Wednesday, May 28, 2008

Model Real Estate Development Operating Agreement from the American Bar Association

The February 2008 edition of The Business Lawyer contains a report on Model Real Estate Development Operating Agreement with Commentary [pdf. ABA membership logon required].

The model agreement was put together by a Joint Task Force of Committee on LLCs, Partnerships and Unincorporated Entities and the Committee on Taxation, ABA Section of Business Law.

Here is the fact pattern that the model agreement addresses:
The Project. The real estate project involves the acquisition of undeveloped land and the construction of an ice skating rink complex with a hotel, retail shops, condominiums, and an office building.

The Venturers. The proposed venturers are: (1) a real estate development and management company (the “Developer”), whose focus is to organize the venture, acquire the land, obtain appropriate permits, oversee construction of all the buildings in phases, manage all of the buildings, and hire the appropriate leasing agents and ancillary specialists necessary for the project; (2) the owner of the undeveloped land (the “Land”) upon which the project is to be constructed (the “Landowner”); and (3) an investor who will provide the necessary equity financing for the venture to obtain the needed debt financing for the construction and subsequent operation of the project (the “Financial Investor”).

The Entity. The venture (the “Company”) is to be organized as a manager-managed limited liability company under the Delaware Limited Liability Company Act (Del. Code Ann. tit. 18 §§ 101 et seq.) as in effect on August 1, 2007.

Debt Financing. While in many (if not most) cases, the construction financing will require guaranties or other forms of credit enhancement, it is assumed, for simplicity sake, that the construction loan, the permanent refinancing loan, and the operating capital line-of-credit will not require any credit enhancement and, therefore, will be treated as “nonrecourse debt” under applicable federal income tax regulations.

The Ownership/Membership Interests. The contributed capital will consist of the Land contributed by the Landowner (which is assumed to have a fair market value of $5,000,000 and an adjusted tax basis at the time that it is deeded to the Company of $1,000,000) and the cash contributed by the Financial Investor (which is assumed to be $10,000,000). The Developer does not contribute any capital to the Company. The Landowner and the Financial Investor are entitled to receive a preferred return on their contributed capital. Any residual profits will be shared 40% to the Developer, 20% to the Landowner, and 40% to the Financial Investor. These percentages were selected for mathematical convenience. The amount of the Developer’s “carried” or “promoted” interest and the amount of the investors’ preferred return (if any) will need to be discussed and agreed upon by the parties.

Tax Treatment of the Company. The Company is to be treated as a partnership for federal tax purposes as provided under Treas. Reg. § 301.7701-3(b)(i). For that reason, in many parts of the operating agreement and the commentary, the Company is referred to as a “partnership” and the members are referred to as “partners.” See, for example, the rules of construction in Section 11.8(b).

Cash Flow. In addition to the Developer’s carried or promoted interest, the Developer likely will be entitled to certain fees (e.g., development and management fees). Those fees, and the services to be provided in exchange for those fees, often are contained in other contracts between the Company and the Developer. Those fees will be paid “other than in the Developer’s capacity as a member” of the Company within the meaning of Code § 707(a) and, therefore, are not to be treated as “distributions” by the Company. Distributions of available cash after the Company has serviced its debt obligations and paid or made provision for its other liabilities are to be made to the members first, in the amount of their presumed aggregate, net income tax liabilities on their shares of the Company’s net income; second, in the amount of any remaining accrued, but unpaid, preferred return (i.e., net of applicable tax distributions) on their contributed capital; and the balance, in proportion to the members’ residual profits percentages (adjusted for any applicable tax distributions that they previously received on those profits). An exception to the foregoing distribution regime is made or proceeds received from the sale or refinancing of the Company’s property. Under hose circumstances, the members’ contributed capital is to be repaid before the remaining sale or refinancing proceeds are distributed in accordance with the members’ residual profits percentages.

Allocations. Capital accounts will be maintained in accordance with applicable Treasury Regulations. Allocations of the Company’s income, gains, losses, and deductions are to be made in a manner that allows all distributions to be made as described in the preceding paragraph while complying with applicable Treasury Regulations.
I will put up some future thoughts on the model agreement. My initial reaction is that I am not used to running into a situation where there are three parties. Usually, there is the Financial Investor and the Developer. The Landowner throws a different curve into the agreement.

Saturday, May 24, 2008

Rev. Proc. 2008-28 and Foreclosure Relief for Securitizations

The Internal Revenue Service issued Revenue Procedure 2008-28 [.PDF ] which provides for the modification of certain mortgage loans will not jeopardize the favorable tax treatment of the capital structure for certain securitization capital structures.

