Orange Groves, Pay Phones, Visas, and Violins: Why Your Real Estate or Small Business Investment May be Subject to Securities Regulation

By Elizabeth A. Whitman

A recent Wall Street Journal (WSJ) headline announced “SEC Looks Into Kushner Cos. Over Use of EB-5 Program for Immigrant Investors.”[1]

It is not unusual to hear that a company is being investigated by the government over immigration issues. But, what is unusual about this particular investigation, however, is that it is being conducted by the Securities and Exchange Commission (SEC), which regulates securities, rather than the United States Citizenship and Immigration Services (USCIS), which regulates immigration and visas, including EB-5 visas.

To understand why the SEC has jurisdiction over Kushner Co.’s EB-5 program, one needs to go back more than 70 years.

In 1944, the then ten-year-old SEC failed to convince a Florida federal court that the sale of Florida orange groves with an optional management and production agreement (for buyers who did not have the knowledge to manage an orange grove themselves) was in the nature of agriculture and was not under SEC jurisdiction.[2]  A youthful, but determined SEC appealed but once again lost, when in 1945, a federal appeals court agreed with the Florida district court.[3]  Not to be outdone, the SEC appealed to the United State Supreme Court.

In 1946, the Supreme Court held in SEC v. W.J. Howey Co. [4] that the sale of the orange groves with the optional management agreement was an “investment contract” under the Securities Act of 1933. In Howey, the Supreme Court developed the investment contract test, which is still in use today.  Simply put, a business dealing or transaction is an investment contract if:

  1. There is an investment of money (or other assets).
  2. The investment is in a common enterprise (generally this means a pooling of assets).
  3. There is an expectation of a profit.
  4. The profit comes from the efforts of a promoter or a third party.

The Howey test brings many routine transactions under securities law regulation, much to the chagrin of clients coming to me wanting to move into a new business venture. They may want to build a new hotel, buy and operate an assisted living community, flip houses, or engage in another commercial real estate project.  They may want to buy an existing business, or they may have an idea for an entirely new business involving a cloud-based application or to provide a service to busy parents.  Many times, those clients need funding to start their business or pursue their commercial real estate venture, and they may turn to friends and family to invest in their new business venture.

Many of these new businesses or commercial real estate investment structures, however, meet the requirements in the Howey test because they involve an investment of money by the family or friend into a common enterprise with an expectation of profits from the efforts of my client. Unfortunately for my clients, there is no securities exemption for investments by relatives or friends, so even though the only investors may be friends and family, my clients in those situations must comply with securities laws.

Indeed, over the years there has been a surprising variety in the types of investments which have been found to be investment contracts. Whiskey warehouse receipts, commercial real estate funds, pay phones and ATMs with placement contracts, interests in a lumber mill, fine art collections, certain time share arrangements, and, of course, investments as part of the EB-5 immigrant visa program have been found to be investment contracts subject to SEC regulation based upon the Howey test.  Generally, those investments have involved situations in which investors expected a profit from a passive investment.

Further, when the stock market is high and there is a concern bond values might drop due to future interest rate increases, many people turn to alternative investments for diversification. Those alternative investments, traditionally available only to high income or high net worth accredited investors, include commercial real estate funds, oil and gas investments, and even musical instrument collections.[5] For instance, even fine violins are becoming more popular as investments and could be sold to a syndication of investors.[6] Most of those alternative investments are structured so that they are investment contracts under the Howey test.

Yet, not every investment in a common enterprise is an investment company subject to SEC regulation.

In 1975, the Supreme Court held in United Housing Foundation, Inc. v. Forman[7] that investments in stock in a New York City cooperative housing project were NOT investment contracts even though the investors might expect a profit from that common enterprise from the efforts of the developer.  The Supreme Court differentiated the housing cooperative from the investment in, for instance, the Howey orange groves or commercial real estate funds, because the primary purpose of the investment in the housing cooperative was to obtain housing, not to generate a profit.

Investors in EB-5 visa programs, are primarily investing to obtain one of a limited number of available annual immigrant visas from USCIS leading to conditional permanent resident status. To qualify, they must invest at least $500,000 ($1,000,000 under some circumstances) in an investment that results in the creation or preservation of a requisite number of permanent, full-time jobs for US workers.[8]

EB-5 investors typically receive a small, fixed return on their investment, but their main incentive for investment is to obtain permanent resident status in the US, rather than to make a profit. Nevertheless, the SEC treats EB-5 investments as securities under the Howey test, and most reputable EB-5 sponsors attempt to comply with US securities laws when offering and selling EB-5 investments.

