Unit 15 Escrows

To Defer Capital Gain Taxes, The Following Apply:

1. all of the net proceeds from the relinquished property must apply to the purchase of the replacement property. 2. a mortgage must be obtained on replacement property equal to, or greater than, the mortgage on the past property. 3. the mortgage obtained on the replacement property may be reduced by putting equal amounts of cash in the exchange. 4. the escrow holder must prevent delivery of the "constructive receipt" of funds during the 1031 exchange process to the exchangor.

Eligible Real Property: 4 Types

1. apartment buildings 2. commercial properties (office, retail, industrial, etc.) 3. farms, lands, orchards, and vineyards, unharvested crops 4. other unimproved land

Toxic or Contaminating Materials Include:

1. automotive and manufacturing chemical spills, 2. hazardous waste, 3. PCBs - manmade chemicals 4. abandoned industrial operations, or 5. underground storage tanks.

Work of Phase II Includes the Following:

1. hand auger borings and sampling (for shallow-depth sampling) 2. direct push borings and sampling (for medium-depth sampling) 3. drill rig borings and sampling (for deeper sampling 2-4 feet deep) 4. limited-access drill rig 5. groundwater sampling 6. soil gas survey 7. geophysical survey

Information Required for Buyer's Lender

1. name of each tenant 2. tenant's move-in date 3. if under a lease, the expiration date of the lease 4. current rent amount 5. security deposit 6. date of the last rent increase 7. date the last rental payment was made 8. amount of any delinquency 9. any other special terms of the lease agreement

A typical Phase I ESA includes the following tasks:

1. site surveys with a review of neighboring property use 2. review of historical sources, including aerial photographs, historical maps, and city directories 3. review of regulatory agency records; interview local fire, health, building, and water quality agencies 4. interviews with property representatives: owners, occupants, past owners, tenants, neighbors, etc. 5. review surrounding area regulatory database reports 6. review of physical information, including site topography, geology, and hydrology 7. visual survey of asbestos, lead, and PCBs

Work of Phase III Includes the Following:

1. vapor extraction 2. soil excavation 3. underground storage tank and pump removal 4. groundwater purging 5. groundwater monitoring 6. air strippers installation and maintenance 7. hazardous waste disposal

Federal Laws and Ordinances

1. walls or fences to be constructed 2. landscaping requirements or restrictions 3. water conservation 4. sign restrictions and ordinances 5. lessening noise 6. trash containers and disposal 7. zoning (variances and conditional-use permits) 8. underground tanks 9. registration, if necessary, with the state board of equalization

Contingencies and Conditions of the Commercial Property Transaction

A buyer, either an investor or one intending to occupy a commercial property, will investigate factors that may impact the use of the property. The buyer's research may include physical inspections of the property, surrounding properties, and infrastructure. The investigation may also involve contacting various government agencies in compliance with certain city, county, state or federal laws and ordinances

The Commercial Property Transaction

A commercial property transaction involves the transfer or refinance of a business subject to local and state regulations. The escrow holder may assist in preparing or delivering additional documentation necessary for closing escrow. More inspections, government reports, and studies are done in a commercial property sale than in an apartment transaction. If buyers plan to use the property for their business, limitations on its use are made with appropriate governmental agencies.

Environmental Questionnaire

A lender may require the seller to complete an environmental questionnaire before ordering a Phase I environmental report. The questionnaire results and the lender's physical inspection of the property determine whether a Phase I inspection will be performed. Many lenders require Phase I inspection for larger properties with higher loan amounts.

Lockout

A loan cannot be paid off for a specified term without the borrower being required to pay the entire interest due and payable during the term of the lockout. Lockouts are for a limited number of years, followed by a standard "capped fee" prepay penalty for several years.

Yield Maintenance

A lump sum payment to the lender is required to cover the loss of reinvesting the prepaid amount, if the reinvestment rate is less than the interest the lender receives. Usually, there is a minimum 1 percent penalty regardless of yield difference.

