I’m happy to announce that the website for my new book, Illinois Commercial Real Estate is now live.  Visit www.Illinois-CRE.com for a book excerpt.

Illinois Commercial Real Estate, Due Diligence to Closing, with Checklists, is intended as a practical handbook for investors, developers, brokers, lenders, attorneys and others interested in commercial real estate projects in Illinois. This book zeros-in on commercial real estate due diligence, and walks the reader through the due diligence process, from conception to closing, with a focus on making sure the commercial real estate project functions as intended after closing.  Checklists are provided as an aid to commercial real estate professionals to assist on evaluation of the property and the transaction on the path toward successful closing. As people in the real estate industry understand, if the deal doesn’t close, it doesn’t count.

I’d like to extend Special Thanks to:

My clients, whose passion for creative commercial development I share;

My partners and staff at Robbins, Salomon and Patt, Ltd., who work with me tirelessly to earn our client’s business every day.

Catherine A. Cooke and Emily C. Kaminski, attorneys at Robbins, Salomon & Patt, Ltd. who provided legal research, advice, counseling, and technical editing;

James M. Mainzer, tax partner at Robbins, Salomon & Patt, Ltd., for his insights and assistance on tax matters;

The editing staff at the Illinois Institute for Continuing Legal Education, for editing early versions of chapters 11, 12, 25, 27 and 28, which were first published in IICLE Practice Handbooks;

Dale V. Weaver, Illinois licensed surveyor, who was kind enough to convert my rough draft drawings into the diagrams included at chapter 25;

. . . and, of course, my friend and valuable resource, Linda Day Harrison, founder of theBrokerList, for her ongoing encouragement and support.

If you are buying, developing, financing, selling, leasing or otherwise dealing with commercial real estate in Illinois, I hope you will find Illinois Commercial Real Estate, Due Diligence to Closing, with Checklists to be a useful resource.

ENJOY!!!

R. Kymn Harp

 2016 Updat

Are you planning to purchase, finance, develop or redevelop any of the following types of commercial real estate in the USA?

• Shopping Center
• Office building
• Large Multifamily/Apartments/Condominium Project
• Sports and/or Entertainment Venue
• Mixed-Use Commercial-Residential-Office
• Parking Lot/Parking Garage
• Retail Store
• Lifestyle or Enclosed Mall
• Restaurant/Banquet Facility
• Intermodal logistics/distribution facility
• Medical Building
• Gas Station
• Manufacturing facility
• Pharmacy
• Special Use facility
• Air Rights parcel
• Subterranean parcel
• Infrastructure improvements
• Other commercial (non-single family, non-farm) property

A KEY element of successfully investing in commercial real estate is performing an adequate Due Diligence Investigation prior to becoming legally bound to acquire or finance the property.  Conducting a Due Diligence Investigation is important not just to enable you to walk away from the transaction, if necessary, but even more importantly to enable you to discover obstacles and opportunities presented by the property that can be addressed prior to closing, to enable the transaction to proceed in a manner most beneficial to your overall objective. An adequate Due Diligence Investigation will assure awareness of all material facts relevant to the intended use or disposition of the property after closing. This is a critical point. The ultimate objective is not just to get to Closing – but rather to confirm that the property can be used or developed as intended after Closing.

The following checklists – while not all-inclusive – will help you conduct a focused and meaningful Due Diligence Investigation.

Illinois LLCs – The Asset Protection Advantage

A Technical Analysis

Among sophisticated investors and other high-asset/high-net worth individuals and businesses, the topic of “asset protection” is bound to arise. As many became painfully aware during the recent Great Recession, bad things can happen to good people. In my article Asset Protection – Lessons Learned, I discussed how properly structuring one’s holdings could have prevented, or at least mitigated, much of the financial devastation and anguish experienced by business owners, investors, real estate developers, doctors and others caught off-guard by the drastic economic collapse of 2007-2010.

Often, there is confusion about what the term asset protection really means. Some imagine a shadowy network of off-shore trusts and secret bank accounts in foreign lands set up by unscrupulous characters to cheat innocent creditors. This is simply not true. In this article I will not debate the claimed pros and cons of secret bank accounts and so-called off-shore asset protection trusts. I will say, however, that under most circumstances, they don’t work for U.S. citizens residing in the U.S.A.

Legitimate asset protection is nothing more or less than properly ordering one’s business and financial affairs in a way that does not unnecessarily expose all assets to claims of creditors.

The right of persons and businesses to limit their liability and exposure of their assets to claims of creditors is the well settled in the U.S.A. The United States of America, and each individual state, has a plethora of laws authorizing and recognizing the legitimacy of corporations and other limited liability entities as a means by which an investor can segregate assets and limit exposure to liability.

