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.

If You Play A Wrong Note, The Entire Orchestra Now May Pay The Price — Be Aware Of New Partnership Tax Audit Rules That Take Effect On January 1

In 1985, the “participatory journalist” George Plimpton worked as a temporary percussionist, playing sleigh bells, triangle, bass drum, and most notably, gong, with the New York Philharmonic. During a performance, he once struck the gong so hard and created such an overwhelming sound that Leonard Bernstein, who was conducting at the time, burst into applause.  Although one of the world’s most famous orchestras was playing, it was Plimpton, not the orchestra that received the credit or blame for the huge gong sound.

Likewise, most of the time, if one musician in an orchestra misses a note, it doesn’t impact the orchestra as a whole. Certainly, if a musician misses a note in one performance, it should not impact a future performance of the orchestra or musicians who join the orchestra in the future. Until now, the same as been true of partnerships, limited liability companies, and other entities taxed as partnerships under federal tax law.

Partnerships are considered “pass-through” entities under federal tax law. Partnerships have to file a tax return on Form 1065, but partnerships do not have to pay federal income taxes.  Instead, the partnership issues a Form K-1 to each partner allocating partnership income and expenses to that partner.  The partner puts the information from the Form K-1 onto the partner’s tax return and pays any taxes attributable to the partnership income.

In this way, partnership taxation is not unlike musician responsibilities an orchestra. The orchestra manager or conductor provides each orchestra member with his/her part.  However, it is up to the individual orchestra members to play the part.

Just as an orchestra may sometimes have critics passing judgment on its performance, sometimes the Internal Revenue Service (IRS) may audit a partnership tax return. Under the current rules (referred to as the TEFRA rules), when the IRS adjusted partnership income in an audit, it was up to the IRS to collect any tax deficiency, interest, and penalties from the taxpayer.  Since the partners, not the partnership, are the taxpayers, the IRS, then, collected any amounts due after an audit from each individual partner.  This is akin to a critic commenting adversely on the orchestra’s performance but then attributing the “blame” for the performance on the individual musicians who failed to perform their parts.

Just as it may be difficult to name every musician who failed to perform his/her part as well as expected, it is a hassle for the IRS to collect amounts for several different partners. Therefore, the Bipartisan Budget Act of 2015 replaced the TEFRA rules effective January 1, 2018 the IRS adopt new rules (I will call the new rules the post-TEFRA rules).  The post-TEFRA rules allow the IRS to collect any amounts due after a partnership tax audit from the partnership, itself, but allow the partnership to pass those amounts on to individual partners.  The post-TEFRA rules also provide that any additional taxes determined upon audit are to be computed at the maximum rate, even though the rate paid by the partners, who are the taxpayers, may be lower.  If the post-TEFRA rules were applied to music critics, they would allow music critics to blame the orchestra for a poor performance and leave it to the orchestra to allocate blame to individual musicians.

At first glance, this sounds reasonable. However, unlike a music critic’s article, which typically will be published the day after a performance, a partnership tax audit typically will occur years after the tax year in question.  Just as orchestra personnel may change from year-to-year, the partners in a partnership also may change over time.  So, under the post-TEFRA rules, a partnership is left in the unenviable position of paying taxes for a previous tax year and either allocating those taxes to partners who weren’t even part of the partnership in the tax year in question or tracking down former partners to get reimbursed for the taxes, interest, and penalties the partnership must pay.

As the IRS undoubtedly experienced in trying to collect these taxes, interest, and penalties, this is easier said than done. The partnership may not be able to find its former partners.  If a former partner is an individual, he/she may have moved, changed names, or even died.  If a former partner is a corporation, trust, limited liability company, or other entity, it may no longer be in existence.

However, even when the former partner is easy to find, the partnership agreement, itself, could provide obstacles that prevent the partnership from collecting taxes, interest and penalties from former partners. Unless the partnership agreement or other written documents signed by a partner obligates a former partner to reimburse the partnership for these amounts, the partnership and ultimately, the current partners could end up shouldering the burden of taxes for years in which they were not even members of the partnership.