One issue impacting the downturn in the real estate market is the inability of some lenders to revise the loan terms to avoid foreclosure. The packing of loans into a securitization structure was usually accomplished by using a REMIC or other tax-favorable structure. By adhering to the REMIC rules, the payments to the lender passed through the REMIC structure would not be taxed until received by the investors in the REMIC structure. REMICs are governed by Section 860A - 860G of the Internal Revenue Code.

One of the limitations in the REMIC structure is that the loans cannot be materially modified. If modified, the IRS imposes a hefty tax penalty. Section 860F(a)(1) imposes a tax on a REMIC equal to 100 percent of the net income derived from “prohibited transactions.” The disposition of a qualified mortgage is a prohibited transaction unless the disposition is pursuant to "(i) the substitution of a qualified replacement mortgage for a qualified mortgage; (ii) a disposition incident to the foreclosure, default, or imminent default of the mortgage; (iii) the bankruptcy or insolvency of the REMIC; or (iv) a qualified liquidation."860F(a)(2)

The IRS promulgated Rev. Proc. 2008-28 to give the servicers of residential mortgage loans some more flexibility in providing foreclosure relief, without jeopardizing the capital structure of the mortgage loan securitization. This revenue procedure applies to "a modification of a mortgage loan that is held by a REMIC, or by an investment trust, if all of the following conditions are satisfied:
  1. The real property securing the mortgage loan is a residence that contains fewer than five dwelling units.
  2. The real property securing the mortgage loan is owner-occupied.
  3. (1) If a REMIC holds the mortgage loan, then as of either the startup day or the end of the 3–month period beginning on the startup day, no more than ten percent of the stated principal of the total assets of the REMIC was represented by loans the payments on which were then overdue by 30 days or more; or (2) If an investment trust holds the mortgage loan, then as of all dates when assets were contributed to the trust, no more than ten percent of the stated principal of all the debt instruments then held by the trust was represented by instruments the payments on which were then overdue by 30 days or more.
  4. The holder or servicer reasonably believes that there is a significant risk of foreclosure of the original loan. This reasonable belief may be based on guidelines developed as part of a foreclosure prevention program similar to that described in Section 2 of this revenue procedure or may be based on any other credible systematic determination.
  5. The terms of the modified loan are less favorable to the holder than were the unmodified terms of the original mortgage loan.
  6. The holder or servicer reasonably believes that the modified loan presents a substantially reduced risk of foreclosure, as compared with the original loan."
If the modification meets those requirements, then
  • The IRS will not challenge a securitization vehicle’s qualification as a REMIC on the grounds that the modifications are not among the exceptions listed in § 1.860G–2(b)(3);
  • The IRS will not contend that the modifications are prohibited transactions under section 860F(a)(2) on the grounds that the modifications resulted in one more dispositions of qualified mortgages and that the dispositions are not among the exceptions listed in section 860F(a)(2)(A)(i)–(iv);
  • The IRS will not challenge a securitization vehicle’s classification as a trust under section 301.7701-4(c) on the grounds that the modifications manifest a power to vary the investment of the certificate holders; and
  • The IRS will not challenge a securitization vehicle’s qualification as a REMIC on the grounds that the modifications resulted in a deemed reissuance of the REMIC regular interests.
This revenue procedure governs determinations made by the Service on or after May 16, 2008, with respect to loan modifications that are effected on or before December 31, 2010.

Tuesday, May 6, 2008

A Tale of Two Property Markets

While commercial property owners are worried about property market, much of the commercial property market remains stable or strong. In contrast, the residential market is still spiraling down and take lots of people and companies with it.

First up, the summary of REIT earning reports show that most of the public real estate companies are still hitting their earnings targets: REITs Cautious Despite Strong Quarter.
Given fears that a sagging economy and a crippled credit market might wreak havoc on the commercial property market, real-estate investment trusts delivered surprisingly strong earnings for the first quarter, with many companies beating analysts' estimates.
The implosion of the residential markets is taking down builders: Falling Prices Hit Builder Horton - Home Cancellations, Write-Downs Spur $1.31 Billion Loss.

The implosion is also showing the weakness in the underwriting and origination processes for mortgage lender. It was apparently bad enough at Countrywide that it is giving Bank of America second thoughts about its takeover: Acquisition of Lender Is Possibly in Jeopardy. According to an older story, Loan Data Focus of Probe:
The investigators are finding that Countrywide's loan documents often were marked by dubious or erroneous information about its mortgage clients, according to people involved in the matter. The company packaged many of those mortgages into securities and sold them to investors, raising the additional question of whether Countrywide understated the risks such investments carried.

Many of these companies mentioned are clients of The Firm. I have no knowledge of the background except what was in these stories.