Dry Cleaners Restrcitions

A major concern to the buyer and buyer's lender is government restrictions on dry cleaners having a "plant on the premises." If this is the case, the escrow will include additional inspections on the part of the buyer and buyer's lender. Many commercial lenders won't originate loans of real estate with a dry cleaning plant on the premis due to zoning and environmental issues.

Rent Roll and Lease Agreements

A rent roll, a list indicating the names of all tenants with the amount of their individual rents and security deposits, and rental or lease agreements will be requested by the buyer from the seller or listing agent. The seller usually delivers these to the escrow holder, who forwards them to the buyer or buyer's agent.

Adjacent Property History

Adjacent property history significantly impacts the liability of a buyer, seller, or lending institution.

Appraisal for Commercial or Multifamily Property Home

An appraisal for a commercial or multifamily property is more detailed, takes longer, and is more expensive than for one-to-four-unit properties. The lender may require the appraiser to have the MAI or SRPA professional appraisal designations, which is rarely required in one-to-four-unit appraisals.

Environment Inspection

An environmental inspection, either a limited or full Phase I environmental assessment report, is required for many commercial properties. They are not required for most apartment loans unless the property appraisal called attention to a condition of the property, or the property is near commercial properties whose current or prior occupants used toxic or contaminating materials.

Certified Public Accountant (CPA)

An exchange accommodator who is a certified public accountant (CPA) or an attorney can guide the principal through complex transactions.

Identifying the Replacement Property

An exchangor has several options for identifying replacement property, depending on certain conditions being present.

Ideal Exchange Transaction

An ideal exchange transaction is one in where the exchanger (or seller) locates the desired property to acquire and trades "equities" with the property owner, paying any difference. Such a transaction seldom happens.

200% Fair Market Value Rule

Any number of properties may be identified, as long as their aggregate fair market value does not exceed 200% of the market value of the past, relinquished property.

Apartment Buildings

Apartment Buildings, called multifamily properties, especially those with five housing units or more, require additional inspections and reports not required for typical owner-occupied single-family homes. They may be subject to rent control or other governmental restrictions. The escrow officer is involved with these responsibilities in an apartment building escrow.

Apartment Appraisal Costs

Apartment appraisals cost $150 to $200 per unit or more. Some lenders, using staff appraisers, charge a flat rate, regardless of units. Fees for commercial appraisals depend on the size and character of the property and range from $1,500 to $3,500 or more.

Financing Apartment Buildings

Buyer's loan requirements are more complex for apartment buildings than for single-family homes. The lender originating a loan on an apartment building relies on the property to generate income to "service" the monthly loan payment. The lender will ask the escrow holder or the seller's agent to provide a record of income and operating expenses for the past two calendar years plus the current year.

What does the appraisal process consider?

Cap Rates

Capital Improvements

Capital improvements are such a large amount that, if treated as a repair expense rather than a capital improvement, might negatively impact the loan available to the buyer and jeapordize closing escrow.

Special Concerns for Unique Properties

Certain commercial properties may require the escrow officer to know special requirements such as hospitality (hotels and motels, gas stations, restaurants, and dry cleaners).

LTV for Commercial Properties

Commercial properties are defined as any property not intended for residential dwelling use. These properties have lower maximum loan-to-value (LTV) ratios than residential properties and apartment buildings.

General Commercial Property Types

Commercial properties may be divided into many property types, some requiring additional inspections, reports, and disclosures by government agencies or the lender who might originate the buyer's loan. 1. Office buildings, including medical 2. Free-standing retail buildings 3. Mixed use (usually retail and residential combined) 4. Retail strip centers, unanchored (no major tenant) 5. Retail strip centers, anchored 6. Retail shopping centers or malls 7. Industrial buildings 8. Industrial condominiums or planned unit developments 9. Medical office buildings and hospitals 10. Restaurants 11. Recreational facilities (health clubs, amusement parks) 12. Golf courses 13. Automotive repair facilities 14. Automobile car-wash facilities, full service 15. Automobile "coin-op" car-wash facilities 16. Mobile home parks 17. Hospitality (i.e., hotels and motels) 18. Hospitality, non-flag (independent) 19. Agriculture properties (croplands, vineyards, and orchards) 20. Other properties (usually owner-user), liquor stores, dry cleaners, coin-op Laundromats, theaters