The post-TEFRA rules also replace what previously was known as a “tax matters partner” with a “partnership representative.” Since a partnership representative has different (and generally broader) authority than a tax matters partner, partnerships need to appoint a partnership representative. Typically, this is done in the partnership agreement.

The post-TEFRA rules will take effect to every existing new and existing partnership on January 1, 2018 UNLESS the partnership elects every year to opt out and instead, to operate under the TEFRA rules. Conventional wisdom is that every partnership that is eligible to opt out of the post-TEFRA rules should do so.

Unfortunately, however, the post-TEFRA rules do not allow all partnerships to opt out. In order to opt out, a partnership must have fewer than 100 schedules K-1, and generally must be individuals or estates or be taxed as a C corporation, S corporation. This means that partnerships which have other partnerships (or limited liability companies taxed as partnerships) or trusts (including grantor trusts) as partners usually must operate under the post-TEFRA rules. If the partnership discloses all indirect owners (e.g., beneficiaries of the trust and partners of the partnership member), then it still may be able to opt out of the post-TEFRA rules.

With the post-TEFRA rules taking effect in January, every partnership (and limited liability company taxed as a partnership) should do the following to prepare for the post-TEFRA Rules:

  1. Consult with its attorney and amend its partnership (or LLC) agreement to appoint a partnership representative.
  2. If necessary, amend the partnership (or LLC) agreement so that partners agree to reimburse the partnership for additional taxes, interest, and penalties determined after an audit, even if they are no longer a partner when the audit occurs.
  3. Amend the partnership (or LLC) agreement to direct the general partner (or LLC manager) to opt-out of the post-TEFRA rules if the partnership qualifies to do so.
  4. If the partnership qualifies, request that its tax preparer elect to opt out of the post-TEFRA rules. This must be done every year.
  5. If the partnership has fewer than 100 Schedules K-1 but cannot opt out of the post-TEFRA rules because one or more of its partners is a trust or partnership (or LLC taxed as a partnership), then consider requesting those partners to provide information about their partners/beneficiaries to see if the partnership can opt-out of the post-TEFRA rules by providing that information to the IRS.

With awareness and diligent preparation, many partnerships should be able to opt out of the post-TEFRA rules and continue to operate as they have in the past the TEFRA rules, but they still should amend their agreements in case they find themselves subject to the post-TEFRA rules in the future. For those partnerships that cannot opt out of the post-TEFRA rules, amendments to their partnership agreements can help prevent tomorrow’s partners from paying for today’s partners’ “wrong notes.”

For more information, please contact Elizabeth A. Whitman at (301) 664-7710 or eawhitman@mirskylawgroup.com.

© Elizabeth A. Whitman

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.

When it Looks Like a Stradivari Violin but Isn’t: Protecting Yourself from Wire Fraud in Your Real Estate Transaction

Fine violins do not have serial numbers, but they do typically have a label inside identifying the maker and frequently the year and location where the violin was made. Many violin makers, or luthiers[i] as they are known, like to copy well-known instruments, sometimes even down to the label inside the instrument, and the most famous violin maker, Antonio Stradivari, is also the most frequently copied.

Usually, the luthiers do not try to pass their Stradivari copies off as originals.  Even if they were to try to do so, the instrument’s age and sound quality of the copies usually would fall far short of a Stradivari and give them away.

Where there is a question regarding the origin of an old violin, modern technology provides additional tools, such as chemical analysis of varnish and dating of the wood, which can further aid in distinguishing genuine violins from famous makers from copies. Yet, identification of old instruments remains as much art and conventional detective work as it does science.

Unfortunately, in the banking world, fakes may not be as easy to detect. Many title and escrow companies have started putting warnings on their e-mails, which read something like this:

Online banking fraud is on the rise. If you receive an email containing Wire Transfer Instructions call your escrow officer immediately to verify the information prior to sending funds.

