Understanding Special Purpose Entities
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Oftentimes in apartment investing, a holding company takes the form of a special purpose entity, or SPE. Special purpose entities, sometimes known as special purpose vehicles, are legal entities — typically in the form of a limited company or a limited partnership — created to fulfill specific or temporary business needs. SPEs are generally deployed by apartment investors to isolate the financial risk of a single commercial real estate asset. Using an SPE to hold a single asset also makes it much easier for the sale or transfer of that asset later on, should the owner choose to do so.
SPEs, commonly created and registered in tax havens, are often utilized for financing large projects, or to delineate separate layers of equity infusion within complex financing agreements. Real estate investment trusts, or REITs, are a popular form of special purpose entity within the industry wherein the capital from multiple investors is pooled under one company for the purposes of acquiring and operating income-producing assets.
Beyond the aforementioned usage, SPEs play a special role when it comes to securitization — a critical aspect of CMBS financing. Pooled commercial mortgage loans need to be legally separated from any other obligations of the bank to ensure holders of mortgage-backed securities have the first priority right to payment on the loans in the pool. In most cases, to execute this separation, a special purpose entity is created, which retains ownership of the pool of loans.
Special purpose entities may be owned by one or more other entities. In certain jurisdictions, SPE ownership is regulated such that different parties are required to own a set percentage of the company. In general, a crucial caveat of special purpose entities is that they are typically not owned by the sponsor for which they were created, as a means of further protecting the sponsor or the sponsor’s company from any liability. This is why many SPEs are set up as 'orphan' companies. These orphaned entities typically have their shares settled on charitable trusts and utilize third-party directors to ensure that there is no legal connection with the sponsor.
Related Questions
What is a special purpose entity (SPE) in commercial real estate?
A special purpose entity (SPE) or single purpose entity (SPE) — also known as a special purpose vehicle (SPV) — is a legal entity used to acquire and finance a specific investment while limiting risk for all parties involved. The main benefit of an SPE is that it is bankruptcy remote, which means that if the firm that owns the entity declares bankruptcy, there is only a limited risk that the SPE will become ensnared in the bankruptcy proceedings. For commercial real estate lenders, this means that a borrower is far more likely to be able to repay their loan, even if they, individually (as an individual person or a company) experience financial trouble.
In addition, the isolated nature of a special purpose entity makes it easier to sell or transfer commercial real estate in the future. Plus, the fact that SPEs are held “off balance sheet” of the parent company, and are legally segregated, can add an additional layer of anonymity for investors and companies who wish to keep their dealings more private.
What are the advantages of using an SPE for commercial real estate financing?
The main advantage of using a Special Purpose Entity (SPE) for commercial real estate financing is that it is bankruptcy remote, meaning that if the firm that owns the entity declares bankruptcy, there is only a limited risk that the SPE will become ensnared in the bankruptcy proceedings. This makes it easier for borrowers to repay their loan, even if they experience financial trouble.
In addition, the isolated nature of a special purpose entity makes it easier to sell or transfer commercial real estate in the future. Plus, the fact that SPEs are held “off balance sheet” of the parent company, and are legally segregated, can add an additional layer of anonymity for investors and companies who wish to keep their dealings more private.
Finally, in some situations, holding commercial real estate in a special purpose entity can have significant tax benefits. When disposing of the asset, an investor can simply sell shares in the entity that owns the real estate, instead of directly selling the piece of real estate itself. This can often be beneficial from a tax perspective, as the sale of stock can sometimes be taxed at a lower rate than the sale of real estate.
What are the risks associated with using an SPE for commercial real estate financing?
Using an SPE for commercial real estate financing can have some risks associated with it. For example, if the SPE is distanced from its parent company, it may be more difficult to access funds in the event of a financial issue. Additionally, if the SPE is used in a joint venture, there may be disagreements between the parties involved in the venture. Finally, if the SPE is used for tax purposes, there is always the risk of an audit or other tax-related issues.
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What are the legal requirements for setting up an SPE for commercial real estate financing?
In order to be classified as a single purpose entity, an SPE will need to state its purpose in its operating statement, as well as provide a series of operating covenants (or rules) which demonstrate how it will isolate itself from any other potentially affiliated entities. Common stipulations include:
- The SPE will have a separate tax identification number (TIN)
- The entity should have a separate bank account or accounts
- The SPE cannot guarantee the obligations of other entities (such as using a property held by an SPE as collateral for a separate loan on a different property)
- The entity cannot mix its assets with those of any other entity
In many cases, such as with CMBS loans, agency loans, and HUD multifamily loans, lenders actually require a borrowing entity to be set up as a special purpose entity. That way, if a borrower or a borrower’s business runs into financial difficulties or declares bankruptcy, their commercial real estate is less likely to be taken by a creditor.
What are the tax implications of using an SPE for commercial real estate financing?
In some situations, holding commercial real estate in a special purpose entity can have significant tax benefits. When disposing of the asset, an investor can simply sell shares in the entity that owns the real estate, instead of directly selling the piece of real estate itself. This can often be beneficial from a tax perspective, as the sale of stock can sometimes be taxed at a lower rate than the sale of real estate.
Whether you hire someone to work with you or use independent contractors, the wages you pay them will be tax deductible on Schedule E of the tax return. Keep in mind that if you work with independent contractors and you pay them more than $600 in a single calendar year, you will have to send and file 1099s for them, since you qualify as a professional commercial real estate investor.
If you incur any professional fees, you can deduct those, as well. This would include things like legal fees, property management fees, and accounting fees.