<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported): October 4, 1996
CRESCENT REAL ESTATE EQUITIES, INC.
(Exact name of Registrant as specified in its Charter)
Maryland 1-13038 52-1862813
(State of Incorporation) (Commission File (IRS Employer Identification Number)
Number)
900 Third Avenue, Suite 1800
New York, New York 10022
(Address of Principal Executive Offices) (Zip Code)
(212) 836-4216
(Registrant's telephone number, including area code)
<PAGE> 2
Item 7. Financial Statements and Exhibits.
(c) Exhibits
The exhibits listed in the following index relate to the Registration
Statement on Form S-3 (No. 33-97794), as amended, of the registrant and are
filed herewith for incorporation by reference in such Registration Statement.
<TABLE>
<CAPTION>
Exhibit No. Description
----------- -----------
<S> <C>
1.01 Terms Agreement, dated October 3, 1996
5.01 Opinion of Shaw, Pittman, Potts & Trowbridge as to the legality of the
securities being registered by the registrant
8.01 Opinion of Shaw, Pittman, Potts & Trowbridge regarding certain material tax
issues relating to the registrant
8.02 Opinion of Locke Purnell Rain Harrell (A Professional Corporation) regarding certain
Texas franchise tax matters
23.01 Consent of Shaw, Pittman, Potts & Trowbridge (Included in its opinions filed
as Exhibits 5.01 and 8.01)
23.02 Consent of Locke Purnell Rain Harrell (A Professional Corporation) (Included in
its opinion filed as Exhibit 8.02)
</TABLE>
<PAGE> 3
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Dated: October 4, 1996 CRESCENT REAL ESTATE EQUITIES, INC.
By: /s/ Dallas E. Lucas
-------------------------
Dallas E. Lucas
Senior Vice President and
Chief Financial Officer
<PAGE> 1
EXHIBIT 1.01
CRESCENT REAL ESTATE EQUITIES, INC.
(a Maryland corporation)
COMMON STOCK
(Par Value $.01 Per Share)
TERMS AGREEMENT
---------------
Dated: October 3, 1996
To: CRESCENT REAL ESTATE EQUITIES, INC.
777 Main Street
Fort Worth, Texas 76102
Attention:
Ladies and Gentlemen:
We (the "Representative") understand that Crescent Real Estate
Equities, Inc. ("the Company") proposes to issue and sell shares of its
Common Stock, $.01 par value per share (the "Common Stock"), such shares of
Common Stock being collectively hereinafter referred to as the "Underwritten
Securities". Subject to the terms and conditions set forth or incorporated by
reference herein, the underwriters named below (the "Underwriters") offer to
purchase, severally and not jointly, the respective numbers of Underwritten
Securities set forth below opposite their respective names, at the purchase
price set forth below.
<TABLE>
<CAPTION>
Number of Shares of
Underwriter Underwritten Securities
----------- ---------------------------
<S> <C>
Merrill Lynch , Pierce, Fenner & Smith 96,750
Incorporated
Dean Witter Reynolds Inc. 96,750
PaineWebber Incorporated 96,750
Smith Barney Inc. 96,750
Alex. Brown & Sons Incorporated 4,500
CS First Boston Corporation 4,500
Donaldson, Lufkin & Jenrette 4,500
Securities Corporation
</TABLE>
<PAGE> 2
<TABLE>
<S> <C>
A.G. Edwards & Sons, Inc. 4,500
Furman Selz LLC 4,500
NatWest Securities Limited 4,500
Salomon Brothers Inc 4,500
Southwest Securities, Inc. 4,500
UBS Securities LLC 4,500
EVEREN Securities, Inc. 2,250
Friedman, Billings, Ramsey & Co., Inc. 2,250
Hanifen, Imhoff Inc. 2,250
Harris Webb & Garrison, Inc. 2,250
Edward D. Jones & Co., L.P. 2,250
Legg Mason Wood Walker, 2,250
Incorporated
Principal Financial Securities, Inc. 2,250
Rauscher Pierce Refsnes, Inc. 2,250
Raymond James & Associates, Inc. 2,250
Sutro & Co. Incorporated 2,250
Total 450,000
========================
</TABLE>
<PAGE> 3
The Underwritten Securities shall have the following terms:
Common Stock
Title of Securities: Common Stock, par value $.01 per share
Number of Shares: 450,000
Public offering price per share: n/a
Purchase price per share: $ 42.00
Number of Option Securities, if any, that may be purchased
by the Underwriters: none
Delayed Delivery Contracts: not authorized
Additional co-managers, if any: Dean Witter Reynolds Inc., PaineWebber
Incorporated and Smith Barney Inc.
Closing date and location: October 9, 1996, Hogan & Hartson L.L.P., Columbia
Square, 555 Thirteenth Street, N.W., Washington, DC 20004-1109
All the provisions contained in the document attached as Annex
A hereto entitled "Crescent Real Estate Equities, Inc.-Preferred Stock, Common
Stock and Common Stock Warrants-Purchase Agreement" are hereby incorporated by
reference in their entirety herein and shall be deemed to be a part of this
Terms Agreement to the same extent as if such provisions had been set forth in
full herein. Terms defined in such document are used herein as therein
defined.
(Annex A Omitted)
<PAGE> 4
Please accept this offer no later than 5:30 o'clock P.M. (New York City time)
on October 3, 1996 by signing a copy of this Terms Agreement in the space
set forth below and returning the signed copy to us.
Very truly yours
MERRILL LYNCH, PIERCE, FENNER & SMITH
INCORPORATED
By: /s/
--------------------------------------------
Acting on behalf of itself and the
other named Underwriters.
Accepted: October 3, 1996
By: CRESCENT REAL ESTATE EQUITIES, INC.
By: /s/
-------------------------------
<PAGE> 1
EXHIBIT 5.01
[SHAW, PITTMAN, POTTS & TROWBRIDGE LETTERHEAD]
October 3, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue, Suite 1800
New York, New York 10022
Ladies and Gentleman:
We have acted as counsel to Crescent Real Estate Equities, Inc., a
Maryland corporation (the "Company"), in connection with the registration of up
to 450,000 shares of its common stock, par value $0.01 per share (the "Shares"),
pursuant to a Registration Statement on Form S-3 (Registration No. 33-97794),
including the prospectus and all amendments, exhibits and documents related
thereto (collectively, the "Registration Statement"), under the Securities Act
of 1933, as amended, and with the proposed sale of the Shares to the public
through certain underwriters.
