REAL ESTATE SYNDICATION
PHILLIPS
K.
CAMPBELL, JR.
REAL ESTATE SYNDICATIONS
Prior to the advent of real estate syndications, only
the very wealthy investor made money from real estate .
day, that is not the case.
Real estate syndication
To-
a~s
several smaller investors to pool their funds and abilities in order to take advantage of lucrative opportunities.
Syndications benefit the investor by giving him Ita
low equity position in a highly leveraged, low interest,
owner financed situation. "
The investor also gets
:>
a~
-
shelter through deductions for interest, taxes , and depreciation.
Also
o~~~~~e
sses from the investment would offset
of the investor.
The investor will get capi-
tal gain treatment when he sells his invJstment.
The investor is not the only one to profit.
o~r
The land-
if he has a low tax basis may sell his land to the
syndication through an installment method and thus spread
out his taxable gains over a lengthy period of time.
The
landowner no longer has to pay real property taxes and interest payments are an additional source of income to him.
In selecting a tract of land, the syndicator must look
for land that is undevalued either as to
to future
resent value or
The syndicator-broker
otent'
i
needs to then get the landowner to sign a listing agreement,
1
2
letter of committment, or earnest money contract which will
spell out the terms upon which the landowner will sell.
The syndicator must have a binding agreement bet ore he tries
to sell to his investors .
Selection of the OWnership Vehicle
In order for the syndication to be as profitable to
the investors as possible, careful consideration must be
given to the type of business form of the syndication.
The
major consideration is to choose a vehicle that will allow
losses and other benefits to pass to the owners.
The syn-
dicate should be based on a purchase price of borrowed
funds so each investor can derive maximum benefits from
deduction~
for interest as well as a low equity in the
property.
The vehicle should not be a taxable entity if
,
-
. one of the desired results to the investors is a tax shelter.
Finally, some entities more than othe rs are subject to
Federal and state regulations which are expensive and burdens orne on the investors.
A brief discussion of the vari-
ous business forms follows.
A corporation does limit the liability of each investor
and can utilize the financial leverage; however franchise
taxes and taxes on long term debt (more than 1 year) are
due in Texas . 2 Plus if the syndicate has employees, ~­
holding and unemployment tax retprns must be filed.
The
corporation is a taxable entity so it -does not pass losses
3
and other deductions to the investor-shareholders.
-
A Subchapter S3 Corporation election allows corporations to be taxed as small businesses .
Simply, this elec-
tion allows shareholders to be taxed directly on corporate
income with the exception of capital gains in certain situations. 4 The losses are dedJlctjble at the shareholder
level up to the extent of the
the corporation.
sharehQJder'~
iRvee~ffieRt
in
This severely restricts the use of Sub-
chapter S corporations in high leverage real estate projects where losses usually exceed investment and that excess is not usable as a deduction.
S is further restricted , as
§
The use of Subchapter
1372(e) (5) (A) limits a Sub-
chapter S corporation to no more than 20% of passive inc~e.
Passive income is defined as receipts of royalties J
rents, dividends, interest, annuities , an~ sales or exchanges of stock or securities. 5
A simple trust could be created with legal title in
the trustee and beneficial title in the inyestors. 6 Each
.......
investor would thereby hold an undivided interest in the
corpus (the real estate).
Problems arise when one of the
beneficiaries ,dies.
The Texas Trust Act does not apply to
real estate syndications. 7
The Internal Revenue CodeS allows preferential treat-
ment for,qualifying trusts most of whose income comes from
real estate, property, or mortgages.
The requirements to
4
qualify as a treal estate investment trust are quite complex
so only very large investments can practically use this
form.
A qeneraJ partnership is advantageous because it al-
lows direct taxation of the partners and no franchise taxes
are levied.
But it does not allow for limited liability
so each investor could be held jointly and severally / liable
for the indebtedness.
Each partner is entitled to partici-
pate actively in the management of the partnership.
The limited partnership achieves
results.
t~ation
~9st
of the desired
The limited partnership acts as a conduit so
occurs only on the partner leyel and not on the
entity level as well.
The limited partnership provides
limited liability for those investors who do not actively
manage the business. 9 If the limited pa~tner does actively
manage the business he will lose his limited liability.lO
Active management of the business is left to the general
partners who have joint and several liability for the
partnership debts. ll Since this is the most popular form,
a more detailed discussion of the establishment of a limited partnership will follow.
Normally the broker-syndicator or if the syndicator
is a corporation, the individual broker will be the general
partners and investors are the limited partners.
As pre-
viously stated, the syndicator signs an earnest money con-
5
tract with the landowner.
This contract allows the
syn~-
cator to assign the contract which he does prjor to the
closing to the limited partnership.
p~rtner(s)
Then the general
pay the cash downpayment plUS a prgmisory pote
at the closing.
The general partner(s) calJect all pay-
ments on the note due from each limited partner and apply
it toward the note; they also pay taxes on the property and
otherwise manage the property.
All offers of sale are
w-
warded to all limited partners who have the right to terminate the partnership through sale of all its assets.
The certifjcate for a limited partnership is required
t~he filed. 12 The certificate sets out the amount of each
13
partner's contribution
and any future contribution that
14
are due and when.
In a limited partnership the amount of
liability is the maximum of each limited ' partner's contribution; however,
profits~
losses, etc., may all be recog-
nized in prop'ortions different from copt.teution which must
be set out in the certificate.
The certificate should also
give the date of termi~ation of the partnership15and for
I
tax and other purposes, may want to limit the otherwise
16
free transferability of each partner's interest.