The National Association of Realtors has recommended that its members include the following language on their e-mail signature lines:

IMPORTANT NOTICE: Never trust wiring instructions sent via email. Cyber criminals are hacking email accounts and sending emails with fake wiring instructions. These emails are convincing and sophisticated. Always independently confirm wiring instructions in person or via a telephone call to a trusted and verified phone number. Never wire money without double-checking that the wiring instructions are correct.

Unfortunately, computer hackers are increasingly targeting real estate investors and home buyers for wire fraud via phishing. Unlike the luthiers who make Stradivari copies, the hackers in the real estate transactions can create realistic communications which can fool even the discerning investor.

How Hackers Can Steal Your Money in a Real Estate Transaction

In August 2017, a Washington, DC couple filed a lawsuit against their title company, claiming either title company fraud or lack of adequate security measures. The couple received an e-mail appearing to be from the title company requesting a wire transfer for their closing.  Since the e-mail appeared legitimate, they wired more than $1.5 million.  When the title company said it did not receive the money, the couple had to come up with an additional $1.5 million to close on their home purchase.

It sounds like this couple and title company may have been the victims of an all-too-common hacking scheme, which has been occurring in real estate transactions in recent years.  Here is how the fraud is carried out:

A hacker gains access to the e-mail account for one of the parties of the transaction.  Real estate brokers and title and escrow companies are common targets, because they advertise their services and conduct many transactions.

The hacker monitors the e-mail relating to one or more transactions, gathering detailed information about the transaction only known to the parties to those transactions. The hacker may even participate in communications by sending spoofed e-mails to parties so as to better set up the hacker’s end game.

When the hacker sees that the transaction is nearing the closing so that the buyer might be amenable to wiring funds into escrow, the hacker acts.

The hacker sends the buyer an e-mail, which appears to come from the real estate broker or title/escrow agent (and which in fact may be from the hacked account).  The e-mail provides wire transfer instructions, along with detailed information about the transaction and the amount of money to wire into the “escrow account,” which make the request seem legitimate.

If the buyer wires the funds, they go into the hacker’s bank account, possibly in a foreign country, and the funds are nearly immediate withdrawn.  It may be one or more days before the buyer shows up for his/her closing, only to learn that the payment is not in escrow and in fact has been stolen.

How to Protect Yourself  from Wire Fraud in Your Real Estate Transaction

Given this very real and potentially expensive threat, every real estate investor should take the following steps to protect him/herself from these very convincing phishing schemes in real estate transactions:

When entering financial information into a website, be sure it is legitimate and that it is secure (it should start with https, rather than http).

If you receive wire transfer instructions via e-mail, call to verify the information.

Before calling to verify the wire transfer instructions, verify the phone number you are calling – do not use a phone number from the e-mail sending the wire transfer instructions.

Both real estate investors and professionals should take the following steps so that they do not become the “weakest link” in the security for the real estate transactions in which they participate:

Do not send financial or other confidential via unencrypted e-mail.

Keep your virus and malware software up-to-date.

Install all security patches to your computer’s operating system.

If you use your laptop or tablet on a public Wi-Fi be sure your firewall is turned on

Use complex passwords containing a combination of capital and lower-case letters and numbers, and do not use the same password for every account. Passwords consisting of the first letters of the words in a phrase you find easy to remember combined with a number may be a good option.

Do not open attachments to e-mails or click on links in e-mails unless you are expecting them.

Use an account that does not have administrator privileges for your everyday computer usage. That makes it less likely that malware will be able to make changes to your system.

Modern technology may provide tools which aid in the evaluation of old violins, but other modern technology also can be used by hackers to commit wire fraud in real estate transactions.  By using a combination of old-fashioned detective work and the thoughtful use of technology where appropriate and being aware of the existence of copies or fakes, both string instrument professionals and real estate investors alike can prevent themselves from being the victims of fraud.

[i]  Music Geek Fact:  The term “luthier” is used to describe someone who makes or repairs string instruments.  Originally, however, luthiers made only lutes. The term “luthier” derives from the French word for lute, which is luth.

