fair market value of the home. The entire loan balance must be quantified.
  • Debt May not be Discharged in a Short Sale: Even if a lender agrees to a short sale, the lender may not agree to forgive the total debt. A homeowner should consult legal counsel to determine whether any ‘anti-deficiency protection’ is available.
  • Tax Effect: Relief of debt may be treated as income for tax purposes. Again, a homeowner should consult legal counsel to determine whether debt relief will be recognized as income for federal or state tax purposes.
  • Credit Score: The impact of a short sale, versus other alternatives, depends on numerous factors. In order to qualify for a loan to purchase another home, the ‘short sale’ homeowner will likely suffer a waiting period.
LEASING COMMERCIAL REAL ESTATE-ISSUES & NEGOTIATING

LEASING COMMERCIAL REAL ESTATE-ISSUES & NEGOTIATING

Contrary to popular belief, the most important aspect of a real estate lease is not the stipulated rent. The rent provision is important, to be sure, but the primary value of a lease for both a landlord and a tenant is to anticipate the unanticipated and control its outcome as much as possible. A landlord wants to assure an uninterrupted rental stream and preserve the property; the tenant desires quiet enjoyment of the premises.

The parties’ bargaining power will dictate the lease’s ultimate form. Particularly if more knowledgeable, sophisticated and enjoying greater bargaining power, a party will naturally seek strong language to favor his position. If a problem later materializes, the language in the lease often controls the outcome. Subject, of course, to good faith and fair dealing–while negotiating the lease and during the lease term.

Landlord Motivations. The fundamental source of revenue from owning investment real estate is income from tenants. Rental income, after deductions for operating expenses and debt service, indicates a property’s cash flow. Moreover, since tenant income is often capitalized in order to arrive at a sales price for income property, tenant income typically dictates the “value” of the property. Often overlooked, however, is how great an impact the tenant lease agreement(s) can have on this income stream.

A landlord should look upon his lease as an insurance contract: its provisions can protect an owner from unanticipated loss, tenant disputes, problems obtaining a loan or refinancing and unwanted obligations. In fact, a lease can be the primary vehicle to insure increasing future income from the landlord’s property. A lease is hardly a necessary evil; the value of investment property is inextricably interwoven with its leases.

The relationship of a commercial property’s leases to its value is critically important to a lender which intends to secure its loan to the landlord with a mortgage or deed of trust on the property. Essentially, tenant income is the lender’s security for its loan, and its officers will examine with great care the leases regulating that income. The lender’s ultimate decision whether or not to loan against the property will often turn on the leases affecting that property and income derived from it. It behooves the landlord to paying similar attention to his commercial leases.

The investor involved in commercial real estate who recognizes the significance of leases, then, is most prepared to obtain the highest values from his real estate holdings. But recognizing the value of leases is not enough; the sophisticated investor should be intimately familiar with common lease provisions. He can then understand–at least generally–their terms and be able to recognize alternative lease language.

Tenant Motivations. Many small business owners opt to rent retail, office or industrial space because it is more affordable than purchasing an entire property. Once having selected a home for his business among several possible locations, the businessman will then typically negotiate with an attorney or real estate broker who’s representing the property owner by himself. Six months, maybe a year later, a provision in the lease suddenly haunts him.

The best laid business plans all to often get mired in a landlord’s quicksand lease. Unfortunately, the small business owner is not in business to locate and then lease commercial real estate. His expertise lies in running his business. Yet, without advice and often without even negotiating, he will sign a lease that will bind him for a year or (typically) more.

Such a tenant sees no need to negotiate a lease. But when problems arise, and he blows the dust off his lease, he’s amazed at how fast he can learn lease terminology. Other tenants avoid having a written lease. There is no guarantee, however, that a tenant in the future will be dealing with the same landlord. Furthermore, parties to an agreement commonly have curious memory lapses unless there is a document to remind them of specific points. Finally, a lease of duration longer than a year, together with any modifications, must be in writing to be enforceable in court.

Lease Agreements. Lease agreements are an amorphous lot. There is no uniform length, content, structure or language since anyone can draft one. Yet many of the same problems have plagued landlords and tenants over past centuries and a lease professionally drawn by an attorney would typically have many provisions similar to a lease drawn by another attorney. Naturally, variation in leases is greatest among the uncommon provisions. Arguably, the greatest value of a lease is to anticipate the unanticipated, and one lease may anticipate different contingencies than the next. A party can best prepare for the lease negotiations by educating himself on the common provisions found in leases and being mindful of how recurring contingencies can be provided for in a lease.

Although it is standard practice for landlords to use their own lease form, the savvy tenant would, if circumstances permit, attempt to use his own. It is easier to negotiate from your own draft. If a landlord insists on using his own lease, however, the tenant should be aware that most property owners recognize that all form leases have clauses heavily favoring the landlord. A reasonable landlord would certainly agree to modifying some of these clauses to make them more palatable to his tenant.

Several types of clauses commonly appear in leases, and the prospective tenant should consider their actual as well as potential impact on his total cost of occupancy. Each lease clause ultimately has an economic impact although few deal with expenses and costs of managing the property:

  1. Basic Provisions. Namely, the who, where, when and how much. A precise reference to the parties to the lease, to the premises to which the lease refers, to the dates of the lease term and possession of the premises, and to the lease rental is elemental. First, the landlord and tenant should be named, and any representative signing on behalf of either should provide evidence of, or at least warrant, his authority to sign. Second, a complete description of the premises should include the location of the property, as well as what part of the property is the leased premises. Third, pin down the dates from when and to when the landlord is entitled to receive rent; these dates may be different from when the tenant actually occupies the premises. Finally, and most important to all concerned, the rental should reflect the total amount of rent to be paid during the lease term and contain clear language as to any rent increases (or decreases), be they in the form of fixed “step” amounts, percentage rent (in which the tenant’s rent obligation is typically tied to his sales), cost-of-living adjustments (to insulate the landlord from the impact of inflation on his rental stream), or some other form. A lease without all of the above is like a car without wheels; it simply serves no purpose.
  2. Use of the Premises. Limiting the type of use on the premises is most important to a landlord with many interdependent retail tenants. For example, integral to a shopping center’s success is foot traffic, and a good tenant mix will attract shoppers. A landlord, via lease agreements, can preserve the tenant mix by restricting the type of tenants who take possession. That way, an insurance office next to a bank cannot transfer its lease an abortion clinic. On the other hand, a tenant should resist a landlord’s effort’s to define narrowly the business use allowed on the premises, particularly if non-retail. The tenant’s business may change scope or the tenant may later wish to assign his lease to another type of business.
  3. Acceptance and Surrender of the Premises. This lease clause should stipulate that the tenant shall accept the premises, “as is” or subject to specified conditions, upon the commencement of the lease term to avoid the tenant’s untimely later objections. Upon the termination of the lease term, the tenant will restore the premises to their condition upon taking occupancy, reasonable wear and tear excepted. To measure such deterioration, including in the lease file some photographs of the demised premises (taken immediately prior to the tenant’s taking possession) is prudent. Either party will incur costs of preparing the premises for the current tenant, and of restoring the premises for the subsequent tenant, so its best to clarify whom and to what extent. The tenant’s bargaining power will ordinarily dictate how much of an outlay the landlord will make to attract the tenant to move in.