Based upon our examination of the originals or copies of such documents,
corporate records, certificates of officers of the Company and other instruments
as we have deemed necessary and upon the laws as presently in effect, we are of
the opinion that the Shares have been duly authorized for issuance by the
Company, and that upon issuance and delivery in accordance with the purchase
agreement and related terms agreement referred to in the Registration
Statement, the Shares will be validly issued, fully paid and nonassessable.
We hereby consent to the incorporation by reference of this opinion as
an exhibit to the Registration Statement. We also consent to the reference to
Shaw, Pittman, Potts & Trowbridge under the caption "Legal Matters" in the
prospectus.
Very truly yours,
/s/ SHAW, PITTMAN, POTTS & TROWBRIDGE
-------------------------------------
SHAW, PITTMAN, POTTS & TROWBRIDGE
<PAGE> 1
EXHIBIT 8.01
[SHAW, PITTMAN, POTTS & TROWBRIDGE LETTERHEAD]
October 3, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue
Suite 1800
New York, New York 10022
Ladies and Gentlemen:
On October 14, 1995, Crescent Real Estate Equities, Inc. ("Crescent
Equities") filed a Registration Statement on Form S-3, file number 33-97794,
with the Securities and Exchange Commission, which was declared effective on
June 18, 1996. Such registration statement (the "Registration Statement")
includes a prospectus supplement filed on or about October 3, 1996 (the
"Prospectus Supplement") to the prospectus contained in the Registration
Statement (the "Prospectus"). In connection with the filing of the Prospectus
Supplement, you have asked us to render certain opinions regarding the
application of the U.S. federal income tax laws to Crescent Equities,(1)
Crescent Real Estate Equities Limited Partnership (the "Operating Partnership")
and certain partnerships and limited liability companies in which the Operating
Partnership has an ownership interest (the "Subsidiary Partnerships"). The
Subsidiary Partnerships currently include Crescent Real Estate Funding I, L.P.
("Funding I"), Crescent Real Estate Funding II, L.P. ("Funding II"), Crescent
Real Estate Funding III, L.P. ("Funding III"), Crescent Real Estate Funding IV,
L.P. ("Funding IV"), Crescent Real Estate Funding V, L.P. ("Funding V"),
Waterside Commons Limited Partnership ("Waterside"), G/C Waterside Associates
LLC ("Associates"), Woodlands Office Equities - '95 Limited (the "Woodlands
Partnership"), 301 Congress Avenue, L.P ("301 Congress"), Crescent/301, L.L.C.
("Crescent/301") and Spectrum Mortgage Associates, L.P. ("SMA"). All
capitalized terms used but not otherwise defined herein shall have the
respective meanings given to them in the Prospectus Supplement, unless
otherwise noted.
- ----------------------------------
(1) Unless otherwise noted, all references to Crescent Equities herein
refer to Crescent Equities and its wholly owned subsidiaries,
Crescent Real Estate Equities, Ltd. ("CREE"), CRE Limited
Partner, Inc. ("CLP, Inc."), CRE Management I Corp., CRE Management II
Corp., CRE Management III Corp., CRE Management IV Corp. and CRE
Management V Corp.
<PAGE> 2
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 2
We have acted as tax counsel in connection with the preparation of the
Prospectus and the Prospectus Supplement. Specifically, you have requested
that we render opinions addressing the following:
1. Whether Crescent Equities qualified as a REIT under sections
856 through 860 of the Internal Revenue Code of 1986, as
amended (the "Code") with respect to its taxable years ending
on or before December 31, 1995, whether Crescent Equities is
organized in conformity the requirements for qualification as
a REIT, whether its manner of operation enabled it to meet the
requirements for qualification as a REIT as of the date of the
Prospectus Supplement, and whether Crescent Equities' proposed
manner of operation, as set forth in the Registration
Statement, will enable it to meet the requirements for
qualification as a REIT in the future;
2. Whether the Residential Development Properties will be treated
for federal income tax purposes as owned by the Residential
Development Corporations;(2)
3. Whether amounts derived by the Operating Partnership with
respect to the stock of the Residential Development
Corporations will be treated as distributions on stock (i.e.,
as dividends, a return of capital, or capital gain, depending
upon the circumstances) for purposes of the 75 percent and 95
percent gross income tests of section 856(c) of the Code;
4. Whether the Residential Development Property Mortgages
constitute debt for federal income tax purposes;(3)
5. Whether contingent interest derived by the Operating
Partnership from the Residential Development Corporations
under the terms of certain of the Residential Development
Property Mortgages will be treated as being based on a fixed
percentage of sales, and therefore all interest derived
therefrom will qualify as interest paid on mortgages on real
property for purposes of the 75 percent and 95 percent gross
income tests of section 856(c) of the Code;
- ----------------------------------
(2) For purposes of this letter, the term "Residential Development
Properties" will be deemed to include any assets of HBCLP, Inc.
("HBCLP"), unless otherwise noted, and the term "Residential
Development Corporations" will be deemed to include HBCLP, unless
otherwise noted.
(3) For purposes of this letter, the term "Residential Development
Property Mortgages" will be deemed to include the $25,000,000
line of credit secured by HBCLP, Inc.'s limited partner interest in
Hudson Bay Partners, L.P. (the "HBCLP Note"), unless otherwise noted.
<PAGE> 3
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 3
6. Whether the leases of the Hotel Properties will be treated as
leases for federal income tax purposes and whether the rent
payable thereunder will qualify as "rents from real property"
for purposes of the 75 percent and 95 percent gross income
tests of section 856(c) of the Code;
7. Whether Crescent Equities will be considered to own any of the
voting securities of the Residential Development Corporations
for purposes of section 856(c)(5)(B) of the Code;
8. Whether the Operating Partnership and each of the Subsidiary
Partnerships will be classified for federal income tax
purposes as partnerships and not as (a) associations taxable
as corporations or (b) publicly traded partnerships; and
9. Whether the material under the heading "Federal Income Tax
Considerations" in the Prospectus Supplement is accurate and
summarizes the material federal income tax considerations to a
prospective holder of Common Stock.
