THE TENNESSEE REAL ESTATE LAW AND PRACTICE SECTION OF THE 2021 CHAMBERS USA REGIONAL REAL ESTATE GUIDE WAS ORIGINALLY PUBLISHED HERE.
The Tennessee section of this year’s Chambers USA Regional Real Estate Guide was contributed by Butler Snow LLP and co-authored by Jason G. Yarbro, Robert M. Holland, Jr., Christopher J. Tutor and John C. Taylor, Jr..
Law and Practice
1.1 Main Substantive Skills
Real estate law requires not only an understanding of buying and selling real estate, closing processes, real estate title, leasing and finance, but also experience in other areas that are important to many real estate deals and specific industries. In particular, law firms must have professionals who are familiar with environmental laws, land use and zoning matters, development and construction, joint ventures, complex financing structures, restructurings and workouts. In addition to good analytical, organizational and negotiating skills, effective real estate lawyers must have an understanding of their client’s industry and business objectives.
Several current trends have impacted the skills required by real estate lawyers, including the popularity of large mixed-use projects and the increasing use of tax credits and other complex financing structures for large real estate projects. Many traditional real estate projects involve primarily the acquisition, sale or development of a single building, parcel or contiguous parcels of real estate by one owner, with financing from a single lender or lender group. By contrast, large mixed-use projects often involve the development of large areas and sometimes multiple blocks of non-contiguous real estate by multiple owners with various lenders and financing structures.
These projects frequently have complex land use and entitlement issues and a variety of ownership structures that require greater experience with corporate and business laws. Likewise, the increased use of tax credits requires experience with tax law and the structuring of these credits and project financing in a manner compatible with the business interests of the owners, developers and lenders.
1.2 Most Significant Trends
Some of the most significant trends in the Tennessee real estate market have been:
- the popularity of large mixed-use projects, both in urban cores as part of the redevelopment of blighted areas and in suburban areas as standalone projects;
- the use of tax credits, including historic tax credits and new markets tax credits, in large redevelopment projects; and
- a construction boom in Nashville with a number of large office, hotel and residential towers.
The most significant real estate deals in Tennessee include the following:
- the FedEx Hub expansion, an approximately USD1.5 billion project;
- the Nashville Yards Project, an approximately USD1 billion mixed-use project that includes a new Amazon operations center;
- the FedEx Logistics headquarters in downtown Memphis;
- the Broadwest project, an approximately USD540 million mixed-use development in downtown Nashville;
- the One Beale project in downtown Memphis, an approximately USD225 million mixed-use project;
- the Fifth & Broadway project, an approximately USD450 million mixed-use development in downtown Nashville;
- the Walk on Union project, an approximately USD1 billion mixed-use project in downtown Memphis;
- the oneC1TY project, an approximately USD400 million mixed-use project in Nashville;
- the Snuff District project, an approximately USD200 million mixed-use project in downtown Memphis;
- the W Hotel development, an approximately USD190 million hotel in downtown Nashville;
- the USD2 billion expansion of the St. Jude Children’s Research Hospital, including a USD412 million research tower, in downtown Memphis;
- 222 Second Avenue, a USD250 million high-rise in Nashville;
- the Capitol View project in Nashville, a USD750 million, 32-acre mixed-use development in Nashville; and
- the Pinch District, an approximately USD605 million mixed-use project in downtown Memphis.
As a result of the COVID-19 pandemic, including social distancing guidelines and “stay home” orders and travel restrictions, many tenants, in Tennessee as elsewhere, especially in the restaurant and hospitality industries, were forced to suspend operations and negotiate rent deferrals and lease workouts. Parties are also pursuing other contractual remedies in light of the pandemic, including force majeure provisions and “frustration of purpose/impossibility/impracticability” doctrines. Businesses are also making claims for business interruption with their insurers. Additionally, with bricks-and-mortar retail declining, demand for office space declining while many employees work from home, and e-commerce on the rise, the traditional retail and office market has softened state-wide but industrial has strengthened as demand for warehouses and logistics facilities has surged, especially for online retailers.
Nashville, TN, has also seen continued population and market growth as the increase in businesses embracing a “work-from-home” or digital work environment has prompted businesses in media, healthcare, and finance to migrate from more expensive cities such as Los Angeles or New York.
1.3 Impact of New US Tax Law Changes
The primary effects from the Tax Cuts and Jobs Act adopted in 2017 (the “2017 tax act”) on real estate investment and development are as follows:
- the allowance for non-C Corporation taxpayers to deduct up to 20% of their qualified business income earned through pass-through businesses;
- the increase in the long-term capital gains holding period to three years for taxpayers receiving a “carried” or “profits” interest;
- the limitation on a taxpayer’s ability to deduct interest expenses up to 30% of the taxpayer’s net income; and
- limiting interest deductions for home mortgage indebtedness and home equity loans to USD750,000 from USD1 million.
In certain circumstances, the 20% deduction is limited to 50% of the taxpayer’s allocable share of W-2 wages or 25% of the taxpayer’s allocable share of W-2 wages, plus 2.5% of the taxpayer’s allocable share of the unadjusted basis of “qualified” property (to be “qualified”, property must be depreciable), whichever is greater. The provision for 2.5% of the unadjusted basis is beneficial to real estate investors and developers in capital-intensive sectors with large capital investments and comparatively minor labor costs. In addition, taxpayers are allowed to deduct 20% of REIT dividends without being subject to the limitations described above.
The 2017 tax act included a new incentive designed to encourage investment in qualified opportunity zones, which are certain low-income communities designated within each state. A list of eligible census tracts in Tennessee is online. This incentive allows investors to defer capital gains tax by reinvesting the gain in a qualified opportunity fund within 180 days after the creation of the gain. In addition, 10% of the gain is permanently forgiven if the investment is held for five years and another 5% is permanently forgiven if the investment is held for seven years.
Finally, if the investment is held for ten years, the investor’s basis in the asset becomes the fair market value of the asset at the time of any sale, meaning the investor would pay no tax on any appreciation of the asset. Several Opportunity Zone funds have been created which should provide capital for eligible projects in the near future.