No person has a legal or moral obligation to structure his or her affairs in a way that makes it easy for a creditor of one business or professional enterprise to attach assets of the investor not committed to that enterprise. This protection may be impinged if the person or business engages in conduct tantamount to fraud, but actions explicitly authorized by applicable statute can hardly be characterized as being fraudulent. Fraud is an intentional tort requiring, among other elements, intentional breach of a duty owed to the person claimed to be harmed. If a statute expressly authorizes conduct, it implicitly, if not explicitly, negates any duty to act in a manner contrary to that authorized by the statute.

This article presents a technical analysis of certain asset protection attributes of an Illinois limited liability company expressly authorized by the Illinois Limited Liability Company Act, 805 ILCS 180/1-1 et seq (the “Illinois LLC Act”). The remarkably robust asset protection value of an Illinois limited liability company is measured by two key attributes:

1. The ability, expressly authorized by the Illinois LLC Act, to include in an LLC operating agreement provisions that protect the limited liability company and its business and assets from claims owed to others by members of the LLC – an attribute that creates a huge advantage vs. a corporation, as discussed in Part I, below; and

2. Enhanced protection of Members and Managers from liability for debts, contracts and torts incurred by the LLC, or resulting from acts or omissions of a Member or Manager while acting on behalf of the LLC, to an extent measurably greater than the protection afforded officers, directors and shareholders of a corporation.

Although one might reasonably expect that the order in which these key attributes are discussed would be reversed, the Part I discussion precedes the Part II discussion because the matters to be discussed in Part I are best considered at the outset, when the operating agreement is being drafted; while the matters discussed in Part II will most directly apply later, once a judgment creditor is seeking to enforce its judgment.

PART I: Key Statutory Provisions to Consider When Drafting the Operating Agreement

I read once that if you took all the lawyers in the world and laid them end to end along the equator — it would be a good idea to leave them there.

That’s what I read. What do you suppose that means?

I have written before about the need to exercise due diligence when purchasing commercial real estate. The need to investigate, before Closing, every significant aspect of the property you are acquiring. The importance of evaluating each commercial real estate transaction with a mindset that once the Closing occurs, there is no going back. The Seller has your money and is gone. If post-Closing problems arise, Seller’s contract representations and warranties will, at best, mean expensive litigation. CAVEAT EMPTOR! [“Let the buyer beware!”]

Paying extra attention at the beginning of a commercial real estate transaction to “get it right” can save tens of thousands of dollars versus when a deal goes bad. It’s like the old Fram® oil filter slogan during the 1970’s: “You can pay me now – or pay me later”. In commercial real estate, however, “later” may be too late.

Buying commercial real estate is NOT like buying a home. It is not. It is not. It is NOT.

In Illinois, and many other states, virtually every residential real estate closing requires a lawyer for the buyer and a lawyer for the seller. This is probably smart. It is good consumer protection.

The “problem” this causes, however, is that every lawyer handling residential real estate transactions considers himself or herself a “real estate lawyer”, capable of handling any real estate transaction that may arise.

We learned in law school that there are only two kinds of property: real estate and personal property. Therefore – we intuit – if we are competent to handle a residential real estate closing, we must be competent to handle a commercial real estate closing. They are each “real estate”, right?

ANSWER: Yes, they are each real estate. No, they are not the same.

The legal issues and risks in a commercial real estate transaction are remarkably different from the legal issues and risks in a residential real estate transaction. Most are not even remotely similar. Attorneys concentrating their practice handling residential real estate closings do not face the same issues as attorneys concentrating their practice in commercial real estate.

It is a matter of experience. You either know the issues and risks inherent in commercial real estate transactions – and know how to deal with them – or you don’t.

A key point to remember is that the myriad consumer protection laws that protect residential home buyers have no application to – and provide no protection for – buyers of commercial real estate.

Competent commercial real estate practice requires focused and concentrated investigation of all issues material to the transaction by someone who knows what they are looking for. In short, it requires the experienced exercise of due diligence.

I admit – the exercise of due diligence is not cheap, but the failure to exercise due diligence can create a financial disaster for the commercial real estate investor. Don’t be “penny wise and pound foolish”. If you are buying a home, hire an attorney who regularly represents home buyers. If you are buying commercial real estate, hire an attorney who regularly represents commercial real estate buyers.

Years ago I stopped handling residential real estate transactions. As an active commercial real estate attorney, even I hire residential real estate counsel for my own home purchases. I do that because residential real estate practice is fundamentally different from commercial real estate.

Maybe I do harp on the need for competent counsel experienced in commercial real estate transactions. I genuinely believe it. I believe it is essential. I believe if you are going to invest in commercial real estate, you must apply your critical thinking skills and be smart.

POP QUIZ:

Here’s a simple test of YOUR critical thinking skills:

Please read the following Scenarios and answer the questions TRUE or FALSE:

GUEST BLOG BY DAVID RESNICK of ROBBINS, SALOMON & PATT, LTD.

