¶ 5101
Overview
Scope of the chapter. The limited liability company is now the standard vehicle for holding, financing and developing real estate in the United States. A single apartment building, a portfolio of warehouses, a hotel financed with layered debt and a joint venture between a developer and an institutional investor are all ordinarily owned through one or more LLCs. This chapter examines the features of LLC law, real property law, finance and taxation that bear on that use. It addresses the choice among ownership structures (¶ 5110), the conveyancing questions raised when property moves into or out of an LLC (¶ 5120), the transfer, recording and reassessment taxes that apply to such conveyances and to transfers of interests in property-owning LLCs (¶ 5130), the nonrecourse mortgage loan and its carve-outs (¶ 5140), special-purpose covenants and mezzanine financing secured by LLC interests (¶ 5150), the governance of real estate joint ventures (¶ 5160), the federal income tax rules most often encountered in real estate LLCs (¶ 5170), questions of liability, creditors and transparency (¶ 5180), and drafting (¶ 5190).
Relation to other chapters. Several topics that arise constantly in real estate practice are treated elsewhere and are cross-referred here. Series LLCs and protected series, often proposed for multi-property portfolios, are the subject of Chapter 10. Special-purpose and bankruptcy-remote entities are treated in Chapter 11 and, in the bankruptcy setting, in Chapter 49. Preferred returns, waterfalls and financing terms are treated in Chapter 16. Mergers, conversions and divisions, including the transfer tax consequences of those transactions, are treated in Chapter 34. The partnership tax rules on contributions, allocations, distributions and transfers are treated in Chapters 40 and 41, and disregarded entities in Chapter 42. The use of LLCs to protect assets from the creditors of members, and of the LLC itself, is treated in Chapter 55. This chapter applies those rules to real estate and adds the bodies of law peculiar to it.
Why real estate gravitated to the LLC. Three features of the LLC explain its dominance in real estate. The first is the liability shield. Real estate produces liabilities that are tied to a particular parcel: premises claims by tenants and invitees, environmental conditions, construction defects and obligations under leases and service contracts. Placing each property in its own LLC confines those liabilities to the assets of that LLC, so that a judgment arising from one building does not reach the equity in another. The shield also permits investors who supply capital and take no part in management to invest without the exposure that general partners of a partnership bear. Chapter 25 describes the shield and Chapter 26 the circumstances in which a court will disregard it.
Pass-through taxation. The second feature is partnership taxation. An LLC with two or more members is classified as a partnership unless it elects otherwise, and an LLC with one member is disregarded. Chapter 39 explains the classification rules. Partnership classification avoids an entity-level income tax on rents and gains, permits the depreciation deductions generated by improvements to flow to the members, and allows the members' shares of entity-level debt to be included in their bases under section 752. That last point has particular weight in real estate, where leverage is high and depreciation deductions frequently exceed cash flow in the early years of an investment. A corporation, including an S corporation, provides no comparable basis for entity debt. Chapter 43 explains why the S election is seldom used for appreciating real estate.
Contractual flexibility. The third feature is the freedom of contract that LLC statutes confer, especially in Delaware. Real estate investments are commonly organized around distribution waterfalls in which capital is returned first, a preferred return is paid next, and the remaining cash is divided in shifting percentages that reward the sponsor for performance. Those arrangements, together with the major-decision lists, capital-call mechanics, removal rights and buy-sell provisions that accompany them, can be written into an LLC agreement without the constraints that corporate law places on classes of stock or that the S corporation rules place on distributions. Chapter 3 discusses the limits of that freedom.
The lender's preference. Lenders have reinforced the trend. Commercial mortgage lenders, and in particular lenders whose loans are pooled in commercial mortgage-backed securities, require the borrower to be a single-purpose entity whose organizational documents restrict its activities, prohibit other debt and separate it from its affiliates. The LLC accommodates those requirements easily: its agreement can incorporate separateness covenants, provide for an independent manager whose consent is needed for a bankruptcy filing, and admit a special member who becomes a member if the last member ceases to be one. Mezzanine lenders take a pledge of the LLC interests in the borrower's parent and enforce it under the Uniform Commercial Code. The resulting capital stack, with a mortgage at the property level and a pledge of equity one level above, depends on the separation between the LLC and its members that the statutes provide. ¶¶ 5140–5150.
Terminology. In this chapter, "property LLC" means an LLC that holds title to one parcel or project; "holding LLC" means an LLC whose principal assets are the interests in one or more property LLCs; "sponsor" means the person who organizes the investment, manages it and usually receives a promote; and "investor" means a member who supplies capital and does not manage. "Mortgage borrower" and "mezzanine borrower" refer to the property LLC and to the LLC that owns it when the two levels of debt are present.