Congress most likely believed it was doing real estate professionals and their advisors a favor when it enacted Section 469(c)(7). That section excepts real estate professionals from a general rule on losses generated from real estate rental activity. That general rule provides that real estate rental activity is per se “passive” under passive activity rules of section 469. In other words, generally, no matter how much time a taxpayer spends on a real estate rental activity, all losses from that activity will be passive losses.

            The real estate professional exception changes the passive activity rules for a class of taxpayers who are real estate professionals. It allows real estate professionals to use losses from real estate rental activities under certain conditions. And because those conditions are so complicated (perhaps necessarily so), a lot of people don’t really understand how to qualify for the exception, though they firmly believe that they do. So, Congress may have thought it was doing us a favor, but, they actually created a trap for all but the most careful taxpayers and advisors.

           This post surveys the rules that apply for the real estate professional exception of section 469(c)(7). It does not go into detail. Detailing technical rules would risk overwhelming points I am trying to make in this post:

• The real estate professional exception is available in limited cases. Qualifying for the exception is not as easy as the title of the exception implies or as easy as many in the profession believe; and

• The real estate professional exception can be a cruel tease even to those who qualify. Supporting a claim to the exception requires some good record keeping about how the taxpayer spends time. With deep respect and admiration for my colleagues in the real estate industry – especially real estate developers – many are not naturally inclined – and don’t have any patience – to keep contemporaneous records of time spent.

The Real Estate Professional

             The exception under Code Section 469(c)(7) only applies to a person if that person passes two separate tests:

1. The Personal Services Test, and

2. The 750 Hour Test

            The Personal Services Test is satisfied if:

• The taxpayer performs personal services in real property trades or businesses during a given year,

• The taxpayer materially participates in one or more of those real property trades or businesses for that year (the “Material RP Businesses”), and

• More than half of the personal services performed by the taxpayer during a given year are performed in the Material RP Businesses.

            A “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

            The key elements of this test are:

• Materially participating in one or more real property trades or businesses, and

• Performing more than half of personal services for the year in those businesses.

            So, for example, if you spend all of your time in a real estate brokerage business in which you materially participate, then you pass the test.

            If you spend half of your time performing personal services in a business management consultancy and half in managing your real estate rental properties, you do not qualify (must be MORE than half).

            If you devote all of your personal services to a real property trade or business but do not materially participate in that business, you do not qualify.

            The 750 Hour Test is satisfied only if you devote at least 750 hours in the Material RP Businesses. So, if you are a material participant in only one Material RP Business because you are the only one who participates in that business (See Treas. Reg. 1.469-7(a)(2)), but you participate less than 750 hours in that trade or business, you will not qualify for the real estate professional exception. Further, for this rule, you don’t count the participation of your spouse. So, if you and your spouse collectively participate more than 750 hours, but, you participate less than 750 hours, you will not qualify.

            As you can see, satisfying material participation tests matters a lot in determining whether one is a real estate professional. Satisfying the material participation test on audit requires record keeping to show your participation. Contemporaneous record keeping carries a lot of weight. Reconstructed record-keeping in the heat of an audit does not. So, if you intend to rely on the real estate professional exception, it’s best to keep records of participation in your real property trades and businesses.

Material Participation in the Rental Activities

            Even if you are a real estate professional, you will not get the benefit of Section 469(c)(7) unless you materially participate in the rental activity that generates the passive loss. Sometimes, the records that you keep for establishing that you are a real estate professional will suffice to establish that you materially participate in the rental activity, too. Managing rental properties is a real property trade or business.

            You may, however, be required to supply evidence of material participation for your rental activity that is completely different from the evidence you use for the real estate professional tests. In those cases, you have an option that can be very useful. Under Treas. Reg. 1.469-9(g) a real estate professional can group real estate rental activities for the material participation test. If elected, grouping combines the rental activities as though they were one activity. If you materially participate in that one grouped activity, you are a material participant for all of the activities in that group. So, for example, let’s say you are invested in 5 real estate rental activities, and you participate at least 500 hours a year in 3 of them. If you elect the grouping exception, you can treat all 5 of the activities as activities in which you are a material participant.

            Use care in making this grouping election. Before making the election, you need to discuss its implications with your accountant.