    Even if a landlord’s concern for his fellow man is inadequate, the tremendous exposure in tort liability dictates a careful inspection of the leased premises prior to the tenant’s acceptance. Notwithstanding any lease, local laws may hold the landlord responsible for dangerous conditions existing at the commencement of the lease term which he knew about, or should have known about, and which the tenant would not have reasonably discovered.

    The lease should provide that the premises shall be in rentable condition when the tenant takes possession. Specific remedies for the tenant are important if the landlord is “building out” the space and fails to complete in time. And if a retail property is new, a tenant should insist on the right to terminate the lease in the event a minimum occupancy level for the entire property is not reached. Numerous new and otherwise unoccupied Houston shopping centers sport a lone retail tenant, like so many bleached bones littering a desert.

  4. Security Deposit and Guarantees. Landlords often require security deposits to ensure the tenant’s faithful performance of his lease obligations. A landlord unsure of a potential tenant’s financial strength, e.g., a small, local, start-up concern, should require the tenant to put up a security deposit prior to taking possession. Typically, the amount is equal to one or two months’ rent. If the tenant defaults under the lease, such as failing to make required repairs or payments, the lease should provide that the landlord may apply the security deposit to correct the default and that the tenant will restore the security deposit to the original sum upon curing the default. If the security deposit segregated from other funds is refundable upon the tenant’s full performance under the lease and does not substitute for last month’s rent, the landlord need not report it on tax returns as income.

    If the lease is for, say, three years or longer, a tenant should ask for the earned interest the landlord would otherwise keep.

    Having a third party guarantee a tenant’s performance is another way a landlord can assure his tenant income stream. If the tenant fails to perform on the lease, the guarantor obligates himself to pay the rent. Guaranties are often signed by parent corporations for their subsidiaries, by individuals for their corporation, and by an original tenant assigning (transferring his contract rights under the lease; see below) the lease for the new tenant. A guaranty can become worthless unless carefully drafted, however, so an attorney should be consulted.

  5. Operating Costs for the Building and Premises. Local customary practices will have a profound effect on whether the landlord or tenant will absorb the cost of taxes, utilities (including gas, electricity, water, and garbage removal), property management and other overhead costs. In a multi-tenanted property, the fairest and most common method to bill the tenants is to prorate the operating costs based upon the square footage occupied by each tenant as a percentage of the property’s total area.

    The percentage allocation, and the square footage upon which it is based, should be preceded by such language as “mutually agreed by the parties to be …”. Otherwise, a tenant may later challenge the lease, arguing that the landlord misrepresented a material term. To obtain a concession from the tenant, such as a different lease term or size of rented premises, the landlord may consider “capping” (limiting) all or a portion of the operating costs that the tenant must pay. In a net lease, the tenant will pay for all the above costs; in a gross lease, the landlord will pay for “base” charges and the tenant will pay thereafter for any increases in cost over the base period.

    Landlords and tenants now bargain as readily over utilities as they do over rent, due to the ever-increasing cost of utility services. Operating costs for a building or its leased space, however, are rarely limited to utilities. A landlord concerned about maximizing his net income from rental property would want to have his tenants help pay for janitorial service, elevator repair, legal and accounting services related to the property, etc. A big ticket item is taxes and assessments, and the landlord bears the legal responsibility of paying them. A landlord could seek to pass this cost along to the tenant by either requiring the tenant to pay for only the personal property (e.g., tenant improvements) taxes, to pay for any increases in taxes or assessments, or to pay for any tax or assessment levied against the property.

    A tenant should try to exclude or limit (at least) increases in real property tax pass-throughs if the property is sold during the lease term. Most important, the exhaustive list of operating costs should be read carefully and the tenant should insist absolutely on an annual statement of expenses to insure against overcharges. Otherwise, the lazy tenant may find himself skipping through a minefield.

  6. Repair and Alteration of the Premises. Special care in drafting lease language is crucial where the economic impact is most felt. So both the landlord and the tenant need to specify in the lease not only who is responsible for–but to distinguish between–repairs (i.e., maintaining something which existed at the time the tenant accepted the leased premises) and alterations (i.e., materially changing the premises, such as reconfiguring the partition walls within the leased space) in the leased space. This is another area with tremendous latitude for bargaining and potentially involving large costs, particularly if the exterior of the building and its roof are concerned. Any right of the tenant to make repairs or alterations should be conditioned upon the landlord’s prior review of, and written consent to, the proposed repairs or alterations. The landlord must maintain control over the property to manage it properly and avoid unforeseen problems such as liens. (Liens are a form of statutory protection provided to contractors with unpaid claims and they attach to the real estate for work done on it.) A landlord may post a notice of non-responsibility to avoid a lien filed for work authorized by the tenant, but this presupposes that the landlord has been previously informed by the tenant of the work.

    The tenant should be aware that if he takes the space “as is,” his true rental cost after his “build-out” will be considerably higher at the time of moving in than the rent rate he was originally quoted. The tenant will want the lease to provide specifically that personal property which is installed, or affixed, to the premises may be removed by the tenant prior to the termination of the tenancy, as long as the tenant will repair any damage caused by the removal. This is because affixed personal property acquires the character of a “fixture,” and becomes a part of the real estate. If the landlord sells or mortgages the property containing the leased premises, the new property owner could have title to those fixtures or the mortgage could “attach” to them.

    Regardless of the applicable lease provisions, a thorough inspection by both parties of any repairs or alterations made to the premises or building is advised to avoid potential tort liability.

