Co-owning California Commercial Properties: Structuring Agreements and Exit Strategies

Commercial real estate in California represents a significant financial commitment. For many investors in San Diego and throughout the state, purchasing retail centers, office buildings, or industrial warehouses is simply not feasible as a solo endeavor. Pooling resources through co-ownership structures allows investors to access higher-value assets, diversify their portfolios, and share the burdens of property management. However, entering a partnership without a clear roadmap is a recipe for conflict.

Common Forms of Co-ownership in California

The legal structure you choose to hold title determines your rights, your liability, and your ability to transfer your interest. California law recognizes several distinct forms of co-ownership, each with specific implications for commercial investors.

Tenancy in Common (TIC)

Tenancy in Common is a frequent choice for unrelated investors. In this structure, each owner holds a distinct, undivided interest in the property. These interests do not need to be equal; one investor might own 60% while another owns 40%. A key feature of TIC ownership is that there is no right of survivorship. If a co-owner passes away, their share transfers to their heirs, not to the other co-owners. This structure is often utilized by investors seeking to complete a 1031 exchange, as it allows them to hold a direct interest in the real estate rather than an interest in a business entity.

Limited Liability Companies (LLCs)

For many commercial ventures, forming a Limited Liability Company is the preferred approach. In this scenario, the LLC owns the title to the property, and the investors own membership interests in the LLC. This structure provides a layer of protection, shielding the individual investors’ personal assets from liabilities arising from the property. Governance is dictated by an Operating Agreement rather than property deed language, offering significant flexibility in management and profit distribution.

Joint Tenancy

Joint Tenancy is less common in commercial investment contexts involving unrelated parties. It requires equal ownership shares and includes a right of survivorship. If one owner dies, their interest automatically passes to the surviving owners. This automatic transfer bypasses probate but can create unintended consequences for investors who wish to leave their share of a valuable asset to their family.

General Partnerships

If two or more people carry on a business for profit as co-owners without filing paperwork for an LLC or corporation, they may inadvertently form a General Partnership. California law imposes strict fiduciary duties on partners. In this structure, each partner is personally liable for the debts and obligations of the partnership, which presents a substantial risk in commercial real estate.

The Necessity of a Written Co-ownership Agreement

Relying on a handshake or a generic template is insufficient for high-value commercial assets. California statutory law provides default rules for co-owners who lack a written agreement, but these default rules rarely align with the investors’ intentions. A customized Co-ownership Agreement (for TICs) or Operating Agreement (for LLCs) acts as the private law between the parties.

Key governance issues that must be addressed include:

• Decision-Making Authority: Define which decisions require a simple majority, a super-majority, or unanimous consent. Routine maintenance might require 51% approval, while refinancing or selling the property should likely require a higher threshold.
• Management Duties: Specify who is responsible for day-to-day operations, such as collecting rent, handling tenant complaints, and coordinating repairs. If one owner acts as the property manager, the agreement should outline their compensation.
• Voting Rights: Clarify whether voting power is tied strictly to ownership percentage or if certain partners have enhanced voting rights regarding specific operational matters.
• Reporting and Transparency: Establish requirements for financial reporting, bank account access, and the frequency of partnership meetings to ensure all owners remain informed.

Managing Financial Obligations and Capital Calls

A commercial property is an active asset that requires ongoing capital. Vacancies, unexpected repairs, and tenant improvements can create cash flow deficits. A robust agreement must anticipate how these costs will be covered when the property’s income is insufficient.

Mechanisms for handling capital contributions include:

• Mandatory Capital Calls: The agreement may grant the manager the right to demand additional funds from members to cover necessary expenses like taxes, insurance, or emergency repairs.
• Dilution Penalties: If an owner fails to meet a capital call, the agreement should specify the consequences. A common remedy is the dilution of the non-contributing member’s percentage interest. The contributing members cover the shortfall, and their ownership stake increases mainly based on the current valuation of the property.
• Member Loans: Alternatively, the agreement can allow contributing members to treat the shortfall payment as a high-interest loan to the non-contributing member or to the company, which must be repaid from future distributions before the non-paying member receives any cash flow.
• Third-Party Financing: The partners may agree to seek external financing to cover costs, though this often requires personal guarantees that not all partners may be willing to sign.

Resolving Internal Disputes and Deadlocks

Disagreements are inevitable in any long-term business relationship. When co-owners reach an impasse, the property’s value can suffer. A well-drafted agreement includes tiered dispute resolution procedures to resolve conflicts without resorting to litigation.