2. Sale and Purchase
2.1 Ownership Structures
Purchasers typically acquire commercial real estate through the use of limited liability companies and corporations. Depending on the nature of the purchaser’s business, the use of single or special-purpose entities that own solely commercial real estate is a common legal tactic to limit liability to such single or special-purpose entity, thereby protecting the assets of the purchaser’s affiliates.
2.2 Important Jurisdictional Requirements
No special jurisdictional rules apply to the transfer of title to real estate in Tennessee. Statutory law does not require specific language to transfer title, but does provide examples of conveyance language that is sufficient for the transfer of title by general and special warranty and quitclaim, and for purposes of a deed of trust (Tennessee Code Annotated (TCA) Section 66-5-103). A deed of conveyance must be acknowledged in accordance with Tennessee law, or proved by two sworn witnesses (TCA Section 66-5-106).
Sellers of residential one to four-unit properties (including single-family homes) are typically required to deliver disclosure statements to prospective purchasers containing all items set forth in TCA Section 66-5-210. Transfers of residential real estate must also comply with applicable federal laws and regulations.
2.3 Effecting Lawful and Proper Transfer of Title
A purchaser can effectuate the transfer of title to real estate by recording its deed in the office of the register of deeds in the county where the acquired property lies.
2.4 Real Estate Due Diligence
In performing their due diligence on real estate, buyers typically rely on various third parties to determine the suitability of the property for their intended use such as engineers, environmental consultants, title agents, zoning consultants, and surveyors. Attorneys for buyers will primarily be responsible for a detailed review of the survey and recorded instruments affecting title and which may ultimately affect the buyer’s economic return on the property.
2.5 Typical Representations and Warranties for Purchase and Sale Agreements
Purchase and sale agreements typically contain representations and warranties with respect to:
- the seller’s existence and authority to sell the property;
- the status of the seller’s title to the property;
- pending or threatened litigation or administrative proceedings, including environmental or zoning violations;
- the seller’s compliance with applicable laws;
- any leases in effect at the property;
- the accuracy of seller-provided property information; and
- the seller’s absence from restricted lists maintained by the Office of Foreign Asset Control.
Implied and statutory warranties do not exist with respect to transfers of title to real property, but sellers commonly seek to disclaim any implied warranties and transfer property in “as-is” condition, subject only to representations and warranties expressly contained in the purchase and sale agreement.
If the purchase and sale agreement does not provide that a seller’s representations and warranties will survive closing and delivery of the deed then the terms of the purchase and sale agreement are deemed to merge into the deed, whereby the deed is deemed the final contract between the parties. Fraud and mutual mistake of the parties are exceptions to the doctrine of merger.
In the event of a seller’s misrepresentation, a buyer may generally terminate a pending purchase and sale agreement prior to closing and occasionally may be able to be reimbursed for all or some of its due diligence costs. Assuming that the Purchase and Sale Agreement provided for post-closing survival of the seller’s representations and warranties, a buyer may recover its actual damages as a result of losses resulting from the misrepresentation. Parties to a commercial real estate sale frequently negotiate threshold amounts for buyers to recover damages for misrepresentation and maximum amounts (anywhere between 1% and 10% of the purchase price) over which the seller will have no liability, but fraud or intentional misrepresentation of the seller are usually excluded from such contractual limitations.
2.6 Important Areas of Law for Foreign Investors
Foreign investors purchasing real estate in the USA should carefully consider the impact of potential US tax liabilities and reporting obligations incurred in connection with the acquisition of real estate. Specific reporting obligations may stem from:
- the choice of entity, jurisdiction of formation, and transaction structure;
- anti-money laundering laws and Financial Crimes Enforcement Network (FinCEN) reporting requirements; and
- sanctions administered by the Office of Foreign Asset Control (OFAC).
Tax consequences and additional specific reporting obligations may result from the following:
- transaction structure;
- income from the property is or will be ‘effectively connected’ to a US trade or business;
- the imposition of branch profits on foreign corporations, if applicable;
- the provisions of the Foreign Investment in Real Property Tax Act (FIRPTA);
- the requirements of the US Department of Commerce Bureau of Economic Analysis, including the filing of either Form BE-15 Claim for Exemption or the appropriate annual report;
- the imposition of other US income tax return requirements and filings; and
- potential US gift and estate tax liability.
None of the housing markets in Tennessee are currently subject to the additional disclosure requirements the FinCen has imposed on title companies regarding foreign buyers paying cash for high-end residential properties. However, FinCEN encourages title companies, financial institutions, brokers and other professionals to voluntarily file suspicious activity reports (SARs) in order to report any suspicious transactions or activity. Also, a SAR is required to be filed for currency and similar transactions in excess of USD10,000.
Expanded CFIUS Powers
The Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) provided the Committee on Foreign Investment in the US (CFIUS) with expanded powers of regulation.
First, CFIUS may now review non-controlling foreign investments in US businesses involved in certain technologies, certain infrastructure, or personal data of US nationals. However, there are exceptions for certain foreign countries, investors, and private equity funds.
Second, CFIUS may now review “Covered Real Estate Transactions” which include the purchase, lease, or concession of real estate by a foreign person or entity and such real estate is located within or is part of an airtime or maritime port or that is near specific military installations or other US government sensitive facilities. There are exceptions here, as well, including, but not limited to, certain transactions relating to real estate within urban areas or involving commercial office space and retail, accommodation, and food establishments. Certain foreign investors may also be exempted.
2.7 Soil Pollution and Environmental Contamination
Under both the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), as amended by the 1986 amendments to CERCLA, known as the Superfund Amendments and Reauthorization Act (SARA), and the Tennessee Hazardous Waste Management Act of 1983, after a buyer takes title to property, it becomes a potentially responsible party (PRP), even if the buyer did not cause or contribute to the existing pollution or contamination. However, in some cases, CERCLA and SARA allow the apportionment of liability for site clean-up (see TCA Section 68-212-207). Further, there are also defenses to prevent a Buyer being declared a PRP. In all cases, the buyer must conduct “All Appropriate Inquiry” prior to purchasing the property and comply with any continuing obligations related to the allowable use of the property and the management of existing pollution.