© 2017 by Elizabeth A. Whitman

 

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.

How Your Real Estate Transaction is Like an Orchestra (And Why You Need a Conductor)

Recently, while in the midst of a managing a complicated commercial real estate closing, I took a few hours off to attend an orchestra concert. During intermission, while orchestra took a break, a string quartet played in the lobby.

The quartet, which has only four musicians, each playing his/her own part, played beautifully together and created a unified musical expression without an obvious leader.  The orchestra, which had about 75 musicians playing at least 15 different parts, also played beautifully together and created a unified musical expression, but under the direction of a conductor.

It was then that I realized that the typical commercial real estate transaction frequently has at least 15 different roles and is much more like an orchestra than a string quartet.  A commercial real estate transaction has a huge cast of characters, including a buyer, seller, and each of their respective real estate brokers, mortgage lenders, property managers, and attorneys.  In addition, there is a title company and escrow agent, a surveyor, and in a more complicated ownership structure, partners or investors in the buyer and/or seller or mezzanine or other secondary lender, and many of them have their own attorneys, as well.

Just as each instrument in an orchestra has a role, each of the parties and attorneys involved in a commercial real estate transaction has a role.  Just as the instruments in an orchestra sometimes will have the melody and sometimes will provide supporting harmony, the parties and attorneys involved in a real estate transaction may migrate from central roles to supporting ones and back again during the course of the transaction.

The members of an orchestra have a common goal – a unified musical expression. The parties to a commercial real estate transaction also have a common goal – the successful completion of the transaction on terms acceptable to the party they represent.  And, like an orchestra conductor, an attorney experienced in transaction management helps the players in a commercial real estate transaction work together to reach their common goal.

Michael Tilson Thomas, conductor of the San Francisco Symphony, said “Being a conductor is kind of a hybrid profession because most fundamentally, it is being someone who is a coach, a trainer, an editor, a director.” World-famous violinist Joshua Bell commented on the plight of the conductor:

Being a director or a conductor is a balance of many things. And to do it right is a very difficult tightrope to walk. I’ve come to the conclusion that there’s really no way to be one hundred percent popular as conductor.

Like an orchestra conductor, an attorney serving as transaction manager likewise must wear many hats and carefully navigate while serving as both attorney and business advisor to his/her client (frequently the buyer), while also creating a roadmap for the transaction and taking steps to remove obstacles blocking the road to closing.

There is a difference between the role of an orchestra conductor and an attorney transaction manager, however. An orchestra conductor is coordinating individuals who do not probably could do his or her job themselves. Virtually every musician in an orchestra has studied conducting – it is usually a requirement to obtain a music degree – and some probably have conducted orchestras themselves.

Many orchestra musicians may have studied the music score being performed and even more frequently, the musicians have played the music with an orchestra previously, so they are familiar with its intricacies. String quartet members similarly are likely to be intimately familiar with the music they are playing.

With the string quartet, it is that experience with the music, combined with the collaborative nature of a quartet that enables the musicians to create a common musical message without the benefit of a formal conductor. With an orchestra, however, due to the sheer number of different parts, someone needs to select the path the orchestra will follow to a unified musical message. Among other things, a conductor fills that role.

Unlike either an orchestra or a quartet for that matter, a real estate transaction, the parties may have varying degrees of experience in commercial real estate. Unlike a musical ensemble, real estate transaction parties most likely have received on-the-job training, as it is uncommon for people to formally study real estate in college or graduate school.

Further, unlike with an orchestra or string quartet, it is very rare for the individuals in a transaction to have previously worked with the real estate involved and to be aware of its intricacies – and its pitfalls.

Therefore, in addition to selection of a unified pathway to the common goal of closing, the parties to a real estate transaction need someone walking ahead of them with a machete to create that pathway by the most direct route possible. As Joshua Bell noted, this may not always make the real estate transaction manager popular, but it does make her essential to the transaction’s efficient and successful closing.