The opinions set forth herein are based upon the existing provisions
of the Code, Treasury Regulations, and the reported interpretations thereof by
the Internal Revenue Service ("IRS") and by the courts in effect as of the date
hereof, all of which are subject to change, both retroactively or
prospectively, and to possibly different interpretations. We assume no
obligation to update the opinions set forth in this letter. We believe that
the conclusions expressed herein, if challenged by the IRS, would be sustained
in court. However, because our opinions are not binding upon the IRS or the
courts, there can be no assurance that contrary positions may not be
successfully asserted by the IRS.
I. Documents and Representations
For the purpose of rendering these opinions, we have examined and
relied on originals, or copies certified or otherwise identified to our
satisfaction, of the following: (1) the First Amended and Restated Articles of
Incorporation of Crescent Real Estate Equities, Inc.; (2) the First Amended and
Restated Agreement of Limited Partnership of Crescent Real Estate Equities
Limited Partnership, as amended (the "Operating Partnership Agreement"); (3)
the First Amended and Restated Agreement of Limited Partnership of Crescent
Real Estate Funding I, L.P. (the "Funding I Agreement"); (4) the First Amended
and Restated Agreement of Limited Partnership of Crescent Real Estate Funding
II, L.P., as amended (the "Funding II Agreement"); (5) the Limited Partnership
Agreement of Waterside Commons Limited Partnership, as amended by the First
Amendment to the Limited Partnership Agreement of Waterside Commons Limited
Partnership, dated August 23, 1995 (the "Waterside Agreement"); (6) the
Articles of Organization
<PAGE> 4
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 4
of G/C Waterside Associates LLC (the "Associates Articles"); (7) the
Regulations of G/C Waterside Associates, LLC (the "Associates Regulations");
(8) the Amended and Restated Agreement of Limited Partnership of Woodlands
Office Equities - '95 Limited (the "Woodlands Partnership Agreement"); (9)
Limited Partnership Agreement of 301 Congress Avenue, L.P. (the "301 Congress
Partnership Agreement"), (10) the Limited Liability Company Agreement of
Crescent/301, L.L.C. (the "Crescent/301 Agreement"), (11) the Registration
Statement, as amended through the date hereof; (12) the Prospectus Supplement;
(13) copies of all existing leases (including amendments) entered into as of
the date hereof with respect to property owned or probably to be acquired by
the Operating Partnership or the Subsidiary Partnerships; (14) copies of the
Residential Development Property Mortgages; (15) the Agreement of Limited
Partnership of Crescent Real Estate Funding III, L.P. (the "Funding III
Agreement"), (16) the Agreement of Limited Partnership of Crescent Real Estate
Funding IV, L.P. (the "Funding IV Agreement"), (17) the Agreement of Limited
Partnership of Crescent Real Estate Funding V, L.P. (the "Funding V
Agreement"), (18) the Amended and Restated Agreement of Limited Partnership of
Spectrum Mortgage Associates, L.P. (the "SMA Agreement") and (19) such other
documents or information as we have deemed necessary for the opinions set forth
below. In our examination, we have assumed the genuineness of all signatures,
the legal capacity of natural persons, the authenticity of all documents
submitted to us as originals, the conformity to original documents of all
documents submitted to us as certified or photostatic copies, and the
authenticity of the originals of such copies.
In addition, these opinions are conditioned upon certain
representations made by Crescent Equities and the Operating Partnership as to
factual and other matters as set forth in the attached letter and in the
discussion of "Federal Income Tax Considerations" in the Prospectus Supplement.
These opinions are also based on the assumptions that (i) the Operating
Partnership will be operated in accordance with the terms and provisions of the
Operating Partnership Agreement, (ii) each of the Subsidiary Partnerships will
be operated in accordance with the terms and provisions of its organizational
documents, (iii) Crescent Equities will be operated in accordance with the
terms and provisions of its First Amended and Restated Articles of
Incorporation, and (iv) the various elections, procedural steps, and other
actions by Crescent Equities or the Operating Partnership described in the
discussion of "Federal Income Tax Considerations" in the Prospectus Supplement
will be completed in a timely fashion or otherwise carried out as so described.
Unless facts material to the opinions expressed herein are
specifically stated to have been independently established or verified by us,
we have relied as to such facts solely upon the representations made by
Crescent Equities and the Operating Partnership. We are not, however, aware of
any facts or circumstances contrary to or inconsistent with the
representations. To the extent the representations are with respect to matters
set forth in the Code or Treasury
<PAGE> 5
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 5
Regulations, we have reviewed with the individuals making such representations
the relevant provisions of the Code, the Treasury Regulations and published
administrative interpretations.
II. Opinions
1. Qualification of Crescent Real Estate Equities, Inc. as a REIT
Based on the foregoing, it is our opinion that (i) Crescent Equities
qualified as a REIT under sections 856 through 860 of the Code with respect to
its taxable years ending on or before December 31, 1995, (ii) Crescent Equities
is organized in conformity with the requirements for qualification as a REIT
and its manner of operation has enabled it to meet the requirements for
qualification as a REIT as of the date of the Prospectus Supplement, and (iii)
Crescent Equities' proposed manner of operation will enable it to meet the
requirements for qualification as a REIT in the future.
2. Ownership of the Residential Development Properties and Treatment
of Amounts Derived by the Operating Partnership with Respect to the Stock of
the Residential Development Corporations
If the Residential Development Corporations are not respected for tax
purposes, then the Operating Partnership would be treated for tax purposes as
directly owning certain of the Residential Development Properties. In such a
case, the income from the sales of the Residential Development Properties
treated as directly owned by the Operating Partnership would not qualify under
the 75 percent and 95 percent gross income tests and would count as gain from
the sale of assets for purposes of the 30 percent of gross income limitation.
In addition, such income would be considered "net income from prohibited
transactions" and thus would be subject to a 100 percent tax. Moreover, to the
extent that the Operating Partnership would be treated as directly owning
HBCLP's limited partner interest in Hudson Bay Partners, L.P. ("HB Partners"),
the Operating Partnership would be treated as owning any securities held by HB
Partners, and such deemed ownership could cause Crescent Equities to be treated
as owning more than 10 percent of the voting securities of one or more issuers
in violation of section 856(c)(5)(B). However, as a general rule,
corporations, as long as they have a business purpose or carry on any business
activity, are not disregarded for federal income tax purposes. Moline
Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943).
