1031 LIKE-KIND EXCHANGES: A Way to Defer Liability for Capital Gains Taxes In a Real Estate Transaction

Generally speaking, when the owner of real property sells or otherwise disposes of that property and makes a profit, he or she will be liable for capital gains taxes on those capital gains.  The amount of capital gains to be taxed is calculated as the amount realized on the transfer minus the owner’s “basis” in the property (with the “basis” being the original cost of the property to the owner, adjusted for various factors set out in the Internal Revenue Code).

Section 1031 of the Internal Revenue Code (“Section 1031”) affords owners of appreciated business or investment real estate property the ability to leverage 100% of the property’s value by deferring tax liability for the capital gains at the time the property is disposed of – so long as another like-kind property is acquired per the requirements set forth in Section 1031.

It’s important to keep the following in mind regarding a Section 1031 “like-kind exchange”.   In a Section 1031 transaction, the tax on the gain from the sale is only deferred to a later date, not eliminated entirely.  Furthermore, after the Tax Cuts and Jobs Act of 2017 became effective on January 1, 2018, the tax-deferral benefits of Section 1031 are limited to exchanges of real estate property held for use in a trade or business, or for investment, and are no longer available for the exchange of personal property such as stock or corporate membership interests.  Finally, the availability of Section 1031 is dependent on satisfying all of its specific requirements (discussed further below).

Nonetheless, Section 1031 remains a potent mechanism for deferring taxes on capital gains. There is no limit on how many times or how frequently an owner can use Section 1031 to roll over gain from one given property to another property and then another.  Although there may be a profit on each transaction, payment of capital gains tax is deferred until the owner sells the property in a non-Section 1031 transaction at a later time.  In some instances, there will be no tax at all when the owner’s heirs inherit the property at the time of his death, because they will receive a stepped-up basis equal to the property’s fair market value as of the date of the owner’s death (effectively making any appreciation of the property during the decedent’s life tax-free).  When the property is subsequently sold by the heirs, they will pay capital gains tax on only the increase in value over the stepped-up basis.

I.  What Property Qualifies as Like-Kind Property?

Both the transferred property (“Relinquished Property”) and the property received in exchange (“Replacement Property”) must be held for use in a trade or business, or for investment, and must be similar enough to qualify as “like-kind.”  The meaning of “like-kind” property is very broad and only requires that the properties be of the same nature, class, or character.  Dissimilarities in grade or quality between the two properties does not matter.  Virtually all real estate is like-kind to other real estate. For example, an office building will be like-kind to farm land or other unimproved property to be held for investment.

However, the exchanged properties must be of similar value for the like-kind exchange to defer all taxes.  If there is cash or other non-qualifying property left over after the Replacement Property is acquired (so-called “boot”), the owner will owe taxes on the boot.  Furthermore, debt on both the Relinquished Property and the Replacement Property must also be considered when evaluating the exchange.  If the purchase price plus any new loans on the Replacement Property is less than that of the sale price of the Relinquished Property, gain will be recognized to the extent of the difference.  Thus, for example, if an owner (the “Exchangor”) sells a Relinquished Property for a sales price of $1,000,000 that carries a $600,000 mortgage, the purchase price of the Replacement Property would need to be at least $1,000,000 with $600,000 or more in loans in order to maximize the benefits of Section 1031.

II.  Who Qualifies for the Benefits of Section 1031?

Individuals, C corporations, S corporations, partnerships, limited liability companies, trusts, and any other tax-paying entity may set up an exchange under Section 1031.  It is important to note that the name of the Exchangor on its tax return and its deed to the Relinquished Property must be the same as the name on the tax return of the acquiring entity and in the deed to the Replacement Property.  However, there is an exception for single member limited liability companies.  In that case, the Relinquished Property may be sold by the entity, but title to the Replacement Property may be in the name of the single member of the limited liability company because the single member entity is disregarded for tax purposes.