The rare real estate investor may be a swashbuckling, real estate guru who is familiar with every square inch of the property, is experienced in real estate titles and finance alike, and is willing to personally forge a new trail towards the closing. However, if that doesn’t describe you, then you, like a major orchestra, should consider hiring your own real estate transaction to “conduct” your transaction.

© 2017 by Elizabeth A. Whitman

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.

Taking Your Real Estate Investments “On Tour”

Consider that you are a professional violinist who lives in Maryland. To build your career as a solo violinist you are planning your first tour to Pennsylvania and Ohio, and you need to attract local audiences in those states.  How would you connect with potential concertgoers?  Newspaper ads, Internet advertising, and mass mailings all could be effective in attracting individuals in Ohio and Pennsylvania who would be interested in hearing you perform.

It would be a lot more difficult if there were rules that required that your advertisements for the Ohio concerts only reached individuals in Ohio and the advertisements for the Pennsylvania concerts only reached individuals in Pennsylvania. If the rules were changed again so that only musicians who resided in Ohio could seek Ohio concertgoers, that would derail any opportunity for your Maryland orchestra to go on tour.

That is the exact dilemma real estate securities sponsors faced if they attempted to issue securities under the exemption in federal securities Rule 147 – at least until the Securities and Exchange Commission adopted Rule 147A, which became effective on April 20, 2017.

Under the previous rules, the intrastate exemption in Rule 147 was available to a securities sponsor only if the securities were issued by an entity formed in the state in which the real estate was located and that securities were only offered and sold to investors resident in the same state. Since advertisements might be considered offers to sell securities, from a practical matter, that prevented sponsors from using advertisements, such as the Internet or newspaper ads, which might reach individuals outside of that state.

Now, in recognition of changes in business practices and technology since Rule 147’s adoption in 1974, the SEC has adopted Rule 147A[1], which eliminates the requirement that the securities offeror be organized in the state in which the real estate is located. Rule 147A also eliminates restrictions on the offer of securities, as long as securities are only sold to individuals residing in the state.

Rule 147A offerings will not be exempt from state securities laws, so issuers will need to find a state securities exemption or qualify their securities in the state in which they are sold. Nevertheless, just as the Maryland violinist can perform for audiences in other states, a national real estate securities sponsor now can “go on tour” and develop custom real estate programs consisting of real estate in a single state for sale to residents of that state – and like the violinist, the real estate sponsor can use modern advertising to reach qualified prospective investors without running afoul of federal securities laws.

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[1]  Legal Geek Fact:  Much of the SEC’s authority is derived from the Commerce Clause of the US Constitution, which gives Congress the power to regulate interstate commerce.  Rule 147 was a safe harbor implementing Securities Act Section 3(a)(11), and is known as the “intrastate exemption.” Although the Supreme Court has significantly expanded the scope of the Commerce Clause of the US Constitution since its adoption, arguably, Section 3(a)(11) was not an exemption at all, but rather a tacit acknowledgement that an offering by a state’s resident entity that is offered and sold only to that state’s residents and is used entirely in that state might well not involve interstate commerce and therefore, be outside of the SEC’s jurisdiction.  Rule 147A, on the other hand, was NOT adopted under Section 3(a)(11), but rather, was adopted under the SEC’s general exceptive authority in Section 28 of the Securities Act, thereby eliminating any statutory requirement that the offering be made entirely in a single state. Section 3(a)(11) and an amended Rule 147 remain in effect, so securities offered pursuant to the intrastate exemption remain a possibility if the issuer can comply with the more strict standards imposed by that section.

© 2017 by Elizabeth A. Whitman

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 attorneys.

The “Tourte” of a Real Estate Investment

Most people have heard of Antonio Stradivari, who likely is the most renowned violin maker of all time. Few outside of the violin world, however, have heard of Francois Tourte, who developed the modern violin bow and has been called the “Stradivari of the bow.”