  7. Landlord Entry and Inspection. A tenant enjoys an “implied covenant of quiet enjoyment” along with his exclusive right of possession. Breach of this fundamental covenant by the landlord relieves the tenant of his lease obligation. To satisfy himself that the tenant is properly taking care of the premises, the landlord must provide for his right, upon reasonable notice to the tenant and during reasonable hours, to enter, inspect and make necessary repairs to the premises during the lease term. The creditworthiness and the business of the tenant should indicate how often the landlord should exercise this right. Additional language should also enable the landlord to show the premises to prospective tenants just prior to the end of the current tenant’s lease term.
  8. Insurance, Subrogation and Indemnification. It can’t be emphasized enough: each party must carry enough casualty and liability insurance. Landlord and tenant also should receive assurance, such as insurance certificates, that the other party indeed has its own. Coverage for other risks, such as business interruption, plate glass, liquor consumption, should be considered, too. A good, reliable tenant or landlord would obtain the insurance anyhow. For uninsurable losses, such as those caused by earthquake or flooding, a landlord might attempt to pass the risk to the tenant, particularly a triple net tenant (who obligates himself to take care of all taxes, insurance and repair). In any event, special attention is warranted here, because potential losses can be enormous.

    Landlord and tenant typically waive rights of subrogation, or their rights “to stand in each other shoes,” in the event of a loss. Their mutual agreement bars their respective insurers from seeking recovery of proceeds paid for the loss against the other party. The theory is that an insurance company should not charge a premium for risk exposure and then collect again (from the other party) when the loss actually occurs. In practice, the landlord does not want to risk losing a tenant’s rentals if the landlord’s insurer goes after the tenant.

    Landlords typically seek to insulate themselves from responsibility (by providing that the tenant will indemnify and “hold harmless” the landlord) for damages to, or losses of, the tenant or third parties at or near the premises. In essence, the tenant absolves the landlord of financial responsibility and acts as his insurer. But what if the landlord or his agents caused the damage? What if a tenant undertakes an insurance obligation he cannot meet, such as earthquake or mudslide damage? In the event of partial damage to the premises, a tenant should insist on an abatement of rent, and a termination of the lease if near expiration. On the other hand, because the tenant rarely has the financial muscle of an established insurance company, the wise landlord will have a tight insurance provision (see above).

  9. Reconstruction. Will the tenant be on the hook for rent if his leased premises are destroyed? The lease should clearly define what the parties’ responsibilities to each other are after destruction and this may turn on the extent of damage. Normally, partial destruction is distinguished from total destruction as a percentage of rental space, e.g., 25 percent; the tenant’s rent would be abated in proportion to his loss of use up to that percentage but either party may terminate the lease if the damage exceeds 25 percent. It may not be economical for the landlord to restore the premises, or for the tenant to remain, if the damage is major. A landlord would typically obligate himself to make the necessary repairs to restore the premises if they can be done within, say, 60 days. If the repairs would take longer, the landlord should retain the option of whether to restore the premises, subject to notifying the tenant. Also, if the damage occurs near the end of the lease term, either the tenant or the landlord may want to cancel the lease, particularly if the premises are let to a special use tenant whose tenant improvements would not be used by the next tenant.
  10. Assignment and Subletting. Practically any tenant or landlord who has felt the need to read his lease has done so to read this provision. In many instances a tenant does not remain in the leased premises for the full lease term. Rather than continue to pay rent for vacated space, the tenant will seek either to assign the lease or to sublet the premises. An assignment transfers contract rights in the lease, such as the right to possession, for the remainder of the lease term, while a sublease results in the original tenant becoming the new tenant’s landlord. The big distinction is that, in the event of a lease default, the landlord must first seek recovery from the new tenant-assignee in an assignment, but must proceed first against a tenant-sublessor who subleases his space.

    If a tenant wants no further contractual responsibility to the landlord, he must obtain from the landlord a full release or novation when he assigns the lease to another tenant. Assignment of the lease does not remove liability, a neat hat trick (it’s the law!) the unwary tenant only later realizes when he seeks to move out of the leased space.

    Many states still allow a landlord to forbid arbitrarily such a change in tenants. Understandably, the landlord withholds consent when market rent is higher than the contract rent in the lease, depriving the tenant of a windfall. The modern trend, however, is to condition the withholding of consent on reasonable grounds, e.g., if the proposed tenant is non-creditworthy, or if preserving the tenant mix is important.

  11. Tenant or Landlord Default. Another critical provision. A tenant may be in default under the lease by his failure to pay rent, or his violation of other lease terms, such as subletting without the landlord’s prior written consent or allowing his dog to recreate the Great Lakes on the newly installed carpeting. Conversely, the landlord might fail to render the premises tenantable or violate the covenant of quiet enjoyment.

    Because the result of a default is such a severe penalty, i.e., loss of the leasehold, and “the law abhors forfeiture,” a default generally may be triggered only after the nonoffending party 1) notifies the other party of the breach and 2) the offending party has failed to correct, or “cure”, the breach within a reasonable period of time. The notice must, therefore, follow “to the letter” the procedure detailed in the notice provision in the lease. Otherwise, the offending party will be able to postpone the default. The time period allowed to cure a breach should be only a matter of days for bringing current past due rent and other payments, but tailored to, say, repairing a wall.

    Each party might consider inserting language in the lease limiting their exposure in the event of their default. Depending on bargaining power, damages could be limited to, say, half of the value of the remaining term of the lease.

  12. Options. Options can have an economic impact that is not readily apparent. Yet landlords routinely grant options to tenants as if they were gift wrap for expensive purchases. An option to renew bestows upon the tenant a valuable right to extend the term of the lease, sometimes under existing rental rates. This option does not normally appear in a standard form lease. Neither does an option to expand space, significant to a tenant owning a growing business. The sophisticated tenant should seek to have as many options in the lease as possible. A landlord should also negotiate for mirror options to obligate the tenant or to excuse the landlord.

    A well-crafted lease should contain many other provisions to protect both parties. A landlord should avoid a tenant’s “recording a memorandum of the lease” clause because it may later be a cloud on the title of the property. The tenant, on the other hand, will want to put the public on notice of his lease rights, particularly if he isn’t occupying the premises. The landlord should always have a “time is of the essence” clause because the courts strictly construe this provision; it could be very important where, say, a tenant delays exercising an option to renew. Finally, both parties should seek to have a liquidated damages provision stipulating a damage amount in the event the other party fails to fulfill an important obligation, i.e., the landlord does not deliver the premises on time or the tenant defaults. Courts will strike the provision, however, unless very specific language is included.