2.8 Permitted Uses of Real Estate under Zoning and Planning Law
A buyer may search for zoning information online but should also contact the relevant zoning authority to obtain a zoning letter confirming those uses for the subject parcel. Alternatively, buyers often engage a third-party service to prepare a planning and zoning report for the target property, which is often more informative than zoning letters and will include information on zoning compliance, special use permits and other details that might prove helpful in the due diligence process. Tennessee and its local jurisdictions enjoy wide latitude to approve developments, including entering into development agreements with developers, and provide public development incentives.
2.9 Condemnation, Expropriation or Compulsory Purchase
Tennessee permits eminent domain by a condemning authority (eg, the Tennessee Department of Transportation, public utility) and, in certain limited situations, a person or corporation, for public purposes or internal improvements, but not a private purpose. Eminent domain is commenced by filing a petition in circuit court against all persons with an interest in the property. Notice must be given upon the filing of a petition.
Just compensation based on the fair market value of the property will be determined in court or by agreement. Overall, Tennessee is fairly permissive regarding the condemning authority’s exercise of the power of eminent domain.
2.10 Taxes Applicable to a Transaction
In the case of a warranty deed transferring title to real property, the recording of the deed requires payment of a recordation tax (sometimes referred to as a transfer tax) equal to USD0.37 per USD100 of either the consideration for the transfer or the fair market value of the property, whichever is greater. The recording of a quitclaim deed requires payment of a tax equal to USD0.37 per USD100 of the actual consideration given for the conveyance. Register offices also assess nominal per-page recording fees, which vary by county.
Buyers pay the transfer tax on sales of real property in Tennessee but seek to offset the transfer tax by negotiating other closing cost divisions, particularly in commercial transactions. The deed tax does not apply in limited situations, such as transfers between spouses or deeds from executors of estates. Mergers, changes of control or transfers of equity ownership (direct or indirect) in property-owning entities are not subject to transfer tax.
2.11 Rules and Regulations Applicable to Foreign Investors
See 2.6 Important Areas of Law for Foreign Investors.
3. Real Estate Finance
3.1 Financing Acquisitions of Commercial Real Estate
Tennessee commercial real estate transactions do not offer any unique financing options or strategies. Buyer-borrowers frequently utilize traditional term financing, bridge and construction financing, and – for buyers pursuing a series of property acquisitions or developments – lines of credit. For larger, ongoing credit facilities, lenders arrange financing through syndication or participation.
Rates of interest, loan charges and commissions in commercial lending transactions governed by Tennessee law are generally subject to a maximum “formula rate” published monthly by the Tennessee Department of Financial Institutions, which is 4% over the average prime rate. However, through a relatively complex statutory framework, federally chartered banks and Tennessee-chartered banks may charge interest of up to 24% annually.
One of the main differences between financing structures in public and private entities is that public entities may also depend on investment through publicly traded securities on the stock market. Many public real estate entities are set up as REITs whereby investors pool their money to build a real estate portfolio which also operates as a publicly traded stock. A public REIT, in particular, may enjoy potentially higher returns and greater liquidity from being traded on the stock market.
Private entities may also be set up as REITs but are not publicly traded. On the other hand, this may allow private REITs to avoid the potential volatility of the stock market for more steady returns.
3.2 Typical Security Created by Commercial Investors
Tennessee law permits a commercial real estate investor to grant several types of security interests to creditors for the purpose of borrowing funds to acquire or develop real property, but deeds of trust are the customary form of security instrument for real estate finance. Tennessee is a title theory state with respect to real property security interests, meaning that legal title to real property is conveyed by the borrower via a deed of trust to a trustee on behalf of the lender. The borrower retains equitable title to the property, including rights of possession and income.
The deed of trust is filed in the register of deeds office in the county where the property is located. Although most deeds of trust include language creating a security interest in the fixtures attached to the real property, creditors commonly file a separate UCC-1 “fixture filing” financing statement in the register of deeds office with respect to the secured fixtures. Typically, a lender will also require a separate assignment of leases and rents from the borrower.
The assignment of leases and rents is also filed in the register of deeds office in the county where the property is located.
3.3 Regulations or Requirements Affecting Foreign Lenders
Out-of-state lenders are generally not required to be qualified to do business in Tennessee or be registered with state agencies in order to make a typical commercial loan secured by real estate as such activities typically do not constitute transacting businesses within the state by themselves. Except for those activities that do not constitute transacting business in Tennessee under TCA Section 48-25-101 and certain others, non-Tennessee corporate entities must qualify to do business in Tennessee with a certificate of authority and register with the Tennessee Department of Revenue for franchise and excise taxes.
Tennessee requires trustees who hold legal title to secured real property on behalf of a lender to be one of the following:
- a Tennessee resident;
- a Tennessee corporation or non-Tennessee corporation whose principal place of business is Tennessee; or
- an individual whose principal place of employment is in Tennessee.
Tennessee also allows a resident of a non-Tennessee state to serve as trustee if such non-Tennessee state permits Tennessee residents to serve as trustees.
3.4 Taxes or Fees Relating to the Granting of Enforcement of Security
The recording of an instrument evidencing indebtedness (eg, a deed of trust or UCC-1 financing statement), whether at the county or state level, requires payment of an indebtedness tax equal to USD0.115 per USD100 of indebtedness, excluding the first USD2,000 of indebtedness, which is exempt from the tax calculation.
3.5 Legal Requirements before an Entity Can Give Valid Security
Tennessee does not maintain any financial assistance or corporate benefit rules with respect to real estate assets.
3.6 Formalities When a Borrower Is in Default
Tennessee allows judicial foreclosure and non-judicial foreclosure upon the default of a loan secured by a deed of trust or mortgage. Judicial foreclosure proceedings are rarely used, as most real estate financing is secured by a deed of trust that allows for power of sale through non-judicial foreclosure.