The Residential Development Corporations are not mere formalities
created for tax purposes. Crescent Equities and the Operating Partnership have
represented that each of the Residential Development Companies will have their
own employees (except HBCLP, which will have no employees), will act
independently in owning, developing, and selling the Residential
<PAGE> 6
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 6
Development Properties, and will not act as agents of the Operating Partnership
or Crescent Equities. Moreover, Mira Vista Development Corporation ("MVDC")
and Houston Area Development Corporation ("HADC") should shield the Operating
Partnership against any liabilities generated by their respective property
development businesses, while Crescent Development Management Corporation
("CDMC") and HBCLP should shield the Operating Partnership from any liabilities
generated by any future business conducted directly by CDMC and HBCLP,
respectively.
Therefore, it is our opinion that for federal income tax purposes the
Operating Partnership will not be treated as owning the Residential Development
Properties held directly by the Residential Development Corporations and,
consequently, all amounts derived by the Operating Partnership with respect to
the stock of the Residential Development Corporations will be characterized as
distributions on stock (i.e., as dividends, a return of capital, or capital
gain, depending on the circumstances) for purposes of the 75 percent and 95
percent gross income tests.
3. Characterization of the Residential Development Property Mortgages
as Debt and Treatment of Amounts Paid Pursuant to Residential Development
Property Mortgages
a. Characterization as Debt. Debt instruments, especially
instruments that are held by persons related to the debtor, may under certain
circumstances be characterized for income tax purposes as equity, rather than
as debt. The characterization of an instrument as debt or equity is a question
of fact to be determined from all surrounding facts and circumstances, no one
of which is conclusive. See Kingbay v. Commissioner, 46 T.C. 147 (1966);
Hambuechen v. Commissioner, 43 T.C. 90 (1964). Among the criteria that have
been found relevant in characterizing such instruments are: (1) the intent of
the parties, (2) the extent of participation in management by the holder of the
instrument, (3) the ability of the corporation to obtain funds from outside
sources, (4) the "thinness" of the capital structure in relation to debt, (5)
the risk involved, (6) the formal indicia of the arrangement, (7) the relative
position of the obligees as to other creditors regarding payment of interest
and principal, (8) the voting power of the holder of the instrument, (9) the
provision of a fixed rate of interest, (10) the contingency of the obligation
to repay, (11) the source of the interest payments, (12) the presence or
absence of a fixed maturity date, (13) a provision for redemption by the
corporation, (14) a provision for redemption at the option of the holder, and
(15) the timing of the advance with reference to the organization of the
corporation. Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968).
Although the Residential Development Property Mortgages are held by
the Operating Partnership, which owns all of the nonvoting stock of the
Residential Development Corporations, and an approximately 39 percent indirect
equity interest in Whitehawk Development Group, LLC,
<PAGE> 7
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 7
these mortgages possess a number of attributes weighing in favor of debt
treatment. For instance, each of the Residential Development Property
Mortgages is clearly denominated as debt, has a fixed term of seven or more
years (except the HBCLP Note which has a term of five years), provides for the
return of a fixed principal amount plus interest, and is secured by the
Residential Development Properties (or in the case of the CDMC Mortgage,
secured by an interest in a limited partnership which holds indirect interests
in several Residential Development Properties, or in the case of the HBCLP
Note, secured by HBCLP's interest in HB Partners). The interest on the
Residential Development Property Mortgages accrues at either a fixed rate or,
in the case of the Whitehawk Note, at the prime rate plus one percent per annum
(not including any additional interest based on gross sales proceeds). In
addition, the Residential Development Property Mortgages are not subordinated
to other indebtedness of the Residential Development Corporations. Crescent
Equities and the Operating Partnership have represented that at the time that
each of the Residential Development Property Mortgages were acquired by the
Operating Partnership, the outstanding principal amount of such mortgages did
not exceed 80 percent of the fair market value of the Residential Development
Properties (or in the case of the HBCLP Note, Crescent Equities and the
Operating Partnership have represented that at the time the HBCLP Note was
acquired by the Operating Partnership the maximum amount that could be drawn
under the line of credit under such note did not exceed 50 percent of the fair
market value of HBCLP's interest in HB Partners) and that the interest to be
charged, including any contingent interest, represents a commercially
reasonable rate of interest. In addition, based on our experience and an
examination of the Residential Development Property Mortgages, the interest
appears to represent a commercially reasonable rate of interest.
Based on the foregoing, it is our opinion that each of the Residential
Development Property Mortgages constitutes debt for federal income tax
purposes.
b. Treatment of Amounts Paid Pursuant to Residential
Development Property Mortgages. Section 856(f) of the Code defines "interest"
for the purposes of section 856(c)'s gross income tests to include contingent
interest that is based on a fixed percentage of any person's receipts or sales.
On the other hand, contingent interest provisions that are based on a specified
portion of the gain realized on the sale of the real property securing a
mortgage (or any gain which would be realized if such property were sold on a
specified date) may be characterized as "shared appreciation provisions" under
section 856(j) of the Code. If the properties underlying such a provision are
primarily held for sale to customers in the ordinary course, any income derived
from such a provision would be treated as income from prohibited transactions.
Such income would not satisfy the 75 percent and 95 percent gross income tests
and would be subject to a 100 percent tax on "net income from prohibited
transactions."
<PAGE> 8
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 8
Any contingent interest payable under the terms of the mortgage in the
principal amount of $14.4 million secured by the Mira Vista Residential
Development Property (the "Mira Vista Mortgage") will qualify as interest on an
obligation secured by a mortgage on real property, rather than income derived
from a shared appreciation provision, because such contingent interest will be
based on a percentage of the gross receipts derived from any sale of portions
of the Mira Vista Residential Development Property, as opposed to a portion of
the gain realized on such sales. Similarly, any contingent interest payable
under the terms of the mortgages in the aggregate principal amount of $14.4
million secured by the Falcon Point Residential Development Property and the
Spring Lakes Residential Development Property (the "Houston Area Mortgages")
will qualify as interest on obligations secured by mortgages on real property,
rather than income derived from shared appreciation provisions, because such
contingent interest will be based on a percentage of the gross receipts derived
from any sale of portions of the Falcon Point and the Spring Lakes Residential
Development Properties, as opposed to a portion of the gain realized on such
sales.
The fact that the contingent interest provided for by the Mira Vista
Mortgage and the Houston Area Mortgages is based on gross receipts, rather than
gain, could have economic significance with respect to the return received by a
holder of such mortgages. For example, if the value of the Falcon Point
Residential Development Property were to increase, but few lots were sold, the
Operating Partnership, as holder of the Houston Area Mortgages would not accrue
any contingent interest. On the other hand, the Operating Partnership would
accrue contingent interest if numerous lot sales were made at the Falcon Point
Residential Development Property, even if such sales were made at a loss.
