Fermatas, Grand Pauses, and Alternatives to Holdbacks in Real Estate Transactions
When writing How Holdbacks Affect Music and Real Estate Transactions, I shared my idea to use the musical terms describing holding back of tempo with a musician friend. In response, she told me she would have used a fermata as the musical example.
The typical fermata is a symbol that looks much like an upside down letter U with a dot in the middle of it (musicians also call fermatas “birds’ eyes”). b A fermata above a note indicates that the note is to be held longer than the duration indicated by the note value.
Less commonly, fermatas may look like an upside down V with a dot in it. That type of fermata indicates that the performer should hold the note only slightly longer than its value. Or, fermatas may look like a three-sided square that is open on the bottom, also with a dot in the middle. That type of fermata indicates that the performer should hold the note a lot longer than indicated. However, with the typical fermata, the musician performing the music decides on the length of the note under the fermata.
Another musical term that “holds back” the music is a grand pause. Usually placed between notes or above a rest, a grand pause looks like two parallel diagonal lines above the musical stave. Musicians call grand pauses “railroad tracks.” A fermata indicates the performer should hold a note longer than its value. In contrast, a grand pause instructs the musician to remain silent longer than the indicated the rest value.
Fermatas and grand pauses are alternatives a composer can use to slow down the pace of the music when the changes to tempo (like ritardando, ritornello, ritenuto, and trattenuto) won't create the desired effect. In a real estate transaction, a holdback is a delay in payment of part of a purchase price for a period of time after the closing or performance of services. However, sometimes, the parties’ circumstances don't allow for a holdback. This article discusses alternatives to holdbacks and how they can be used in a real estate transaction.
Why Parties Might Want an Alternative to a Holdback
Sellers may seek alternatives to a holdback in a real estate acquisition when they need to receive the entire purchase price at closing. This might happen for a short sale, where the sale price is less than the mortgage. In a short sale, the seller likely will need every dime of the sale price to pay down the mortgage. In exchange, the lender agrees to release the mortgage for less than the entire amount due.
A seller’s tax situation also might cause the parties to use a holdback alternative. A seller might be planning a Section 1031 like-kind exchange. That allows sellers to defer capital gains taxes on a sale of real estate -- but only if the seller reinvests sale proceeds in replacement real estate. Sellers doing a Section 1031 exchange may have to pay taxes on a holdback amount, making that option unattractive. A holdback also may complicate a buyer’s Section 1031 exchange.
Other times, a seller might want to receive the entire sale proceeds in a given tax year to receive a particular tax treatment. A delay in payment due to a holdback might result in payment of part of the purchase price in a later year. If the seller’s situation or tax laws change in that later year, the seller could owe more taxes due to the holdback.
If the seller is a real estate fund or partnership, there may be cost savings in distributing all cash to the owners and winding up the entity in the year the property is sold. At a minimum, a delay until the next calendar year will result in increased tax preparation costs for an additional tax return.
Types of Alternatives to Holdbacks
Alternatives to holdbacks include net worth and liquidity requirements, guaranties, liens, assignments of rights, price reductions, and bonds.
Net Worth and Liquidity Requirement. The easiest of these is a post-closing seller net worth and liquidity requirement. Unfortunately, that option is rarely feasible for the same reasons that a holdback alternative might be necessary. A seller will have no liquid assets if it reinvests the sale proceeds in real estate, and it may have no net worth if it distributes all cash and other assets and winds up before the holdback period ends.
Seller Guaranty. Another easy and common holdback alternative is a guaranty where the seller, or a related party guarantees that the post-closing condition will be met. However, a guaranty is only worth as much as the party signing it. Often, a real estate seller will be a special purpose entity (SPE) whose only asset is the real estate being sold. If the seller is doing a Section 1031 exchange or needs to distribute the sale proceeds to partners, then after the closing, the seller not have sufficient wherewithal to back up the guaranty.
Seller Affiliate Guaranty. Individual SPE owners sometimes may step into the seller’s shoes and sign a guaranty, but if they are passive investors, they may not be willing to do so. If the SPE owners are professional real estate investors, most of their net worth may be invested in real estate. That might make it difficult for them to pay the guaranteed amount.
Lien on Seller Property. Where the seller has sufficient net worth but inadequate liquidity, post-closing conditions might be secured by a lien on the seller’s property. However, this will not be an option if the property is already subject to a lien. Not only would a new lien be subordinated to the existing one, but the first lien holder may not allow a second lien. If a seller has unencumbered illiquid non-real estate assets a lien in favor of the buyer might be a good option.
Assignments of Rights. Where the post-closing concern is restoration after a casualty, the seller might assign insurance proceeds to the buyer. Then, the buyer, rather than the seller, will complete the renovations using the assigned insurance proceeds. However, the insurance company usually has to agree to the assignment.
Purchase Price Reduction. As a last resort, a buyer might assume the risk or cost of the post-closing matters which were the seller’s responsibility. In exchange, the seller should provide a purchase price reduction commensurate with the risk or cost the buyer is assuming.
Bonds. A bond may be an option where the post-closing concern involves completion of significant construction. Bonding companies will require a guaranty or other assurance of payment the work not be completed, however. Therefore, this option may not work if a guaranty or lien is not feasible.
Considerations for Holdback Alternatives
Holdback alternatives are more complicated than the escrow of a fixed amount of the sale prices in a holdback. Parties need to consider the following when deciding what holdback alternative to use:
Liquidity and Net Worth. Liquidity and net worth are critical when selecting a post-closing liquidity or net worth requirement holdback alternative. However, liquidity and net worth are important for guaranties, also. The buyer needs assurance that the guarantor can pay the amount guaranteed. The guaranty document, itself, also should include the net worth or liquidity requirements.
Encumbrances. Before accepting a lien on a seller’s property, buyers should conduct a title search (for real estate) and a UCC search. Those searches will reveal how much equity the seller has in the pledged assets. Searches also will reveal whether other creditors might stand in line ahead of the buyer should the seller default. If the searches reveal existing mortgages or security instruments, the buyer should review those documents. It is important to confirm that the seller can pledge the assets to buyer.
Review Contracts. Before accepting an assignment of insurance proceeds or a bond, buyers should review them to confirm that they are assignable. Buyer also should require that seller obtain any required approvals before the assignment.
Risk Analysis. Buyers should evaluate how much it would cost buyer if seller didn’t complete its post-closing conditions. That will determine the dollar amount of a guaranty. It also will determine the amount of any required a liquidity or net worth or purchase price reduction. A purchase price reduction might equal the expected cost of completing the conditions. However, guaranties and liquidity or net worth requirements may be set at 125% or more of the expected cost.
Documenting a Holdback Alternative
A composer needs to make a written notation of a tempo marking, fermata, or grand pause to convey a musical “holdback.” Likewise, parties to a transaction need written documentation of their holdback alternatives.
Before the closing, the parties’ attorneys should prepare documents detailing the holdback alternative. The parties should sign these documents at the closing.
If there is a purchase price reduction, the parties should amend the real estate purchase contract before the closing to reflect the new price. At closing, the seller should receive a release from the buyer, either in closing documents or otherwise, from the risk that the buyer has agreed to assume in exchange for the reduction in price.
The required documents will vary depending upon the transaction and the holdback alternative. However, by agreeing on these important holdback details in advance, the parties can assure that the end result meets their needs.
© 2018 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality.
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