Restaurants

Considerations in restaurant transactions include local health and fire departments as well as zoning and parking issues. While the loan process for restaurants is not complex, the lender's underwriter must rigidly follow the guidelines when discovering credit risk to the bank. Restaurants have the highest failure rate of all businesses and escrows can easily fall out if the buyer is not prepared to resolve qualifying issues.

Debt Service

Debt service is the term used to refer to loan payments.

Defeasance

Defeasance is a provision of a mortgage agreement that states that the borrower will be given the full title to the property once mortgage terms are met. In doing, so the borrower provides different treasury instruments to the lender in an amount that yields the cash flow that the lender receives from loan interest. The note remains in effect with the real estate as original collateral, to be replaced with Treasury notes. Often, defeasance is less costly than yield maintenance and can be accomplished at a discount if the treasury yields exceed the note rate. Because it requires costly structuring, the borrower usually hires a company to handle the process.

Estoppel Certificates

Estoppel certificates for verifying rents are delivered to the escrow holder to give to the buyer. Estoppel certificates request each tenant confirm the amount of the rent payment, the security deposit, and any terms of the lease or rental agreement, such as parking or concessions. Estoppel certificates are prepared by the buyer's lender or by the escrow officer for the buyer paying all cash.

Exchanges under IRS Code Section 1031

Exchanges refer to IRS Code Section 1031, which allows for the tax-deferred acquisition of investment real estate in which any tax due on gain (profit) may be deferred to a later date. The exchange team typically consists of the principal's tax advisors, accountants, attorneys, and the exchange accommodator (a third party used to exchange property under Section 1031). The exchange escrow officer understands the importance of meeting IRS and California Franchise Tax Board guidelines for deferring taxes that may otherwise be due and payable in a real estate sale transaction.

Delayed Exchange: 45-180 Day Rule

Exchangors have 45 calendar days from the close of sale of property to identify replacement property. Exchangors have 180 calendar days from the close of the sale (not 180 more; includes 45-day identification term) to acquire replacement property. If a tax return is due during the 180-calendar-day period, an extension of time to file the return is obtained. It is difficult to find a suitable property within 45 days. Section 1031 exchanges must be completed within these strict time limits with no extensions, except for federally declared disasters. Identification of property may be revoked anytime during the 45-day term.

Franchised Hotels

Franchise hotels and motels are called "flag" operated and considered by lenders to be a more secure lending risk than non-flag properties.

Lender's Insurance Requirements

Hazard insurance for apartment and commercial properties is more expensive than for one-to-four-unit residential properties.

Hospitality Properties

Hotels and motels are either owned and operated independently or franchised.

Phase III

If removal work is indicated by the Phase II report, depending on site goals, regulations, and costs to accomplish them ($10,000 to $100,000), corrective actions may be required. The buyer and seller should know that some lenders may not approve a loan subject to Phase III work.

Apartment Buildings + Buyers

If the buyer obtains financing, the lender must comply with these conditions.

Reverse Exchange

If the exchangor purchases replacement property before selling the past property, a reverse Section 1031 exchange is used. The accommodator must take title to the property being sold before the replacement property is acquired, or the accommodator can also take title to the replacement property.

Level Prepay

If the loan has a three-year prepay penalty, is paid off within three years, and carries a 2% penalty, the borrower will be charged 2% of the unpaid loan balance. After the third year, no penalty is charged.

Rent Control

If the property is located in a community subject to rent control, it must be conveyed to the buyer in the escrow instruction.