Based on the foregoing, it is our opinion that any contingent interest
derived from the Mira Vista Mortgage and the Houston Area Mortgages will be
treated as being based on a fixed percentage of sales and therefore such
interest will constitute interest received from real estate mortgages for
purposes of the 75 percent and 95 percent gross income tests, and that,
consequently, all amounts derived by the Operating Partnership from the
Residential Development Corporations under the terms of the Residential
Development Property Mortgages (other than the HBCLP Note) will be
characterized as interest or principal, as the case may be, paid on mortgages
on real property for purposes of the 75 percent and 95 percent gross income
tests. It is our opinion that all amounts derived by the Operating Partnership
from the HBCLP Note will be characterized as interest or principal, as the case
may be for purposes of the 95 percent gross income test.
<PAGE> 9
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 9
4. Characterization of the Leases of the Hotel Properties and the
Treatment of Amounts Paid Pursuant To Such Leases as "Rents From Real Property"
On January 3, 1995, we provided the Operating Partnership with a
memorandum (a copy of which is attached hereto) in which we expressed our
opinion that, based on certain assumptions, that the lease of the Hyatt Regency
Beaver Creek would be treated as a lease for federal income tax purposes and
that the rent payable thereunder would qualify as "rents from real property."
On April 1, 1996, we provided the Operating Partnership with a letter (a copy
of which is attached hereto) in which we updated the facts relating to the
lease of the Hyatt Regency Beaver Creek as expressed in our January 3, 1995
memorandum and affirmed the opinions expressed in that memorandum.
On June 30, 1995, we provided the Operating Partnership with a
memorandum (a copy of which is attached hereto) in which we expressed our
opinion that, based on certain assumptions, that the lease of the Denver
Marriott City Center would be treated as a lease for federal income tax
purposes and that the rent payable thereunder would qualify as "rents from real
property." On September 27, 1996, we provided the Operating Partnership with a
letter (a copy of which is attached hereto) in which we affirmed the opinions
expressed in our June 30, 1995 memorandum.
On December 19, 1995, we provided the Operating Partnership with a
memorandum (a copy of which is attached hereto) in which we expressed our
opinion that, based on certain assumptions, that the lease of the Hyatt Regency
Albuquerque Plaza would be treated as a lease for federal income tax purposes
and that the rent payable thereunder would qualify as "rents from real
property." On April 1, 1996, we provided the Operating Partnership with a
letter (a copy of which is attached hereto) in which we updated the facts
relating to the lease of the Hyatt Regency Albuquerque Plaza as expressed in
our December 19, 1995 memorandum and affirmed the opinions expressed in that
memorandum.
On July 26, 1996, we provided the Operating Partnership with a
memorandum (a copy of which is attached hereto) in which we expressed our
opinion that, based on certain assumptions, that the lease of the Canyon Ranch
resort would be treated as a lease for federal income tax purposes and that the
rent payable thereunder would qualify as "rents from real property."
We hereby affirm the opinions expressed in our January 3, 1995, June
30, 1995, December 19, 1995 and July 26, 1996 memoranda, as updated by our
letters dated April 1, 1996 and September 27, 1996, and authorize you to rely
upon those opinions in connection with the preparation of the Registration
Statement.
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Crescent Real Estate Equities, Inc.
October 3, 1996
Page 10
5. Ownership of Residential Development Company Voting Stock
Section 856(c)(5) restricts the types of assets that can be held by an
entity seeking to qualify as a REIT. Specifically, section 856(c)(5)(B)
provides that at the close of each quarter of the taxable year, a REIT must
hold no more than 10 percent of the outstanding voting securities of any one
issuer.
The term "voting securities" as used in section 856(c)(5)(B) is not
defined in the Code. However, section 856(c)(6)(F) provides that terms not
defined in sections 856 through 859 shall have the same meaning as when used in
the Investment Company Act of 1940, as amended (the "ICA"). The ICA defines
"voting security" as "any security presently entitling the owner or holder
thereof to vote for the election of directors of a company."(4)
The Internal Revenue Service (the "Service") has not issued any
revenue rulings discussing what constitutes "voting securities" for purposes of
section 856(c)(5)(B). However, the Service has issued one revenue ruling
discussing what constitutes "voting securities" for the purposes of section
851(b), which provides rules for qualification as a regulated investment
company (a "RIC"). (The RIC qualification provisions, like section
856(c)(5)(B), incorporate the definition of "voting securities" found in the
ICA.(5)) In Rev. Rul. 66-339,(6) the Service held that a shareholders' voting
agreement was not a voting security for purposes of section 851(b)(4). The
taxpayer in the ruling was a small business investment company which had made a
loan to a corporation. Under the terms of the loan agreement, a shareholders'
agreement was executed, which required the election of one director designated
by the taxpayer during the term of the loan and, thereafter, as long as the
taxpayer owned or had the right to acquire at least 10 percent of the
outstanding stock of the corporation. The Service held that the shareholders'
agreement was not a voting security because the enforceability the taxpayer's
rights under the agreement depended upon the taxpayer's status as a party to
the agreement, rather than as a shareholder.
However, the Service has not been entirely comfortable with Rev. Rul.
66-339. In G.C.M. 36823,(7) which dealt with the definition of "voting
securities" for purposes of the REIT provisions, the Service recommended that
Rev. Rul. 66-339 be modified to reflect the interpretation of the term "voting
security" as expressed in an opinion of the chief counsel of the
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(4) ICA Section 2(a)(42).
(5) Section 851(c)(5).
(6) 1966-2 C.B. 274.
(7) 1976 IRS GCM Lexis 114 (Aug. 24, 1976).
<PAGE> 11
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 11
Securities and Exchange Commission ("SEC"). This opinion held that "unless
there are compelling considerations to the contrary in a particular case, the
definition of 'voting security' in the ICA should generally be interpreted to
include not only the formal legal right to vote for the election of directors
pursuant to the provisions of the law of the state of incorporation and the
corporation's charter and by-laws but also the de facto power, based on all the
surrounding facts and circumstances, to determine, or influence the
determination of, the identity of a corporation's directors."(8) Despite this
recommendation of G.C.M. 36823, however, Rev. Rul. 66-339 has never been
modified and would therefore continue to constitute good authority.