When considering a lease, tenants are usually focused on the location, size and quality of the leased space, and perform some minimal diligence on the landlord and property manager to ensure fair treatment over the course of the term. Landlords have a more difficult task,however. A prospective tenant, and most importantly, that tenant’s ability to pay rent, is often unknown to the landlord. In recent years, real estate professionals have witnessed expansion in the array of users of commercial space and at the same time, property owners have been compelled to seek out new types of tenants. Increasing numbers of start-ups and new ventures are seeking to lease space, many of which are backed by various types of equity financing. As a result of these changes, landlords should be particularly vigilant in understanding how their tenants make money, as well as the financial identities of the parties backstopping the obligations of those tenants.

Analyze Tenant Credit

Landlords should always analyze tenant credit in the context of the lease. After all, the success of leased real estate, as well as the property owner’s ability to borrow against that asset, is dependent upon the stability of its tenants. While rent is the primary economic factor in any lease transaction, other factors such as term (including rights of extension), area of the premises (including rights of expansion and rights of first refusal on additional space) and the scope of tenant improvements create the platform upon which a tenant’s credit can be evaluated. For example, substantial build-out (regardless of who pays for it) that may inhibit the re-letting the space following a default. Therefore, landlords should be mindful of the tenant’s capacity to pay its construction obligations, which capacity is usually encapsulated in the tenant’s credit and litigation history.

A proper underwriting of a tenant’s credit requires a thorough understanding of that tenant’s business. A prudent landlord will pay attention not only to the tenant’s sources of revenue, but to the market upon which the tenant relies and the business plan upon which the tenant charts its future success. What are the contours of the business model? Is the revenue sustainable? What is the plan for future growth? Has the tenant gone through restructuring or been forced to lay off personnel? Landlords can avoid doing business with troubled or unstable tenants by performing background, lien and litigation searches on the tenant parties as part of the underwriting process. This kind of diligence can usually be completed in a short time-frame at a reasonable cost, and may save substantial time and money if the landlord is forced to evict a tenant it should have known to be at increased risk of default.

Technology has given rise to new products which enhance the process of underwriting tenant credit. For example, the Chicago firm (RE)Meter has created the first “credit score” for commercial tenants, which captures and synthesizes proposed lease transaction terms and basic tenant financial information with exclusive data maintained by a number of federal agencies, including the U.S. Census Bureau, the Department of Labor and the Internal Revenue Service ((RE)Meter is the first firm to access IRS information in this context). The end product, called the TIL Report, can be completed in a mere 15 minutes and offers landlords a sector- and market-specific analysis of its prospective tenants, reflecting a number of detailed metrics including growth trends, profitability and rent per employee. Innovations like these have altered the landscape of tenant underwriting and will enable landlords to make more prudent decisions when marketing space and assessing the risk of potential tenants.

Tenant Credit Enhancements

Conventionally, several mechanisms exist to enhance the credit of a prospective tenant who fails on its own to meet the underwriting criteria of the landlord. The first and foremost of these is the security deposit, which is posted by the tenant in the form of cash or letter of credit and held by the landlord for all or part of the duration of the lease. The deposit may be applied by the landlord towards unpaid amounts payable under the lease like rent, proportionate common area expenses or taxes, or reimbursement of amounts expended to repair damage to the premises. A stronger credit tenant may receive the benefit of a return of all or part of the deposit held by landlord over time, provided the tenant has not defaulted.

Security Deposits

While cash security deposits have historically been the industry standard in commercial leasing, landlords are increasingly requiring letter of credit security deposits instead. For many landlords, the benefits of cash on hand are overshadowed by the security of an obligation issued by a third-party bank, particularly when the landlord is able to draw on the letter of credit following a default without notice to or consent by the tenant. Letters of credit also may bear advantages to the landlord following a bankruptcy by the tenant, as the obligation of the issuing bank to pay on the letter of credit is independent of the tenant’s obligations under the lease. However, some courts have found that letter of credit security deposits are part of the tenant’s bankruptcy estate and thus subject to the cap on a landlord’s claim for damages under Section 502(b)(6) of the United States Bankruptcy Code.

Lease Guaranties

Guaranties are a common alternative for securing the credit of a commercial tenant. In the context of commercial leasing, a guaranty is a legally enforceable undertaking by a third party to fulfill the payment or performance obligations of the tenant under a lease. A guaranty may be given by an entity, such as a corporate parent or affiliate, or an individual, such as a majority owner or other key principal of the tenant. To most effectively backstop the credit of the tenant, a guaranty should be a guaranty of payment as opposed to a guaranty of performance. This distinction ensures that the landlord will not be forced to exhaust its remedies against the tenant before pursuing enforcement of the guaranty. Rather, the landlord may pursue the tenant and guarantor simultaneously for unpaid amounts under the lease.