Phase II Inspection

If the results of Phase I indicate contamination may be present, a Phase II inspection is ordered. Because the Phase II inspection may require an engineer to drill into the property's surface or perform expensive actions to be repaired after inspection, all parties should discuss the impact before proceeding, including who is responsible for incurring costs. Phase II inspection finds potential surface soils, subsurface soils, and groundwater contamination. The buyer and seller must be aware of the intrusive nature of the Phase II inspection, which may involve drilling into the property's exterior or interior.

Refinance Transactions (IRS 1040 Schedule E)

If the transaction is a refinance, the borrower's lender will require an IRS 1040 Schedule E for the past two years and an operating statement (profit and loss statement) for the current year through the most recent quarter's ending. The lender will also want a list of capital improvements made during the current or last tax return year. This is important to the buyer because the seller's operating expenses will influence the amount of the buyer's loan.

Coverages to be Requested by Buyer or Buyer's Lender

In addition to typical coverage offered by homeowners insurance policies, the following coverages may be requested by the buyer or required by the buyer's lender: 1. loss of rent due to property damage 2. loss of rent due to a reduction in percentage lease income from damage 3. loss of business income 4. glass coverage (retail stores) 5. environmental hazard insurance 6. general business liability Special extended coverage may offer protection for items usually excluded from basic policies, such as water damage.

Operating Expenses

In obtaining additional property rental information, the buyer (and the lender if the buyer obtains financing) will ask the seller to provide a list of operating expenses. It is not always easy to get the expense information, and unless the buyer obtains financing, the buyer may decide not to make delivery of operating expenses a condition of the escrow.

Escrow Holders + LTV

It is helpful for the escrow holder to understand typical LTV, especially if the buyer is unrepresented by a commercial real estate agent. In such a case, the escrow officer must encourage the buyer to visit a lender before the transaction.

Gas Stations

Like hospitality properties, gas stations are independent franchises and thus subject to the same challenges in obtaining financing, especially with restrictive franchise agreements. Environmental issues present time-consuming and costly inspections and renovations to aboveground improvements and underground tanks.

Major Considerations of Franchise Agreement

Major considerations of the lender are the terms and restrictions indicated under the franchise agreement. A franchise agreement may be so restrictive that the lender may not approve the loan. For example, some franchise agreements exist with conditions and terms that make the franchisee an employee of the franchisor, even though he is the owner-operator.

Prepay Penalties Imposed on Seller's Loan at Payoff

Nearly all loans for commercial and apartment buildings with five or more units carry prepay penalties. Some penalties do not allow loans to be paid off for a designated period of time. Other penalties require the borrower to compensate the lender for interest income revenue lost from the payoff if the current market interest rate is less than the borrowers. Another penalty requires the borrower to substitute the yield lost to the lender with a similar yield from others. If the property seller has a prepay penalty, it may significantly reduce net proceeds to the seller at closing or impact the equity available for an exchange.

Funds from Taxpayer

No funds from the transaction should be received by the taxpayer until all replacement property has been acquired.

Typical Exchange Transactions

Normally, an exchangor finds the property to be acquired but the seller is not interested in the exchangor's property. The exchangor's property is then listed for sale by the agent, subject to the buyer's cooperation with the exchangor processing.

Construction or Rehabilitation

Often a hotel or motel requires renovation or the acquisition and replacement of personal property (furniture and equipment). If the work is performed during escrow, the escrow officer must provide documentation to and from vendors, contractors, lenders, and government agencies. In cases where the lender allows escrow to close, the escrow officer is instructed by the parties to continue escrow for "hold-back" funds, also true for commercial and apartment properties.

The Accommodator's Process and the Escrow Holder

Once a replacement property is identified, the escrow process begins. Although more than one escrow company may be involved, a smoother escrow occurs if one escrow company handles the escrow for all properties.

Personal Property: Like-Kind Property

Personal properties of a like class are like-kind properties. Livestock of different sexes are not like-kind properties. Personal property in the United States vs outside the United States are not like-kind properties.