It’s not clear why the SEC is interested in Kushner Cos.’ EB-5 commercial real estate investment program. However, traditionally, the SEC has used its regulatory authority over EB-5 investments to combat fraudulent use of funds.  For instance, in 2017, the SEC resolved a complaint against Serofim Muroff, an Idaho EB-5 sponsor, who allegedly used EB-5 money for his personal expenditures and for other projects outside of the purposes for which the investments were made.[9]  A similar case is underway involving EB-5 investments in Vermont ski resorts, which the SEC alleges were used by Ariel Quiros and his partner for personal expenditures.[10]

Unless the SEC believes there has been a violation of securities laws, we may never find out why the SEC is interested in Kushner Cos.’ EB-5 program. However, what we do know is that the SEC has jurisdiction over a commercial real estate investment through a vehicle created by Congress to be administered by USCIS. That, in and of itself, should serve as a reminder to businesses, commercial real estate sponsors, and even to future violin syndicators that if they are asking others to invest money with the expectation of a profit, the securities regulators also may have jurisdiction over them, as well.

Before attempting to raise funds from third parties, everyone should consult with an experienced business and securities attorney, who can help assure that the transaction is in compliance with any applicable securities laws.

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[1]  Article by Erica Orden, The Wall Street Journal, Politics, January 6, 2018.

[2] SEC v. W.J. Howey Co., 60 F. Supp 440 (S.D. Fla. 1945).

[3] SEC v. W.J. Howey Co., 151 F.2d 714 (5th Cir. 1940).

[4] 328 U.S. 293 (1946).

[5] E.g., http://liquidrarityexchange.com/musical-instruments.html

[6] There have always been investors interested in vintage violins. Some invest out of a philanthropic desire to support the arts, but yet, investments in violins can result in a steady gain in value, without the need to pay taxes on the gain until the violins are sold. According to a 2017 article by Emily T. Lane, President & Curator of Elan Fine Instruments, in Futures Magazine, interest in violin instruments has moved from the famous Cremonese masters, such as Stradivari and Guarneri del Jesu, which have a minimum value in seven figures, to more “moderately” priced instruments in the $100,000-$500,000 range, including Vuillaume (who was mentioned in my previous blog You Now Can Trade Up Your Violin, but Not the Bow or Case – New things to Consider in Section 1031 Exchanges After the 2017 Tax Law) and Balestrieri, an 18th century violin-maker from Mantua.  See http://www.futuresmag.com/2017/01/21/investing-rare-violins . Although I am not aware of any violin-specific syndications, Liquidity Exchange (mentioned in the previous footnote) does offer a musical instrument syndication, which includes the possibility of investment in violins.

[7] 421 U.S. 837 (1975).

[8] For more information about the EB-5 program, check out the USCIS website at https://www.uscis.gov/working-united-states/permanent-workers/employment-based-immigration-fifth-preference-eb-5/about-eb-5-visa-classification

[9]  https://www.sec.gov/news/press-release/2017-87

[10] http://www.burlingtonfreepress.com/story/news/2017/11/22/jay-peak-owner-quiros-strikes-tentative-deal-sec/888577001/

© 2018 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or eawhitman@mirskylawgroup.com

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC or any of its attorneys.
This blog’s reference to any third-party website is for illustration and attribution purposes only and does not indicate endorsement or approval of the website or any product mentioned on or sold through the website or its owner.

Minimum Wage Increases are Coming to Montgomery County

By Scott A. Mirsky

Montgomery County businesses need to start preparing for the gradual increase of the minimum wage as it heads towards $15 per hour. After some compromising between lawmakers and the County Executive, the deadline for businesses to comply with the $15 per hour requirement will vary depending upon the number of employees who are employed by the business, as follows:

  • July 1, 2021, for employers with 51 or more employees
  • July 1, 2023, for employers with 11-50 employees
  • July 1, 2024, for employers with fewer than 11 employee

In addition, businesses will have to comply with gradual increases to the minimum wages as it approaches $15 per hour. The new law specifically excludes (1) employees who are exempt under State or Federal law; (2) employees who are subject to an opportunity wage under State of Federal law; (3) employees who are 18 years old or younger if they work no more than 20 hours per week.  In addition, if the employee is 19 years old or younger, the new law permits an employer to pay that employee 85% of the County minimum wage for the first six months of employment.