A properly executed, acknowledged, and recorded deed of trust or mortgage provides constructive notice to all persons and will establish priority over subsequent liens and interests.
Non-judicial foreclosure proceedings are initiated by providing the debtor with notice of default. Next, the creditor must publish notice of the foreclosure sale at least three times in a newspaper published in the county where the property is located and in compliance with any additional requirements in the deed of trust. A non-judicial foreclosure sale must comply strictly with the language in the deed of trust.
The notice of foreclosure sale must include information such as the names of interested parties, a description of the property, the time and place of the foreclosure sale, and other related items. Tennessee law requires the trustee to search for state tax liens on the property, and also governs the manner and timing of the sale process. Specifics may be found in TCA Section 35-5-101 et seq. Non-judicial foreclosure in Tennessee typically requires around 30 days from start to finish.
3.7 Subordinating Existing Debt to Newly Created Debt
The holder of a deed of trust or mortgage may consensually subordinate its lien by contract pursuant to a subordination agreement. The subordination agreement should be recorded in the same manner as the original deed of trust or mortgage in order to be valid against third parties. Taxes and mechanic’s liens, if certain requirements are followed, may also take priority over a recorded lien.
3.8 Lender’s Liability under Environmental Laws
A lender holding or enforcing security over real estate may be liable under environmental laws, even if it did not cause any pollution of the real estate under federal laws or the laws of Tennessee if it engages in “active participation” in the management of a facility. “Active participation” must be more than “the mere capacity, or ability to influence, or the unexercised right to control a site, vessel or facility operations”, and requires “actual participation in the management or operational affairs by the holder of the security interest”. The Tennessee Waste Hazardous Waste Reduction Act of 1990 (the Tennessee Superfund Act) generally follows the provisions of SARA, which afford certain liability protections to lenders that are not active participants in the management of a facility (TCA Section 68-212-301, et seq (2018)).
If a lender’s indicia of ownership are held primarily to protect a security interest, they do not indicate active participation (TCA Section 68-212-401(B)). In the event of a foreclosure, a holder of a security interest will continue to be considered as an un-active participant, provided that the holder undertakes to sell, re-lease or otherwise divest itself of the property or facility in an expeditious manner (TCA Section 68-212-403).
3.9 Effects of Borrower Becoming Insolvent
The automatic stay, effective upon the filing of a federal bankruptcy petition, will stay all foreclosure actions against a debtor’s real property. Furthermore, under Tennessee law, a non-judicial foreclosure becomes final upon execution of a trustee’s deed to the purchaser – not upon final oral cry at the non-judicial foreclosure sale or upon a memorandum of sale. If a federal bankruptcy petition is filed any time before the execution of a trustee’s deed, the foreclosure action will be automatically stayed by bankruptcy and the lienholder will be forced to proceed in the federal courts to get relief from the automatic stay before finalizing the foreclosure under Tennessee law.
Furthermore, Federal bankruptcy law will allow a bankruptcy trustee or debtor in possession to avoid any lien that has not been properly recorded in a timely manner under Tennessee law, or a lien that was given for less than reasonably equivalent value while insolvent or other fraud. Tennessee allows fraudulent liens to be avoided any time within four years after the lien attaches.
The primary protection against bankruptcy risks is a disciplined credit program. A lender should understand its risks before deciding to lend. In addition, timely perfected security interests in collateral with real value assure that a loan will be repaid even in the event of bankruptcy.
Most efforts to contract around bankruptcy will be determined void as against federal bankruptcy policy.
3.10 Taxes on Mezzanine Loans
Tennessee does not have any taxes specifically applicable to mezzanine loans. Under T.C.A. Section 67-4-409, however, the recording of an instrument evidencing indebtedness (eg, UCC-1 financing statement in connection with a mezzanine financing) requires payment of an indebtedness tax equal to USD0.115 per USD100 of indebtedness, excluding the first USD2,000 of indebtedness, which is exempt from the tax calculation.
4. Planning and Zoning
4.1 Legislative and Governmental Controls Applicable to Design, Appearance and Method of Construction
Tennessee and its political subdivisions use a variety of legislative and governmental controls or regulations, such as county, municipal and historical zoning laws, and building ordinances that govern design, appearance and construction methods of new buildings and refurbishments at the regional and municipal level.
Additionally, historical zoning commissions exist at the county or municipal level; in any area of the state served by a regional planning commission, the local legislative bodies of the region served by such commission may create a regional historic zoning commission. The growth and construction of non-residential or multi-family residential buildings located in areas of historical significance are also regulated. Counties have the authority to create design review commissions, which then may develop general guidelines for the exterior appearance of and entrance to properties located in historical areas.
4.2 Regulatory Authorities
Tennessee has planning commissions on the regional, municipal, and community level.
The types of legal restrictions and requirements on development and use of real estate include regulations promulgated by the regional and municipal planning commissions. Examples of requirements include plat approval and building permitting. There are also county, municipal and historic zoning regulations, which vary but are generally enacted for the purpose of promoting the health, safety, morals, convenience, order, prosperity and welfare of the present and future inhabitants of the state and of its counties.
The chief legislative body of a municipality is responsible for enacting zoning ordinances, which regulate the location, height, bulk, number of stories, and various other aspects of properties.
At the neighborhood level, pursuant to Tennessee’s Neighborhood Preservation Act, owners of residential property are required to maintain the exterior of such property and the lot in accordance with community standards of other residential property in the area.
4.3 Obtaining Entitlements to Develop a New Project
The process for obtaining entitlements to develop a new project or to complete a major refurbishment in Tennessee includes submitting preliminary and schematic plans to the appropriate planning commission for approval. The commission will review and approve or disapprove of a plan, often requiring changes which can then be re-submitted for approval once made. Plans are subject to a public hearing where third parties may support or object to the plan.
With respect to historically zoned areas, all applications for permits for construction, alteration, repair, rehabilitation, relocation or demolition of any building or structure, or for other improvements to real estate situated within a historic zone or district are referred to the local historic zoning commission or the regional historic zoning commission. The applicable zoning commission is also authorized to review construction or alteration plans even where a permit is not required.