Since the issuance of G.C.M. 36823, the Service has issued several
private rulings in which it has not treated a REIT as owning "voting
securities" of other corporations for purposes of section 856(c)(5)(B), despite
the fact that such securities were actually owned either by officers or
shareholders of the REIT.(9) In each of these rulings, the REIT either
directly or indirectly held substantial amounts of the other corporation's
nonvoting stock. None of these rulings makes any mention of either Rev. Rul.
66-339 or the de facto voting power issue raised by the Service in G.C.M.
36823.
Although private rulings like those mentioned above were issued by the
Service until June 8, 1994, the Service subsequently announced that, for the
indefinite future, it would no longer issue private letter rulings with regard
to fact situations involving corporations whose voting stock is held by
relatives of principal REIT shareholders and/or REIT employees. The Service
has not provided an explanation for this "no ruling" policy. Nonetheless, it
could indicate that the Service is reconsidering its position on the treatment
of fact situations similar to those involving Crescent Equities and the
Residential Development Corporations.
Crescent Equities does not directly or indirectly own any of the
voting stock of any of the Residential Development Corporations. In the case
of MVDC, the voting stock is owned by James Bartlett, Nick Hackstock, Tom
Nezworski, John C. Goff and Gerald W. Haddock (together, the "MVDC Voting
Shareholders"). In the case of HADC, the voting stock is owned by Sam Yager,
John C. Goff and Gerald W. Haddock (together, the "HADC Voting Shareholders").
In the case of CDMC, the voting stock is owned by Harry Frampton, John C. Goff
and Gerald W. Haddock (together, the "CDMC Voting Shareholders"). In the case
of HBCLP, such stock is owned by K-Holdings Co. and David Lesser (together, the
"HBCLP Voting Shareholders" and together with the MVDC Voting Shareholders, the
HADC Voting Shareholders and the CDMC Voting Shareholders, the "Voting
Shareholders"). Moreover, the
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(8) Id.
(9) P.L.R. 8825112 (Mar. 30, 1988); P.L.R. 9340056 (July 13, 1993); P.L.R.
9428033 (April 20, 1994); P.L.R. 9436025 (June 8, 1994).
<PAGE> 12
Crescent Real Estate Equities, Inc.
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Page 12
voting stock of the Residential Development Corporations owned by the Voting
Shareholders is registered in the names of such Voting Shareholders, and all
dividends accruing on stock are delivered to the addresses of such Voting
Shareholders. Therefore, unless Crescent Equities is deemed to own some of the
shares of voting stock of the Residential Development Corporations actually
held by the Voting Shareholders, it will not own more than 10 percent of the
voting securities of any of the Residential Development Corporations in
violation of section 856(c)(5)(B).
The Service could argue that the ownership of some or all of the
voting stock actually held by the Voting Shareholders should be attributed to
Crescent Equities under two possible theories: (1) a "nominee" or "de facto
ownership" theory or (2) a constructive ownership theory. However, there is no
authority indicating that the Service could successfully assert either of these
theories in a fact situation similar to that involving Crescent Equities and
the Residential Development Corporations. Therefore, it is our opinion that
Crescent Equities will not be deemed to be the owner of the voting stock of the
Residential Development Corporations held by the Voting Shareholders for
purposes of section 856(c)(5)(B). In connection with this opinion we note that
both John C. Goff and Gerald W. Haddock are presently officers and directors of
Crescent Equities and officers of some of Crescent Equities' subsidiaries,
while David H. Lesser was an employee of Crescent Equities prior to his
acquiring voting stock in HBCLP.
a. "Nominee" or "De Facto Ownership" Theory. Under a
"nominee" or "de facto ownership" theory, the Service could attribute ownership
of the Residential Development Company voting stock from the Voting
Shareholders to Crescent Equities for tax purposes, based on the "effective
control" that Crescent Equities exercises over the Voting Shareholders.
However, the Service has only applied a "nominee" or "de facto ownership"
theory in situations where there was a written or oral agreement transferring
"effective control" of the stock away from the record owner. No such agreement
exists between Crescent Equities and the Voting Shareholders.
For example, in G.C.M. 36823, discussed above, the Service based its
determination that a taxpayer was the "true owner" of another corporation's
voting stock for purposes of section 856(c)(5)(B) on the fact that the actual
owner of such stock had executed a written agreement giving the taxpayer a
proxy to vote the stock in a number of key situations. Under the agreement,
the taxpayer was given a proxy to vote all of the borrower's voting stock in
the event the borrower proposed (1) a merger or reorganization, (2) a
liquidation and dissolution, (3) any substantial change in business, (4) a sale
or disposition of all or substantially all of its assets, (5) any amendment to
the certificate of incorporation, (6) the organization of any significant
subsidiary, or (7) any substantial investment in any other corporation,
partnership, or joint venture. However, the proxy did not give the taxpayer
the right to vote for the borrower's
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Page 13
directors. Nonetheless, the Service concluded that the taxpayer should be
deemed to own the borrower's voting stock for purposes of section 856(c)(5)(B),
because the agreement with the actual owner of the borrower's voting stock
provided the taxpayer "with the type of control over directors' decisions that
is usually reserved to those having the power to elect directors, that is, the
owners of voting stock."(10)
In contrast, the Service has never attributed ownership of voting
securities to a taxpayer for purposes of section 856(c)(5)(B) in situations
where there was no agreement between the taxpayer and the actual owners of the
securities regarding how such securities were to be voted. For example, in a
series of private letter rulings issued after the issuance of G.C.M. 36823, the
Service ignored the "effective control" that taxpayers might exercise over
voting stock in situations where such stock was held by the taxpayer's officers
and shareholders.(11)
Similarly, outside the context of section 856(c)(5)(B), the Service
has treated the actual owners of corporate stock as mere nominees only in
situations where there was a written or oral agreement that provided another
party with effective control over such stock. For example, in Rev. Rul.