Tax treatment of partnerships is one of the prime motives for its wide use.
However, care must be taken or
the partnership will be taxed as a corporation if the partnership has more than 4 of the IRS'S 6 characteristics of
6
a corporation.
Normally both corpgrations and limited
partnerships have (1) associates and (2) intent to carryon
a bus iness and divide the profits, so the difference must
be achieved in the remaining 4 characteristics.
(3) Continuity of life i§ not acbjeyeq jf the limited
partnership is organized under the pnifgrm
s~~p
Act.
I,; mj ted Partner-
So a limited partnership way provide for continu-
ation of the business upon the death of a general partner
17
if all the remaining general partners agree .
(4) Centralized WpP?3oment exists nnder the tax regulations if the general partner has continuing and
exclusiV~
authority to manage the business, and the limited partners
own substantially all of the partnership.
But if a limited
partner participates in managing the business , he will
-
his limited liability.18
~e
This leaves ma~agement solely in
the general partner's hands and the limited partnership
finds it has the corporate characteristic of limited man19
agement.
However the Tax Regulations provide a narrow
exception.
If the limited partners do not own substan-
tially all the interests in the
so that the
general partner does own some
limited part-
nersh i p will not be held to h
e centralized management .
( 5) The corporate characteristic of limited concerns
the liability of the general partner and not the limited
partners.
The IRS feels that if the general partner does
7
not have any substantial assets and merely acts as an agent
for the limited partners, the general partner does not have
any liability.
This is especially true for corporate gen-
era 1 partners.
Therefore the IRS has prepared a schedule
which must be followed closely.
Limited Partner Contribution
$1
Net Worth of General Partner
to $1,666,667
15%
$1,666,667 to $2,500,000
$250,000
10%20
$2,500,000 and up
Under the schedule,
ea£nh-£c~o~~~~~~~~LJ~~~~llluus~t
and
satisfy the re uirement
all
additional con-
(6) Transferability of interest is the last corporate
characteristic.
-
It is easily avoided as f t will be deemed
to not be present of each
i
ficate to
the
artner is required in the certi-
o~~-m~~.s
of
th~
partnership.
does not exist if the li,m ited partner
Also transferability
as~qns
his right to
but does
share in
his right to
value to
0
Otherwise, any transfer to an out-
sider without the consent of the other partners which
al~
lows the transferee to ~cquire all the rights of the transferor will be a transferable interest.
~
8
The Corporate General Partner
Problems are created by provisions requiring substantial worth of the individual or corporate general partner.
Corporate taxation may result if the worth is too low.
In order to achieve the limited liability benefits of
a limited partnership to the limited partners, cQrporations
have been formed for the purpose of becoming the general
partner.
Nom~nally
capitalized corporations whose Bole
function was to be a general partner, would be used so that
if the venture failed creditors could reach only a dummy
corporation as a general partner.
Due to the early efforts
at this, the IRS has issued Reyenue Prgcedure 72-13 21 to
set guidelines
for~corporate
general partners to meet.
The purpose of Revenue Procedure 72-13 is to insure the
general partner will not be judgment proJf and haye substantial worth.
Revenue Procedure 72-13 sets forth the
following circumstances which should be followed closely:
(1)
(2)
The limited partners will not own directly more than twenty percent Q~
the stock of the corporate general
partner or an affiliate corporation.
For purposes of determining stock
ownership, the attribution rules of
section 318 of the Code are applicable.
The purchase of a limited partner's
interest does not entail either a
mandatory or discretionary purchase
of any type of security of the corporate general partner or its affiliates.
'
9
(3)
The net worth of the corporate general partner, computed on the basis
of the current fair market value of
the corporation's ass e ts, is at all
times equal to at least fifteen per:
cent of the total contr1Dutions made
to the partnersh1p by the partners
(both general and limited) where such
total is less than 2,500,000 dollars,
and ten percent of such contributions
where in excess of 2,500,000 dollars.
In computing the corporate general
partner's net worth, its interest in
the limited partnership and accounts
and notes receivable from the limited
partners is excluded. 22
If this criteria is met the IRS should view a sole
corporate general partner favorably, but simply because the
criteria are
S
met does(jiO) insure a disfavqrable appear-
ance in the IRS's eyes.
To save time, a syndicator should
CQJDP':.r with Reyepue procedure 72-13 as advance rp,in"s by
,
the IRS are time consuming and not binding in court.
Of
important note is the fact that if in addition to a coran in-
porate general
dividual
72-13'
compliance with Revenue Procedure
not necess
; however, if an advance ruling is
sought, the financial worth of the individual general partner must be proved.
23
An additional requirement to obtaining a favorable
ruling is the presence of no more than 2 of the 4 corporate
characteristics previously discussed.
The net worth requirements of Revenue Procedure 72-13
provide the most problems.
Current fair market value is
10
used to compute the net worth.
ner must
meet
the reg,,; rements
The general corporate partat
Qtimes so disgualifi.:r
cation after a valid start is guite
possible~
Valuation
of the fair market value of assets, large liabilities, and
disagreement with inspecting revenue agents are the main
areas of concern.
The net worth percentage is figured on the total contribntjepS to the partnership--not the value of
'
24
ners h ~p.
~he
part-
Although unclear the total contributions prob-
ably includes all paid-i~ COmmitted but Pot paid-in
capital contributions; contingent contributions are not
used.
