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By Robert E. Dady and Robert S. Freedman
Development of a timeshare enterprise can be a challenging process for a developer and its lawyer, since it combines a hotel business with sales of real estate interests and is subject to regulation in many states and foreign countries.
A timeshare plan is generally defined as any arrangement in which a purchaser receives ownership rights in or a right to use vacation accommodation for a period of time less than a full year, with the rights exercisable for a stated number of years. Timeshare plans take the form of either a timeshare estate, consisting of a fee interest title, or a timeshare license. A timeshare license is a right for a defined period of years to use vacation accommodations and related facilities but without an underlying real estate interest in the accommodations and facilities.
One of the most significant issues to consider in developing a timeshare project is whether the nature of the interest that purchasers will acquire should take the form of a fee simple title to the timeshare period or be a license or right to use the facilities under specified terms and conditions. The following is a point-counterpoint discussion between two lawyers to explore the question: to deed or not to deed?
Dady: Don't you think most developers like to give a warranty deed to purchasers? I believe that most purchasers like to receive a warranty deed. It makes them feel like they have ownership in something they understand--like their homes. It's a comfort thing.
Freedman: I understand that, but a timeshare license also has a well--established legal standing. Although it might be difficult to make purchasers comfortable with this type of ownership, they become more accepting when we tell them the money they are saving. A warranty deed, for example, has to be recorded. There is a cost to that, and most states charge some type of tax on top of that, like tax stamps on the deed, which are paid by the purchaser.
Another cost passed on to the purchaser is the cost of a title insurance policy. The amount of coverage is small, but in many states there is a minimum fee for each policy. Title insurance is pretty expensive, but the issuance of policies for the purchasers can result in overall savings to the developer if a lender requires a mortgagee policy for a loan secured by the receivables.
Dady: Yes, you make a good argument on the economics of saving dollars for the purchaser. But the lawyer's goal is not only to protect the developer from liability and save his capital, but also to help the developer in making his sale; without the latter, there would be no reason for us to have this conversation.
In a state like Florida, for instance, where approximately 35% of all timeshare resorts are located, you will find that most developers are conveying a fee title. If the developer believed-as they do in most states-that conveying fee title was important to making a sale, how would you then advise the developer?
Freedman: Well, there is no question that the sale comes first. Although there is an economic incentive in creating a timeshare license, if it meant giving an inch to my client's competition, I would draft the documents so that a fee interest was conveyed to the purchaser.
Freedman: One disadvantage to the fee is the difficulty of reacquiring the timeshare interest when the fee owner does not pay the mortgage or falls behind on paying fees for the maintenance of the timeshare plan and the timeshare property. The association and the mortgagee, which are basically in the same position, have only two options: (1) sue the nonpaying party for the amount of the indebtedness or (2) foreclose to reacquire the deeded interest.
Many jurisdictions require judicial foreclosure, a lengthy and costly process. Even if nonjudicial foreclosure procedures are available, a myriad of notice and publication requirements must be met.
Dady: What you say is true. The American Resort Development Association (ARDA), the timeshare trade industry organization, helped the Florida legislature pass a law that has streamlined the process of making judicial foreclosures. In Florida, a developer can now undertake numerous foreclosures at one time in a single lawsuit. Fla. Stat. Ann. § 721.83 (West 2000).
Also, isn't it a fact that many owners will walk away from the deeded interest and deed the property back to the developer in lieu of foreclosure in order to keep their credit ratings from being affected? That doesn't cost much at all.
Freedman: Yes, ARDA did a good job in Florida. Foreclosure has been made a bit easier in that state, and ARDA is working to get other states to follow suit. As for the deed in lieu of foreclosure, the problem is that when owners stop paying and walk away, they very often ignore any developer inquiries for reconveyance.
Securing reconveyance is especially difficult with foreign purchasers, who are a very large segment of the timeshare-purchasing population. I guess you could always bring a lawsuit against the individual, which might prompt the delivery of a deed back to the developer.
Dady: That personal lawsuit is not a very good substitute for foreclosure, because many timeshare owners do not live in the state where the resort is located. Developers would have to bring these actions for collection in the state where the timeshare owner resides. This would be very expensive and a public relations nightmare. Moreover, if the owners resided in foreign countries, you would have difficulty getting a judgment.
Freedman: But let's compare this procedure with the situation where a license or right-to-use owner fails to make his required payments for the purchase or for maintenance. The developer or the association, or both, will have to follow certain procedures to repossess the interest, but this would be done nonjudicially. In most cases, this is accomplished by the secured party's merely canceling the membership and retaining the amounts paid as liquidated damages. It's quick, clean and easy.