People understand that a quality violin can make a huge difference in the quality of sound produced. Students will spend weeks trying different violins to find the one which is “just right” for them. In the 17th and early 18th centuries, as is the case for many today, the bow was an accessory that came as part of the “violin package.”

Francois Tourte, an 18th century French violin maker, elevated the bow so great violinists now know that finding a bow of the best material[1], weight, balance, and suppleness for the violin and the violinist can make just as much difference in the music produced as the quality of the violin, itself. Indeed, many of the advanced violin techniques found in 19th and 20th century music are not playable using a 17th century-style “Baroque” bow.

Like the violin student, some real estate investors will spend months seeking out the perfect parcel of real estate. After signing a contract, the investor will spend a month or more and thousands of dollars conducting due diligence to be sure that the property meets the investor’s requirements.

Just as the violin student may overlook the importance of the bow, the real estate investor may overlook the importance of financing options and structure. Yet, the types and terms of financing used in the capital stack for a real estate investment, like the violin bow, can make just as much difference in the returns produced by a real estate investment as the selection of the real estate, itself.

In real estate finance, the various components of the “capital stack,” which can consist of various types of debt and equity are comparable to the material from which the bow is made. A simple structure might be one where the purchase puts 30% down as cash equity and obtains a standard, fixed-rate, 30-year mortgage from a bank for the remaining 70%.  More complex structures can contain preferred equity, mezzanine debt, and even multiple tiers of ownership.

However, the types of debt and equity and the balance between them isn’t all that needs to be considered, however.   The terms of the debt and equity also are important.  If the required debt service payments and preferred equity returns are too high, then the real estate investment may not be able to survive even a small, temporary dip in revenue or a small downturn in the economy.

Aside from the interest rate, the terms of the loan can make the difference between a successful investment and a financial failure. For instance, the term of the loan generally should be at least as long as the expected holding period for the property, so re-financing is not necessary.  On the other hand, prepayment penalties should be minimized or avoided altogether, as they may provide economic obstacles to disposition of an asset when necessary.  Further, in times of low interest rates, an assumable loan which, as interest rates increase will have a below-market interest rate, can add additional value to a real estate investment.

While in general increased leverage may improve returns on equity, an unrealistic debt service ratio could lead to foreclosure. Aggressive terms for triggering a lockbox will tie up cash, reduce flexibility in handling the property and very easily spiral into a mortgage default.

A real estate lender may be willing to negotiate some flexibility in the terms to accommodate the specific needs of the investor and accommodate unexpected events. However, once the situation arises all the negotiating power is with the lender. Taking the time and spending the money to have an experienced real estate attorney review and negotiate loan documents up front when the borrower still has some negotiating leverage will save time, reduce friction, and could save a real estate investment from loss.

Finally, capital stack structure can impact the tax consequences of a real estate investment, including the amount of deductions, whether cash flow is taxed at ordinary income or capital gains rates, and whether a Section 1031 exchange will be feasible upon exist from the investment. An experienced real estate attorney can, to the extent the investor’s needs are foreseeable, structure the capital stack optimally for the individual investor.

Just as Francois Tourte enabled violinists to perform at new, higher levels, an experienced real estate attorney can help the real estate investor structure the capital stack and negotiate debt and equity terms which provide greater protection of the investment and help to maximize investment returns.

[1]  Geek Note: Violin bows come in many different materials, the most desirable of which is Pernambuco, the heart of a tree grown in Brazilian rainforests. As modernization has encroached upon the rainforest, Pernambuco has become increasing scarce. Bow makers have turned to “Brazilwood,” which despite its name comes from a completely different tree and may not even be from Brazil. More recently, manufacturers have developed bows made with carbon fiber, which can compete with wood bows in responsiveness and are virtually indestructible, making them good options for young, advancing players, like my 12-year-old son, who enjoy testing bow destructibility. Finally, beginner bows may be made from fiberglass, which is also almost indestructible, but lacks in the suppleness necessary to produce more advanced bow techniques.

© 2017 by Elizabeth A. Whitman

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.