If the corporate general partner is also a corporate
general partner in several limited partnerships, the Revenue Procedure 72-13 requirements must bd met
separate limited partnership.
value of
eneral
forcfa~lb
In computing net worth the
artner's interest in th
limited partnership will be excluded.
The attribution rules of
§
318 apply to the 20% limit
on direct and indirect ;ownership of the limited partners
in the general partner.
,,
Section 318 is broad to begin with,
but it is yet not clear if "stock" is defined as voting
stock solely or includes other equity-type securities.
So
care should be exercised by not issuing the limited partners c o nvertible debts, non-voting common stock or pre-
11
ferred stock which could push them over 20%.
Since it is often difficult to meet the net worth
standards, a corporate genera l partner might form a sub-
~
sidiary sglely to function as the sole general partner Of~
a particular limited partnership.
The subsidiary could
be given cash which is invested in a certificate of deposit
or other stable investment for the life of the general
partnership in order to insure the net worth requirements.
Some Basic Problems
One of the main benefits of real estate syndication is
to provide losses which will extend t o shelter some of the
investor's other income.
The Code provides that a partner
(general or limited) may not deduct losses to the extent
that the same exceed basis in the partne,shiP.25
ng problem in a genera] partnershjp,
There is
Tax losses are allowed
to an individual partner only to the extent of the basis of
his partnership interest.
partner
~o
Section 752 allows each general
increase his basis by the proportionate share
of the liabilities.
-
The proportionate share is determined
by the ratio by which losses are shared .
The theory behind
this is that each partner is liable on all liabilities
whether or not the partner is personally liable or the
26
partnership itself is liable .
However, a different rule exists as to limited partne r ships .
According to the Regulations, a limited part-
12
ner's share of partnersh'
xceed the
difference between his total capital contribution and the
total contribution he is required to make.
But if no part-
ner is personally liable on a partnership liability, then
all partners ma y increase their basis by their proportionate
share of the liability. ; The theory is that partners who
risk personal liability should be able to raise their
basis, but if no one is personally li a ble, then the liability will be paid from the profits; therefore, all partners should be able to raise their basises.
For this
rea-~
son, limited partnership debts should be financed by a no- - '
personal liability loan.
.
Also existing loans on property
,
acquired by the limited, partnership may increase the limited
partner ' s basis.
No- ersonal liability loans are usu All
qonstruction financing.
So the p~a~r~t~n~e~r~s~~~~~~g~e~t~~a~n
i ncrease in basis in the beginning .
with n -
sonal liability attribute
limited partner's basis once obt
--==~~==~~~~~~~
~
will increase a
Therefore , careful
timing of losses with increases in basis becomes crucial.
A further technical requirement is that the limited
partner be obligated to gontrjhlJt e to the partporfibip it-
self and not to a general partner or third party .
27
-
No
increase in basjs WOUld he allowed a limited partner if
that limited partner guarantees a portion of a loan
~or
13
which the general partner is personally liable.
Also if
the partnership gets a no-personal ljabjlity Joan, ~he
general partner is required to personally gnarantee a portion of it, no increase in basis is allowed
the
ljmited
partners fpr their proportion of the eXCeS5 Of the 'Jpar-
aI}teed am g lJ pt. 28
If a limited partner is not allowed to deduct his entire loss,
.§
704(d) allows the loss not used t9 be
aP9l~ed
at any later time in which that partner has a sufficient
basis to absorb the
1055.
29
Problems with Special Allocations
In a general or limited partnership, allocation of income and
items may be made disproportionately among
the partners. 30 This can be of great advantage to the
1055
;
partners as partners can Quickly recover their capital in-
vestment especially with disproportionate allocation of
. losses during the early years when losses will be the
largest.
However special allocation of cash flow, losses ~
and deductions for depreciation and interest payments mus.:J
be handled carefully.
Section 704(a) allows a partner's distributive share
of income, gain, loss, deduction, and credit to be governed
by the partnership agreement.
Section 704(b) provides that
the use of the partner's distributive share of gain or loss
is to be used if there is no provision in the partnership
14
agreement or if the prime motive of the allocation is tax
avoidance.
Regulation 1.704-l(b) (2) gives prime factors to be
used in determining~he prime motive of the allocation
was tax avoidance in relation to the surrounding circumstances.
The points to be considered are:
(1) whether the
partnership or partner individually has a business
for the allocation,
purpos~
(2) whether the allocation has a sub-
stantial business effect;
(3) whether the related items of
income, gain, loss deduction, or credit from the same source
are subject to the same allocation,
(4) whether the alloca-
tion was made without recognition of normal business factors
and only after the amount of the specially allocated item
could reasonably be estimated,
location,
(5) the duration of the al-
(6) the overall tax consequenc~s of the alloca-
tion.
Of these criteria, the substantial business effect
3l
is the most important.
.
32
In Stanley £. Orrisch,
the tax court found that
there was no substantial economic effect and that the principal purpose of the allocation was tax avoidance.
In
Orrisch, the parties agreed that aJl the depreciation deductions would be allocated to the high bracket partner,
and if the property were sold at a gain, the high bracket
partner would pay the tax attributable to such depreciation.
The Tax Court reasoned that no economic effect re-
15
Bulted if the sale produced gave equal to or greater than
the depreciation.
was no
agreemen~
And if the sole produced a loss, there
between the partners that the high bracket
partner woulQ bear a larger portion of the 10SB.
The court
indicated that if the latter agreement as to the loss had
been proved, the allocation would have had substantial
economic effect.