Other provisions customarily included relate to condemnation, holding over, surrender, notices, cumulative remedies, and so on.

These issues and negotiating points barely scratch the surface. Leases are legal documents, however, and deserve serious scrutiny. Until they have consulted a real estate professional, the commercial landlord and prospective tenant should not make any firm lease commitments regarding technical and legal issues. The final business decision to sign the lease, however, must ultimately reside with the parties.

Leases, like all business transactions, involve some risk. But leases can, and should, be negotiated to minimize such business risk. The value of having negotiated important terms into a lease to protect against an otherwise unanticipated contingency is inestimable.

Title Insurance and Survey Review: What You Need to Know

Title Insurance and Survey Review: What You Need to Know

The Title Commitment

1.1 Overview.
A Title Commitment is a promise to issue an insurance policy on a piece of property. It’s equivalent to a binder for other types of insurance, which commits, or binds, the insurance company to issue the policy as set forth in the commitment. It is not a title insurance policy.

The Title Commitment is organized into five main parts: the insured, the amount of insurance coverage, the property being insured, what is required to insure the title and what is not insured—those matters affecting the property which in some way limit the free use of the property, usually called “title exceptions.” Most title exceptions are customary and do not affect the marketability of the property. A title search by the title insurance company will typically result in additional exceptions to title particular to the property.

1.2 Schedule A Identification Page.
As soon as you receive your title commitment, carefully review the information on Schedule A to ensure that the information referring to the parties, the property, and the insurance is correct. Ensure also that the real estate contract governing the transaction is consistent with the title insurance commitment. If you find any discrepancies between Schedule A and the contract, advise the title officer at the insurance company via a letter of instructions immediately.

1.3 Schedule B-1 Requirements.
Review this schedule on the title commitment to satisfy the title insurance company’s requirements to issue the title insurance policy at closing. Pay particular attention to requirements for powers of attorney, organizing documents for entities involved in the transaction, financing liens, tax and judgment liens and death certificates to avoid last-minute delays.

1.4 Schedule B-2 Exceptions to Title.
Schedule B-2 describes the exceptions to title—items not being insured over by the title company—including standard exceptions (listed below), taxes, and other burdens that will affect the subject property after closing. These include items such as covenants, conditions, and restrictions (CC&Rs); easements (for example, utility or access); possessors in interest at the property; discrepancies disclosed by a survey; mechanic’s liens; taxes and assessments not yet due or payable and special assessments not yet certified defects and other encumbrances including mineral reservations. The purpose of the Standard Exceptions is to limit the liability of the title insurer for matters that are not disclosed in the public record, or matters that would be shown by a survey or inspection of the premises. Title companies group standard exceptions at the beginning and list exceptions to title specific to the property uncovered by a title examination, such as lender liens, afterwards.

Requests and Revisions to Consider

Title exceptions may be removed or revised by the title officer based upon further review and/or documentation supplied by or on behalf of the landowner. Many Standard Exceptions can be removed either by a Comprehensive Endorsement, or by an affidavit from the landowner. A properly certified survey will typically be required to remove numerous Standard Exceptions, but may result in additional Specific Exceptions shown on the policy in lieu of former Standard Exceptions. Affidavits and acceptable proof that liens listed as exceptions may suffice to remove them as well.

Survey Review: Why and What to Look For

A property survey is often extremely helpful in obtaining a clear understanding of the condition of title for the land subject to the real estate transaction. The survey will disclose matters such as zoning, setbacks, distances, north orientation, easements, boundaries, monuments and possible encroachments and environmental issues. The reviewing attorney should confirm that the legal description corresponds with both the boundaries shown on survey and with the legal description set forth in the real estate contract. The reviewing attorney should also confirm items disclosed on the survey such as right-of-way issues, access, contiguous properties, parking space count, floodplain matters and so forth. Finally, the survey certification should be examined and verified.

Beneficial and Burdensome Easements

An easement is the legal document, signed by the landowner, which provides a [typically permanent] right authorizing a use on or of the land or property of another for a particular purpose. Easements ordinarily involve at least two land parcels. Easements create benefits and burdens on parcels of land. One parcel acquires a benefit and another is subject to a burden and vice versa. A “benefit” is an appurtenance to a recordable or recorded interest in a parcel and “burden” is a restriction or limitation on the use and enjoyment of a parcel that attaches to a recordable or recorded interest in a parcel. The land gaining the benefit of the easement is also said to be the dominant estate (or dominant tenement), while the party granting the burden is the servient estate (or servient tenement).Unlike a license, the easement “runs with the land,” and is therefore part of the chain of title for the benefited and burdened parcels of land. A right-of-way is the actual land area acquired for a specific purpose, such as a transmission line, roadway or other infrastructure. An easement is a land right document, and a right-of-way is the physical land upon which the facilities (transmission line, roadway, etc.) are located. Easements are further classified into subsets based on use such as public and private easements, affirmative and negative easements, appurtenant and in gross easements, and floating easement, and can be created in multiple ways, whether by document, intention of the parties or by the courts.

Determining the Best Course of Action When Dealing with Title Defects and Encumbrances

Title defects and encumbrances are typical in real estate transactions, and the real estate attorney should thoroughly understand the condition of title before seeking to cure title defects and removing encumbrances. Due diligence including a thorough review of the title commitment and survey is incumbent at the outset. The prudent attorney will then need to decide whether a business or legal solution best serves the interests of his/her client[s] and then proceed. In some cases, the interests of the parties are aligned against those of the title company, and in other cases, the title company can be a valuable ally in resolving title defect and encumbrance problems.

The Title Policy and Endorsements

6.1 Overview.
A title insurance policy is a contract of indemnity that promises to pay for a loss [1] up to the face amount of the policy [2] if [i] the state of the title is different than is set out in the policy and [ii] if the insured suffers a loss as a result of the difference. A title insurance policy may cover both claims arising out of title problems that could have been discovered in the public records and ‘non-record’ defects that could not be discovered in the record even with the most complete search. A title insurance policy will protect the insured for as long as the insured [and typically certain types of successors] have an interest in the property. The title insurance provides monetary damages, but does not insure that the landowner will obtain the property back if there is a title defect.