III.  What is the Process for Conducting a 1031 Exchange?

To qualify for Section 1031 treatment, the exchange must be distinguished from a situation where an owner sells a property and then uses the cash proceeds to buy another property.  Section 1031 offers four types of exchanges to choose from (to be discussed in more detail below).  The simplest form involves the direct exchange of one property for another on the same day.  The exchange must occur simultaneously and any delay, such as wiring funds to an escrow company, could result in disqualification of the exchange.  However, it is unlikely that an Exchangor will find a buyer for the Relinquished Property and a seller of a Replacement Property at the same time.  Therefore, most exchanges are deferred three-party exchanges that require the use of a “qualified intermediary” to successfully complete a Section 1031 tax deferred exchange.

A.  Qualified Intermediaries. There are many companies that can be selected to act as a qualified intermediary to facilitate a Section 1031 exchange.  However, the qualified intermediary may not be the taxpayer or a disqualified person (i.e., anyone who is related to the taxpayer, or who has had a financial relationship with the taxpayer).

The qualified intermediary will enter into a written exchange agreement with the Exchangor under which the intermediary will agree to transfer the Relinquished Property and acquire the Replacement Property.  The exchange agreement must expressly limit the Exchangor’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property received in the sale of the Replacement Property.  If the Exchangor takes any control of cash or other proceeds before the exchange is completed, it may disqualify the entire transaction from tax deferred treatment.  The use of an experienced qualified intermediary can significantly reduce the complexity of an exchange by assuring the proper execution and processing of required documentation. However, since the qualified intermediary industry is not regulated, the careful selection of the qualified intermediary is essential to ensure the highest level of expertise and security for funds.

B.  Time Limits. There are certain time limits that must be met for an exchange to qualify for Section 1031 tax deferred treatment.  First, the Exchangor of the Relinquished Property must clearly identify possible Replacement Properties to the qualified intermediary in writing within 45 days of the sale of the Relinquished Property.  Second, the Replacement Property must be purchased and the exchange completed no later than 180 days after such sale.  More than one property may be identified as a possible Replacement Property and it is not necessary to purchase all the potential Replacement Properties identified, but at least one must be purchased within this timeframe to qualify as a Section 1031 exchange.

  1. Types of Deferred Exchanges: Delayed, Reverse, and Construction Exchanges.  As discussed above, a “simple” Section 1031 exchange involves a same-day sale and purchase of two like-kind real properties.  Deferred exchanges are more common and require that the sale of a Relinquished Property and the purchase of a Replacement Property be dependent parts of an integrated transaction.  There are three types of deferred exchanges, which are often referred to as delayed, reverse, and construction exchanges.

a.  In a delayed exchange, which is the most common form of deferred exchange, the Exchangor must (i) market, (ii) find a buyer for, and (iii) enter into a sales agreement for, the Relinquished Property.

  • Once this has occurred, the Exchangor enters into a written exchange agreement with a qualified intermediary and assigns the existing sales agreement to the qualified intermediary prior to the closing of the sale.
  • Once the closing of the sale occurs, the qualified intermediary receives the proceeds (the Exchangor cannot receive the proceeds without disqualifying the exchange).
  • After the sale, the proceeds must be held in a trust by the qualified intermediary during which time the proceeds must be used for the purchase of a Replacement Property for the Exchangor.
  • The Replacement Property must be specifically identified by the Exchangor to the qualified intermediary within 45 days of the Relinquished Property’s sale. The property identification must be in writing, must describe the Replacement Property with a legal description, street address, or other distinguishable name, and must be delivered to the qualified intermediary or the seller of the Replacement Property.  Identification of the Replacement Property to the Exchangor’s real estate agent, CPA, or lawyer is not sufficient.
  • The Replacement Property must be acquired by the Exchangor, and the exchange completed within 180 days after the Relinquished Property was sold or by the due date (including any extensions) of the income tax return of the Exchangor for the year in which the Relinquished Property was sold.

b.  In a reverse or forward exchange, the Replacement Property selected by the Exchangor will be acquired first and “parked” with the qualified intermediary until it is transferred in a simultaneous exchange for the Relinquished Property. The qualified intermediary will obtain the funds to purchase the Replacement Property by borrowing it from the Exchangor or a lender.