Personal Property Included in Transaction

Personal property included in the transaction (such as appliances) in a bill of sale or indicating "to which no value is attached" must be included. Compliance with state and local health and safety requirements will be required (smoke detector information and fire extinguisher requirements). A list of vendors (e.g., gardener; pool-service company; trash and cable service; water, gas, and electrical service providers) will be necessary. A list of tenant concessions (as indicated in estoppel certificates) regarding parking, and free rent/discounts are also a part of the required documentation.

Phase I Environmental Site Assessment (ESA)

Phase I environmental site assessment (ESA) is the standard non-intrusive environmental investigation, limited to visual inspections and data research, to assess potential environmental concerns of a property. When a property is sold, transferred, refinanced, or foreclosed, the current and past practices of the property will identify toxic materials, contaminants, or environmental hazards that influence the buyer's purchase decision and the lender's loan decision. Federal law prohibits the transfer of any real property to a new owner if identified environmental hazards or materials are present.

Escrow Special Requirements - Commercial Real Estate

Processing the escrow for the sale or refinancing of apartment buildings and commercial real estate includes special provisions that involve the escrow officer. To provide the level of service required in these transactions, the escrow officer must meet the principal's fiduciary obligation.

Real Property: Like-Kind Property

Real properties generally are of like-kind, regardless if the properties are improved. However, real property in the United States and real property outside the United States are not like-kind properties.

Ineligible Personal Properties: Six Types

Six types of property are not eligible for an exchange: 1. stocks, bonds, or notes 2. evidence of indebtedness or interest 3. partnership interests 4. certificates of trust or beneficial interests 5. chose in action (a legal term meaning title to or right to something).

Earn-Out

Some lenders offer a solution referred to as an earn-out. The lender funds the loan based on current rental income to close escrow, allowing the buyer up to one year to improve the property to justify the higher loan based on the higher rental income. At that time, the lender will release the balance of the loan proceeds back to the buyer.

Small Business Administration

Such a franchise (whose franchisee becomes an employee of the franchisor) is ineligible for a loan guaranteed by the U.S. Small Business Administration (SBA). Learning this early in escrow, even before escrow is opened, can avoid escrow fallout and give the buyer time to explore alternatives to financing.

DSCR Limitation

The DSCR limitation causes escrow fallout in apartment transactions when income is too low for the loan amount specified in escrow instructions. Income may be too low if rents are too low/under market or the property has high vacancies. A common cause for both is that the property requires renovation.

IRS Real Property Eligibility

The IRS does not specify that to be like-kind, eligible properties must be of the same nature or character. The IRS accepts exchanges of real estate used in trade or business (investment and rental real estate is acceptable businesses),whether an office building is exchanged for an apartment building. They are both considered like-kind.

Other Causes that Reduce the LTV

The LTV may be reduced by factors such as property age, condition, construction, low cap rate, unit mix, and understated expenses.

Capital Gains Tax

The Section 1031 exchange allows owners of investment property or property used in trade or business to sell that property to reinvest in a property of equal or greater value, without paying capital gains tax. Once a sale occurs, the property owner pays the combined capital gains tax due from profit on both properties. Not only does the seller avoid paying the capital gains tax in the year of the sale, but can also use the equity used to pay taxes to purchase a larger property and achieve a greater future gain.

Accomodator

The accommodator accepts title, monies, and disburses the monies to escrow. The primary purpose of the accommodator is to prevent title and monies from being received by the principals before escrows close.

The Accommodator in Exchange Transactions

The accommodator usually sends the exchangor's funds to the escrow holder of the replacement property when escrow opens. The escrow company handling escrow for the replacement property sends the escrow instructions to the accommodator with the preliminary title report.

Days for Escrow Closing for Commercial or Multifamily Homes

The agent and escrow holder should suggest that the principals consider at least 6090 days for escrow closing.

Section 1031 Exchange Requirements

The apartment or commercial property transaction often involves a Section 1031 exchange. Escrow officers in exchange transactions acquire training and education relative to the IRS and Franchise Tax Board regulations to handle these complex escrows.