Summary

            Satisfying the Section 469(c)(7) exception does not simply apply to everyone who participates in real property trades or businesses. Further, and most importantly, it does not apply to everyone who qualifies as a “real estate professional”. The exception only applies to a real estate professional that is a material participant in the rental activity that generates the loss.

Frontline (the PBS program, not the flea and tick treatment) aired a program on affordable housing last night (May 9, 2017). They made some good points about the NIMBY reflex based on false stereotypes and prejudice, and potential for fraud in the LIHTC program in some states (not Maine!). For the most part, Frontline did a reasonably decent job.

There was, however, an element of the Frontline program that was particularly irksome. Senator Charles Grassley, current Chair of the Senate Finance Committee, complained about the low number of IRS audits in the LIHTC world. Listening to Senator Grassley talk, you’d think the IRS is neglecting its duty. However, that would be incorrect. IRS audits on LIHTC projects and generally are rare only because Congress keeps cutting IRS funding to the point that IRS lacks the funds to effectively enforce federal tax laws. Persuade your colleagues to fund IRS appropriately, Senator Grassley, and you’ll no doubt see increased audit activity, including increases in LIHTC audits.

Hopefully, Congress does not simply target the LIHTC program for scrutiny the way it targeted the earned income tax credit program. In other words, I hope Congress does not limit its focus on taxpayer abuse to programs that benefit people in poverty.

Every partnership agreement should address how and when its cash is distributed to its partners. In the simple deal, the partners share cash according to a fixed metric, like “percentage interest”. In more complicated cases, partners share cash according to a waterfall with several steps, each step providing for a different cash split among the partners. For example, partnership waterfall provisions may provide that “available cash” is distributed as follows:

• First, to Limited Partners (LPs) until the LPs have been returned all Invested Capital;
• Second, 10% to the General Partner (GP) and 90% to the LPs until the LPs have achieved a 10% (Internal Rate of Return) IRR;
• Third, 15% to the GP and 85% to the LPs until the LPs have achieved a 15% IRR;
• The balance, 20% to the GP and 80% to the LPs.

The partnership agreement defines the term “available cash” and usually directs the managers or general partners to calculate and distribute “available cash” at certain times or in management’s discretion. The partnership agreement also typically defines the term “Internal Rate of Return”. A typical Internal Rate of Return provision reads as follows:

“Internal Rate of Return” as to a Unitholder as of a given time means the discount rate that would equate the net present value of Unitholder’s Capital Contributions as of that time to zero dollars. The Internal Rate of Return shall be calculated using Microsoft Excel’s XIRR function.

Defining the Internal Rate of Return with reference to how it will be calculated is a good thing. However, we don’t need to define what the discount rate is. That’s a given. The waterfall designates the rates of return for each distribution step. That rate of return is the discount rate. We also know the present value and the compounding periods. The future value is the only unknown. So, in defining the Internal Rate of Return, we need to define it with the goal of determining the future value (i.e., the distribution amount).

So, now you might be thinking, “let’s use the FV (future value) Microsoft function to determine the payment amount.” But, that would not be right. The Microsoft FV function is quite limited. It only works if all of the distribution amounts are the same. That’s seldom the case.

So, maybe we use the Microsoft XIRR function after all. Unfortunately, though, Microsoft XIRR function uses annual compounding. If your internal rate of return analysis of investments requires a different compounding period, Microsoft XIRR will not be useful. You’d have to adjust for the annual compounding. That’s a lot of work.

Unfortunately, the Microsoft IRR and NPV functions are not any more useful. Those functions assume that payments are made on a regular basis, like quarterly or monthly.

So, how should Internal Rate of Return be determined? The simplest approach includes using a Microsoft function with some assumptions. For example, you can use the XIRR function if all partners agree to annual compounding. You can also use the IRR function assuming that all payments are made as of a given date, regardless of when made. So, for example, you can provide in the partnership agreement that each distribution is made as of the last day of the quarter within which it is actually made.

The simple approach of using a Microsoft comes with a cost. An investor who relies on accurate internal rate of return to compare investment options will likely be unsatisfied with using a Microsoft function.  In the alternative, the investor might require that higher internal rates of return from the partnership investment to take account of the risk that cash might not flow in the way assumed for purposes of the chosen Microsoft function.

In any case, regardless of how you mechanically determine the internal rate of return, it needs to be defined in a way that provides a path to determine future value. Bradley Borden, a law professor at Brooklyn College of Law, wrote an excellent article on this topic. The article first appeared in a 2014 edition of Tax Notes. It was republished about a year ago. In that article, Brad walks through the technical financial logic behind the internal rate of return. He then suggests language for a good internal rate of return definition.