  • The qualified intermediary can hold the parked property for no more than 180 days from the date of purchase during which time the Relinquished Property must be identified, sold, and the Replacement Property transferred to the Exchangor.
  • Such identification must occur within 45 days after the purchase of the Replacement Property.
  • After the initial 45 day identification period, the Exchangor has an additional 135 days to complete the sale of the Relinquished Property through the qualified intermediary.
  • The failure to identify the Relinquished Property within such 45 days and to close on its sale during the 180 day period will result in the exchange failing to qualify for Section 1031 tax deferred treatment.
  • Proceeds from the sale of the Relinquished Property will go to the qualified intermediary and will be used to repay loans incurred to purchase the Replacement Property.

c.  The construction/improvement exchanges are the most complex of the deferred exchanges but allow the Exchangor to make improvements to the Replacement Property before it is transferred to the Exchangor using the funds received from the sale of the Relinquished Property.

  • In this type of exchange, the Exchangor and the qualified intermediary will, in addition to the exchange accommodation agreement, enter into a construction management agreement pursuant to which the Exchangor is granted the right to make improvements to the Replacement Property on behalf of the qualified intermediary, and is made fully responsible for the supervision and performance of all of the work and the payment of all expenses related to the design and construction of such improvements.
  • If there will be any third-party occupancy of the Replacement Property prior to the date that ownership will be transferred to the Exchangor, the parties will also enter into a lease (ending no later than the 180th day) under which the third-party may occupy the Replacement Property during construction of the improvements.
  • To qualify the construction exchange for the benefits of Section 1031, all of the funds from the sale of the Relinquished Property must be used to pay for the Replacement Property and improvements, and such improvements and the exchange must be completed within 180 days of the Relinquished Property’s sale.
  • The Exchangor must receive substantially the same Replacement Property as it identified to the qualified intermediary, and the improved Replacement Property must be of equal or greater value than the Relinquished Property in order to defer 100% of the tax.

IV.  How is the Basis of the Replacement Property Calculated?

As noted previously, in a Section 1031 transaction the tax on the gain from the sale is merely deferred, not eliminated.  Therefore, the basis of the Replacement Property must be calculated to preserve the deferred gain for taxation in the future.  The basis of the Replacement Property is the basis of the Relinquished Property, decreased by the amount of any money and non-like-kind property received from the sale of the Relinquished Property, and increased by the amount of any gain (or decreased by the amount of any loss) recognized in the exchange.  If boot is also received in the exchange transaction, the basis of the Relinquished Property must be allocated between the Replacement Property and the boot, assigning to the boot an amount equal to its fair market value on the date of the exchange.

It is clear that a Section 1031 exchange provides the Exchangor with a significant tax deferral benefit.  However, there are two potential downsides to the exchange.  First, in most instances, the basis for depreciation of the Replacement Property will be less than the value of the Relinquished Property at the time of exchange, and second, when the Replacement Property is sold, even at a loss, capital gains tax will be owed on all amounts received in excess of the basis of the Replacement Property.  For example, if the Relinquished Property had a basis of $1,000,000 and a value of $2,000,000 at the time of exchange, the basis of the Replacement Property for depreciation will only be $1,000,000 not $2,000,000, thus preserving the $1,000,000 in deferred capital gain.  If the Replacement Property is later sold for $1,800,000, there will be capital gains taxes owed on $1,000,000, even though the Replacement Property was sold for $200,000 less than the value of the Relinquished Property.  Any decision by a property owner to utilize the Section 1031 process should be discussed thoroughly with a qualified tax consultant.

If you have any questions regarding Section 1031 exchanges or other commercial real estate matters, contact Chip Gerry at CGerry@fh2.com  or (770) 399-9500 for more guidance.

Buying Commercial Real Estate—Practical Tips for Buyer’s Due Diligence

No matter what type of commercial property you may be considering, whether office building, apartment, warehouse, or shopping center, the savvy prospective buyer needs to undertake a thorough investigation of a variety of elements that affect the value of that property. This is the due diligence process, and a buyer’s careful and comprehensive performance of this phase can mean the difference between a successful purchase and severe buyer’s remorse.

The Increasing Importance of Buyer’s Due Diligence.