Dady: Yes, but if the developer is the one retaking possession, there may be obligations or assessments that will need to be paid to the timeshare owners' association. Although most states make the developer responsible for assessments even if the developer forecloses, some states allow the foreclosure to cut off the assessments or limit the assessments to a brief time period.
Freedman: That's true, but remember that the developer will take back the right to use much more quickly than a fee foreclosure process and can then sell the membership, in many cases at a higher sales price. Although the developer would rather have the purchaser pay out his contract, the developer does have the opportunity to recoup these lost costs.
Freedman: Another matter not to be underestimated is the greater degree of flexibility afforded by a right-to-use plan. The developer can modify the members' rights at any time to adjust to whatever the current trend is and, in that way, not lose the people to a new, more modern project.
Many developers are now using a point system with a right-to-use program, which allows the timeshare owner all types of vacation interests to be added to the program at an increased cost-which, of course, will enhance the developer's profitability. By contrast, the only manner in which the owner of a deeded interest can increase the level of ownership in any fashion is to purchase an additional interest or to pay for additional occupancy rights, often at a higher rate per night than if purchasing another interest.
Dady: Well, it's easy to impose the point system on the right-to-use plan. But with a little creativity, a developer can achieve a similar result with a fee interest. For example, the rules and regulations that go with fee ownership can be superimposed on the deeded interest and can carry with them extra benefits for that same extra cost. They can also increase developer profitability while giving the owner the assurance that goes with having a deed to a piece of real estate. A simple example of this would be to allow the deeded interest to be governed by a floating use plan, where the reservation system of the timeshare plan management company allows people to make reservations within a flexible time period rather than forcing them to show up on a day certain every year for their vacation. Exchange companies have accommodated their vacation experience to allow exchanges throughout a period of time based on the floating aspect of the timeshare use.
Freedman: There is a further advantage of a right-to-use plan. In a deeded interest development, the only 100% accurate way to ensure that the developer does not sell more of an interest than legally allowed involves an analysis of the recording index in the local public records. In a large project, this analysis can be a painstaking and costly process and, because there are delays in indexing deeds, the information provided is almost always incomplete. On the other hand, with the right-to-use memberships, the developer must maintain the occupancy records and thus has no choice but to ensure that only proper sales are made.
Dady: That argument assumes that developers who sell deeded interest intervals are not as good at record keeping as those using the right-to-use membership, and I don't believe that. Both programs need accurate records, and, in the deeded interest program, a title insurance company usually provides checks and balances to make sure that the property has not been conveyed twice. But I must concur with you that when mistakes are made, going back to the owners to get them to deed back to the developer and perhaps take a new interest, even in a floating plan, is a painstaking and costly process. With the right to use, however, you would just make the change in your records and that would be the end of it. Unless, of course, the purchaser objected, but I know you don't want to go there!
Freedman: Another burden that goes along with deeding interests is that you have to follow the truth-in-lending and RESPA requirements. Those requirements do not have to be followed with right-to-use memberships because they are exempt, intangible property.
Dady: Good point. Still, today's computer programming is so good that, given the basic information of a sale, the computer automatically prints out the Regulation Z disclosures and the HUD-1 settlement statements. Developers also have learned to employ properly trained and qualified personnel to ensure compliance with these laws.
Freedman: When the developer of a deeded interest project goes to finance its receivables through the hypothecation of the notes and mortgages, the process of creating a lien and security interest on the property to secure payment is fairly complicated. By contrast, the security interest created in connection with a right-to-use membership arises under the Uniform Commercial Code. A UCC-1 financing statement filed with the Secretary of State and, if applicable, in the local public records is sufficient.
Dady: But if you talk to lenders, they don't really care much about a program to ease the developer's burden. They like the certainty that comes with an assignment of mortgages and delivery of original notes to them or their custodians, which almost always perfects their security interest. Lenders have also indicated that they find it easier to track their interest in a deeded project. They like the security of relying on those county clerk property records, and they don't have to worry at all about what state to file those UCC-1 statements in when purchasers are coming from all over the world. By recording the receivables assignment in the state where the real estate is located and taking delivery of the note, they have a security interest they can rely upon.
Freedman: Well, here's an argument you cannot possibly rebut: right-to-use plans are a lot easier to draft, and the overall project documentation is a lot simpler than with a deeded property. In a great majority of circumstances (although I will admit that the trend is moving in the opposite direction), a deeded interest is created through condominium structure. Now that many states have homeowner's statutes, it is also possible to do so through a subdivision and a homeowner's association.