Brad’s suggested approach is very good. It is one of many that can be used. Whether you use Brad’s approach or another accurate approach does not matter so much. Properly defining “Internal Rate of Return” to provide a path for determining distribution amounts does matter. It matters to your investor partners. It also matters to the “general partners”, too. It would be a good practice for all of us who draft partnership waterfall provisions to draft accordingly.

Section 1541 of Maine’s Limited Liability Company Act provides that, in the absence of a Statement of Authority, any manager, member, president or treasurer has the authority to bind the limited liability company. We (the Maine LLC Act Drafting Committee) added this provision to the LLC Act to address concerns of the real estate and commercial finance Bar. In retrospect, I don’t think we’ve done enough to explain to the rest of the Maine Bar the potential for damage and mischief this provision creates, and why filing a Statement of Authority is so critical to limiting or eliminating this potential. This post is my attempt to define the potential. The idea for the post came to me from reading some recently issued opinions from California and New York. These cases provide examples of harm that could have been avoided with carefully crafted limits on apparent authority.

Apparent Authority – Cases in Point

A limited liability company does not act on its own. It acts through natural persons. Only natural persons authorized to act on the LLC’s behalf can legitimately bind the LLC. Authorizing persons to act on its behalf allow the LLC to borrow money, buy and sell assets, contract for services, and otherwise engage in commercial transactions with others to conduct its business. In other words, authorizing persons to act on its behalf is essential to the achieving the LLC’s purposes.

However, authorizing persons to act on its behalf also exposes the LLC to risks. In the absence of checks on the power of these persons, the LLC could suffer significant losses. Two recent court opinions highlight these risks. The first opinion comes from the Second Appellate Division of New York’s Supreme Court[1] and concerns the case of CitiMortgage, Inc. v. Kenneth Caldaro, et. al., 145 A.D.3d 851 (2016). Per the facts of the opinion, Vicky Caldaro, a member of R.V.P. Associates, LLC, deeded R.V.P.’s real estate to herself and Kenneth Caldaro. That raises the first issue:  did Vicky have the authority from the other members of R.V.P. to do that? Vicky and Kenneth then borrowed money from QuickenLoans, pledging a mortgage interest in their recently acquired (from R.V.P.) real estate as collateral for the QuickenLoans debt. QuickenLoans then sold the debt and the security interest in the real estate to CitiMortgage. Presumably, Vicky and Kenneth defaulted on that debt because CitiMortgage attempted to enforce its claimed rights against the real estate pledged as collateral.

When CitiMortgage sought to enforce its rights to the real estate, it discovered that the deed from R.V.P. to the Caldaro’s was never recorded. Further, according to the Caldaro’s, the deed was lost. CitiMortgage then went to court to force R.V.P. to execute a deed to the Caldaro’s so CitiMortgage could enforce its claim against the real estate pledged to it. R.V.P. said, “not so fast”. They said Vicky did not have authority to convey the real estate to herself and Kenneth.

The Appellate Division judges held that Vicky had apparent authority to bind the LLC. She had apparent authority because she was listed as a member of the LLC on the LLC’s Statement of Organization. In fact, she was the only person listed as a member on the Statement of Organization. Further, the members of R.V.P. never executed an LLC Agreement or Operating Agreement. Based on the Statement of Organization and the absence of any contrary documents available to CitiMortgage, Vicky had apparent authority to bind R.V.P. As CitiMortgage had no notice that Vicky intended to defraud it in pledging an interest in the real estate as collateral, CitiMortgage was a bona fide encumbrancer. In other words, CitiMortgage had a valid mortgage interest in R.V.P.’s property.

The other members of R.V.P. seem like innocent victims here. However, they were not completely powerless to prevent the real estate from being pledged as collateral. At the very least, they could have amended the Statement of Organization and entered into a binding Operating Agreement. Still, they were (it seems) victims of risks created by unchecked apparent authority.

The second opinion was issued in the case of Western Surety Company v. La Cumbre Office Partners, LLC, — Cal.Rptr.3d — (2017), 2017 W.L. 445408 comes from California’s Court of Appeal for the Second District. To get the gist of the case, imagine that you become a member of an LLC (La Cumbre) with others to acquire a medical office building in Santa Barbara. One of the members of the LLC (Crespano) is an LLC owned by Melchiori. Melchiori is the managing member of La Cumbre’s manager, MIC. Melchiori also owns a majority interest in a construction company, MCC.