In past years, a buyer’s due diligence was not as crucial as it is today because the purchase agreement contained seller representations and warranties regarding everything from title, the condition of the improvements and environmental conditions to the property’s compliance with zoning requirements. Buyers often limited their investigation of the property in reliance on the truth and accuracy of a seller’s representations and warranties, and a seller could be held liable for damages if the representations and warranties proved to be materially inaccurate or untrue. In fact, the buyer might even have been entitled to rescind (reverse the sale) the purchase agreement for such reasons.

These days, however—particularly in connection with the purchase of smaller commercial properties—the purchase is often on an “AS-IS”-“WHERE-IS”-“WITH ALL FAULTS” basis with the buyer undertaking the responsibility of thoroughly investigating the property and assuming the risk of almost everything about the property that the buyer does not uncover during its due diligence. Purchase agreements still include various seller representations and warranties that buyer can rely on, and similar remedies are available to buyer to pursue, but the representations and warranties are often limited to title, authority to sell and certain environmental conditions. Instead, the more likely scenario is that the purchase agreement will allow a limited period of time, typically 60 to 120 days, for the buyer and its representatives to conduct tests, inspections and examinations regarding the property and even discuss issues regarding the property with the seller’s agents and employees (the “Due Diligence Period”). Such examinations may include the environmental conditions of the property, the physical condition of any improvements and the state of any mechanical and electrical systems. It is also common for the purchase agreement to include a provision requiring buyer to hold seller harmless from any claims, losses or damages arising from such inspections, or any damage caused to the property in the course of such inspections.

The sole purpose of the Due Diligence Period is to give buyer the right to make its independent determination of whether it wants to purchase the property, or, in other words, to “kick the tires.” Typically, the buyer will have the right to terminate the purchase agreement at any time during the Due Diligence Period for any reason, or no reason at all, without incurring any liability to the seller. In the event of such termination, the buyer will receive a refund of any earnest money that may have been deposited. However, if the buyer does not terminate the purchase agreement within the Due Diligence Period, any earnest money paid becomes non-refundable.

The purchase agreement will also typically require the seller to provide the buyer with a variety of information (to the extent it has such information) that will assist the buyer in its investigation of the property. This information may include copies of tax and utility bills, tenant rent rolls, tenant leases, environmental reports and tests, licenses, permits, contracts relating to the property, and any surveys that seller has. The purchase agreement will often either allow buyer (or require seller) to obtain a current survey if the survey provided by seller is too old or not satisfactory to the title insurance company.

Things A Buyer Needs to Investigate During the Due Diligence Period.

So now that the purchase agreement has been executed, the Due Diligence Period has commenced and buyer has received seller’s due diligence disclosure documents, what are some of the matters the buyer should investigate?

First Things First: Title and Surveys.  In the first instance, and before any other time is spent or expense incurred, buyer should engage a title insurance company or attorney to examine the title to the property for the purpose of obtaining satisfactory evidence, in the form of an attorney’s certificate, or better yet, a title insurance policy, that the property is indeed owned by the seller. This examination is very important even though title may be warranted by a solvent seller since liability for seller’s breach of its warranty of title is often difficult to enforce, does not cover the cost of litigation, and recovery is limited to the original purchase price (not covering subsequent improvements or increases in value). The goal of the title examination is to establish that the seller is the holder of good and marketable fee simple title (a 50 year unbroken chain of successive ownership into seller) to the property and to determine what liens, covenants, restrictions, and other matters the property may be subject to.

The survey should also be reviewed during the Due Diligence Period to determine if it discloses physical problems with the property such as improvements (e.g., a driveway) that encroaches an adjoining property or easements that would impair buyer’s intended use of the property.

The purchase agreement should provide that if the title examination or the survey review discloses matters that are not acceptable to the buyer (“defects”), the buyer will have the right to request that the seller cure such defects. Purchase agreements often provide that a seller is not obligated to cure any defects, other than those that can be cured by the payment of money at or before the closing. If the seller cannot, or will not, cure the defects, the buyer must then decide whether to terminate the purchase agreement or proceed with the transaction with the defects uncured.

Additional Things to Investigate During the Due Diligence Period.

Once the buyer is satisfied with the title examination and survey review, the buyer should consider investigating some or all of the following matters.