This is consistent with the Regulations
which refer to "whether the allocatioz(?~€) actually affect
the dollar amount" of~each partner's participation. 33
A safer method than allocations of specific items is
to provide for a seneral allocation of net partnership
profits and losses for a specified period of time.
Here
also the economic effect must be given to the general allocation such as by charging and then giving effect to the
capital accounts.
After Orrisch, a special allocatjon needs to bave 5ph-
stantial economjc effect to be permissible.
Also the other
5 requirements must be met, but to what extent is not yet
clear.
Other Problems
A partnership or individual partner does not recognize
gain or loss on the contribution of property to the partnership.34
transfer. 35
There is no recapture of depreciation on this
The partnership gets a carryover basis of the
contributing partner in the contributed property.
The con-
16
tributor gets a substituted basis in the partnership equal
to his basis in the property CODtrjhpt<>d.36
If there is
unrealized appreciation , on the contributed property, that
appreciation when realized in a sale is usually allocated
37
to the contributor.
The developing partner can receive
an interest in the partnership in return for his services.
Contribution of property whjch is subject to liability
can cause many problems.
The
con~ributing
partner is held
to h2ve been relieved of part of the liability which each
other remaining partner is held to aSSlJme according to his
pro rota share.
Section 752(b) treats this reduGtion pf
liability as a cash distribution to the contributing part~.
-
This distribution reduces the contributing partner's
basis and is taxable as a capital gain if i t exceeds that
b asis.
There is more danger of this in
d
limited partner-
ship as a limited partner is considered to be relieved of
~liability on contribution .
This can be avoided if the ~
partnership acquires the propertya[ubject ~tbe mortgage
without assuming the contributing partner's liability so
no personal liability w.ould exist.
38
Of course a partne,r may sell pr.operty to the partnership with normal tax results of recognized gain and loss
and recapture .of depreciati.on.
Depreciation
Depreciation must be accelerated in order t.o pr.ovide
17
a larger tax shelter.
The Tax Reform Act of 1969
the accelerated depreciation statutes.
39
amended
New residences
(never lived in before) may use double declining balance
and sum of the year's digits (the most liberal) methods.
40
New office buildings and similar property may use 150%
declining balance.
41
Used residential property may use
125% declining balance or straight line methods.
Used non-
residential property is restricted to the straight line
method. 42
Disposition of the
On
d~position
~
Shelter
of the investment, the investgr
to have capital gains treatment.
expects
However, this is not a]-
ways the case as several IRC sections "convert" what one
would consider a capital gain into ordinary income.
The
~
investor needs to be advised of this possibility from the
beginning.
Normally the Code provides for capital gain or loss on
the sale or exchange of a partnership interest 43 o~ sale
-
of partnership assets and dissolution of the partnership.44
But problems arise as the gain is realized to the partners
(general and limited) due to treatment of the partnership
debt as a distribution 45 and the effect of accelerated depreciation recaptufe.46
If a partnership sells i ts assets which are Subject
to a mgrtgage or other incumbrance, the amount of the mort-
18
gage is considered to be proceeds of the saJe and as a result, gain from the exch a nge. 47
The same js trpe if the
partner sells his interest, beoanse his proportionate part
of the mortgage is held to be gain. 48 Therefore, the debts
of the partnership are critical in analyzing a sale.
Accelerated depreciation allows tax shelters.
Norm-
ally between the sixth and eighth year of the investment
the incgme frgm the prgperty will be greater
than
terest and accelerated depreciation deductions.
the
in-
This is
the point at which the investment is sold.
The Code now has accelerated depreciation recapture
provis i ons in
§
49
1245 dealing with personal property
and
.
50
1250 dealing with depreciable real property.
These
§
provisions recapture the e x cess depreciation takeD over
straight line method and tax
j t
as
ordina'n, income
nat
capital gain.
Under
§
1250, recapture is eliminated i f the iP]TPstor
has held the property for 200 months (16 years 8 mgnths).5l
However if the holding period is less, there will be recapture .
For residential real property, in a sale during
the first JOO mgnths and non-residential rea' proporty,
the excess of the depreciation deducted over the straight
1 ~ , but
on.!.l:i.y~tOl.0wt~h~e=....;e!:.x~t~e:!1n~t:.......!t:!h!.!e:.....!g:l.;a5!.\.ioLln....
rJ;ie~COl.QI.I.\ilj.ln,j.jl.<z"-le
..d~,....;!;i.:;:s.-l;r-Se-
captured. 52
Disposition during the second 100 months of
residential real property only allows a reduction of the
~
19
recapture
dredth
by 1% per month for
each
wout h Da§t
the ope hup-
mon~53
There are some possible ways to avoid the tax.
One
is to incorporate the partnership when it begjns to make a
profit and later sell or merge the corporation at capital
However problems with collapsjble COrpgratiops
gain rates.
could ruin this approach to the unwary taxpayer.
54
Also
the existence of excessive debts can cause problems in fitting under
§
351 (non-taxable asset transfers to a corpora-
tion for voting stock).55
Also 357(c) treats liabilities
on assets which are transferred to corporations as gains
to the extent the liabilities exceed basis.
An alternative is to refinance
pr9fjt making poiQt.
the investment at the
This approach has the benefits of
allowing the partners to take out of the~usiness the mortgage funds which exceed the balance on the prior debt without a tax if the amount taken out does not exceed the partner ' s basis.
Also appreciation of investment assets are
realized tax free as no sale or exchange is involved.