Once a landlord has determined that it will require a guaranty to secure the tenant’s obligations under the lease, what should the landlord look for in evaluating potential guarantors? The most straightforward factor, notwithstanding whether the proposed guarantor is an individual or an entity, is cash on hand and other liquid assets. In satisfaction of the landlord’s inquiry, an guarantors may produce income tax returns, bank statements, financial statements, balance sheets or other evidence of personal holdings. The review process for publicly traded companies is simplified in that pertinent financial information is publicly available. Of course, testing for liquidity has its flaws. There exists no iron-clad protection against fraud, and disclosures only present a snapshot of a party’s credit at the time of the test as opposed to a forecast of future liquidity and stability. A review of tenant and guarantor financial information, as well as credit reports for collections, pledging of material assets or opening of new lines of credit, should be performed at regular intervals throughout the term of the lease.

Financial Disclosure Challenges

Financial disclosures may be problematic or some privately-held concerns. Particularly in the modern era of start-up firms financed by venture capital and private equity interests, tenants and proposed guarantors may be limited by investor confidentiality. With this in mind, parties to a lease should clarify in the lease or guaranty the form of any future disclosures to be made. Tenants and guarantors may resist delivering full-fledged audited financial statements in favor of reduced balance sheets or nominal form of profit and loss statement. Depending on the profile of the market and building, landlords may be willing to accept less than full disclosure if the statements deliver a reasonable picture of the financial health of the party delivering them.

Tenant Stability and Performance Incentives

As lease term and the disclosure provisions are negotiated, tenants may push the landlord for a variety of concessions that effectively incentivize and reward tenant stability. Perhaps the most common examples of this request are limitations on the security deposit, pledged assets or the liability under or the term of the guaranty. Limitations like these can take a variety of forms, from a fixed term to a cap on the guarantor’s liability based upon a fixed dollar-figure or factor of rent payable under the lease, to an automatic reduction of either the security deposit or the cap on the guarantor’s liability over time. In each instance, the landlord should be cognizant of the hurdles the tenant party must overcome to receive the benefit of these limitations, none more important than the uninterrupted timely payment of rent without default.

Tenant Credit is a Key to Successful Lease Performance

In light of the crises our industry has withstood in recent years, a landlord’s exuberance in welcoming new tenants is understandable. But in the current era of increasing economic growth, landlords should adopt a cautious approach in understanding and monitoring the business of their tenants. No landlord can predict with certainty the success or failure of its tenants; however, perhaps now more than ever, a thorough and complete examination of tenant credit is essential to the financial success of any leased real estate.

At long last, the real estate investment market is beginning to show signs life. Commercial and industrial property transactions are increasingly common, and multifamily properties of all sizes are being snapped up by investors. Historically low interest rates, high occupancy rates, increasing rental rates, and rising property values are contributing factors.

Early transactions have often been cash deals, where the investor paid cash for the property rather than seek financing. This can be a great opportunity to achieve high yields for investors flush with cash, but what about everyone else?   What about potential investors who have limited cash on hand?

Unlike the easy-credit days preceding the Great Recession, real estate investment financing is more difficult to obtain and requires a significantly higher equity contribution by investors.  Common loan to value ratios are 60% to 65%, which means that for each $1,000,000 the investor needs, the investor can likely borrow only $600,000 to $650,000. Consequently, the investor must come up with between $350,000 and $400,000 in equity for each $1,000,000 of purchase price. For many investors, this may not be an easy task.

Solution? Go back to the way we did things in the old days – before the days of easy, near 100% financing: pool funds with other like-minded investors.

When raising capital from investors, keep in mind that you are engaged in a securities offering governed by state, and perhaps federal, securities laws. This is true even if the money is being invested by friends and family. A private placement memorandum (“PPM”) is advisable to protect against claims by investors that the investment turned out to be other than what it was portrayed to be. This is particularly important if the investment goes bad – as investments sometimes do.

PPM’s for real estate investments need not be particularly complicated, but they need to comply with applicable securities laws and include the disclosures and information necessary to protect the promoter from liability. The promoter must be particularly cautious if funds are being obtained from investors other than “accredited investors” as that term is defined by Rule 501 of Regulation D. Helping promoters comply with the law while raising capital is a key function for lawyers.

In September 2013, as required by the Jumpstart Our Business Startups Act (JOBS Act), new rules were established by the U.S. Securities and Exchange Commission to permit general solicitation or general advertising for certain securities offerings limited to accredited investors only. While this may prove helpful to promoters’ efforts to find investors and raise funds, the importance of a carefully crafted PPM has not diminished. Thoughtful promoters and lawyers will recognize that a well-crafted PPM may now be more important than ever.