Effective dispute resolution clauses often involve:

• Mediation: A requirement that parties attempt to resolve the dispute with the help of a neutral third-party mediator before filing a lawsuit.
• Arbitration: A binding process where a private arbitrator hears the evidence and renders a decision, which is often faster and more private than court trials.
• Buy-Sell Provisions (Shotgun Clause): In a deadlock, one partner can name a price at which they are willing to either buy the other partner’s interest or sell their own. The other partner must then choose whether to buy or sell at that price. This ensures a fair valuation, as the offeror must be prepared to be on either side of the transaction.
• Tie-Breaker Mechanism: Designating a trusted neutral third party, such as a CPA or an industry advisor, to cast a deciding vote on specific operational deadlocks.

Structuring Exit Strategies and Buyouts

Investors often enter a deal with different timelines. One partner may want to hold the asset for decades, while another intends to sell after five years. Without a clear exit strategy, an investor can become trapped in an illiquid asset.

Common exit mechanisms include:

• Right of First Refusal (ROFR): If an owner receives a bona fide offer from a third party to purchase their interest, they must first offer it to the other co-owners on the same terms.
• Right of First Offer (ROFO): An owner wishing to sell must first propose a price to the other owners. If they decline, the seller can market their interest to third parties, typically at a price no lower than what was offered to the partners.
• Tag-Along Rights: If a majority owner sells their interest to a third party, the minority owners have the right to join the transaction and sell their shares at the same price.
• Drag-Along Rights: If a majority owner finds a buyer for the entire property, they can force the minority owners to sell their interests, preventing a minority holder from blocking a lucrative full exit.
• Put and Call Options: These provisions allow one partner to force another to buy them out (Put) or force another to sell their interest (Call) upon specific triggering events or after a certain period.

The Remedy of Partition Actions in California

When co-owners of a property cannot agree on its management or disposition, and there is no governing agreement to resolve the dispute, California law provides a judicial remedy known as partition. A partition action allows a co-owner to petition the court to divide the property.

Types of partition include:

• Partition by Sale: This is the most common outcome for commercial properties like office buildings or shopping centers, which cannot be physically divided. The court orders the property to be sold, often through a court-appointed referee, and the proceeds are distributed to the owners after paying off debts and costs.
• Partition in Kind: This involves physically dividing the property into distinct parcels. While this may work for large tracts of raw land, it is rarely feasible for improved commercial real estate.
• Appraisal Buyout: Under the Uniform Partition of Heirs Property Act (which California has adopted in modified form), co-owners may have the right to buy out the interest of the party seeking partition at a court-determined appraised value, potentially avoiding a forced market sale.

Partition actions are expensive and time-consuming. They involve legal fees, referee fees, and potential sales costs. A comprehensive co-ownership agreement typically waives the right to partition in favor of the agreed-upon exit strategies, giving the owners control over the process rather than a judge.

Tax Implications of Co-ownership Transfers

The structure of your co-ownership agreement significantly impacts tax liabilities, particularly regarding 1031 exchanges. Investors often wish to defer capital gains taxes when selling real estate.

Key tax considerations:

• Drop-and-Swap Transactions: If a property is owned by an LLC, the individual members cannot independently perform a 1031 exchange because they own membership interests (personal property), not real estate. Partners often attempt to dissolve the LLC and distribute the deed to the members as Tenants in Common shortly before a sale. This technique requires careful timing and adherence to Franchise Tax Board regulations to avoid being challenged as a sham transaction.
• Property Tax Reassessment: Transferring interests between partners or to new entities can trigger a Proposition 13 reassessment, leading to a significant increase in property taxes. California rules regarding “Change in Ownership” are complex, involving specific thresholds for transfer of control that must be monitored closely.
• Partnership Tax Allocations: Partnership agreements can provide for “special allocations” of depreciation or gain, subject to IRS “substantial economic effect” rules. This allows partners with different tax profiles to maximize the efficiency of the investment.

Why Local Knowledge Matters in Agreement Drafting

Structuring a commercial co-ownership arrangement requires more than just general legal knowledge; it demands familiarity with the specific real estate market and local regulations. An agreement for a multi-tenant retail strip in El Cajon faces different challenges than one for a downtown San Diego high-rise. The attorneys at Garmo & Garmo assist property owners in drafting robust co-ownership agreements and resolving partnership disputes. Whether you are forming a new investment group or need to disentangle a troubled partnership, having experienced counsel is vital to protecting your financial interests.

Contact us at (619) 441-2500 or visit our website to schedule a consultation regarding your commercial real estate matters.