The
new mortgage may be able to return the investment to a tax
shelter from a profitable operation.
Installment sales are quite useful in spreading the
gain over several tax years.
56
Here payments made each
year must not exceed 30% of the total purchase price.
Again the debts of the 'i nvestment can cause problems as
20
the debts are included in the sale price and are a payment
in the year of the sale by the amount that the debt exceeds
the basis. 57
The final alternative, like-kind exchange, offers no
recognition of gajn or loss if investment property is exchanged solely for like-kind investment property.58
Like-
kind property is property having the same nature or character, and has been liberally construed so that a farm or
ranch is like-kind to city real estate. 59 Section 1031
does not allow depreciation recapture of
But
§
1031 does have a
pro~lem
§
1245 and
§
1250.
which involves liabilities
that follow the property.
These liabilities are treated
. as boot received on the , exchange and fuily taxable. 60
problem may be averted if the mortgagee would allow the
newly acquired property, to be substitute~for the old debt
security.
As to individual partners, a sale or exchange of a
. partner's partnership interest will produce capital gains
or loss under
§
741.
The purchaser takes a
§
742 basis.
This transfer will not effect the partnership itself unless
more than 50% of the total interest in profits and capital
are sold within a one year period in which case, the partnership is held to have terminated.
A liquidation of a partner's interest is a non-taxable
event to both the partner and the partnership.
I
But if any
21
money is received by the partner, it is income to the e x tent it exceeds the partner's basis in the partnership.6l
On disposition of the distribution, the partner will recognize gain or loss.
Character of the assets is decided
in the partner's hands and the holding period includes that
of the partnership.
Depreciation receptive of 1245 and
1250 also applies.
Application of Security Laws
62
Bo th the Securities Act of 1933
and the Texas Se't'~es Ac t 63
,
cur~
requ~re
' t '~on
reg~stra
of non-exempt securities.
be met.
0
f a 11
0
ff ers and sa 1 es
Each statute's provisions must
Registration procedures are time consuming and
expensive ,for small issues.
Therefore, real estate syn-
dications issuing small offerings will w,nt to fit under
one of the exceptions.
A security is defined by
of 1933 as
It.
•
•
§
2(1) of the Securities Act
any note, stock, •
. . bond,
debenture,
evidence of indebtedness, certificate of interest, or participation in any profit sharing agreement • • • (or) inves .t rnent contract
• •"
Most financial transactions in-
volve notes, stock, etc., so securities are involved.
Then
securities must meet the requirements of the Federal and
64
state s ecurity . Acts. The SEC in a recent release
has
held limited partnerships concerning real estate to constitute an offering of a profit sharing agreement or invest-
22
ment contract under
§
2(1) of the 1933 Act.
Further, the
Supreme Court has held in SEC v. W. J. Howey Co. , 65 that
the test for the scheme is whether the scheme involves an
investment of money in a common enterprise with profits to
come solely from the efforts of others.
A limited partner-
ship dealing in real estate syndication should clearly fit
under this test as the general partner will manage while
the limited partners invest the money and reap the profits
(including tax shelters).
Also "offer" and "sale" are defined.
A "sale" in-
cludes "every contract of sale or disposition of a security
•• for value.,,66
Similarly the term "offer to
sell" or "offer" "shall· include every attempt or offer to
dispose of, or solicitation of an offer to buy, a security
. . . f or va 1 ue. ,,67
Thus, every disposi~ion of a "se-
curity" or attempt to dispose of a security, other than a
wholly non-business donative transaction, will constitute
a "sale" or "offer" which must be made in compliance with
applicable securities laws.
Exemptions from Registration
The purpose of registration is to provide for full
and complete disclosure of all material facts so that the
ordinary investor will be enabled to make a sound judgment
on the investment.
Exemptions from registration are allowed
if the offer or sale occurs under such circumstances that
23
the investor will not need the protection of the securities
acts. 68 The proponent of the exemption has the burden of
proof tQ establish it by clear and convincing evidence.
Federal Act Exemptions
There are two federal exemptions applicable to real
estate syndications.
1.
Private Offering Exemption
The 1933 Act in
§
4(2) allows an exemption of "trans-
actions by an issuer not involving any public offering.,,69
Generally, to comply, the offering must be made to a small
number of investors who are sophisticated therefore not
needing the protection of the Act, who have adequate access
,
to corporate information, 70 and who invest without intent
to resell or distribute. 71
The courts h ~ve held the number
of people extended the offer is not important;72 however
the SEC will automatically investigate offerings with over
25 offerees.
So to be safe offerees should be limited to
25,73 remembering the greater number of offerees the more
likely it is to be held a public offering.
The main turning points are the sophistication of the
offeree and his access 'to adequate information about the
transaction .
The careful syndicator should evaluate each
offeree's sophistication before the offer is made to that
offeree.
Under this
e~ception,
interstate commerce may be
24
used to facilitate the offer and sale and sales may be made
to residents of different states.
If the offer is made to
sophisticated individuals there is no limited on the number
of offerees or purchasers or dollar amount of the offering.
In November, 1972, the SEC announced Proposed Relle
74
146.