For more information on wage and hour issues, please contact Scott A. Mirsky at (301) 664-7710 or samirsky@mirskylawgroup.com.

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.

Fraud and Forgery: From Vintage Violins to Today’s Real Estate Transaction

By Elizabeth Whitman

Fraud has a long history.

In a recent blog You Now Can Trade Up Your Violin, but Not the Bow or Case – New Things to Consider in Section 1031 Exchanges After the 2017 Tax Law, I discussed how famous violin maker Jean-Phillipe Vuillaume started his career in a violin forger’s shop, only to become a violin maker whose work was so valued that it, ironically was forged by others.

Although Vuillaume turned away from forgery, in the early 20th century, a trio of luthier brothers, William, Charles and Alfred Voller, were less scrupulous. Although the Vollers are known to have created nearly perfect “copies” of a number of early Italian violins, it was their forgery of the Balfour Stradivari violin, which was so good that it was certified as a real Stradivari by a famous London violin dealer.[1]

Violin fraud aside, real estate investors, title companies, and yes, real estate attorneys, are finding themselves to be the target of cyber fraud in real estate transactions and in connection with real estate closings. Last summer, inspired by a local story of an incredibly blatant real estate fraud, I wrote a blog post entitled When it looks like a Stradivari but Isn’t: Protecting Yourself from Wire Fraud in Real Estate Transactions. Little did I know that in just a few, short months, I would be put to the test to follow my own advice.

My previous blog post on fraud in real estate transactions focused on financial wire fraud in connection with the real estate settlement, where a hacker takes over a title company’s e-mail account and causes closing funds to be wired to the fraudster’s bank account. However, I experienced a different type of attempted fraud in connection with a real estate transaction.

My Close Encounter with a Real Estate Transaction Fraudster

A few weeks ago, out of the blue, I received an e-mail purporting to be from a real estate paralegal at a law firm with which I had been working on a real estate transaction several months before. The e-mail included a link, which appeared to be a legitimate link from a well-known electronic signature processor, asking me to securely download a document for electronic signature. In the course of a real estate closing, it would not be uncommon for me to receive such e-mails, mainly so my clients can securely sign documents.

However, this particular e-mail made me suspicious because I had no open real estate transactions with the law firm that sent me the link. I thought it was possible that the paralegal had sent the link to me in error, meaning to reach another Elizabeth. But it was also possible that it was an attempt at fraud, possibly to load a virus or ransomware onto my computer.

Remembering my own blog’s instructions about verifying information, I responded to the paralegal asking her two things 1) whether the e-mail was in fact intended for me, and 2) the real estate transaction to which it related. I had done only one real estate transaction with this particular law firm months before, and I thought it was unlikely that a fraudster would be able to identify the transaction accurately.

I then went one step further. I blind copied a partner real estate attorney in the same law firm with whom I had worked and asked that attorney also to confirm the e-mail was legitimate. By blind copying, if the e-mail from the paralegal was fraudulent, the fraudster would have no way of guessing I had sent the e-mail to someone else at the firm. Plus, if the paralegal’s account hand been compromised my e-mail to the attorney also would alert the law firm of the breach of security.

Almost immediately, I received a response from paralegal, confirming that the link was legitimate and in fact was intended for me – but not identifying the real estate transaction to which it related. I replied to the paralegal and asked her to please identify the transaction for additional security. She did not respond with the requested information, so I did not download the document. Apparently, my e-mail to the senior partner did its job, because less than an hour later, I received another e-mail from the law firm telling me that the original paralegal e-mail I received was in fact a virus and that I should delete it.

How to Protect Yourself from Cyber Fraud in Real Estate Transactions

Although I was not hurt by this attempt at real estate fraud, this experience has caused me to realize how important it is to slow down and think before clicking on a link, downloading a document, or providing sensitive information. The fraudsters are always thinking up new ways to try to trick us, but with care we can prevent them from getting the upper hand.

Having almost been the victim of real estate fraud, this seems a good time to reiterate and expand upon my previous advice to individuals involved in real estate transactions:

Verify all e-mailed wire transfer instructions or requests for personal information via a phone call. Do not use the phone number in the e-mail sending the request. Instead, go to the company’s website to obtain the phone number or obtain the phone number off a business card or letterhead received in paper format.

Confirm that the sender really sent any e-mail that requests that you click on a link, even if no financial information is requested. As part of the confirmation, ask the sender to provide very specific information that a hacker would not know and could not easily obtain from a hacked e-mail account. When in doubt, make a phone call (again, not to the phone number in the e-mail) to confirm.