MCC acquires surety bonds to provide financial backing for its obligations under construction contracts. The surety bonds are issued by Western Surety. Under the bonds, if MCC defaults on its construction contracts, Western Surety will make the damaged parties whole, financially speaking. As a condition of issuing the bonds, Western Surety demands to be indemnified. Like any other person in its business, it will seek an indemnity promise from MCC and any person related to MCC. So, when MCC asked Western Surety to issue the surety bonds, MCC sought an indemnity from Melchiori. In satisfying Western Surety’s diligence demands, Melchiori submitted his financial statement. His financial statement showed his (indirect) interest in La Cumbre.

While the parties dispute how this happened, La Cumbre became a party to Western Surety’s indemnity agreement. However, Western Surety’s counsel made a significant error in drafting the signature page of the Indemnity Agreement. He drafted the signature block for La Cumbre as follows:

LA CUMBRE

By: ______________________
Melchiori, Managing Member

Melchiori, however, is not the managing member of La Cumbre. He is the managing member of MIC. MIC is the manager of La Cumbre. So, the signature line should have been drafted as follows:

LA CUMBRE
By: MIC, its Manager

By: ___________________
Melchiori, Managing Member

Judge Yegan, writing for the Appeals Court, stated that, under California law, Melchiori’s signature binds La Cumbre, even though he signed as managing member of La Cumbre. Melchiori was, in fact, the managing member of MIC, the Manager of La Cumbre. The right person signed the Indemnity Agreement, even though the position granting him the power to bind La Cumbre was misstated. If the person with apparent authority for an LLC signs an agreement on the LLC’s behalf, his or her signature binds the LLC, even if his or her position is misstated.

That Western Surety dodged the proverbial bullet in this case is interesting, but not central to our issue. Our issue is about the apparent authority Melchiori had and which, had he signed a properly drafted agreement, would not have been questioned. Because Melchiori had this authority, and Western Surety could rely on it, La Cumbre’s medical office building was now subject to Western Surety’s claims for indemnity. So, imagine how you would feel when you realize that your share of about $3.65 million of capital contributions made to La Cumbre was subject to risks that had nothing to do with La Cumbre’s business and of which you were completely unaware.

Back to the Maine Act

Section 18-402 of the Delaware LLC Act effectively limits apparent authority to the authority provided in the LLC Agreement. In other words, under Delaware law, apparent authority of LLC members and managers is governed by the LLC Agreement. If the LLC Agreement does not address the authority of members and managers, any member or manager may bind the LLC.

The Maine Act addresses apparent authority similarly to the Delaware Act. However, instead of requiring third parties to reference the LLC Agreement, the Maine LLC Act makes the Statement of Authority the central and primary governing document for apparent authority. To the extent it addresses apparent authority, the Statement of Authority governs. In the absence of a Statement of Authority, pretty much anyone connected with a Maine LLC has authority to bind the LLC. As the two cases above illustrate, a situation in which a large group of people have authority to bind an LLC is not a good situation. Ideally, apparent authority would be limited to persons who have actual authority, and their apparent authority would be no greater than their actual authority.

Tailoring apparent authority to match apparent authority can be accomplished by restating in a Statement of Authority relevant provisions of the LLC Agreement. But, that’s not a perfect solution. The authority provisions of the LLC Agreement could be amended. If that happens, and the Statement of Authority is not amended, then the Statement differs from the LLC Agreement, and that could be bad.

Perhaps, there’s another way of tailoring apparent authority to match actual authority. Perhaps you can file a Statement of Authority that simply states, for example, “[T]he Managers of the Company have the power and authority to conduct the business and affairs of the Company per the terms of the [LLC Agreement], as amended.” Would that, in effect, give you the same result that applies under the Delaware LLC Act?

Apparent authority of the members and management of a Maine LLC should be addressed.  The best way to address apparent authority is to file a Statement of Authority. Failing to file the statement creates, in many cases, unnecessary risks.

[1] The Supreme Courts in New York are trial courts. The Appellate Courts of the Supreme Courts are the intermediate appeals courts. The Court of Appeals is the highest appeals court.