The rule contains definite standards for the private offering exemption:
(1)
(2)
(3)
(4)
(5)
(6)
The offer must be made in a negotiated transaction involving direct
communication between the buyer and
seller or their representatives and
the issuer must not use any means of
general advertising;
The offeree or his investment representatives must have access to the
same kind of financial and other information available in a registration
statement under the 1933 Act and sufficient access to allow verification
of that information;
Before the offer is made, the issuer
must reasonably believe th ~ t each
offeree or his investment representative is sufficiently sophisticated to
understand and utilize the required
information and that the offeree is
able to bear the economic risks;
Purchasers (not offerees) within a
twelve-month period must not exceed
thirty-five persons, but investors of
$250,000 or more are not counted in
the thirty-five person limitation;
The issuer, after reasonable inquiry,
must not be aware that any purchaser
takes with a view to distribution ,
and the issuer must take c ertain
steps to assure that no deferred distribution is made; and
The issuer must file a report with the
SEC within forty-five days following
any quarter in which sales are effected
in reliance upon the rul e . 75
2S
Proposed Rule 146 is not mandatory, but compliance
with it would insure application of the exemption.
A few cases have taken very strict interpretive stands
on the private offering exemption.
Therefore, the syndica-
tor must be more careful in using it.
Hill York Corp. v. American Franchises, Inc.,76 said
public advertising is incompatible with the private offering exemption.
Newspaper ads are definitely not allowed
and it is very doubtful if publicized investment education
sessions would be allowed.
The court also discussed the
relationship of the offerees to each other and to the issuer.
As to the relationship among the offerees, the court
stated that if the group of offerees were diverse and unrelated ("lawyers, grocers, plumbers, etc.") that the offering would appear to be a public one. 77t
In SEC v. Continental Tobacco Co., 78 the SEC argued
in their brief that offerees needed to have the status of
insiders in the meaning of Rule lObS.
the SEC.
The Court held for
But SEC Commissioner Hugh P. Owens later publicly
stated that the brief meant only two things:
(1) offerees
must be shown to have material information concerning the
issuer;
(2) the access to criteria cannot be met merely by
gratuitously providing a promotional prospectus and by having each offeree saying 'he has received and read the document. 79 If this is the ,present policy of the SEC, the
26
private offering rule has not been construed out of existence.
There is a conflict of interpretations as to who is
the issuer.
One version says the general partner of a
limited partnership is;80 the other view says the limited
' ~' tse I f '~s. 81
par t ners h ~p
The most logical approach is the
latter with the general partner viewed as the principal of
the issuer.
2.
Intrastate Exemption
The intrastate exemption
§
3(a) (11) of the 1933 Act,82
exempts issues that are local in nature from registration.
A security offerred and sold only to residents of one state
by an issuer who is a resident of the same state with substantially all the offeree's invested
that state is local in nature.
to be spent in
But if only one offeree 83
mo~ey
or purchaser is a non-resident, the exemption will be lost
to all shares.
Once the distribution is complete, all
shares must be in the hands of resident purchasers.
The
SEC will pierce a share transaction where a resident purchaser is acting as trustee for non-residents.
If the
. intrastate exemption applies, the issuer may use means of
interstate commerce, make the offer to as many residents
I
as he pleases, and sell' as much of the security as he is
able without having to comply with registration under the
1933 Act. 84 But there will probably be state requirements
27
of registration if the issuer is too excessive.
Also the
use of means of interstate commerce may bring the issuer
'th'~n th e d'~sc 1 osure B5 an d
w~
'
'1 l'ab'l'
~
~ ~ty B6 sections of
c~v~
the 1933 Act.
Integration of other offerings with the offering in
question can cause both offerings to be considered as one
making it difficult to comply with any exemption.
A typi-
cal example would be if an issuer buys one tract which is
divided into smaller tracts each having its own limited
partnership, all the limited partnerships will be lumped
together and be deemed the single issuer. B7 The SEC has
given factors that are important in considering the integration problem:
(1) whether the offerings are part of a
single plan of financing;
(2) whether they involve issu-
ance of the same class of securities;
(31 whether the of-
ferings are made at or about the same time;
(4) whether
the same type of consideration is to be received; and
(5) whether the offerings are made for the same general
purpose.
BB
Normally a syndicator who is the sole general
partner in several limited partnerships dealing with different property at different times with different investors
will not have integration problems. B9
The residence requirements can raise problems.
The
issuer must be a resident of the same state as the offerees
and purchasers.
A corporate or partnership issuer must be
28
organized or formed under the laws of the state and in the
case of the partnership all general partners must be residents of the state. 90 An individual issuer, must have his
residence in that state.
Also the issuer must be doing
business within the state.
Proposed Rule 147 defines doing
business within the state as 80% of gross income is from
business in the state and 80% of assets are located in the
91
state.
Also the offerees and purchasers must be residents of the state.
Here the syndicator must be quite care-
ful and full notice of this requirement should be given to
all offerees on the cover of the investment information
material.
The syndicator should investigate the residences
of potential offerees and purchasers carefully before the
offer is extended.
The syndicator should be on guard for
a purchaser who acts as trustee for non-nesidents or inter
The SEC in Proposed Rule
92
147 and in Brooklyn-Manhattan Transit corporation
suggests
as to sell to a non-resident.
a one year holding period of the issue by all purchasers
before sale to non-resident purchasers will not effect the
exemption requirements.
Note that no advertising at all is allowed.
Texas
~
Exemption Requirements
The Texas Act at
§
5.l allows an exemption if the
sale is made "without public solicitation or advertisement"
and if the total number of purchasers does not exceed 35.
29
Texas requires the purchasers to be sophisticated in
terms of financial standing and past dealings.
Further the
issuer should only make an offer to relatives or long stand.