  1. Adverse Claims, Liens and Encumbrances: Whether: (i) any person (other than seller and tenants disclosed in seller’s due diligence documents) claims or is entitled to possession of all or any portion of the property; (ii) there are any unpaid or unsatisfied security deeds, mortgages, claims of lien, special assessments, or bills for sewerage, water, street improvements, taxes or similar charges that constitute a lien against the property.
  1. Flood Plain: Whether: any portion of the property is in a flood plain.
  1. Access to the Property: Whether: (i) access to the streets and roads adjoining the property is limited or restricted, except by applicable zoning laws; (ii) the streets are complete, dedicated, and accepted for maintenance and public use by appropriate governmental authorities; and (iii) any and all curb cuts and similar permits or licenses necessary or appropriate to provide or facilitate such access to the property have been properly issued and remain in full force and effect.
  1. Utilities: Whether: (i) all utilities for the property, including but not limited to, water, sanitary sewer, storm sewer, electricity, telephone, high-speed data service, trash removal, and garbage removal, are in good working order and good repair; and (ii) all utility services serving the property are publicly or privately owned and operated and are available and operating for the benefit of the property in such a manner and capacity as are necessary and appropriate for the operation of the property for their present use at standard rates, without any requirement for the payment of any tap-on fees or other extraordinary charges.
  1. Access for Utilities: Whether the property has: (i) all appurtenant easements that are necessary and appropriate for the installation, maintenance and use of all necessary and appropriate facilities for water, sanitary sewer, storm sewer, drainage, electricity, gas, telephone and high-speed data services, disposal and garbage disposal; and (ii) the right to connect and use all of said facilities from the property to the sources of said services.
  1. Improvements: Whether: (i) the improvements on the property and all portions thereof, including without limitation, all roofs, walls, windows, elevators, foundations, footings, columns, supports, joists, heating, ventilating and cooling systems, electrical systems, plumbing systems, paving, and parking facilities and landscaping are in good order, repair and operating condition; (ii) there is any termite or other pest infestation, dry rot, or similar damage with respect the improvements; (iii) all of the improvements are water tight; (iv) there is any soil subsistence or other soil condition that presently does or may in the future adversely affect the property; and (v) the storm water detention facilities have been properly installed on the property, are in compliance with applicable laws, and are of sufficient capacity for buyer’s intended use of the property.
  1. Environmental Issues: Whether the property: (i) has been used for the generation, discharge, release, storage, or disposal of hazardous materials; (ii) is free of any hazardous materials; (iii) has been excavated, has landfill deposited on, or taken from, the property; (iv) contains any underground storage tanks; (v) has or had any underground storage tanks on it and that any underground storage tanks that were on the property have been removed or decommissioned in accordance with applicable law; and (vi) has any construction debris or other debris, rocks, stumps, or concrete that have been buried on the property.
  1. Property Boundaries: Whether, based on the survey and a physical examination of the property, there are any disputes concerning the location of the property lines and corners of the property.
  1. Violation of LawsTax or Insurance Increases and Condemnation: Whether seller has received any written notice of: (i) any alleged violation of any covenant or legal requirement affecting the property, including applicable zoning laws, building codes, anti-pollution laws, health, safety and fire laws, sewerage laws, environmental laws or regulations, or any covenant, condition, or restriction affecting the property; (ii) any possible widening of any streets adjoining the property; (iii) any possible condemnation of all or any portion of the property; (iv) any possible imposition of any special tax or assessment against all or any portion of the property, or any proposed increase in the tax assessment of the property; (v) the need or advisability of special flood or water damage insurance; or (vi) any possible increases in tax rates or insurance rates for all or any portion of the property.
  1. Suits or Proceedings: Whether seller has received notice of (whether actual or threatened) any actions, suits or proceedings related to the property.
  1. Zoning: Whether the property is presently properly zoned for buyer’s intended use.

Whether a buyer is purchasing commercial property for investment or as a location for its business, such a purchase is a large commitment of time and money. Thoughtful and thorough due diligence by the buyer may be the most important part of the process, and, regardless, can help alleviate headaches down the road.