Raising capital through a private offering of securities is a viable strategy for real estate investment, but it must be done with skill and great care.  Failure to fully comply with the law can be financially catastrophic.  Take care to do it right.

This is the second installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explained WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covers the key rules for HOW to implement a Section 1031 like-kind exchange. Part 3 will cover special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.

KEY RULES FOR SECTION 1031 EXCHANGES

The following is an outline of key rules applicable to Section 1031 exchanges. Become familiar with these rules. Unless you intend to completely cash out of real estate investing, a Section 1031 exchange may work to your benefit. If you intend to keep investing in real estate or using real estate in your trade or business, a Section 1031 exchange will maximize the capital you have available to reinvest.

Key Elements of a Section 1031 Exchange*

What is Section 1031?

Section 1031 refers to Section 1031 of the Internal Revenue Code of 1986, as amended.

What does it do?

Section 1031 permits a taxpayer (the Exchangor) to dispose of certain real estate and personal property and replace it with like-kind property without being required to pay taxes on the transaction.

What property qualifies?

To qualify for a Section 1031 exchange, the property being disposed of (the Relinquished Property) must have been used in the Exchangor’s trade or business and/or must have been held for investment purposes. The property being acquired (the Replacement Property) must likewise be acquired for use in the Exchangor’s trade or business or for investment.

What property is considered like-kind?

For real estate, to be like-kind means simply that real estate must be exchanged for real estate. The rules related to personal property are significantly more complex. Personal property is any property that is not real estate.

Real estate exchanges are fairly straightforward. A warehouse may be exchanged for another warehouse or for any other qualifying real estate including, for instance, a factory building, office building, shopping center, single-tenant store, parking garage, or even a parcel of vacant ground so long as it qualifies as being acquired for use in the Exchangor’s trade or business or is to be held for investment. This is not a difficult test to pass. Similarly, a qualifying parcel of vacant ground or a shopping center or office building or factory or other parcels of investment real estate may be exchanged for any other qualifying real estate investment.

Personal property exchanges are not so straightforward. For personal property, the property must be substantially similar and of the same type or class. For example: a car can be exchanged for another car; and a bull can be exchanged for another bull; and a cow can be exchanged for another cow; but, a bull may not be exchanged for either a cow or a car.

Although personal property exchange rules are substantially more technical and complicated than real property exchange rules, generally speaking, depreciable tangible personal property held for productive use in a trade or business can be exchanged for other depreciable tangible personal property held for productive use in a trade or business so long as they fall within the same NAICS classification code.

For instance, Limited Service Restaurants such as fast food restaurants, pizza delivery, sandwich shops, etc. fall within 2012 NAICS Code 722513. Accordingly, the assets of one can be exchanged for the assets of the other under Section 1031. But, note that the NAICS Code for a bar, tavern or nightclub is 722410, and the NAICS Code for a full service restaurant is 722511, so an exchange of assets of either of these for the assets of the other, or the assets of a Limited Service Restaurant (even though otherwise physically identical), may not likely be considered “like kind”.

The point, for purposes of this post, is that exchange rules for personal property are substantially more complex than exchange rules for real property. Accordingly, if you are exchanging personal property – either in conjunction with an exchange of real property or purely as a personal property exchange – great care must be taken to comply with the personal property exchange rules to receive the benefits of a tax deferred exchange under Section 1031.

What property is excluded?

Some types of property are expressly excluded from tax deferred exchange treatment by statute, rule or regulation The following types of property do not qualify for aSection 1031 exchange: stocks, bonds, partnership interests, limited liability company interests, personal residences, stocks in trade or inventory, and certain other intangible property.

Are there timing issues?

Section 1031 exchanges can be simultaneous, but they are not required to be. In fact, most exchanges made pursuant to Section 1031 are not simultaneous. There are, however, strict timing rules that apply tonon-simultaneous exchanges and strict rules prohibiting access to funds.

What are the time limits?

The Replacement Property or properties must be identified, in writing, not later than forty-five days after the Relinquished Property is transferred (the Identification Period). The Replacement Property or properties must be acquired not later than the earlier of (i) 180 days after the Relinquished Property was transferred, or (ii) the due date for the Exchangor’s tax return, including any extensions (the Acquisition Period). The Identification Period is included within the Acquisition Period.

How many Replacement Properties may be identified?

There is no fixed limit to the number of Replacement Properties that may be identified, but there are two primary rules that apply: (1) the Three-Property Rule, and (2) the 200% Rule.

1. The Three-Property Rule allows you to identify up to three (3) properties as potential Replacement Properties, regardless of value. You need not acquire all three properties, but as of the end of the Identification Period, not more than three properties may be identified. This is the most commonly used identification rule.

2. The 200% Rule allows you to identify any number of potential Replacement Properties so long as the aggregate value of all identified properties does not exceed 200% of the value of the Relinquished Property. You need not acquire all identified properties.