6.2 Types of Title Policies.
There are different kinds of title policies. An Owner’s Policy assures a purchaser that the title to the property is vested in that purchaser and that it is free from all defects, liens and encumbrances except those listed as exceptions in the policy or are excluded from the scope of the policy’s coverage. It also covers losses and damages suffered if the title is unmarketable, and for loss if there is no right of access to the land. A Lender’s Policy is issued only to mortgage lenders, and ordinarily follows the assignment of the mortgage loan, meaning that the policy benefits the purchaser[s] of the loan if the loan is assigned, or sold. A Construction Loan Policy is also available in many states for construction loans. Title insurance for construction loans requires a Date Down endorsement that recognizes that the insured amount for the property has increased due to construction funds that have been vested into the property. In commercial real estate transactions, there are basically two types of title insurance– the California Land Title Association “Standard Coverage” (CLTA), and the American Land Title Association “Extended Coverage” (ALTA). The CLTA policy covers matters affecting title, that occurred in the past and that are not specifically excluded from the policy terms. Key coverage guarantees that the insured has a marketable interest in the real property, ownership of title, and so forth. An ALTA Policy covers what the CLTA Policy covers, plus matters that are not “of record,” and matters that are not shown on an ALTA Survey, such as unrecorded liens, encumbrances, taxes and assessments; encroachments; unrecorded easements, and items disclosed by a survey. An ALTA policy requires de minimis a physical inspection of the property and more typically a survey. Neither an ALTA nor a CLTA policy covers matters affecting title such as laws, ordinances, regulations, and policy powers; rights of eminent domain; matters controlled by the seller/insured; or creditor’s rights claims.

6.3 Title Policy Endorsements.
All title companies offer endorsements to correct or modify the exclusions of a title policy or to add additional coverage. The prudent real estate attorney will examine the condition of title and advise his/her client regarding endorsements title companies typically offer, or even one[s] needed in a unique situation. Some of the more commonly recognized Title Policy Endorsements are: Comprehensive, Access, Survey, Zoning, Assessments, Contiguity [if applicable], Environmental Protection, Creditor’s Rights, and Fairway. Since each real transaction is unique to its own facts and circumstances and thus justifying necessitating the involvement of a lawyer, however, a lawyer should bring to bear his/her unique experience and insights to protect the client with title policy endorsements tailored to the client’s specific needs.

CURING TITLE DEFECTS

CURING TITLE DEFECTS

Discharging Old Mortgages

1.1        Overview

At the outset, please note that the term ‘mortgage’ is used also to include the separate creature, a deed of trust, though while different in mechanics, has the same purpose as a mortgage, to create a lien on property pursuant to securing performance of an act. ARS§33-702

But there are real differences between a mortgage and a deed of trust. See Exhibits for the Arizona statutes regulating each. The mortgage requires a civil action, often too lengthy for the taste of lenders, to foreclose the mortgage. After a trustee sale, there is no right of redemption (except as preempted by Federal law, e.g. IRS lien). ARS 33-811(E) Conversely, after a judicial foreclosure, the judgment debtor or his successor in interest has a six-month redemption period per ARS§1282 (B), but only for properties not abandoned and not agricultural land (in which case the redemption period is 30 days) per ARS§1282(A), and each lienor in order of priority has a five-day redemption period thereafter, if the owner does not redeem. And the Arizona anti-deficiency statute ARS§33-729 for mortgages limits its applicability to only purchase money loans for residential properties of 2.5 acres or less, while the parallel statute for trust deeds in the state of Arizona has no such limitation for purchase money loans.

So even though a mortgage or deed of trust typically involves an indebtedness, it may also secure other obligations.

1.2        How to Discharge a Mortgage

A mortgage, which becomes a lien against realty upon its recording, may be disposed of in number of ways. Methods include: discharge by the recording of a satisfaction of the mortgage removing the realty from the lien of the mortgage by recording a release; discharge by court order; and, in some limited cases, discharge by a filing by a third party, such as a title insurer, a court-appointed personal representative, or an affidavit executed by an attorney at law or attorney in fact.

A full repayment of a loan secured by a recorded deed to secure debt will itself operate to cancel the underlying encumbrance. Implicit in ARS§33-707 is that once creditor receives full satisfaction, it will record a sufficient release or satisfaction of mortgage or deed of release and reconveyance of the deed of trust.

An open mortgage or deed of trust of record, however, constitutes an apparent lien or encumbrance against real property. So, to clear marketable title [to be defined below] of the property, the parties to a real estate transaction will demand the actual cancellation and release of the prior mortgage of record.

Therefore, an old mortgage/deed of trust affects both the marketability and insurability of the property’s title. A title insurance company that has actual knowledge that an open-of-record mortgage has been properly paid off will insure title without exception to that mortgage since it can prove that the mortgage does not constitute a lien of the real property and therefore that the mortgage also does not impair the marketability of title of the property.

Although there is a common law distinction between a satisfaction and a release, that is, satisfaction of performance of paying off the debt versus release of the lien encumbering the property, Arizona merges the concepts statutorily. So ARS§33-707 et seq. addresses both satisfactions and releases interchangeably to discharge mortgages and deeds of trust. The requirements essentially are: [1] the property is legally described; [2] the docket and page or recording number of the underlying encumbrance is recited in the recorded document; [3] the document contains language that releases the mortgage or deed of trust and revests in the mortgagor or person who executed the deed of trust, or his legal representatives, all title to the property affected by the mortgage or deed of trust; and [4] the document is duly acknowledged and recorded.

Alternatively, a court order under 33-713 is available to an interested party, so long as the mortgagee meets intrinsic tests of not being a county resident, or is deceased without a state-appointed personal representative for the estate.

2.         Resolving Description Errors, Survey and Boundary Disputes

The intent of the parties in creating the legal description is of prime importance in determining what the words mean. The intent can be determined by the words in the instrument, by words in other instruments from a common grantor, by maps filed by the common grantor, by the actions of the grantor and grantee after the delivery of the deed, by the economic reasonableness of the transaction viewed from both perspectives with all reasonable interpretations of the words in the deed and from current testimony of the parties as to intent, so long as such testimony does not contradict either the actual language used or attempt to give lie to the conduct of the parties after the delivery of the deed.