Affected parties have the right to participate in or object to planning decisions.
The process to re-zone property normally requires a pre-application conference, neighborhood meeting, formal application, planning department review and hearing, and a hearing and decision by the governing body. This process takes several months at minimum.
The process to obtain a variance primarily requires an application, review and recommendation by the planning department, and a hearing and decision by the board of adjustment. This process also typically takes several months.
4.4 Right of Appeal against an Authority’s Decision
Each county and municipality has the authority to create a board of zoning appeals, which has the power to hear and decide appeals where it is alleged by an individual that there is error in any order, requirement, permit, decision or refusal made by the applicable commissioner or any other administrative official in the carrying out or enforcement of any provision of any ordinance.
At the planning commission level, if the applicable commission approves or disapproves a development plat after a hearing thereon then the applicant submitting the plat, or any person who was a party for or against the plat, who so requests at the planning commission hearing has the right within 30 days of such approval or disapproval to have the action of the planning commission reviewed by the appropriate municipal legislative body, which shall approve or disapprove the development plans by majority vote. Any further appeal would proceed in the chancery or circuit court.
Property owners affected by historical zoning guidelines or who do not comply with the guidelines may appeal a decision of the design review committee or the county building commissioner to the county board of zoning appeals.
4.5 Agreements with Local or Governmental Authorities
It is possible in Tennessee to enter into agreements with local or governmental authorities or agencies or utility suppliers in order to facilitate a development project. Such arrangements typically take the form of participation agreements or development agreements with the applicable municipality or utility or even the planning department in order to effectuate certain types of projects – eg, parks, roads, infrastructure, and other public developments that can be built more efficiently with the use of a private developer.
4.6 Enforcement of Restrictions on Development and Designated Use
Public agencies in the state have the administrative authority to remedy noncompliance with planning regulations or zoning ordinances. For example, a zoning board has the ability to institute an injunction, mandamus, abatement or other appropriate action to prevent, enjoin or remove an unlawful construction. Alteration, maintenance or use of any real property in violation of a zoning commission’s regulations is a misdemeanor, with each day that an illegal construction or use of land or structure exists being a separate offense.
5. Investment Vehicles
5.1 Types of Entities Available to Investors to Hold Real Estate Assets
Real estate owners may hold title to their property through limited liability companies (LLCs), corporations, limited partnerships, limited liability partnerships or general partnerships, or in their individual names. Limited liability companies and corporations are most frequently used due to the familiarity of investors and lenders with their organisational structure and their inherent liability protection.
5.2 Main Features of the Constitution of Each Type of Entity
A corporate structure can decrease transaction costs and can expedite the formation and closing timelines in property-related private equity offerings or financing transactions. However, continuing development and the increasing ubiquity of limited liability companies have allowed for greater organisational flexibility while maintaining as simple or sophisticated a capital structure as necessary for a given transaction. General partnerships and individual ownership of commercial property are infrequent, due primarily to the unlimited liability exposure, but their use allows owners to avoid Tennessee franchise and excise taxes on the real property.
In addition, a limited liability vehicle such as an LLC may elect to be an “obligated member entity” to avoid this issue.
5.3 Tax Benefits and Costs
The inefficiency of the double taxation regime applicable to standard C-corporations is the largest tax disadvantage to selecting such corporate structure for ownership of an income-producing real estate asset; however, in certain contexts, owners may be able to elect Subchapter S treatment under the Internal Revenue Code and receive pass-through tax treatment on earnings. Absent the affirmative election to be taxed as a corporation, limited liability companies offer the default benefit of pass-through tax treatment on earnings.
5.4 Applicable Governance Requirements
The governance structure of corporations is characterised by management by a board of directors and the day-to-day operations of the corporation are carried out by officers. Shareholders of a corporation typically have no management rights, but they have voting rights with respect to the election of directors and certain significant corporate transactions, such as merger, dissolution and a sale of substantially all the assets of the corporation. The governance structures of Tennessee limited liability companies are variegated and such entities may be managed by their members, a manager or a board of managers, or a board of directors.
LLCs may also employ officers to oversee day-to-day operations. Default statutory rules apply in the case of corporations and limited liability companies, but Tennessee law provides a much greater degree of flexibility in the drafting of documents governing limited liability companies management and governance rights when compared to default statutory rules.
6. Commercial Leases
6.1 Types of Arrangements Allowing the Use of Real Estate for a Limited Period of Time
Tennessee law broadly recognizes three arrangements under which a person, company or other organization may occupy and use real estate for a limited period of time without buying it outright: by lease, by easement and by license.
Under a lease arrangement, one party (the lessor or landlord) leases real property to another party (lessee or tenant) and grants the right of exclusive possession thereof for a period of time, in exchange for a consideration, which most often takes the form of rent. Leases with a term of more than one year must be in writing and signed by the party against whom enforcement is sought. In order for leases with a term of more than three years to be binding on anyone other than the landlord, the landlord’s heirs and devisees, or third parties with actual notice, they (or memoranda thereof) must be registered in the county where the subject property is located, in accordance with the requirements of the Tennessee recording statutes (TCA Section 66-24-101 et seq). In Tennessee, a lease constitutes an interest in real property.
An easement is also considered an interest in real property and confers upon its owner the right to use the property of another for a particular purpose. To be enforceable, easements created by agreement must be in writing, and to be binding upon subsequent purchasers or interest holders without notice they must be registered in the county where the property is located, in accordance with the requirements of the Tennessee recording statutes.
A license confers to the licensee only a personal right to undertake specific activities on the licensor’s real property, with or without corresponding obligations. A license is generally revocable and, in the absence of express language to the contrary, cannot be transferred or assigned. Unlike the lease and the easement, a license does not create an interest in land and is not governed by the Statute of Frauds, and thus does not need to be in writing.
6.2 Types of Commercial Leases
Commercial leases often take different forms, depending on the use of the leased premises. A lease for an office in an office building will be substantially different from a lease of warehouse space in an industrial park, or retail space in a shopping center, or commercial space in a single-tenant property. There are different considerations, protections for the landlord, representations and warranties, and different ways to handle the charges to be paid by the tenant.