Generally, if you identify more properties than permitted, you are treated as if you have not identified any properties. However, there is one more rule that might save the day. The 95% Rule allows you to identify any number of potential Replacement Properties, regardless of value, so long as you actually acquire within the Acquisition Period at least 95% of the value of all properties identified. Use of the 95% Rule is rare, and is generally considered more a safety valve rule than an intentionally used exchange rule

Must all exchange proceeds be used?

There is no requirement that all proceeds received upon sale of the Relinquished Property be used to acquire the Replacement Property. Any exchange proceeds not used, however, are taxable.

What constitutes exchange proceeds?

Exchange proceeds means the net sale price of the Relinquished Property, including all net equity and the amount of any mortgage encumbering the Relinquished Property, whether paid off at closing or assumed by the purchaser. It is not sufficient to merely reinvest the net equity received upon sale. The purchase price of the Replacement Property must equal or exceed the aggregate of the net equity received upon sale of the RelinquishedProperty plus any mortgage encumbering the Relinquished Property at the time of the sale closing.

Example: If the Relinquished Property is encumbered by a $700,000 mortgage and is sold for $1 million as part of a Section 1031 exchange transaction, to defer all taxes, the purchase price of the Replacement Property must be at least $1 million, not merely $300,000.

When can the Exchangor obtain access to unused proceeds?

Proceeds from sale of the Relinquished Property may be accessed only when the exchange is completed, fails, or expires. If no potential Replacement Properties are identified within the Identification Period, the exchange fails, and the Exchangor may receive the funds. Those funds will, however, be taxed in the year received. But note: If a mortgage was paid off at the Closing of the Relinquished Property, and the amount of the mortgage was greater than the tax basis of the Relinquished Property, the amount paid to satisfy the mortgage in excess of the tax basis of the Relinquished Property is taxable in the year of Closing of the Relinquished Property.

If all properties identified within the Identification Period are acquired within the Acquisition Period, the exchange is completed, and any remaining funds may be received by the Exchangor. Those remaining funds are taxable. If less than all identified properties are acquired, but the Acquisition Period expires, all remaining funds may be received by the Exchangor, but are taxable.

Conclusion:

These are the basics. As tax rates rise, Section 1031 exchanges become increasingly valuable.

A Section 1031 exchange is not a new and exotic tax shelter scheme. Tax deferred exchanges of like-kind property have been recognized by the Internal Revenue Service as a valid tax deferral strategy since the early 1920s. The structure and effect of a Section 1031 exchange were specifically authorized by Congress by enacting Section 1031 of the Internal Revenue Code of 1986, as amended, and the Internal Revenue Service has promulgated extensive regulations for its implementation.

Use Section 1031 to your advantage, but be sure to strictly comply with the Section 1031 rules.

* Special Thanks to my tax partner, James M. Mainzer, for consulting on this post.

_________________________________

As required by the Internal Revenue Service under Circular 230, you are advised that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this article.

This article is being republished as a welcoming salutation to many of my long-lost Real Estate Developer friends.  You have been missed over the past several years. Call me.  Let’s do lunch!

Did I happen to mention I love Real Estate Developers? Not like I love my wife or my kids, or even my dog, but Real Estate Developers are definitely among my favorite people.

Think about it.

Real Estate Developers are like Gods. [Well, miniature gods, at least.] They create much of the physical world we inhabit. The homes and condominiums we live in. The grocery store and pharmacy down the street. The resorts and casinos and golf courses we enjoy for leisure. Restaurants. Shopping centers. Office buildings. Movie theaters. Truck terminals. Medical and surgical centers. Spas. Factories. Warehouses. Auditoriums. Parking garages. Hotels.

You name it; if its man-made, attached to dirt, and we can get inside it, a Real Estate Developer was probably involved.

The Time to Decide – Commercial Real Estate Litigation

A sage once said, “The time to worry about where the ball will drop is before the wheel is spun”.  He was speaking about roulette, of course, but the wisdom of these words has much broader application.  The point is, worry about the outcome before you place the bet, when you can still do something about it.

Commercial litigation, especially commercial real estate litigation, is in some respects like roulette. Once your lawsuit is filed, the wheel is spinning.  Unlike roulette, you may still have a measure of control over the outcome — but you are in it until the ball drops. 

In CRE litigation there is seldom an insurance company prepared to write a check.  There is a substantial risk the case will proceed to trial.  There is no guaranty you will collect anything – especially if payment of money is not the relief you seek. Consequently, there is very little chance your attorney will accept your commercial dispute on a contingent fee basis. A third of nothing is still nothing. 

Lawyers handling commercial litigation are not your partners. Commercial litigators charge by the hour.  Except in rare cases where you can negotiate a hybrid fee arrangement, you will assume the entire financial risk – not your lawyer. Your lawyer is serving as your paid professional advocate; a hired gun, so to speak.