2.1        Resolving Description Errors.

Description errors arise from a multitude of sources, typically bad deed descriptions; inconsistent deed descriptions; conflicting surveys; corners marked inconsistently or misidentified; etc.

2.1.1     Resolving Repeated Typographical and ClericalErrors. Either the attorney or title company, upon general agreement as to the correct and incorrect legal description property line in question, may correct the clerical error in the legal description and attach the corrected version to the new conveyance deed or loan documents. As a matter of good practice, the attorney should notate the corrected call(s) in the newly prepared legal description so as to provide future title examiners with an explanation for the corrected legal description. If a party conveying the property objects to this approach (particularly for a seller providing a warranty of title), then the grantor should execute two conveyance deeds to the grantee: a warranty deed using the historic legal description and a quitclaim deed using the corrected legal description with an explanation of the correction as suggested above. The attorney for the grantee also should advise their client to obtain title insurance based upon the corrected legal description.

2.1.2     Resolving Discrepancies between Prior Deed and New Survey. It is not uncommon for a newly prepared survey to conflict with the historical legal description of the subject property. The tendency is to rely on the current surveyor’s opinion—and the adequacy of his/her professional liability insurance—but prudence dictates that the real estate attorney understands the discrepancy, hopefully a minor one. Examination of the legal description of the chain of title dating back to the first subdivision of the original parcel, as well as the legal descriptions of abutting properties, should help ascertain the correct legal description. Again, the grantor should execute two conveyance deeds to the grantee: a warranty deed using the historic legal description and a quitclaim deed using the survey legal description. Additionally, the grantee should obtain a title insurance policy that includes a “Same as Survey Endorsement.” Further, a more conclusive remedy would be for the parties and the affected neighboring owner(s) to execute a boundary line agreement based upon the survey legal description. 

2.1.3     Resolving Discovered Gaps. Strips and Gores.Discovering gaps, strips and gores in contiguous parcels requires careful evaluation by the attorneys involved in the transaction to ascertain the intent of the parties in the past and to consider the time that has elapsed since the gaps, strips and gores were first created in the chain of title. In a perfect world, one would ask the parties whose interests remain outstanding in the chain of title (including their heirs and devisees) to simply quitclaim to the new grantee these affected areas. In the author’s experience, rarely are such parties identifiable and, even if located, cooperative. Moreover, the parties to the transaction, including the attorney’s own client, may be leery to engage in such conversations with parties from the past. Generally, the more time that has elapsed since the creation of the gap, strip or gore, and the more remote that possible claimants to the disputed area will come forward, the greater likelihood that marketable title can be obtained through the opinion of the attorney certifying title and the recommended use of a Contiguity Endorsement to be issued with the underlying title insurance policy. As with the above examples, and even with the availability of a Contiguity Endorsement, the grantor should expect to provide two conveyance deeds to the grantee: a warranty deed using the historic legal descriptions of the parcels and a quitclaim deed using a contiguous legal description of the intended tract of land without such gaps, strips and gores (often from a survey).

2.2        Resolving Survey Disputes

Many of the legal description and boundary disputes of property, described above and below, emanate from or may be resolved by a correct survey. The real estate attorney should understand both the components that a survey should include, as well as the parcel of real estate that it is legally describing. The issues include the purpose of the survey, to whom the survey is certified, which parcel[s] are being described, reliability of monuments, etc. That said, a lawyer should never attempt to be his own expert, the risk of conflict is too great and the lawyer is by definition incompetent to give an expert opinion in any matter in which he represents a party.

2.3        Resolving Boundary Disputes

A lawyer is engaged to protect and enforce a client’s rights in a boundary line dispute. Responsibilities include:

  • making a thorough and diligent search of the public records made for all matters that affect the boundary line(s) in question.
  • locating any existing surveys of the premises in question and all adjoining parcels of land, and upon consultation with his client obtaining a current survey correctly depicting the boundary lines of his client’s property from a surveyor capable of giving expert testimony in any litigation over the boundary line.
  • obtaining an expert determination of the respective rights of the parties in dispute from a reliable independent expert witness.

In any boundary line dispute, there is a problem of conflicting claims of title to a portion of the client’s real property. These claims can range from a dispute over a three-inch strip on the outside of a historic fence line, to improvements built over the property line (new construction), to improvements built beyond the property line (seventy-year old building), to the absence of frontage on a public right of way. The dispute may involve negligible monetary impact to the value on the property, but then the discrepancy may not be “minor” in nature, e.g., it materially affects the existing or intended use of the property by the grantee. If a negotiated solution is not possible, be prepared to litigate the boundary line in question in a quiet title action. Without agreement of the adjoining parcel owners, a title insurance company may not be willing to insure over the discrepancy, for example, where the neighboring owner may have installed a fence, landscaping or other improvements in the disputed area based upon their title to the property (as opposed to a blatant act of trespass or encroachment), all of which would be taken by the title insurer as an exception to the title insurance policy.

The preferred approach to efficiently, timely and effectively resolve the cloud on title, therefore, would be for the neighboring owners to execute a mutually agreeable and recorded boundary line agreement.

3.         Clearing Judgment Liens, Tax Liens, Mechanics’ Liens and Other Liens

A very common problem in land transactions, whether with conveyances or in real estate lending, is the discovery of tax liens, mechanic’s liens, judgment liens and other types of liens. Liens are claims against a specific real property. In each instance, the attorney for the party relying on providing or receiving marketable title must ascertain first whether or not the specific lien secures an obligation which remains unpaid. Then, once confirming that payment previously or concurrently has been made or, by operation of state law the lien has expired, the attorney will work with the parties to remove the lien of record or otherwise obtain title insurance that insures the property interest without exception for the subject lien.

Provided below are the most common liens that a real estate transaction attorney will encounter in their daily practice — judgment liens, tax liens, mechanics’ liens,  and property owner association liens. ARS Title 33 contains a list of liens recognized by Arizona.