Cap Rates

The appraiser considers the market cap rate (capitalization rate), which reveals the return on investment that the investor requires. Rents are validated by comparing the subject property's rents to the market. The appraiser will be asked to provide estoppel certificates to the tenants confirming the amount of rent paid and the terms of the leases.

Franchisee

The buyer, licensee or dealer, is the franchisee.

Common Prepay Penalty Programs

The common prepay programs include a 3-to-10-year level, or a declining prepay penalty, "capped fee," with no prepay penalty after the specified term.

Declining Prepay

The declining percentage varies among lenders. A four-year prepay could charge a 4% penalty if the loan is paid during the first year, 3% penalty the second year, 2% penalty the third year, and 1% penalty the fourth year. No penalty is charged after that.

Seller, Escrow Holder, and Buyer Roles

The escrow holder asks the seller to submit to the buyer (or buyer's lender) certain items. These items include representation of the income and expenses for the property for the past two complete calendar years plus the current year-to-date.

Escrow Officer + Accommodator

The escrow officer works more closely with the accommodator than any third party, except the real estate agents.

95% Fair Market Value Rule

The exchangor acquires at least 95% of the aggregate fair market value of all identified replacement property before the end of the 180-calendar-day period.

Franchise Agreement

The franchise agreement is a contract involving the owner of a business "name," with its products and services. he escrow officer involved in a flag transaction (franchise hotel) provides and receives documentation to and from the owner of the business, including obtaining copies of the franchise agreement for the buyer/buyer's lender approval

Debt Coverage Ratio

The lender utilizes a process called a debt service coverage ratio (DSCR) calculation to determine this. The lender's DSCR represents the amount of cash flow the lender requires the property to generate after the monthly loan payment.

Property Taxes for Investment Properties

The main concept in exchanging investment property (property used in trade or business) is that the properties must be like-kind or "like for like." A personal residence is ineligible for a tax exchange

Maximum LTV for Commercial Properties

The maximum LTV is normally 75% and often considerably less. Some commercial lenders will not loan more than 60% to 65% LTV for commercial real estate.

Franchisor

The owner of the business is referred to as the franchisor.

Deferred, Not Exempt Taxes

The seller is not exempt from paying the capital gains tax but can defer payment until sold. Nothing prevents property owners from exchanging after the first exchange.

Coverage Ratio

The term coverage ratio is the net operating income required to "cover" (pay) the loan payment plus the cash flow amount.

Time to Close Escrow with Gas Stations

The time necessary to close escrow may be six months or longer.

Calculation of Yield Difference

The yield difference is calculated by: the unpaid loan balance x the difference in the yield x the number of years remaining.

Commercial (Non-Residential Properties)

These provisions, including the loan analysis and DSCR process, are also applicable to commercial nonresidential properties while additional requirements may apply.

Exchange Acommodator

To accomplish a Section 1031 exchange, the owner of an investment property should employ an exchange accommodator to prepare the necessary paper work, hold the exchange funds, and guide the exchangor through the process. The exchange accommodator should be bonded, insured, and be a corporation in the full-time business of offering qualified intermediary services.

Like-Kind

To meet the tax-deferred test, personal property must be exchanged for personal property and real property must be exchanged for real property. The IRS states that properties are of like-kind if they are of the same nature, even if they differ in grade or quality.

Three Property Rule

Up to three replacement properties may be identified within the 45-day maximum identification period.

Escrow Holder Role in Prepayment Penalty

Upon receipt of the lender's demand, the escrow holder identifies the prepayment penalty and its amount on the closing statement.

Amendment to Escrow Instructions, Exchange of Replacement Property Form

Using the escrow instructions and preliminary title report information, the accommodator prepares an Amendment to Escrow Instructions, Exchange of Replacement Property form. These documents are returned to escrow to obtain the signatures of the exchangor and seller (the owner of the replacement property).