84-79,(12) the Service found that the grantor and sole beneficiary of a
revocable voting trust "directly" owned stock for purposes of section 1504(a),
despite the fact that it had transferred the stock to the voting trust. The
Service reached this conclusion because the voting trust agreement effectively
allowed the grantor to retain control over the stock, permitting it to revoke
the trust or replace the trustee without cause at any time.(13) In contrast,
the Service has not found that corporations retained effective control of stock
for purposes of section 1504(a)(4) in situations where they transferred such
stock to their shareholders, in the absence of a voting trust agreement.(14)
The Service has also refused to treat purchasers of corporate stock as
mere nominees when applying the "solely for voting stock" requirement for
section 368(a)(1)(B) reorganizations. For example, in Rev. Rul. 68-562,(15)
the Service found that an acquisition of all the stock of one corporation ("Y")
by another corporation ("X"), in exchange for X corporation voting stock
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(10) G.C.M. 36823; 1976 IRS GCM Lexis 114.
(11) See footnote 7 supra.
(12) 1984-1 C.B., 190.
(13) See also, Rev. Rul. 70-469, 1970-2 C.B. 179; Miami National Bank v.
Commissioner, 67 T.C. 793 (1977).
(14) See, e.g., T.A.M. 9206005 (Oct. 24, 1991); T.A.M. 9137003 (May 20,
1991).
(15) 1968-2 C.B. 157.
<PAGE> 14
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 14
qualified as a section 368(a)(1)(B) reorganization. The Service reached this
conclusion despite the fact that an individual who owned 90 percent of X's
voting stock had purchased 50 percent of Y's stock for cash two months before
the such acquisition. The Service did not attribute this purchase of Y stock
to X, because the actual purchaser, even though he was X's principal
shareholder, was under no obligation to surrender such stock to X.(16) In
contrast, the Service has attributed third-party purchases of corporate stock
to the acquiring party in a 368(a)(1)(B) reorganization in situations where a
third-party purchaser had previously agreed to transfer the purchased stock to
the acquiring party.(17)
Moreover, under the three-factor test for nominee status set forth by
the Supreme Court in Commissioner v. Bollinger, none of the Voting Shareholders
qualifies as a nominee of Crescent with respect to the Residential Development
Corporation voting stock.(18) Bollinger involved partnerships that developed
apartment complexes in Kentucky. In order to avoid Kentucky's usury laws,
which limited the annual interest rate for noncorporate borrowers, the
partnerships entered into agreements with a corporation wholly owned by an
individual that was a partner in each of the partnerships. Pursuant to the
agreements, the corporation was to hold title to the apartment complexes as the
partnerships' nominee and agent solely to secure financing. The agreements
also provided that the partnerships were to have sole control of and
responsibility for the complexes, and the partnerships were to be the principal
and owner of the property during financing, construction, and operation. All
parties who had contact with the complexes, if they were aware of the
corporation at all, regarded the partnerships as the owners and knew the
corporation was merely the partnerships' agent. Income and losses from the
complexes were reported on the partnerships' tax returns, and the partners each
reported their distributive share of such income and losses on their individual
returns. The Service challenged the inclusion of the complexes' losses on the
partners' individual returns on the ground that the losses were attributable to
the corporation as the record owner of the complexes. The Service argued that
in order for the partners to demonstrate that the corporation was acting merely
as an agent or nominee, they must give evidence of arms-length dealing between
the partnerships and the corporation and the payment of an agency fee.
However, the Supreme Court held that only three factors needed to be present to
assure the genuineness of an agency relationship: (1) the corporation must
execute a written agreement at the time the asset is acquired setting forth the
corporation's agency with respect to the asset, (2) the corporation must
function as an agent and
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(16) Id. See also, Rev. Rul. 72-354, 1972-2 C.B. 216 (Acquiring
corporation satisfied "solely for voting stock" requirement for
a section 368(a)(1)(B) reorganization when it sold stock in the target
corporation that it had recently purchased for cash to a third party
with no commitment on the part of the third party to surrender such
stock in subsequent reorganization).
(17) See, e.g., G.C.M. 36041, 1974 IRS GCM Lexis 73.
(18) 485 U.S. 340 (1988).
<PAGE> 15
Crescent Real Estate Equities, Inc.
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Page 15
not as a principal with respect to the asset for all purposes, and (3) the
corporation must be held out to be an agent and not a principal in all dealings
with third parties relating to the asset.(19)
Although Bollinger expressly dealt with situations where corporations
were acting as nominees for their shareholders, its three-factor test appears
to be relevant in determining the genuineness of all purported agency
relationships for federal income tax purposes. Therefore, if the Service were
to assert that the Voting Shareholders are holding the voting stock of the
Residential Development Corporations as mere nominees of Crescent Equities,
Bollinger's three-factor test should apply in evaluating the relationship
between Crescent Equities and the Voting Shareholders.
When Bollinger's three-factor test is applied to Crescent Equities'
relationship to the Voting Shareholders, it becomes apparent that the Voting
Shareholders are not acting as Crescent Equities' nominees with respect to
their ownership of the voting stock of the Residential Development
Corporations. First, in contrast to the situation in Bollinger, where there
was a written agreement between the corporation and the partnerships setting
forth the corporation's rights and duties as agent, here there is and will be
no written (or oral) agreement between Crescent and the Voting Shareholders
regarding the Voting Shareholders' rights and duties with respect to the voting
stock of the Residential Development Corporations. Crescent Equities has no
control over the ability of the Voting Shareholders to alienate the voting
stock and vote such stock as they choose. Second, unlike the situation in
Bollinger, where the corporation functioned as an agent rather than a principal
with respect to the apartment complexes, here the Voting Shareholders function
as principals with respect to the voting stock. As noted above, the Voting
Shareholders make their own decisions about alienating the voting stock and how
to exercise their voting power, and they are independently obligated to make
their shares of any additional capital contributions. Third, unlike the
situation in Bollinger, where the corporation was clearly held out to all third
parties as a mere agent of the partnerships, here the Voting Shareholders have
been and will be held out to third parties as the true owners of the voting
stock in all respects. For example, the voting stock is registered in the name
of the Voting Shareholders, and all corporate notices and dividends (if any)
are delivered to the addresses of the Voting Shareholders.
b. Constructive Ownership Theory. Under a "constructive
ownership theory," the Service could attempt to attribute ownership of the
voting stock of the Residential Development Corporations from the Voting
Shareholders to Crescent Equities for purposes of applying section
856(c)(5)(B). However, the absence of any relevant constructive ownership
provision should defeat such a position.
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(19) Id.
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Although the Code contains several constructive ownership
provisions,(20) section 318(a) is the only one that could possibly operate to
attribute ownership of the voting stock of the Residential Development
Corporations from the Voting Shareholders to Crescent. This is because section
318(a) is the only constructive ownership provision that provides for
attribution of stock ownership to corporations. All of the other constructive
ownership provisions provide only for attribution of stock ownership away from
corporations.