In nearly all vertical projects the condominium structure is a necessity. Because the condominium statutes have always been consumer-oriented, every year there is new legislation designed for consumer protection. The bottom line is that the lawyer who can draft a really good set of condominium timeshare papers could just as easily draft a treaty between China and Taiwan. It has become too darn complicated for anyone's good.
Dady: Yes, but with such documentation comes developer flexibility and protection. You are correct that new timeshare models exist outside the realm of a condominium or subdivision, even in multistory projects. The developer sells an undivided tenant-in-common fee interest in a building or the overall project and employs a point system to permit occupancy. These projects are very complex to draft, but they do permit a developer to avoid the regimented, consumer-oriented statutory requirements of condominiums. At least until state legislators decide that these projects must be stringently controlled by the state regulatory agencies.
And speaking of drafting, what did the legislators intend in Florida when they created a statutory provision that allows the timeshare license owner to cancel his contract when the accommodations and facilities are no longer available as they were originally described? This right would exist even if the parties had recorded the required subordination or nondisturbance instrument.
For example, if you gave an owner certain extensive beach rights and the state subsequently reduced those rights, the timeshare owner could conceivably cancel his contract and demand his money back. Lenders don't like to be put in that position, and I think it would be tough to finance a right-to-use project with that statute hanging over your head.
Freedman: Another concern is the tax consequences to the developer. Lawyers should be aware of the Windrifter situation, which was addressed in a technical advice memorandum by the IRS in 1977. TAM 7803005 (Sept. 30, 1977).
Under a fairly complicated holding, the IRS concluded that because the developer had not transferred the benefits and burdens of ownership, the developer was, in effect, the landlord and the members were tenants under a presumed lease of 40 years. The result, which would be the situation in any right-to-use project, was that the developer could not write off the development and acquisition cost on the sale of an interest but could only depreciate those costs over an extended period of time of 20 to 30 years.
The critical factor for the IRS was that the project was not of a permanent nature. Therefore, you could have Windrifter tax liability on a deeded interest if title were to revert back to the developer on the expiration of a 40 year membership term that was not renewable or extendable.
Dady: In other words, you could not have installment sales reporting. The cost of construction or other costs of sales, including commissions-- which are probably the major expenses of a timeshare project in the year of the sale-could not be claimed over the initial years of the project. Instead, the cost of acquisition, construction and other deductible costs of sales must be amortized over the term of the timeshare plan.
For example, if it costs the developer 28% of sales to construct the project, there would be a deduction of 28% in the year of the sale at a deeded non- Windrifter project. With a right-to-use project (or a Windrifter-type deeded interest), however, approximately 4% could be deducted based on depreciating a building over 39 years and furniture and fixtures from five to seven years.
Freedman: That's a tough hurdle to overcome, but there are some ways to avoid the Windrifter tax consequences. First, have the term of the right-to-use be perpetual. If it cannot be perpetual, it needs to be at least 40 years, since possible Windrifter exposure should be recognized.
Second, ensure through the offering documents and those creating the membership rights that the material benefits and burdens of ownership are transferred, both in terms of the individual memberships and the right-to-use project itself. Allow the purchasers to make decisions in the event of a casualty. Allow them to decide to rebuild or pay off the construction financing. Relinquish the developer's right to transfer the timeshare property and make the members, through a committee or association, responsible for maintaining and repairing the property.
Dady: In other words, all that control the developer wanted to maintain by using the right-to-use plan must be given up to keep the tax benefits and not have to endure the burden of foreclosing liens.
Freedman: There are still many benefits of right-to-use plans. Although the interval ownership statutes of Florida are somewhat biased against right to use, the California statutes, for example, are kind to these plans. Because states don't want to lose valuable timeshare projects, they should make it easier to develop these right-to-use plans as an incentive to development.
Dady: But, as we both agreed, it's the marketing perception that is going to drive the type of ownership that will be offered. So I think the best approach for a new project is for the lawyer first to understand the marketing plan and then to determine with the developer which approach works best to implement the plan.
Freedman: Good idea, and maybe we'll throw an installment plan and a European trust at them while we're at it.
Dady: Well, Rob, I think we've covered the issue fairly thoroughly, but developers and lawyers need to consider the specific circumstances of a proposed project. The variations can be huge, governed by the type of hotel operation (if any), the states where sales will take place, sales methods and even the sales price of the week. And last but definitely not least, the requirements of the lender providing operating funds through loan hypothecation will have to be considered.
Robert E. Dady is of counsel to Fieldstone, Lester, Shear & Denberg in Coral Gables, Florida. Robert S. Freedman is a partner in Carlton Fields in Tampa, Florida. They are the vice-chair and chair, respectively, of the Real Property Division's Timesharing and Interval Uses (H-4) Committee