As long as you are willing and able to pay your lawyer to apply his or her skill and training to your cause, your lawyer is bound to represent you with zeal and vigor. If you do not pay, you should expect your lawyer to stop work.  The fact that the practice of law is a profession does not make it a charitable enterprise. It is both a profession and a business.  There is no moral or ethical imperative for a lawyer to work without pay while advocating a commercial dispute.  CRE litigation is business litigation – and the business being advanced is yours.

I am not a big fan of commercial litigation. It is expensive for my clients and distracts them from their core business.  It is in their core business where they make money.  It is because of their core business that I am their lawyer.  Still, if you are going to litigate, then commit to litigate. Do not file a lawsuit unless you intend to see it through and win.

If you know anything about law firm profitability, it may surprise you to hear me say I am not a huge fan of litigation. Lawsuits can be very profitable for lawyers. Lawsuits are labor intensive and can take on a life of their own.  Huge legal fees can be run up in a hurry.  If that is how you determine to spend your money then, by all means, call me.  My law firm has an outstanding group of litigators.  In commercial litigation, including CRE litigation, we combine our transactional knowledge with litigation prowess and are unsurpassed. I just think you ought to make an informed and seriously calculated decision before you decide to spend your money in this way.

It is virtually impossible to predict with accuracy how much a lawsuit will cost.  Typically, it will cost much more than you imagine. This is because, unlike a business or real estate transaction you can choose to walk away from if it ceases to make economic sense, lawsuits, once filed, are not so easy to escape.  It’s like choosing to dance with an 800 pound gorilla.  As the joke goes, “When do you stop?  When the gorilla decides to stop.”  Once you have filed a lawsuit, or have taken a position in a dispute that will lead to your adversary filing a lawsuit, you have reached the dance floor and may very well find yourself cheek to cheek with an 800 pound gorilla.

Don’t get me wrong.  There are times when litigation is necessary and appropriate.  There are times when an adversary is so brazenly interfering with your business or trampling on your rights and interests that the benefits of litigation will far exceed your costs.  There are times when litigation is your only reasonable choice. 

In making the decision to proceed, however, understand the tangible and intangible costs.  Attorneys’ fees may run into tens of thousands of dollars, and in a complicated case perhaps even into the hundreds of thousands of dollars. The litigation may also distract you from your core business and subject you to significant emotional strain and sleepless nights.  Do not underestimate these add-on intangible costs. 

If you are going to litigate, be sure to hire a  lawyer experienced in the type of litigation you intend to  pursue.  Litigation strategy is based on game theory.  Each move you make must anticipate your adversary’s next several moves. Your strategy and its implementation must be designed to win and be agile enough to adapt to changing circumstances if your adversary moves forward in an unanticipated way.  Knowledge is power.

Part of what makes litigation emotionally draining is a lack of understanding about how the process works.  It is not as mysterious as clients sometimes seem to believe.

The bones of litigation are this:  You and your adversary are in disagreement. You are convinced your position is superior.  Your adversary is convinced its position is superior. You are unable to reach a compromise that works for you both.  Filing a lawsuit is a decision to let someone else decide. 

The litigation process is a process of gathering useful information to support your position and to undermine your opponent’s position. Your adversary is engaged in the same process. Some of this information is applicable law. Much of the information is supporting facts. Ultimately, you will each present your compiled information to an independent decision maker.  A judge or jury will decide.

If you are going to litigate, the decision to do so should be based upon a sober determination of the benefits likely to be achieved, the costs of obtaining those benefits, and your likelihood of success.  You may have the greatest case in the world; your lawyer may tell you it will be a “slam dunk”; but if it is going to cost you more than you reasonably expect to gain – measuring both tangible and intangible costs – at least consider the choice of not proceeding. The decision to proceed or not to proceed is yours. It is very much a business decision.  

In making the decision to litigate, use the same skills of economic analysis you use to make real estate investment decisions. If you know it will cost you $2,000,000 to develop and market a project, but your likely return is only $1,500,000, would you proceed?  If your disputed claim is for $50,000 but it will cost you $60,000 to $100,000 to collect, should you proceed?  The answer may depend upon other factors as well but, all else being equal, the rational economic choice is obvious.

Too often lawsuits are filed as an emotional response to a perceived slight rather than being based upon an objective determination that the lawsuit is in your best economic interest. Do not let elevated testosterone levels get in the way of making a rational economic decision.  The  lawsuit is likely to continue long after your passions have faded.  By that time, you may be wrapped in the arms of that 800 pound gorilla.  If you have not made the decision to litigate based upon legitimate and dispassionate commercial considerations, you may find that your only way out is to settle on highly unfavorable terms.  This will not help you prosper.