. 1 or b US1ness
'
1ng
SOC1a
contacts. 93
The investor may be educated on the investment so long
as the requirements of public solicitation and advertising
are not breached.
advertisements. 94
Investment brochures are by definition
If the brochures are given only to pri-
vat.e investors, they are not prohibited.
The brochure
should also give a full disclosure of the proposed investment.
Therefore, to insure compliance, the following fac-
tors should be observed.
(1)
Have a limited printing of written material.
No more than 10 copies should be printed. 95
(2)
Make sure the distribution\of printed material is limited to only persons in the
well-informed investor class.
Printed ma-
terial should not be left indescriminately
with offerees so that members of the public
might read it.
(3)
The syndicator should control printing and
distribution.
The syndicator should make
all presentations and promptly · retrieve
any printed material from the investor once
the investor has made his decision.
30
(4)
The printed material should conspicuously
provide on its cover that it is confidential
and that violation of the proper use of the
material will violate the Texas Act.
Broker-Dealer Registration Requirements
A syndicator may be required to register as a dealer
under
§
Dealer is defined by
4.C of the Texas Act.
§
4.C
as
every person or company other than a salesman, who engages in this state, either for
all or part of his or its time, directly or
through an agent, in selling, offering for
sale or delivery or soliciting subscriptions to or orders for, or undertaking to
dispose of, or to invite offers for, or
rendering services as an investment adviser,
or dealing in any other manner in any security or securities in this state • . • 96
However if the exemptions of
transaction,
§
§
5 of the A~ t apply to the
4.C allows an exemption to the dealer ' s
registration requirement.
outside the
§
But as it is quite easy to fall
5 registration exemption, the careful syndi-
cator should register as a dealer.
This requires a com-
prehensive examination on sec urities mainly in the stock
transaction area.
There is an exception made for those
syndicators already licensed under the Texas Real Estate
License Act 97 who seek dealer licensing in order to deal
98
solely in real estate partnership interests.
The exception waives the requirement that these real estate licensees
take the general securities examination so they only have
!
31
to pass an examination on the Texas Act to become registered as dealers.
The Federal Securities Act of 1934 also has brokerdealer requirements.
Section 3(a) (4) defines a broker as
"any person engaged in the business of effecting transactions for the account of others • • • ,,99
Further
§
lS(a)
(1) provides:
No broker or dealer . • • shall make use
of the mails or of any means or instrumentality of interstate commerce to effect any transaction in, or to induce the
purchase or sale of , any security (other
than an exempted security or commercial
paper, banker's acceptances, or commercial bills) otherwise than on a national
securities exchange unless such broker
dealer is registered in accordance with
subsection (b) of this section. 1DD
There is an exemption from registration in lS(a) (1)
for a broker-dealer "whose business is
state."lDl
eX~lUSiVelY
intra-
Exclusively ' is strictly interpreted so the ex-
emption is lost if there is any interstate transaction
(even a telephone call across state lines).lD2
Again to
prevent problems of coming outside this exemption, registration under the Federal Act is the best course.
FOOTNOTES
IMuch of the information for this paper was obtained
from the following
(a)
Burton, Real Estate Syndications in Texas: An
Examination of securities Problems, 51 Texas
L.R. 239 (1973).
(b)
Greenwood, Syndication of Undeveloped Real Estate
and Security Law Imp1~cations, 9 Houston L.R. 53
(1971) •
(c)
Hardymon, The Real Estate Venture as a Tax
Shelter, 51 North Carolina L.R . 735 (1973) .
(d)
Long, Tax Shelter in Real Estate Partnership:
An Analysis of Tax Hazards That Still Exist,
36 J. Tax 312 (1972).
(e)
2
Sonfield, The Texas Limited, Partnership as a
' Vehicle for Real Estate Investment, 3 St. Mary's
L.R •. 13 (1971) .
Tex. Tax--Gen.Ann. art. 12.02 (1969).
3 INT • REV. CODE of 1954,
4
Id.
§
1371-79.
1378.
5Treas. Reg.
6
§§
§
1.1372-4 (b) (5)
(1959).
TEX. REV. CIV. STAT. ANN. art . 7425b-l (1960).
~ (1945).
7 Id • art. 7425b
§
8 26 U.S.C.A.
856-58 (1967).
§§
9uniform Limited Partnership Ac t,
§
10.
33
10 Id •
§
7.
llId..
i
9.
12TEX • REV. CIV. STAT. ANN. art. 6132a,
13Id •
§
14 Id • §
§
3 (1970).
§
3 (a) (1) (E)
3 (a) (1) (I) '(1970).
3 (a) (1)
(G)
(1970).
15TEX • REV. CIV. STAT . ANN. art. 6132a,
(1970).
16 Id •
§
20 (1970) .
17 Id •
§
21 (1970) .
1BUniform Limited Partnership Act,
19Treas. Reg.
§
§
7.
301.7701-2(C).
20sonfie1d, The Texas Limited Partnershi
for Real Estate Investment,
St. Mary S ) L.R.
211972 INT . REV. BULL. No.2, at 26.
22 1972 INT . REV. BULL. No.2.
23Treas. Reg.
§
30 ~ . 7701-2 (d) (2) (1965).
24 Rev . Proc •. 72-13,
2, at 27 .
§
2.02, 1972 INT. REV. BULL. No.
25 INT • REV. CODE of 1954,
l(d) (1) (1956) .
§
704(d); Treas. Reg.
26 INT ·• REV. CODE of 1954,
§
752 (a) .
27 Rev. Ru1. 69-223, 1969-1 CUM. BULL. 1B4 .
2BTreas. Reg ~
§
1.752-1(e).