There are multiple options with respect to the charges to be paid by the tenant, including gross (ie, fully serviced), net, modified gross and percentage. A gross lease is where the landlord pays for the property taxes, insurance and maintenance, and the tenant pays a single flat fee. A net lease is the opposite of a gross lease.
There are three types of net leases: single net, double net and triple net. A single net lease is where the tenant is responsible for rent and property taxes; a double net lease is where the tenant is responsible for rent, property taxes and insurance; and a triple net lease is where the tenant is responsible for rent, property taxes, insurance and maintenance. A modified gross lease is a hybrid between a gross lease and a net lease. A percentage lease is where the tenant pays base rent as well as a percentage of revenue earned from its business on the property.
A ground lease is where the tenant pays rent and also constructs improvements on the property during the term of the lease, after which the land and improvements are turned over to the landlord. Ground leases typically have longer terms.
6.3 Regulation of Rents or Lease Terms
Neither rents nor lease terms are regulated in Tennessee, with the exception of certain limitations placed on the term for oil and gas leases: Tennessee law generally limits the term of such leases to a maximum of ten years from the date of execution, unless natural gas or oil is being produced for commercial purposes at the expiration of the ten-year period (TCA Section 66-7-103).
6.4 Typical Terms of a Lease
Although most terms for commercial leases are the product of negotiation, a lease term of five to ten years with renewal options is not uncommon. Ground leases and build-to-suit leases typically have longer terms.
Typically, the landlord is responsible for the maintenance and repair of any common areas of the building or shopping center, for structural components of the building/demised premises and for any utility lines to the boundary of the demised premises. Tenants are typically responsible for all maintenance and repair within the demised premises.
Rent is often paid in advance at the beginning of each month, but leases in Tennessee must expressly state that rent shall be paid in advance, contrary to the common law presumption.
6.5 Rent Variation
The rents are determined by the terms of the lease agreement. Many rental rates increase during the term, particularly for terms of longer duration.
6.6 Determination of Changes in Rent
Leases may include rent escalation provisions that cause the rent to increase annually based upon agreed percentages (with 2% of 3% being typical), or upon market indicators such as increase in fair market value or increases in the Consumer Price Index. All rent provisions must include a key that allows for the rent amount to be objectively determined.
6.7 Payment of VAT
No VAT or other taxes or governmental levy is payable on rent.
6.8 Costs Payable by Tenant at the Start of a Lease
At the start of a lease, the tenant may be responsible for a security deposit, any application fees and the first month’s rent. In some instances, the landlord could require first and last month’s rent. Tenants are sometimes responsible for the build-out and preparation of the leased premises, as well.
Capital improvements in a lease are typically paid for by the landlord; however, the lease may be negotiated such that certain capital expenses such as improvements to reduce operating costs or comply with applicable laws are passed through to the tenant and amortized over a certain period.
6.9 Payment for Maintenance and Repair
Common area expenses are often divided among the multiple tenants in proportion to the amount of space leased. Unless the rent is structured as a full-service gross arrangement (where tenant pays a set, all-inclusive rent), tenants will usually pay a monthly estimate of these common area expenses (or CAM expenses) to the landlord in addition to monthly base rent payments. All of the common expenses for these areas are estimated and amortized over the lease year. The landlord is typically responsible for maintaining the common areas in good working order and condition, but will recoup those fees and costs from the funds paid by each tenant for CAM expenses.
6.10 Payment for Services, Utilities and Telecommunications
The payment of services, utilities and telecommunications that serve a property occupied by several tenants will likely be determined by whether the separate premises are separately metered. Where separately metered, it is common for tenants to pay utilities directly. If not separately metered, the landlord will usually pay utilities and assess the tenants proportionately or build utilities costs into the base rent.
The negotiated contract will establish specific utilities payments.
6.11 Insuring Real Estate That Is the Subject of a Lease
Various considerations will determine whether the landlord or the tenant ultimately insures the property, including which entity can negotiate lower pricing and better coverage. A multi-tenant site will usually be insured by the landlord with costs passed to the tenants, while a single tenant site may be insured by the tenant. Most events causing damages are insured through an all-risk or special form property policy.
Special endorsements exist in areas where there are high risks of earthquakes or other special casualty events.
6.12 Restrictions on the Use of Real Estate
Restrictions on the use of the premises may generally be imposed within the lease in the form of a narrow permitted use provision, general terms aimed at minimising risk or property damage, or generally applicable rules and regulations that may be amended from time to time by the landlord. Tenants will often expressly be required to use the premises in accordance with all laws.
Tennessee allows for local governments to regulate use through zoning laws, but use restrictions may also arise from private covenants and restrictions, easement agreements, and other recorded instruments governing or restricting the use of property.
6.13 Tenant’s Ability to Alter or Improve Real Estate
The landlord usually wants control or consent rights over any improvements to the premises during the lease term and will usually specify what work can be performed to the demised premises, and can cap the work at a certain dollar threshold or require prior written consent for work beyond a dollar threshold.
6.14 Specific Regulations
Residential leases in Shelby, Davidson, Knox and other populous counties must comply with the Tennessee Uniform Residential Landlord and Tenant Act, which protects residential tenants from certain actions of a landlord. Most provisions of commercial leases, however, are creatures of contract law that override the default landlord-tenant laws.
6.15 Effect of Tenant’s Insolvency
A tenant’s insolvency may cause default under a lease, but federal bankruptcy law will ignore as void any insolvency provision in a lease. If bankruptcy is sought, Section 365 of the Bankruptcy Code states that a debtor tenant may assume, assign or reject the lease. Assumption of the lease is a decision to retain or continue the lease by the bankruptcy estate, whereas a rejection is a decision to terminate.
The tenant must cure any lease defaults and assure future performance under the lease before assuming or assigning the lease.