A common mistake clients make is to assume that if a dispute is over only $10,000 to $50,000, the attorneys’ fees for pursuing or defending the case will be proportionately less than if the lawsuit involved $100,000 to $1,000,000.  This is not necessarily so.  The amount of time it takes to prove your case has very little to do with the amount in dispute.  The facts and issues, and the response of your adversary, determine the amount of time involved.  Since commercial litigation is typically billed by the hour, more time means higher attorneys’ fees regardless of the amount in dispute.  This reality should be taken into consideration when deciding to file suit, and likewise when considering an offer of settlement.

Some protection may be provided by the documents if they provide for the successful party to recover attorneys’ fees and costs from the unsuccessful party. But note: (i) you had better be sure you will be the successful party, or you may end up paying your adversary’s attorneys’ fees as well as your own; and (ii) you should consider whether a judgment against this particular defendant is likely to be collected.  If the defendant is on the verge of bankruptcy, or otherwise insolvent, obtaining a judgment that includes all of your attorneys’ fees will do you little good.  You will have just spent more money that will  not be collectible.  As the saying goes: “When you find yourself in a hole – stop digging.”

Remember.  The commercial dispute forming the basis of your lawsuit is yours, not your attorney’s.  Your attorney’s business is to represent you as your skilled professional advocate. Attorneys are bound to zealously advocate for your success, but they can not guaranty success and collection.

Deciding to file a lawsuit in a commercial dispute should be like deciding to get a kidney transplant.  It should be a decision that is not entered into lightly, and should be made only if the benefits to be obtained are greater than the burdens the procedure will entail. If you decide on a new kidney and go under the knife, be prepared to see it through. If, after the procedure has begun and your kidney has been removed, you change you mind and decide against a transplant, your decision is a bit too late.  The time to make that decision was before you got on the operating table.

I am not saying you should never file a lawsuit.  Each circumstance merits its own evaluation. What I am saying is that the time to decide is before the suit is filed.  Once filed, be prepared to do what must be done to win.  It is too late to un-spin the wheel.

                                                                                    Thanks for listening,

                                                                                                 Kymn

Employment Restrictive Covenants

The issue of enforceability of employment restrictive covenants comes up often in business, including the business of commercial real estate.

A common scenario is as follows:  A person goes to work for a company and is required to sign a Noncompetition and Nonsolicitation Agreement. Typically, it will say something like “during the term of employment, and for a period of one year after termination of employment, the employee will not compete with or solicit any customer or vendor of the employer.”  Sometimes the Noncompetition/Nonsolicitation Agreement is required to be signed as a condition of being hired. Other times the employer will tell an employee who is already employed that signing the Noncompetition/Nonsolicitation Agreement is a condition to continued employment.

Are Employment Noncompetition/Nonsolicitation Agreements enforceable in Illinois?

As a general proposition, Noncompetition/Nonsolicitation Agreements are enforceable in Illinois, as long as they satisfy a three-pronged test:  They: (1) must be no greater in scope and duration than is required for the protection of a legitimate business interest  of the employer-promisee; (2) must not impose undue hardship on the employee-promisor, and (3) must not be injurious to the public.

In a decision filed December 1, 2011, the Illinois Supreme Court shook up the Illinois employment bar by overruling an extensive line of cases that had narrowed the three-pronged test described above to a two-pronged test created by Appellate Court decision in 1973. In a case referred to as the Kolar decision, (Nationwide Advertising Service, Inc. v. Kolar, 14 Ill. Ap. 3d 522 (1973), the Kolar court held that an employment restrictive covenant was valid if there were (i) a near permanent customer relationship with the employer, and (ii) the employee had gained confidential information through its employment. The Illinois Supreme Court emphasized in its December 2011 opinion that the Kolar test is not valid. (Reliable Fire Equipment Company vs. Arredondo 2011 IL 111871). The Illinois Supreme Court, instead, reaffirmed the legitimate business interest test, and clarified that “whether a legitimate business interest exists is based on the totality of the facts and circumstances of the individual case. Factors to be considered in the analysis include, but are not limited to, the near-permanence of customer relationships, the employee’s acquisition of confidential information through his employment, and time and place restrictions. No factor carries any more weight than any other, but rather its importance will depend on the specific facts and circumstances of the individual case.”

For the most part, the Illinois employer’s bar hailed the Arrendondo decision as a victory, believing it gave employers a broader basis for enforcing employment restrictive covenants.  Ironically, many attorney’s representing primarily employees were encouraged by the Arrendondo decision as well, believing it gives employees more room to challenge enforceability by challenging, factually, whether a “legitimate business interest” is at stake.

“Little Known” Two-Year Rule for Employment Restrictive Covenants – Illinois

While the foregoing is all well and good, a fundamental concept of law is that employment