Glenn Fuller was quoted in Kaitlin Ugolik’s Law 360 article titled “3 Tips To Avoid The Pitfalls Of Real Estate JVs.” The full article can be found below.
3 Tips To Avoid The Pitfalls Of Real Estate JVs
By Kaitlin Ugolik Law360, New York (March 28, 2014, 3:47 PM ET) — Buying or developing real estate through a joint venture is a great way to deal with minimal bank financing and skyrocketing prices in primary markets, but experts say attorneys representing sponsors and capital partners should look out for tax, management and capitalization pitfalls.
The joint venture structure has long been a fixture in real estate deals, but the tight lending market of the past several years, coupled with high barriers to entry in some of the most desirable markets, has made buying and selling through joint ventures all the more appealing.
“I’m seeing more and more that people are going to real estate owners, particularly just outside some of the hot areas, and saying: ‘Don’t sell your real estate to me. Contribute it to an entity, then I’ll go out and take care of the development,’” said Glenn Fuller, a partner at Brutzkus Gubner LLP.
The main trick, attorneys say, is to plan ahead. If management responsibilities, tax structure and plans for further capitalization and the potential exit of one or both partners aren’t laid out explicitly from the get-go, trouble could be looming down the road.
Here are three issues to look out for when representing a client in joint venture transactions:
Beware ‘Phantom Income’
A great deal of real estate is purchased and held through limited liability companies so that owners can take advantage of the benefits of being taxed as a partnership, rather than as a corporation. This extends to the creation of joint ventures, which benefit from not having to pay taxes at the entity level.
But Fuller says that up to 90 percent of the problems joint ventures face stem from pitfalls with this type of structure.
For example, only having to file informational tax returns can mean that the picture the Internal Revenue Service has of a joint venture might not be complete, Fuller said. If one party contributes a property to the joint venture, it can appear as if any debt the party held related to that property has been eliminated.
“Where I see really, really difficult things happening with joint ventures is that when [they] want to contribute a property, it looks to the IRS as if they’ve been relieved of that debt, and it can look like income,” Fuller said, and contributing parties can end up paying taxes on income they haven’t actually received.
The problem of so-called phantom income is in fact a common one for many types of LLCs. When a company reports how much money it brought in during a certain time period, there is often a gap between that number and the amount that the company was actually able to distribute to its members.
“What people don’t realize is that when they contribute property to an entity and do a joint venture, if they’re not planning ahead … they could turn around and find themselves getting 1099s for huge amounts of money,” Fuller said. “A lot of times they don’t find out about it until months or sometimes years after, and it’s too late to go back and unwind it.”
There are remedies, though they are varied and depend on the individual joint venture’s situation, according to Fuller. They may include writing guarantees into agreements that allow the existence of remaining debt to be conveyed in tax documents or using subordination agreements with certain lenders.
Agree on Partner Powers
Whether working with a traditional 80-20 or 90-10 joint venture or one in which the equity partner and operating partner share equal ownership, it’s important to explicitly delineate responsibilities, experts say.
One of the biggest issues that often comes up for joint venture partners is that the operating partner, typically the one with less skin in the game, feels it is not given enough leeway to accomplish its goals.
“You have to have a balance between the person who is really running day-to-day, versus the person who may not even be located in the city where the property is but has the money and the true skin in the game,” said Sam Walker, chair of Blank Rome LLP’s real estate practice group.
One of the first and biggest hurdles in structuring a joint venture is often determining the scope of the day-to-day party’s independent power, Walker said.
Because the equity partner has put up the most cash and has the most to lose, it stands to reason that it would want to retain control over some of the biggest decisions affecting the joint venture, but experts say it can also make sense for the partners to share these decisions, depending on the joint venture’s ultimate goal.
“It used to be that the operator was always [the manager], but that has shifted a bit,” said Dean Pappas, a partner at Goodwin Procter LLP. “A lot of capital partners got burned in the last cycle, [and] they have demanded that they are the managing partners of ventures … and then simply contractually give day-to-day control to their partner through a property manager agreement.”
Trust is a major issue, and experts recommend that equity partners investigate their potential operating partners as much as possible before signing a deal.
Anticipate a Breakup
Two major events can take place after the creation of a joint venture that can also cause problems for the partners: the need for additional capitalization and the dissolution of the partnership.
Additional capital is typically raised through a capital call controlled by the equity partner, but problems can arise when one party does not have the funds to proceed, experts say. Joint venture partners often have to agree upon penalties for such situations. In some cases, one party will make a contribution to the other, diluting one partner in a punitive way for not being able to effectively raise capital.
When the parties in a joint venture reach a stalemate, one popular approach is to have one partner buy out the other’s stake. But the partner with a smaller stake often cannot afford to buy out the equity partner, so this dynamic typically works in favor of “the person who has more money,” according to Walker.
One alternative is to agree in the initial joint venture deal that any such disagreements will be settled in arbitration. This is especially good for joint ventures working on developing a property, since they can’t as easily take advantage of the buy-sell option.
Exit rights are also an area of concern as sponsor partners look to realize a promote, or a fee paid when certain milestones are reached in the deal. Promotes can diminish the longer an asset is held, so many opt to encourage, or in some circumstances force, a quick sale.
“I’ve been seeing a lot more folks negotiating for what we call ‘crystallizing’ their promote, where they can force a sale of the asset sometime after the asset has either stabilized or been completed,” Pappas said.
Exit rights need to be carefully thought out, as do loan responsibilities; these issues, along with management, can cause major legal headaches. Planning ahead can avoid many pitfalls, but experts stress that every deal, and every partnership, is different.
“You have to address it up front to an extent, but understand that everything is fluid,” he said.
–Editing by Jeremy Barker and Chris Yates. All Content © 2003-2014, Portfolio Media, Inc.
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