Published in the Illinois Real Estate Journal - November 2005
Real estate oftentimes consists of multiple uses at one property and good reasons may exist to split ownership and operation of the real estate.
This article presents two possible methods to subdivide a mixed-use asset: a condo and a vertical subdivision. For example, in one building, a retail REIT could own a shopping concourse and a hotel owner could own hotel property that rises above the stores. A company experienced in the ownership and operation of office properties could own the office space located beneath residential condos or apartments.
Separate ownership is possible and may be a smart strategy to maximize value of a mixed-use property.
Condo
A building could be converted to condo ownership in order to permit separate ownership of constituent parts. Condos can be retail, hotel, office, or even industrial. Indeed, many owners are presently converting existing office buildings to the condo form of ownership in order to sell the suites rather than the building.
A condo is a creature of statute; it does not exist until a parcel of real estate has been properly submitted to the provisions of the Illinois Condo Property Act. A condo consists of two components: units and common elements. A condo owner owns fee-simple title to the portion of a building that comprises the space of his or her unit and shares ownership of the common elements with the other unit owners in the condo. While each individual unit owner owns a specific percentage of the common elements, each unit owner generally has the right to use all the common elements in the condo.
The principal advantage of the condo structure is the ability to circumvent governmental subdivision approval procedures, which can take months to complete. Condos have the advantage of comprehensive statutory and case law that can provide guidance in many situations. Each condo unit can be independently sold and mortgaged.
On the other hand, by law every condo must follow all the requirements of the act, which was generally written with residential apartments in mind. The owners of a hotel portion, retail portion or office portion of a building may not want to be on a condo Board of Directors, let alone pick a president and treasurer or budget and collect assessments.
Vertical subdivision
The typical suburban residential subdivision starts with a large parcel of land, such as a farm field, owned by one person. This large parcel can be sold as a whole to another person but generally cannot be sold off in smaller parts.
A developer enters the picture and formally subdivides the large parcel into smaller parcels. Each of the smaller parcels can be identified on a survey and can easily be sold by subsequent owners. This typical subdivision can be thought of as a "horizontal" subdivision. Separate, subdivided lots are created side by side. Each individual owner owns the subsurface rights beneath the lot as well as the air rights above the lot.
When subdividing a mixed-use property, a developer follows the same procedure, only the subdivided lots are located on top of each other rather than side by side. Consequently, this type of subdivision is called a vertical subdivision.
For example, the office portion of a building may be located above the retail portion of a building. As with a "horizontal" subdivision, each of the vertically subdivided parcels can be identified on a survey and can easily be sold by subsequent owners.
In contrast to a Declaration of Condo, a subdivision declaration typically does not provide for an association, board of directors or officers. The subdivision declaration must, however, create and explain easement rights necessary for the existence and operation of the mixed-use development.
For example, assume there is a vertically subdivided building with a retail portion on the first two floors and an office portion located on floors 3 through 10. The office portion cannot exist independently. It needs easements for support and access from the retail portion. The declaration is also a convenient place to enumerate the ground rules for day-to-day operation of the mixed-use development.
Not all building systems will exist independently. For example, a single boiler may heat the entire building. The declaration will need to proscribe rules for operation, maintenance, and reimbursement for shared systems such as the boiler. Furthermore, each party will want restrictions to prevent others from doing anything wildly out of context with the rest of the building.
If the building burns to the ground, the parties (and their lenders) will usually want assurances that the building will be rebuilt as nearly as practicable to the condition existing before the casualty loss. The owner of floors 3 through 10 is at a distinct disadvantage in the absence of floor 1 and 2. The declaration will address all of these concerns.
Taxes
When creating a condo or vertical subdivision, multiple copies of the significant documents must be filed with the applicable county recorder. When a developer records condo documents or vertical subdivision documents, the recorder sends a copy to the county assessor. The assessor then issues split tax bills for each of the new condo units / subdivided lots.
Some lag time exists between the date the documents are filed and the issuance of the first split bills, because taxes are paid in arrears in the Chicago metropolitan area. For example, if a developer records in Cook County during 2005, the earliest split bill that can be issued is for the 2006 tax year and, because 2006 taxes are payable in 2007, a split tax bill would not be received until autumn, 2007.
The developer should include in the Condo Declaration or in the Declaration of Covenants, Conditions, Restrictions and Easements (as the case may be) a formula for allocating responsibility for real estate taxes during the interim period between the filing of the documents and the issuance of split tax bills.
This formula can be based on square footage, on assessed or market value of improvements, on income generated by the various components of the property, or another fair, equitable, and defensible method of allocating responsibility provided that condo law, if applicable, must be complied with. The operative declaration should specify who pays the taxes, when, and what happens if the taxes are not paid.
Both a condo and a vertical subdivision can be created at any time. One can start with an empty lot and plan to construct a condo or a vertically subdivided property commencing with the first shovel in the ground. At the other extreme, a 100-year-old building can be subdivided into various parts or converted to condo.
In both instances, the developer's lender must consent to the arrangement. A mortgage lender must formally consent to the plat and the declaration and agree to subordinate its financing documents to the plat and declaration. Without this subordination, a foreclosure could wipe out the plat and declaration, but not the separate tax bills or multiple owners, resulting in quite a mess.
The developer who is subdividing an older building has one additional hurdle to overcome: the developer needs cooperation from the building's occupants, whose leases may or may not fit smoothly into the new order of things after the subdivision. With a condo conversion, state and municipal law provide additional consumer-oriented consumer protections with which the developer must comply.
With little or no physical alterations, a building can be legally subdivided into two or more parts, each of which can be separately owned and mortgaged. Separate ownership may achieve a greater aggregate purchase price than would be obtainable if the building had to be sold as a whole, may attract potential owners and/or investors that would not be interested in the whole property, and can be a smart option for new construction.
Circular 230 Disclaimer
In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document.