If you have any questions regarding commercial real estate matters, contact Chip Gerry at CGerry@fh2.com or (770) 399-9500 for more guidance.

8 Key Terms You Need to Pay Attention to in Your Next Lease

Almost every person or business (the “tenant”) that seeks to occupy space in another’s building (free standing, multi-tenant office or shopping center) will enter into a contract, known as a lease, with the owner (the “landlord”) of the building. A lease is an amalgam in nature, comprised of (i) the conveyance of an interest in real property by the landlord to the tenant, and (ii) a contract between the landlord and tenant that defines all of the elements of the relationship between them regarding the building and premises for the duration (the “term”) of its use by the tenant. Because commercial leases are typically in effect for a relatively long period (three or more years), the lease is a dynamic document that has very real implications for the tenant in years to come.

The lease is comprised of a variety of provisions that define aspects of the landlord/tenant relationship – ranging from the direct economic ones (such as rent, taxes and maintenance) to non-economic ones (such as the manner of use, renewal and tenant relocation). Because the landlord’s and the tenant’s interests are typically divergent, the provisions require negotiation between the landlord and tenant. But which ones are of most significance to the tenant? Unless the tenant is leasing a substantial amount of space in the building the bargaining positions of the tenant and landlord are generally weighted in favor of the landlord, so the tenant must decide which provisions are most crucial to modify in order to meet its needs and which ones can be accepted as proposed by the landlord.

The following are key provisions that merit special attention by a tenant.

1. Rent: While this seems obvious, the tenant must be sure that base rent (per square foot rental rate times the total square feet in the premises) is clearly stated for the term of the lease, and that there are no overlooked rent escalations (such as cost-of-living adjustments) included that have not been specifically agreed to.

In addition to base rent, leases generally provide that the tenant will pay its pro rata share (based on square footage of the premises divided by the square footage of the building) of building operating expenses, taxes and insurance. This will be discussed later in more detail under the heading Building Operating Expenses.

2. Use: This provision defines what the tenant can use the premises for. Landlords will frequently seek to limit the use to a specific one, while it is in the tenant’s best interest to keep the scope of use more broad. For example, the landlord may seek to limit the use to “law offices”, but the tenant should try, at a minimum, to expand the approved use to include “general office purposes” or, better still, any purpose not prohibited by law.

3. Maintenance and Repair: It is critical that the division of responsibility for maintenance and repair of the building (together with its common areas) and the premises (the space within the building actually occupied by the tenant) be fair to the tenant. The tenant will typically be responsible for repairs and maintenance to the premises, while the landlord is otherwise responsible for the building and common areas. In this situation the definition of “Premises” within the lease is very important. The tenant should seek to define the premises for which it is responsible as “below the ceiling grid, above the surface of the floors and inside of the exterior windows”. If the definition of the Premises is not so limited, tenant could find itself liable for maintenance and repair of electrical systems and HVAC above the ceiling grid and plumbing systems below the floor. Additionally, the tenant should try to avoid being made responsible for any “replacement” of components of the premises, like plumbing and light fixtures unless the replacement is necessitated by the tenant’s negligent acts or omissions.

4. Building Operating Expenses: While landlords are typically responsible for maintenance, repairs and replacements of the building and common areas, the costs incurred by the landlord in fulfilling that responsibility are almost always passed to the tenant on a pro rata basis. The amount involved can be substantial, sometimes as much as 30/40% of base rent. The lease will include a comprehensive definition of all such costs which will include taxes (unless addressed separately), insurance and virtually every other cost incurred by the landlord in operating and maintaining the building and common areas and providing services to the building.

During the lease negotiation the tenant should try to avoid including the following items in the definition of building operating expenses:

  • Depreciation on improvements and equipment, especially if a capital reserve is already part of the definition;
  • Costs properly chargeable to landlord’s capital account such as repaving, new roof and construction of additional improvements; and
  • Paying a percentage that varies from 10-20% of base rent, to the landlord for its administrative costs, rather than its actual out-of-pocket costs for administration.

The tenant should also seek to limit its obligations for building operating expenses to paying only those expenses that represent an “increase” over the building operating expenses for a base year established in the lease. The “base year” is typically the year that the lease is entered into. However, many landlords seek to pass on all building operating expenses to tenants, not just increases over a base year.