6.16 Forms of Security to Protect against Tenant’s Failure to Meet Obligations
Typically, a landlord will collect a security deposit at the beginning of the lease term for a month or several months of rent payments. Upon default, a landlord may liquidate the security deposit and use it to cover some of the tenant’s obligations under the lease. A tenant may also be required to provide an irrevocable letter of credit from a financial institution.
If the tenant defaults, the landlord can draw upon the letter of credit to satisfy outstanding rental obligations. Furthermore, for the same reasons, a tenant may also be required to provide a personal guarantee from the principal, a parent guaranty, or some other credit enhancement.
6.17 Right to Occupy after Termination or Expiration of Lease
A tenant does not have a right to occupy the premises outside the stated lease term. However, most commercial leases will contain a holdover provision that converts the tenancy at expiration to a tenancy at will with an increased rental amount; this holdover rent is usually high enough to discourage the tenant’s continued possession. In order to recover possession where the tenant fails to surrender the premises, a landlord will need to terminate the lease, seek a forcible entry and detainer against the tenant, and obtain a writ of possession.
A lease should specify that abandonment of the premises allows the landlord to re-enter, take possession and terminate the lease.
6.18 Right to Terminate Lease
An event of default that could result in termination of the lease is governed by the terms of the lease. Nonpayment is the most common event of default. Events of default should also include the breach of any material provision in the lease.
Upon an event of default, a lease will often require the non-defaulting party to provide notice to the defaulting party and give a reasonable cure period. If the event of default is uncured, the right to terminate should be permitted. Abandonment should also give a right to terminate the lease.
Failure to pay taxes, material changes or termination of insurance and unauthorised or illegal uses of the premises will ordinarily provide a right of termination. It is also common to have anti-assignment provisions that cause termination of the lease. The lease should also specify rights to termination upon certain casualty or condemnation events.
6.19 Forced Eviction
In the event of default prior to the expiration date, a tenant can be forced to vacate the leased premises through the process of eviction. Even though most leases contain a covenant allowing the lessor to re-enter the premises and remove a tenant upon default, Tennessee prohibits landlords from exercising self-help. Instead, a writ of possession must be obtained through the eviction process.
The typical eviction process is a forcible entry and detainer action in general sessions court or circuit court. The time of trial may not be less than six days from the date of service of the summons on the tenant, in accordance with TCA Section 29-18-115. A writ of possession for the recovery of the property from the tenant will not be issued against the tenant until ten days after judgment is rendered in favor of the landlord.
The tenant may appeal within ten days (TCA Section 29-18-101 et seq).
6.20 Termination by Third Party
The government or a municipal authority may terminate a lease by condemnation, which occurs when part or all of the leased premises are taken for a public purpose by an entity with the power of eminent domain. Most leases include a condemnation clause that provides for what will occur in the event condemnation occurs. Any rents paid in advance, prior to any condemnation, are required to be refunded to the tenant.
A senior lender cannot terminate a lease unless it has such right in the lease or a separate subordination, non-disturbance and attornment agreement. For example, if the lender has foreclosed on its leasehold mortgage and replaces its borrower as the tenant under the lease pursuant to certain leasehold mortgagee provisions in the lease, the lender may have termination rights pursuant to such provisions.
7.1 Common Structures Used to Price Construction Projects
Commonly used pricing structures for construction projects include the following:
- fixed price (sometimes referred to as lump sum);
- cost-plus, where the price is based on the actual cost of labor and materials plus a fixed or percentage fee for the contractor’s overhead and profit; and
- cost-plus with a guaranteed maximum price (or GMP), where the contractor agrees that the actual cost plus the fee will not exceed a certain guaranteed maximum price.
Unit prices may be used as a component of fixed price and cost-plus contracts.
7.2 Assigning Responsibility for the Design and Construction of a Project
Responsibility for the design of most projects is allocated to the architect through an agreement between the owner and the architect, and responsibility for the construction of the project is allocated to the contractor through a separate agreement between the owner and the contractor. The allocation of certain design responsibilities is frequently negotiated among the parties. For example, responsibility for site and foundation work may be assigned to an engineer that has contracted directly with the owner.
Likewise, design responsibility for shop drawings and submittals during construction is often negotiated and sometimes shared by the architect and the contractor. For projects utilizing the “design-build” method of project delivery, the design-builder is responsible for both the design and the construction of the project.
7.3 Management of Construction Risk
Construction risk is primarily managed through the contractual provisions between the owner and the contractor. Most construction contracts, including the popular American Institute of Architects (AIA) contract documents, include basic warranties and indemnification provisions. The scope of and exclusions from these provisions are often negotiated. Indemnification provisions are enforceable under Tennessee law, subject to certain limitations and requirements.
Tennessee recognises the nearly “universal rule that there can be no recovery where there was concurrent negligence of both the indemnitor and the indemnitee unless the indemnity contract provides for indemnification in such case by “clear and unequivocal terms” and general words will not be read as expressing such intent” (Kroger Co v Giem, 387 SW 2d 620, 624 (Tennessee 1964)).
Further, an indemnity provision in a construction contract that purports to indemnify a party for damages caused by such party’s sole negligence would be void under Tennessee law as being against public policy (TCA Section 62-6-123); see 7.5 Additional Forms of Security to Guarantee a Contractor’s Performance.
7.4 Management of Schedule-Related Risk
Construction schedule-related risk is managed through contractual provisions and the possible use of liquidated damages for delays. Owners should consider including a “no damage for delay” clause, which provides that an extension of time is the sole remedy of the contractor in the event of a delay. The contract may include financial incentives for the early completion of a project or an acceleration provision giving the owner the right to demand acceleration of the project.
The development of the project schedule and negotiation of events or circumstances allowing for extensions of the contract time are key components of managing schedule-related risks. Liquidated damages clauses providing for the payment of a stipulated amount of damages for the failure of a contractor to complete a project or reach a certain milestone in a timely manner are enforceable in Tennessee, provided that the stipulated amount is a reasonable estimate of damages at the time the parties entered into the contract.
