Economic Damages – Calculating Lost Profits when a Deal Falls Apart

Project Gone Bad In CR-RSC Tower I, LLC (“CR-RSC”) v. RSC Tower I, LLC (“RSC”), CR-RSC owned a 53-acre tract of land in Maryland. It entered into two 90-year ground leases with RSC — a “successful real estate company that has developed a variety of different buildings in the community for over 20 years” — for a total of about five acres. Under the ground leases, RSC agreed to construct two apartment buildings — Towers I and II — that it would sell after construction and initial rental. Construction on Tower II was projected to begin about two years after construction of Tower I. The leases contained provisions obligating the parties to cooperate with each other in the development of the apartment buildings and the rest of the tract. After executing the leases, in late 2004 and early 2005 the parties modified their agreements to permit development of condominium buildings, a hotel and a spa rather than apartments. They executed several agreements related to this project but, in September 2006, the parties abandoned it and entered into a termination agreement. RSC then obtained county approval to revert to the original plan to build apartments and arranged financing to construct Tower I. CR-RSC, however, failed to provide estoppel certificates required to secure financing. In November 2006, RSC sued CR-RSC for breach of contract, and in early 2007 a court ordered CR-RSC to provide the certificates. RSC subsequently sought recovery of lost profits, claiming that the real estate and credit markets had deteriorated to the point that it could no longer obtain financing for the apartment project. After the jury found for RSC, CR-RSC appealed. Post-breach Conditions RSC based its lost profits claim on market projections as of December 2006, the time of the initial breach. CR-RSC contended that, because in 2006 the towers weren’t projected to be fully leased until 2010 and 2012, the actual market conditions in those years were relevant. And in those years, it argued, RSC wouldn’t have profited. In this case, the Maryland Court of Special Appeals held that lost profits damages are measured at the time of the breach. Unforeseeable subsequent events, such as post-breach fluctuations in value, frequently are “irrelevant for damage determinations.” Accordingly, the court affirmed the lost profits award of more than $36 million for collateral damages. Results May Vary The Maryland court cited courts in other jurisdictions, including the District of Columbia and Arizona, that have come to the same conclusion about the irrelevance of post-breach events in construction cases. Some courts, however, have considered such evidence. The laws in each jurisdiction may vary, so be sure to retain a qualified real estate lawyer and consultant who can help you calculate your damages and maximize your recovery if a deal goes bad.

Infrastructure Investing

Many towns and cities along the Missouri River suffered catastrophic damage to their infrastructure in 2011 because of flooding. According to the National Weather Service, almost a year’s worth of rain fell over a relatively short period of time in the upper Missouri River basin which triggered the floods. Some experts project the overall price tag on damages caused by the flooding to run between $3 billion to $5 billion. This event, along with other recent disasters and a mounting backlog of deferred repairs and maintenance, point to the need for significant infrastructure upgrades in the United States which may present valuable investment opportunities. A Safe, Dependable Income Stream Both developed countries — such as the United States and Great Britain — and developing countries will need to replace or revamp their infrastructures in the next few years. With so many governments strapped for cash, the door is wide open for private investors to get involved in financing infrastructure construction and repairs. Whether it’s for bridges and dams, railways and roads, waste disposal, telecommunications, power stations, pipelines, or ports, these worthy projects warrant backing. Infrastructure funds can help investors do just that. Infrastructure funds may offer a safer, more dependable income stream than some other types of investment options. While the real estate market continues to lag in many parts of the world, many governments are ready to spend trillions of dollars on infrastructure projects. In addition, many infrastructure assets have a virtual monopoly on the markets and the large monetary investment required to develop most infrastructure assets makes it highly unlikely that competing assets will ever be built. Unfortunately, the distinct opportunities presented by infrastructure investing are accompanied by unique challenges. Industry growth and consolidation, new investment products, and government intervention and/or regulatory changes could all affect infrastructure investors in years to come. Asset-specific risks relating to the design, construction and operation of infrastructure assets pose additional challenges. EFTs Provide Access In light of the related risk and high capital requirements for infrastructure investing, investors may want to consider accessing this unique asset class through index-based investments such as exchange traded funds (ETFs), which trade like stocks on an exchange and offer diversity similar to that of mutual funds. But unlike mutual funds — which try to outperform the market — index ETFs try to provide returns that track a major market index and can be traded intraday or in after-market sessions. Because they are passively managed, ETFs also offer lower administrative expenses and fees than do mutual funds. Infrastructure ETFs mimic the performance of certain indexes, such as the S&P Global Infrastructure Index and the Macquarie Global Infrastructure 100 Index. These indexes are designed to help investors track infrastructure companies, monitor fund performance, and allow easier investment in ETFs. With their many attributes, infrastructure ETFs may warrant attention from investors interested in defensive, high-yielding securities. However, infrastructure investing isn’t without risk. Rates of return vary vastly from project to project, and, even though infrastructure is somewhat insulated, it isn’t immune to the ebb and flow of economic tides. Think Before You Leap If you choose to invest in any kind of stock or fund, you should, of course, perform proper due diligence before jumping in. Although infrastructure ETFs have been around for a couple of years now, it’s still critical to work closely with your financial and investment advisors.