Encrypt e-mail messages containing sensitive data. If you enter sensitive information into a website, both confirm its authenticity and be sure that the data connection is secure. In popular browsers, this is typically indicated by a symbol (such as a padlock) next to the URL. In Chrome, a green padlock indicates a private, encrypted connection using https. I also have Internet security software which will open a special, secure browser upon request.

Maintain your software. Be sure that your operating system and application software is up-to-date, and be sure that you have reliable virus and malware protection installed.

Protect your laptop and portable devices by turning on a firewall on any public network. If you can avoid using a public network, do so. For instance, I have sufficient data in my mobile plan to enable me to use my own mobile hotspot when working with sensitive information in a public location.

Use Passwords for documents containing sensitive data, and keep passwords in an encrypted file.   Use complex passwords containing a combination of capital and lower-case letters and numbers, and do not use the same password for every account. If others have access to your data through file sharing, require that they also use complex passwords. Your data is only as secure as the weakest password that can be used to access it.

Use Double-Factor Identification where it is available. Yes, it is annoying to have to wait to receive a code on your cell phone before signing into a website, but that will prevent a hacker (who won’t have your cell phone with him/her) from gaining access to your account.

Use Less Common Security Questions for websites that require security questions, select questions for which the answer is not easily available online. If you have your high school on your public social media accounts, then the name of your high school or its mascot is not secure. If you cannot select the security questions, then consider intentionally including the wrong answer – for instance, use your mother’s first name instead of her maiden name as the response or the name of your college instead of your high school.

Inform parties with whom you do business if you believe that their account may have been hacked. Yes, you will be the bearer of bad news (like my post-holiday text), but knowledge of the hack will help the victim to minimize the risk.

It took the Voller brothers years to create a forged violin, but a hacker can commit fraud in a matter of minutes. In our fast-paced world, it is important that we all slow down and take the time to verify authenticity of wire transfer instructions, embedded links, and requests for sensitive information, lest we become the victims of today’s cyber fraudsters in our real estate transactions.

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[1]   Music Geek Info: The Voller brothers were not only master luthiers, but they also were clever fraudsters. They initially started by “copying” famous violins by Guarnari del Jesu and Stradivari, two of the greatest violin makers ever. However, when they realized that violin experts were highly familiar with the work of del Jesu and Stradivari, as well as the provenance and current ownership of most of the know violins made by those masters, the Voller switched to copying violins made by a slightly less well-known early Italian maker, Gagliano. Like Vuillaume, the Voller brothers’ work was so masterful that “authentic” Vollers today are sought after and demand a price in six figures.

© 2018 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or eawhitman@mirskylawgroup.com

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC or any of its attorneys.

You Now Can Trade Up Your Violin, but Not the Bow or Case – New Things to Consider in Section 1031 Exchanges After the 2017 Tax Law

By Elizabeth A. Whitman

In my February 2017 blog post “Sizing Up in Violins and Investment Real Estate,” I discussed how buying increasingly larger (and more expensive) violins compares to real estate investments. I discussed how starting with a 1/32 size, I had purchased a series of violins and then “traded up” to the next size through a 7/8 size violin. Each time, the primary purchase was a violin, but we also had to purchase a similarly-sized bow, case, and accessories in order to play the larger violin.

A real estate investor might start small, with a single duplex and eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple large apartment complexes, office buildings, or even high-rise mixed-use buildings. In those instances, although the primary purchase was real estate, each purchase would come with a certain amount of personal property in the form of appliances, furnishings, supplies, and other equipment necessary to operate the real estate.

Comparing a real estate transaction to a violin purchase, purchasing the violin would be akin to purchasing the real property, and purchasing the bow and case would be more like the personal property that is purchased with the real estate investment.

My previous blog discussed how there are two ways that an investor might owe taxes upon sale of investment real estate – increase in value (i.e. the property is sold for more than what is invested in it) or a “recapture” of depreciation expenses that the investor took while he/she owned the investment real estate.

Since 1921, one thing that has helped real estate investors accomplish growth while deferring taxes is to use a Section 1031 exchange to defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property. Over the years, Section 1031 has evolved, but generally, those changes have provided clarity or expanded the opportunities to defer taxes upon a sale and reinvestment.