7.5 Additional Forms of Security to Guarantee a Contractor’s Performance
Payment and performance bonds are sometimes required by owners to provide security for the contractor’s performance under the contract and payment of its subcontractors and materialmen. Some owners do not require payment and performance bonds as the cost of these bonds is generally passed through to the owner, but such bonds are frequently required by lenders providing construction financing. Public projects in Tennessee require payment and performance bonds, and some public projects also require bid bonds.
Although less common, a letter of credit or parent-company guarantee is sometimes provided by a contractor as an alternative to payment and performance bonds.
Retainage of a small percentage of each progress payment is commonly used to protect the owner. In Tennessee, retainage is limited to 5% of the gross amount of the contract by the Tennessee Prompt Pay Act of 1991 (TCA Sections 66-34-101, et seq). If the prime contract is USD500,000 or more, the retainage must be deposited by the owner into a separate interest-bearing escrow account (TCA Section 66-34-104). This requirement cannot be waived or modified by contract and the interest earned on the account is the property of the contractor.
7.6 Liens or Encumbrances in the Event of Non-payment
Contractors, materialmen, architects and others making improvements to the real property have statutory lien rights in Tennessee; however, only prime contractors have lien rights on residential property consisting of one to four units. These liens relate back to the “visible commencement of operations”, excluding demolition, surveying and certain site work. A construction loan secured by a deed of trust recorded prior to the “visible commencement of operations” has priority over mechanics’ and materialmen’s liens, which can be removed by posting a bond to indemnify against the lien.
7.7 Requirements before Use or Inhabitation
The process for obtaining a certificate of occupancy varies according to the location of the project. Most local jurisdictions have inspection requirements before a certificate of occupancy will be issued, and a temporary certificate of occupancy is sometimes issued when the project is substantially complete. Under Tennessee law, “[s]ubstantial completion means that degree of completion of a project, improvement, or a specified area or portion thereof (in accordance with the contract documents, as modified by any change orders agreed to by the parties) upon attainment of which the owner can use the same for the purpose for which it was intended” (TCA Section 28-3-201(2)). Additionally, state and federal government inspections and approvals may be required for certain projects, such as healthcare facilities.
8.1 Sale or Purchase of Corporate Real Estate
See 2.10 Taxes Applicable to a Transaction.
8.2 Mitigation of Tax Liability
Methods commonly used to mitigate the cost of the transfer tax are the structuring of transactions as mergers, changes of control, or transfers of equity ownership in property-owning entities.
8.3 Municipal Taxes
With few exceptions, Tennessee levies a business tax on gross receipts of all businesses that sell goods or services. Businesses must obtain a business license from the county or municipality and report gross receipts to the Tennessee Department of Revenue on annual returns. Most municipalities – including Nashville, Memphis, Knoxville and Chattanooga – have adopted additional, copycat business taxes on gross receipts.
Exemptions apply to nonprofit, religious, medical, farm, charitable, legal, educational, domestic, accounting services, architecture, engineering, surveying and veterinary entities, and entities that generate less than USD10,000 in sales.
8.4 Income Tax Withholding for Foreign Investors
Tennessee does not have an income tax. When a non-US person disposes of an interest in US real estate, the proceeds are subject to 15% withholding under the Foreign Investment in Real Property Tax Act (FIRPTA). The amount of withholding can be adjusted by obtaining a withholding certificate from the Internal Revenue Service.
8.5 Tax Benefits
The primary tax benefit from owning real estate is that property taxes paid are deductible for federal income tax purposes. While land is not depreciable, improvements to land are subject to depreciation. This depreciation is deductible on the owner’s federal income tax return.
Owners may also take advantage of the IRC Section 1031 exchange rules, assuming all conditions are satisfied.
State Incentives and Tax Benefits
The State of Tennessee and its municipalities offer a number of incentives and tax benefits which may be available to certain real estate projects. The Tennessee Department of Economic and Community Development (ECD) offers grants through its Fasttrack Programs. The Fasttrack Infrastructure Program helps local governing bodies make infrastructure improvements which may benefit companies creating new jobs or making new capital investments. The Fasttrack Job Training Assistance Program grants expanding companies funding to support the training of new full-time employees.
The Fasttrack Economic Development Fund is used to offset costs companies incur when expanding or locating a business operation in Tennessee, including acquiring or developing real property, with reimbursable grants made to local governing bodies. ECD also offers its various Job Tax Credits, Enhanced Jobs Tax Credits, Industrial Machinery Tax Credits, and other Sales and Use Tax Exemptions.
Local Industrial Development
Local Industrial Development Boards and other municipal bodies in Tennessee may also offer various grants and incentives for real estate projects. For example, the Economic Development Growth Engine Industrial Development Board of the City of Memphis and County of Shelby, Tennessee (EDGE) offers its Inner City Economic Development Loans which helps develops inner city business districts through small, forgivable loans and its Neighbourhood Emergency Economic Development Grants which provide relief to neighbourhood serving businesses affected by COVID-19 in the city’s most distressed areas. EDGE also offers a variety of Payment in Lieu of Tax (PILOT) Incentives which provide a temporary, partial abatement of real property taxes for participants in return for a participant’s commitment to employ local minority/women-owned firms and small businesses, to create or retain jobs, and to make an agreed upon investment.
A PILOT transaction typically involves the participant purchasing real property which is then sold to EDGE and leased back to the participant to develop. As the property is then owned by a municipal entity, the property tax is abated but the participant will make lease payments (representing a discounted property tax) instead. EDGE may also engage in tax increment financings (TIF) which reinvests the increase in real property taxes back into the development of a project. Tourism Development Zone (TDZ) financings are yet another method of financing real estate projects in Tennessee whereby the sales tax increase from an area is reinvested back into the development of the project. PILOTs predominate in Memphis whereas other incentives like TIFs are popular elsewhere in Tennessee.
There are a number of similar boards and bodies across Tennessee with similar grants or programs, including various PILOT, TIF, and TDZ programs, which can be utilized to subsidize the costs of real estate projects.
8.6 Key Changes in Federal Tax Reform
See 1.3 Impact of New US Tax Law Changes.