3.1.        Clearing Judgment Liens.

Generally, when a party prevails in a civil matter and a monetary award is granted by the court, the court issues an abstract of judgment for recording a judgment lien on the losing party’s property. A judgment lien in Arizona will remain attached to the debtor’s property (even if the property changes hands), except for homestead property if it is the debtor’s primary residence, for five years. ARS§33-964. The lien is automatic upon judgment, except for a judgment from small claims court.  A simple affidavit of renewal can be completed and docketed the county recorder’s office to extend the judgment lien for another 5 years. ARS§12-1613. Except for judgment liens for child support and spousal support, a judgment lien becomes dormant after five years. Under ARS§25-516, however, a lien for child support trumped by previously filed security agreements [deed of trust, mortgages, etc.] created by the property owner and previously recorded or filed. The holder of a debt secured by real property may record a release of the lien on the real property which secures the debt, but immediately on the payment or satisfaction of the judgment, shall be discharged of record by the judgment creditor or the judgment creditor’s attorney by recording a satisfaction of judgment with the county recorder of the county in which the judgment is recorded. The judgment creditor or the judgment creditor’s attorney shall enter a notation of satisfaction on the docket of the clerk of the superior court of each county in which the judgment has been entered or docketed, and in a like manner enter a notation of satisfaction on the docket of the clerk of the United States district court. ARS§33-964(c)

A demand for the payoff amount is obtained from the creditor, which has 14 days to respond or else incur liability for damages caused by delay to the person or agent making the demand, plus $500 whether or not actual damages are sustained. ARS§33-715

Moreover, care should be taken to ensure that a bona fide purchaser or lender for a particular parcel of property has received no notice of the judgment prior to the conveyance of title and prior to the recording of the judgment lien. In such an event, the bona fide purchaser and lender may become subject to the judgment lien even though the lien was not first in priority.

3.2         Clearing Tax Liens 

3.2.1      Clearing Federal Tax Liens. Generally, federal tax liens must be placed on the property within ten (10) years or else it becomes unenforceable by operation of law. I.R.C at 26 USC §6502.  The period runs from when the tax is assessed and ends either 1) when the tax is fully paid, or 2) “becomes unenforceable by operation of law”, otherwise known as the “Tax Lien Statute of Limitations.” Internal Revenue Code (I.R.C) at 26 USC §6322. Most federal tax liens are addressed in the Federal Tax Lien Act of 1966 as well as 26 U.S.C.A. § 6321 et. seq. Such liens may arise for unpaid income taxes, estate taxes, gift taxes or any other tax due and payable to the United States government. In general, federal tax liens that encumber real property will be found by the attorney or title examiner in the county recorder’s office.

As a general proposition, a federal tax lien is governed by the common law concept of “first in time is first of right”. See United States v. New Britain, 347 U.S. (1954). In other words, federal tax liens do not magically gain priority over all prior liens. Moreover, lender security deeds will be afforded priority over the federal tax lien provided that the loan was made at least 46 days prior to the date of recording of the federal tax lien and the lender had no knowledge of the federal tax lien, which rule is particularly helpful in jurisdictions with a long gap period in the property records. See 26 U.S.C.A. § 6323(b)(2). The same general rule applies to subsequent lender advances made under a construction loan. See 26 U.S.C.A. § 6323(b)(3).

With the exception of estate tax liens (addressed below), most all other federal tax liens will become dormant 10 years after the tax assessment becomes due unless the federal government forecloses upon its lien. See 26 U.S.C.A. § 6323, and 26 U.S.C.A. § 6502 (which provides a ten year statute of limitations to enforce the tax assessment). As above, the grantee to a real property interest should ensure that the federal tax lien has been paid or bonded prior to closing. Typically, the Internal Revenue Service will issue a “Release of the Notice of Federal Tax Lien” within 30 days of receiving payment for the full amount of the unpaid tax, interest, penalties and the costs to file the release in the general execution docket. 26 U.S.C. §§ 6325(a). The process to repay the federal tax lien is standardized and one simply follows instructions found at www.irs.gov as needed to obtain a payoff amount and instructions on where to send payment.

3.2.2      Clearing Arizona Tax Liens.  
A The statute of limitations to file a tax lien is within 6 years after the amount of the tax determined to be due becomes final. Once filed, the lien stays until the debt is paid. ARS§42-17153(2). Is not satisfied or removed until one of the following occurs:

(a) The taxes, penalties, charges and interest are paid.

(b) Title to the property has finally vested in a purchaser under a tax sale.

(c) A certificate of removal and abatement has been issued pursuant to section 42-18353.

Further, per ARS§42-17153(3), a tax lien is prior and superior to all other liens and encumbrances on the property, except (a) state liens or encumbrances, and (b) other tax liens.

Under ARS§42-1153, the Arizona Department of Revenue may on its own accord release or subordinate a lien. Under ARS§42-1153(E), a certificate by the department to the effect that any property has been released from the lien or that the lien has been subordinated to other liens is conclusive evidence that the property has been released or that the lien has been subordinated as provided in the certificate.

3.2.3      Clearing Arizona County Tax Liens

ARS§42-15001 et seq. regulates county ad valorem property taxes in Arizona. Under ARS§42-18055, the county treasurer must record the date of payment and credit the payment to the person or property that is liable for the tax.

A real estate attorney may determine that the property under examination may be entitled to a tax exemption, and therefore is not subject to a tax lien. Arizona Revised Statutes 42-11111 provides in part, “the property of widows, widowers and disabled persons who are residents of this state is exempt from taxation to the extent allowed by article IX, sections 2, 2.1, 2.2 and 2.3, Constitution of Arizona, and subject to the conditions and limitations prescribed by this section.” Also, the state’s Senior Homeownership Protection program is designed to freeze the full cash value of a primary residence owned by seniors based on income and age. More information is available from the County Assessor websites.

ARS§42-18101 et seq. regulates the vibrant investment business of tax lien certificates, whereby investors buy county tax lien certificates. Arizona rate of return is 16% on Tax Lien Certificates.  Property owners have a three-year period to repay the delinquent taxes and penalties for a certificate bought at a tax lien sale, which occurs annually in February. Any time after the redemption period, but not exceeding 10 years, the investor may initiate foreclosure with the superior court in the county in which the property is located.

3.3         Clearing Mechanic’s and Materialman’s Liens

Mechanic’s and materialman’s liens are creatures of  state law, per ARS Title 33, Article 6, and there exists a large body of case law for which the uninitiated should be wary. In summary, contractors, subcontractors, suppliers, and even professionals such as engineers, architects, surveyors and others who provide labor and materials towards the improvement of real property will be entitled under state law to file a statutory lien against the real property for non-payment of their services. While there are many technical elements to the statute and as set forth in the substantial body of case law that has followed, for the real estate transactional attorney in a pending conveyance or loan financing matter, there are several restrictions on a contractor’s ability to place a lien on the property.