§
1.704-
34
29 Id • § 1. 704-1 (d) (1).
30 INT • REV . CODE of 1954,
704(a).
§
31s. Rep. No. 1622, 83d Cong., 2d Sess. 379
32
(1954).
55 T.C. 395 (1970).
33Treas. Reg. 1.704-1(b) (2).
34INT. · REV. CODE of 1954,
35 Id • § 1245 (b) (3) and
§
§
721.
1250 (b) (3) •
36 Id • § 722.
37 Id • § 704(c) (2), Treas. Reg . 1.704-1(c) (2).
38Treas . Reg .
§
1.752-1 (c)
(1956).
39 pub . ' L. No. 91-172, 83 Stat. 487.
40 INT. REV. CODE . 0 f ' 1954,
§
167 (j) (2 j) •
4l Id • § 167 (j) (1) .
42 Id •
§
167(i) •
. 43 Id •
§
741.
44 Id •
§
751.
45 Id • § 752.
46 Id • §§1245, 1250'.
47 Id •
§
752, Treas. Reg.
48Treas. Reg.
§
§
1.752-1(d)
1. 752-1 (d)
(1956)
(1956).
35
49 INT • REV. CODE of 1954,
§
SOld.
§
1250 (c) •
SlId.
§
1250 (a) (1) (C) (iii).
52 Id •
§
1250 (a) (1) (C) (v) •
53 INT • REV. CODE of 1954,
54 Id •
55
§
1245 (a) (3).
§
1250 (a) (1) (C).
341.
Rev. Ru1. 239, 1970-1 CUM. BULL. 74.
56 INT • REV. CODE of: 1954,
57 Id •
§
752.
58 Id •
§
1031.
59Treas. Reg.
60 Id •
§
§
1.1031(a)-1(b)
(1956).
1.1031(d)-2 (1956).
61 INT • REV. CODE of 1954,
62
453-56.
§§
15 U.S.C.
§§
§
731(a) (1).
.
77a-aa (1970).
63TEX • REV. CIV. STAT. ANN. art. 581-1 to art. 582-1
(1964) •
64SEC Securities Act Release No. 4877 (Aug. 8, 1967),
[1966-1967 Transfer Binder] CCH Fed. Sec. L. Rep.1f 77,462.
65 328 U.S. 293 (1946).
66 15 U.S.C.
67 Id •
§
77b(3) 1964.
36
68SEC v. Ralston Purina Co., 346
u.s.
119 (1953).
69 SEC Securities Act Release No. 33-5349 (Jan. 8, 1973).
70 see footnote 68.
711 L. Loss, Securities Regulation 653-96 (2d ed. 1961);
SEC Securities Act Release No . 4552 (Nov. 6, 1962).
72 SEC Securities Act Release No. 4552 (NOV. 6, 1962).
73 Id • No. 33-285 (Jan. 24, 1935).
74SEC Securi ties Act Release No. 33-5336 (Dec. 28, 1972).
75Burton, Real Estate S ndications in Texas:
nation of Secur~t~es Pro lems, 1 Texas L.R.
(1973) •
An Exami-8
!
,
76 448 F.2d
680 (5th, Cir. 1971) •
77 Id • '
78 463 F.2d 137 (5th' Cir. 1972) •
79Address by SEC Commissioner Hugh P. Owens, BNA Sec.
Reg. & L . Rep. No. 152, at G-l (May 17, 1972).
80 SEC No-Action Letter, In re American Plan Investment
Corp. (Feb. 9, 1971), [1970-197r-Transfer Binder] CCH Fed.
Sec. L. Rep. ~ 78,044 .
81SEC No-Action Letter, In re Boetel & Co. (Aug. 30,
1971), [1971-1972 Transfer BInder] CCH Fed Sec. L. Rep.~
68,343 .
82
'
15 U.S.C.
§
77c(a) (11)
(1970).
83 SEC v. Truckee Showboat, Inc., 157 F. Supp. 824 (S . D.
Cal. 1957); SEC v. Wh~tehall Corp., 38 SEC 259 (1958).
37
84 1 CCH Fed. Sec. L . Rep.<j:j- 2270-2277 (1961).
85
15 U.S.C.
771 (1964).
§
86 Id •
§
77q.
· 87 Id •
§
78 ff.
88SEC Securities Act Release No. 4434 (Dec. 6, 1961).
89 SEC No-Action Letter, In re National Ass'n of Home
Builders (Oct. 8, 1971).
90 SEC Securities Act Release No. 33-5349 (Jan 8 , 1973).
91see footnote 92 .
92
1 S.E.C . 147, 162-3 (1935) .
93Tumblewood Bowling Corp. v. Matise, 388 S . W.2d 479
(Tex. civ . App . --Beaumont 1965 , writ ref'd n.r.e.).
94Birchfield v . State , 401 S.W . 2d 82~, 828 (Tex. Crim .
App. 1966).
95Greenwood, 5 ndication of Undevel0 ed Real
Security Law ImpIT~~c~a~t~~~o~n~s~,~~H~o~u~s~t~o~n~L~.~R~.~5~3~,~~~~~-=~
96 TEX. REV. CIV . STAT. ANN. art. 581-4.c (1964) .
97 Id • art . 6573a (1969).
98Texas Securities Board, Policy Statement (Dec . 26,
1972) •
99 15 Q.S . C.
100 Id •
§
§
78c(a) (4)
780 (a) (1) •
101 See footnote 102.
(1970).