Section 1031 Exchanges: The Ins and Outs of Depreciating MACRS Property

Section 1031 — like-kind exchanges — in the commercial real estate arena often include property subject to the modified accelerated cost recovery system (MACRS). If you receive MACRS property in such an exchange, you must comply with complex IRS tax regulations for determining the amount of annual depreciation allowed. Under the IRS regs, the basis of MACRS replacement property comprises both a depreciable exchanged basis and a depreciable excess basis. Catching Up on “Like-kind” Exchanges Section 1031 exchanges allow property owners to exchange appreciated business or investment property without incurring an immediate tax liability. Income taxes are deferred until the replacement property is sold. Specifically, if you exchange business or investment property (relinquished property) solely for business or investment property of a like kind (replacement property), you needn’t recognize any gains or losses. But if you receive additional non-like-kind property or cash in the exchange, you must recognize a gain to the extent of the additional property or cash. “Like-kind property” is defined as property of the same nature or character — even if the property is different in grade or quality. For example, you can exchange a warehouse for a strip mall and enjoy the tax benefits of Section 1031 because both of these properties are investment real estate. Depreciating the Exchanged Basis The basis that remains in the relinquished property in a Section 1031 exchange is known as the “exchanged basis.” The recovery periods and depreciation methods used for the exchanged properties determine which depreciation rules apply to the exchanged basis. To the extent that the relinquished property and the replacement property are subject to the same depreciation rules, you wouldn’t need to change the way the replacement property is depreciated. However, the regs provide additional rules that apply if either the recovery period or the depreciation method — or both — aren’t the same for the relinquished and replacement properties. For instance, if the replacement property has a shorter recovery period than the relinquished property, the exchanged basis of the replacement property must be depreciated over the remaining recovery period of the relinquished property with no change. If, on the other hand, the relinquished property had a shorter depreciation life, you’ll need to depreciate the remaining basis over the longer period. Depreciating the Excess Basis If your basis in the replacement property exceeds your basis in the relinquished property (as would be the case if cash exchanged hands along with the property), the depreciation period for the excess amount is calculated independently of the exchanged basis. For instance, let’s assume you have an office building that you placed in service in 1998 which has an adjusted depreciable basis of $1 million and a depreciable statutory life of 39 years. In 2012, you exchange that building for $2 million in cash and an apartment building that has a depreciable statutory life of 27.5 years. The depreciable basis of the apartment building acquired would be $3 million- $1 million exchanged basis from the relinquished property plus $2 million cash exchanged. Depreciation on the $1,000,000 exchanged basis of the apartment building would be calculated using the statutory life applicable to the office building – 39 years, which is a longer life than the statutory life of the apartment building. Depreciation on the $2,000,000 of cash paid in the exchange would be treated as placed in service in 2012 and would be depreciated using the statutory life of the apartment building or 27.5 years. Land Exchanges The regs specifically address Section 1031 exchanges involving land or other nondepreciable property (as well as depreciation for deferred exchanges). Generally, if depreciable property and land are exchanged for land only, the entire basis of the relinquished property is the basis of the land acquired as replacement property. Where land and improvements are exchanged for land and improvements, the regs simply require the allocation of basis to the replacement land to be “reasonable.” Opting Out of the Regs A taxpayer may elect to opt out of the regs’ two-basis approach. You might want to consider this if you wish to avoid the cost and complications of compliance or if the replacement property has a shorter life or more-accelerated method of depreciation than the relinquished property. If you opt out, you must treat the entire basis of the replacement property (both exchanged basis and excess basis, if any) as having been placed in service at the time of the replacement. The adjusted depreciable basis of the relinquished MACRS property is treated as disposed. Staying in Compliance The depreciation regs for MACRS property in Section 1031 exchanges are extensive and complicated. If you’re involved in such an exchange, consult your tax advisor to ensure you stay in compliance with the rules.

Spotlight on Marks Paneth

Financial Regulations in a Post-Financial Crisis World The stability of financial institutions is improving, said Benjamin M. Lawsky, New York State’s first Superintendent of Financial Services, but they remain in a precarious place. Lawsky delivered his message at a breakfast conversation held Thursday, July 12 at Club 101 and hosted by The New York Observer. He also discussed his newly created agency and offered his thoughts on financial regulation in a post-financial crisis world. Among the challenges, he said, is avoiding one-size-fits-all regulation. Getting it right is hard in this environment as regulators are being pulled in contradictory directions, and the regulatory culture needs to strike a new “symbiosis” with the institutions being regulated. Marks Paneth co-sponsored this event with The McCaffrey Group Limited, Cozen O’Connor, and Women Builders Council, Inc. and The New York Observer. Doing Business Guides Doing business around the world presents a variety of challenges. Morison International (MI), the association of independent accounting and consulting firms of which we are a member, has begun publishing a series of Doing Business Guides. To accompany the China, India and Singapore guides, we have added Australia to the Library on the Marks Paneth website. The guides are written by the MI member firm in the country that is being profiled and provide an introduction to foreign investors on the various aspects of doing business.

For Further Information

If you have any questions, please contact William Jennings, Partner-in-Charge of the Real Estate Services Group at 212.503.8958 or wjennings@markspaneth.com or any of the other partners in the Marks Paneth Real Estate Services Group:

IRS Circular 230 Disclosure

Treasury Regulations require us to inform you that any Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © Marks Paneth LLP 2012 MANHATTAN | LONG ISLAND | WESTCHESTER | CAYMAN ISLANDS


About William H. Jennings

William H. Jennings Linkedin Icon

William H. Jennings, CPA, is a Senior Consultant in the Real Estate Group at Marks Paneth LLP. Mr. Jennings served on the Marks Paneth Executive Committee, which sets policy and strategy for the firm, from its inception until 2019. He is the former Partner-in-Charge of the Real Estate Group and the former Partner-in-Charge of the firm’s Boca Raton, Florida office.   With over 40 years of experience in public accounting and a keen focus on the real... READ MORE +


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