To start the process of obtaining a lien against a project or even to obtain a claim to a bond, the subcontractor or supplier must issue a Preliminary Twenty-Day Notice (sometimes referred to as a “pre-lien”). ARS§33-992  The Preliminary Twenty-Day Notice must be sent to the owner, the lender (if any), the general contractor, and if the issuer is a supplier, to the subcontractor.  The Preliminary Twenty-Day Notice lists the amount that the subcontractor or supplier anticipates the work or supplies will cost for a particular job.The Preliminary Twenty-Day Notice is effective to protect payment of any labor or materials that were used within twenty day prior to the date of the Preliminary Twenty-Day Notice.  A Preliminary Twenty-Day Notice is not a lien.  It is not recorded with the recorder’s office where the project is located and is not subject to any liability for its issuance.

The contractor must have been duly licensed when providing services. Material suppliers and equipment rental companies, however, do not need a contractor’s license.

If suit is filed in the name of an entity, such as an LLC or corporation, the contractor’s or materialman’s legal entity must be in good standing with the Arizona Corporation Commission in order to file suit.

If the subcontractor and supplier have been paid on a job, there is no reason to perfect a lien as the lien amount has already been paid.  If the subcontractor and supplier have not been paid, they must file a “Notice and Claim of Lien” with the appropriate county recorder’s office within 120 days after completion of the project or if a Notice of Completion of the project has been recorded, the supplier or subcontractor only has 60 days after recordation of the Notice of Completion to record a Notice and Claim of Lien.  ARS§33-997 Once a Notice and Claim of Lien has been properly recorded and served, the lienholder has only six months in which to enforce his, her or its lien rights through foreclosure.  ARS§33-998 There are many definitions of “completion” for a project so at the time an account becomes past due and there are potentially lien or bond rights, it is prudent to contact an attorney to determine when a lien or bond claim must be asserted so that those rights are not lost. If the contractor misses this deadline, the lien automatically expires and should not appear as an encumbrance against title. All mechanics’ liens have equal priority with one another, regardless of the date they are recorded, so foreclosing on the lien is time-sensitive.

3.4         Clearing Other Liens

Lawyering skills are essential in removing liens as clouds on title, for, contrary to the typical expectations of the lay public, the junior liens are not removed once the senior lien is paid off. Liens remain until they are released. And liens on real estate can be released, assuming the judgment creditor or taxing authority agree, without payment in full. More time and effort than ever before is spent negotiating with junior lien holders because the property is not worth enough money to pay off lien holders in full.

In any event, the attorney should contact the lienholder shown in the public lien records, confirm the applicable payment amount (including interest), and make the applicable payment (and retain evidence of such payment). Thereafter, the lienholder is required by law to cancel the lien and recording the release of the cancelled lien with the clerk of the superior court with whom the lien was originally filed. See, e.g., ARS§42-18152. As a practical matter, the attorney should coordinate the lien release as between the two parties and not rely upon the lienor to do so.

There are significant penalties for recording an invalid claim or lien against property in Arizona. ARS§33-420. For ascertaining certain penalties, the test is subjective, but in other the more relaxed objective test of the reasonable man is applied. A document purporting to create an interest in, or a lien or encumbrance against, real property not authorized by statute, judgment or other specific legal authority is presumed to be groundless and invalid. ARS§33-420 (D)

4. Foreclosure Considerations

Title 33 of Arizona Revised Statutes, Chapter 6, Article 2 contains statutes regulating foreclosures, including several alternative methods of satisfying mortgages of record.

The real estate attorney cannot assume that a foreclosure is going to eliminate all the title problems that exist on a property. Years ago, there was a general assumption that a “foreclosed title” was a pretty clean title; that is no longer the case. Prior unreleased deeds of trust, unpaid taxes, sewer liens, subdivision liens, IRS liens, and other problems, crop up frequently.

It is likely that many lawyers in these times will consult with a client who wants to buy a property at foreclosure or a foreclosed property from a bank or servicing company. There are a few important concerns of which to make certain the client is aware. First, a title should be run on the property to determine if any liens or matters exist that would not be extinguished by the sale. Sewer lines, IRS liens, (although technically, a junior IRS lien would be extinguished assuming proper notice was given, 26 USC 7425, the IRS nonetheless has 120 days from the date of sale to redeem the property from sale.) c. With regard to purchasing a previously foreclosed property, keep in mind that the bank/seller will want to convey title by a special warranty deed or, even more commonly, by quitclaim deed. Check with the title insurer if there is less title policy coverage.

Arizona has a mishmash of statutes which generally affirm the common law theory concerning liens which commonly is known as “first in time is first of right.” But there are exceptions, such as child support, HOA assessments, etc. Accordingly, with respect to a foreclosure of a secured real estate interest, such as a deed to secure debt, the party pursuing foreclosure should examine title and evaluate which property interests may be superior to their own and which are subordinate. In most instances, both federal and state ad valorem tax liens will provide priority issues for the real estate attorney regardless of the date each was recorded.


5. Other Potential Title Defects

5.1          What Constitutes a Title Defect?

Reasonable minds can differ. Title insurers may have a less exacting definition for purposes of insuring title than the real estate attorney. The legal test is ‘marketable title.’

5.2        Due Diligence Beforehand to Avoid Curing Title Defects Later

As counsel for the property owner or tenant during acquisition, you may offer to assist working with the seller’s/landlord’s counsel or the title company to cure title. Moreover, while counsel to the buyer/tenant, you are in the best position then to avoid having to cure title defects which later become apparent but which earlier arose. In addition, having advised the client to obtaining proper title insurance, while not averting title defects, balm the resulting damages resulting from those title defects.

While the title insurance commitment and title insurance policy forms are “standardized” by the ALTA, there are still significant differences in how title commitment forms are formatted and how discovered title defects are presented.

The real estate attorney is well-advised to review with the title office of the grantee’s title insurer what title endorsements should and may be obtained

5.3        Quiet Title Actions

When there are conflicting claims to real property or to an interest in real property (such as an easement) a lawsuit can be brought to obtain a judicial declaration of the ownership and interests in the property. In Arizona, this is known as a quiet title action. A quiet tile action is a lawsuit. Attorney’s fees can be awarded to the person seeking to quiet title, pursuant to an Arizona statute, if the defendant is given a proper opportunity to acknowledge that the defendant has no interest in the property and if the defendant fails to do so within a specific time period.