SIZING UP IN VIOLINS AND INVESTMENT REAL ESTATE

If you have ever attended an elementary school instrumental music concert, you may need your parental pride to outweigh the general cacophony that is inflicted on your ears. Sometimes, however, you may find a group of violins that sound pretty good. Why is that?

Well, for technical reasons, string players can start younger[1]. As supply meets demand, violins can range from a 1/32 size up to full size.  Therefore, a child can start playing the violin on a tiny instrument at a very young age and “size up” on violins as he/she grows.

There are two strategies for obtaining violins for a child: rent or own. If you rent, you just pay each month for your child’s entire career.  If you choose to buy the violins, you will keep buying and disposing of increasingly more expensive violins.  I looked at the math and decided to buy my son’s violins.

My son started at age three playing a 1/32 size violin, which with an eight-inch body looked more like a toy than a violin. At age five, when he moved to a 1/10 size, we also found a need to move up a step in quality (and therefore, price) with each size increase.  A few months ago, my son traded in his ¾ size violin for a 7/8 size instrument, which is valued at 20 times the price we paid for that original 1/32 size violin nearly nine years before.

When we made the most recent violin purchase, I realized how our “investment” in violins is like real estate investment. A real estate investor might start small, with a single duplex.  That duplex might be sold and the money reinvested in a four-plex, and the four-plex might in turn, be sold and the proceeds reinvested in a more expensive three-story office building.  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.

Unlike with violins purchased for my son, a real estate investor has to think about taxes with every “trade up.” 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.  Although land cannot be depreciated, buildings can be, so there can be a significant tax liability upon sale of the investment.

One thing that helps real estate investors accomplish growth in 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 within 180 days.

When it was first created in 1921, a Section 1031 exchange required a literal swap of the two properties, as would occur if my son were to literally trade in his small violin at the violin shop for a larger sized violin.   For a direct swap, tax deferral makes a lot of sense.  It can be difficult to determine the “sale prices.”  Plus, unlike a sale and reinvestment, a sale doesn’t result in a cash payout from which taxes could be paid.

Therefore, over the years, Section 1031 exchanges have evolved so that they are more useful to real estate investors.

For instance, another option with violins, is to sell the smaller violin to another student and then use the money to buy the larger sized violin from the violin shop. Likewise, a real estate investor might choose to sell that duplex to Company A and use the proceeds to buy the four-plex from Company B.

For the past 30+ years, the tax law has allowed real estate investors to use what is known as a “qualified intermediary” to do the real estate equivalent by for instance, exchanging an apartment building sold to Company A with an office building purchased from Company B.   Without going into the detailed rules for this 1031 exchange, this would roughly equivalent to selling the smaller violin to another student, then putting the proceeds of the sale in a special savings account that could only be used to buy a new violin, once the desired instrument was located.

1031 Exchanges, however, are seen by some as a tax loophole for real estate investors. The Republican tax proposal “A Better Way” would significantly change the tax laws, including those on investment real estate. The proposal includes a full and immediate expensing of investment in place of depreciation.

Although this proposal might simplify the tax laws, it is likely to complicate the tax situation for many real estate investors. 1031 exchanges are not specifically mentioned in “A Better Way,” but some believe that 1031 exchanges might be abolished along with depreciation.  If that were to happen, real estate investors likely would be taxed on their proceeds upon sale of their real estate.  This would limit available cash for real estate investors’ to “trade up” and potentially could slow down the recovery of the real estate market.

Therefore, although it seems likely that there will always be a crop of younger violinists in need fractional-sized violins as you “trade up” to larger instruments, tax laws may not always make it as easy to “trade up” your real estate investment.

© 2017 by Elizabeth A. Whitman

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[1] Geek fact: A partial explanation is that strings of different length can reach the same pitch by changing the tension, while wind instruments require a certain length of the air column to produce a pitch.  So if you want to start your five-year-old on a bassoon, you may need to stretch him a bit first. Also, wind instruments require a developed mouth and certain number of permanent teeth, which are not required for string instruments.

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.