Payments of the building operating expenses are typically made monthly based on the landlord’s estimate of such expenses, with a reconciliation in the first 90 days of the next calendar year based on the actual operating expenses for the preceding year.

5. Extension/Renewal Options. When negotiating for the use of space, the tenant should consider having an extension/renewal option provision included in the lease. This grants the tenant the option (or several consecutive options) to extend/renew the lease for one or more fixed terms on substantially the same terms and conditions as are contained in the original lease, with the exception of base rent, financial incentives and the renewal option itself. This provision will provide that the option may be exercised, if at all, by written notice to the landlord, given within a specified number of months before the then current term expires. Landlords frequently resist such provisions because they restrict the landlords’ rental options in the future. Nevertheless, landlords may be persuaded to agree – particularly if the lease includes a relocation provision in favor of the landlord (see below).

Rent for the renewal/extension period is negotiated by the landlord and tenant and is often based on “market rent” at the time of renewal, with stated criteria for determining “market rent” such as (i) similarly situated second generation space in comparable buildings, (ii) where the building is located, (iii) annual rent escalations, (iv) definition of rentable space, and (v) other similar factors affecting the rental rate.

If the landlord and tenant cannot agree on “market rent”, the option will often provide for determination of market rent by one to three arbitrators who are experienced in representing landlords and tenants of buildings comparable to the building.

The option will almost invariably state that in no event shall the base rent for the renewal term be less than base rent in effect on the last day of the preceding term.

6. Relocation: Landlords of multi-tenant buildings (and sometimes landlords of shopping centers) often include a provision in the lease that allows them to move tenants to other spaces in the building. Landlords want to include such a provision as it allows the landlords the flexibility to adjust its leases in the building to accommodate prospective tenants who need large spaces within the building. If a tenant does not have the leverage to get the landlord to agree to omit the provision, it needs to negotiate adequate protection against the cost and disruption of a “forced” move. If a relocation provision is included it should provide for, at least, the following:

  • No less than 60 days’ advance notice;
  • The new premises should be substantially the same in size, dimensions, configurations, tenant improvements and finishes as the original premises, all paid for by landlord;
  • The relocation shall be at landlord’s sole cost and expense;
  • The relocation shall take place over a weekend and be completed, if possible, before the Monday following the weekend of the move; and
  • Tenant shall be reimbursed for all costs incurred by tenant as a consequence of the relocation including without limitation, moving costs, changing stationery and business cards, moving of computers and telephone systems and re-cabling the new premises to meet the tenant’s technology requirements.

7. Assignments: Leases will frequently prohibit a tenant from assigning the lease or sub-letting all or part of the premises without the landlord’s prior consent. The tenant should seek to limit the landlord’s discretion in prohibiting assignment or sub-letting by providing that the landlord may not unreasonably delay, condition or deny its consent to an assignment or sub-lease. Further, to account for future business transactions and restructurings, the tenant should seek the right to assign the lease, or sub-lease the premises – without any required landlord consent – to any entity controlling, controlled by or under common control with the tenant, or to any entity into or with which the tenant has merged or consolidated or which purchases all or substantially all of the tenant’s assets.

8. Surrender of Premises: This provision often does not receive the attention it needs when the tenant is negotiating the lease. The lease will typically require that, upon expiration or termination of the lease, the premises must be returned, broom clean, in good order and condition (except for normal wear and tear), substantially in the same condition as it was when the lease commenced.

While a provision of this sort is customary and should not be objectionable to the tenant, many leases go further, and require that, in addition to removing its trade fixtures and personal property, tenant must remove all communications wiring and cabling installed by it from the ceiling and walls of the premises – and sometimes even from the premises to the point where it terminates to the building’s wiring. Further, some leases seek to obligate the tenant to pay for the removal of all tenant improvements made to prepare the premises for tenant’s occupancy. Both of these provisions should be rejected if at all possible as the cost to tenant of complying can be substantial. However, tenant should retain the “option” of removing cabling and wiring as tenant may wish to reuse these items in its new location.