The Tax Cuts and Jobs Act signed into law in December (2017 Tax Act) introduces new rules on 1031 like-kind exchanges by limiting the types of assets eligible for Section 1031 exchange. As a result of these changes, effective January 1, 2018, only real estate exchanges will be eligible for tax deferral. Using the violin “trade up” comparison, under the 2017 Tax Act, the violin could be traded for a larger one, but it would not be possible to “trade up” the bow or case.

Most real estate sales include the sale of at least some personal property: from refrigerators in an apartment complex to common area furnishings in an office building or maintenance equipment in a shopping center. Most of that personal property can be depreciated over just a few years or sometimes, expensed entirely under what is known as a Section 179 Deduction[1] which allows a limited amount of capital expenditures to be deducted entirely in the year in which they are made. Therefore, by the time the personal property is sold with the real estate, it likely has a zero basis. As a result, under the 2017 tax law, any amount of the sale price allocated to the personal property is very likely to be taxed either as capital gains or recaptured depreciation.

On the bright side, for many real estate asset classes, either there isn’t much personal property or the personal property doesn’t have much value in its used condition. For instance, even if there are 150 refrigerators in an apartment complex, if each of them is six or seven years old, the sale price isn’t going to be very high, so the resulting taxes won’t be material. However, there are situations where a real estate sale might include more valuable trade fixtures, equipment or machinery, for which a reasonable sale price allocation would result in significant taxes.

Where the potential tax liability for a sale involving both real estate and personal property is significant, careful planning can help to reduce the tax burden of these tax law changes. Strategies to explore include the following:

Consider leasing personal property. Payments made for a true lease (one that is not a disguised sale or installment purchase) can be deducted when made, providing a similar tax liability to depreciation (or a Section 179 deduction). Of course, with a lease, the lessee would not acquire any ownership in the personal property. If the lessee plans to sell the real estate to which the personal property relates and dispose of the lease obligation at the same time, the lease would need to be assumable by the buyer of the real estate or cancellable.

Offset Capital Gains Against Capital Losses. If the taxpayer has capital losses, then many capital gains can be offset against those losses so that no tax is paid. Because real estate assets may be held inside of a separate legal entity, the capital gains and capital losses must be allocable to the same ultimate taxpayer for this strategy to be effective.

Assign Property Values to the Personal Property Upon Sale. There is a natural tension between buyers and sellers when there is a sale of mixed real estate and personal property. Buyers tend to want to purchase price to be as heavily allocated to personal property as possible, both because they can depreciate personal property more quickly and because in some states, a high allocation to real property may result in an increase in real estate taxes or a high transfer tax bill.

Sellers sometimes agree to the buyers’ values in order to move forward with the deal. However, the reality is that many times, used personal property has little to no value in the marketplace – if you look on craigslist for instance, a used refrigerator or other appliance in good condition may sell for no more than 15-20% of the new value, and many times, the personal property sold with investment real estate has been heavily used. Proper valuations of the personal property can result in a smaller portion of the purchase price being allocated to personal property subject to capital gains taxes.

On a related note, the 2017 Tax Law may have adverse consequences for professional violinists. Suppose a professional violinist starts with a nice, $10,000 modern Italian violin, which has appreciated to $40,000 over a period of many years while the violinist saved up to “trade up” to a $150,000 Vuillaume[2] violin.  Under the 2017 Tax Law, this violinist is out of luck; since a violin is personal property, under 2017 Tax Law that violinist now may have to write a check to the IRS for the gain on the sale of the $40,000 Italian instrument acquired for $10,000 many years before.

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[1]  The 2017 tax law also modified the Section 179 deduction limitation so that many taxpayers will be able to expense up to $1 mil. per year in capital purchases instead of depreciating those items over time.

[2]  Music Geek Fact: Jean-Phillipe Vuillaume was a 19th century French violin maker. He started his career in the shop of Francis Chanot, who had a reputation for forging violins. Before long, Vuillaume was copying violinists made by Stradivari and Guarneri del Gesu, two 18th century Italian master violin makers, whose instruments were already quite valuable. Vuillaume’s skill was so great that some of his instruments reportedly were mistaken for the originals. Vuillaume turned away from forgery and instead produced violins he acknowledged as copies (the difference between forged and copied violins being only whether the lack of authenticity is disclosed).  Ironically, after Vuillaume won violin competitions in his own right, violins bearing his name became some of the most commonly forged (or shall we say “copied”) in the late 19th century. Today, a Vuillaume might sell for more than $250,000, with his copies of the famous “Messiah” Stradivari violin being among the most desirable.

©   2017 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or eawhitman@mirskylawgroup.com.

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.