The Service should not be successful in attributing ownership of the
voting stock of the Residential Development Corporations to Crescent Equities
under section 318(a), because that section applies only to other Code sections
that expressly provide for its application. There is no indication anywhere in
the Code or Treasury regulations that taxpayers are to apply the constructive
ownership rules of section 318(a) in determining ownership of voting securities
for purposes of section 856(c)(5)(B).
Furthermore, the Service and the courts have rejected all attempts to
apply section 318(a) to Code sections other than those to which it is expressly
made applicable. Thus, for example, in Brams v. Commissioner,(21) the Sixth
Circuit affirmed a decision of the Tax Court holding that a transfer of
property by a taxpayer to a corporation did not qualify for nonrecognition
treatment under section 351. Section 351 offers nonrecognition treatment to
persons who transfer property to corporations in exchange for stock, only if
such persons are in control of the corporation immediately after the exchange.
Section 368(c) defines "control" for this purpose as ownership of 80 percent of
the total combined voting power of all classes of stock entitled to vote and at
least 80 percent of the total number of shares of all other classes of stock.
In Brams, the Sixth Circuit determined that the taxpayer directly owned only
31.6 percent of the outstanding stock of the corporation immediately after the
transaction, and it refused to apply section 318(a) to attribute to the
taxpayer the ownership of an additional 52.6 percent of the outstanding stock
of the corporation held by the taxpayer's sons.(22)
Similarly, the Service has refused to apply any attribution rules in
interpreting "control" for the purposes of interpreting the reorganization
provisions of section 368. For example, in Rev. Rul. 56-613, the Service did
not treat a corporation as satisfying the control requirement of section
368(a)(1)(B) of the Code when it acquired 100 percent of one class of shares of
a target
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(20) See, e.g., Sections 267(c), 318(a), 544(a), 554(a) and 1563(e).
(21) 734 F.2d 290 (6 Cir. 1984).
(22) Id. See also Yamamoto v. Commissioner, 51 T.C.M. 1560 (1986) (Section
351 does not apply to a transfer where the taxpayer owned part
of the transferee's stock directly and owned 100% of the stock of
a second corporation which owned the balance of the transferee
corporation's stock).
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Crescent Real Estate Equities, Inc.
October 3, 1996
Page 17
corporation, despite the fact that all the other shares of the target
corporation were owned by the acquiring corporation's wholly owned
subsidiary.(23)
Moreover, even if section 318(a) of the Code were applicable to the
determination of ownership of voting securities for purposes of section
856(c)(5)(B), it would not operate to attribute ownership of the voting stock
of the Residential Development Corporations from the Voting Shareholders to
Crescent Equities. Section 318(a)(3)(C) provides that stock ownership is to be
attributed from a shareholder to a corporation only if the shareholder owns,
directly or indirectly, 50 percent or more of the value of the stock of such
corporation. Crescent Equities' charter currently contains limitations on
stock ownership that will prevent any shareholder, other than Richard E.
Rainwater, from owning, actually or constructively, more than 8.0 percent of
the value of Crescent Equities common stock. Crescent Equities' charter also
prevents Richard E. Rainwater from owning, actually or constructively, more
than 17.9 percent of the value of Crescent Equities' common stock. Therefore,
unless these ownership limitations are waived, no person can possibly own,
actually or constructively, the 50 percent of the value Crescent Equities'
common stock required for the application of section 318(a)(3)(C).
Consequently, it is our opinion that Crescent Equities will not be treated for
federal income tax purposes as owning any of the voting stock of any of the
Residential Development Corporations.
6. Characterization of the Operating Partnership for U.S. Federal
Income Tax Purposes
a. In General. Section 301.7701-2(a) of the Treasury
Regulations provides that an entity which has associates and an objective to
carry on a business for joint profit will be treated as a partnership, and not
as an association taxable as a corporation, if it has not more than two of the
following four characteristics of a corporation: (i) continuity of life; (ii)
centralization of management; (iii) limited liability; and (iv) free
transferability of interests. The entity must also have no other
characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics. See Rev. Rul. 79-106, 1979-1 C.B. 448.
The IRS has issued Rev. Proc. 89-12, 1989-1 C.B. 798, which specifies
the conditions which must be satisfied for an entity to receive a favorable
advanced ruling that it will be classified as a partnership for federal income
tax purposes. The Operating Partnership may not meet all of the requirements
necessary to obtain such a ruling. However, such requirements are applicable
only in determining whether rulings will be issued and are not intended as
substantive rules for the determination of partnership status.
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(23) Rev. Rul. 56-613, 1956-2 C.B. 212. See also Berghash v. Commissioner,
43 T.C. 743 (1965), aff'd, 361 F.2d 257 (2d Cir. 1966) (the
option attribution rules of section 318(a) do not apply in determining
whether the control requirement of section 368(a)(1)(D) is satisfied);
Rev. Rul. 76-36, 1976-1 C.B. 105 (section 318(a) has no application in
determining "changes in ownership" under pre-1987 section 382).
<PAGE> 18
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Page 18
b. Limited Liability. Under section 301.7701-2(d) of the
Treasury Regulations, an entity lacks the corporate characteristic of limited
liability if there is at least one member who is personally liable for the
debts of or claims against the partnership. In the case of a limited
partnership, a general partner of a limited partnership is personally liable
under the Treasury Regulations if (i) it has substantial assets other than its
interest in the partnership or (ii) it is not a dummy acting as the agent of
the limited partners. As general partner of the Operating Partnership,
Crescent Real Estate Equities, Ltd. ("CREE") is personally liable for all the
debts and obligations of the Operating Partnership and owns a general
partnership interest therein of approximately one percent. However, section
856(i) of the Code provides that qualified REIT subsidiaries are treated as the
same entity as their REIT parent for federal income tax purposes. Therefore,
Crescent Equities will be treated as directly owning CREE's one percent general
partnership interest in the Operating Partnership. Crescent Equities will
also be treated as directly owning a 82 percent limited partnership interest in
the Operating Partnership through its interest in CRE Limited Partner, Inc.
("CLP, Inc."). Furthermore, Crescent Equities and the Operating Partnership
have represented that CREE will act independently of the Operating
Partnership's limited partners other than CLP, Inc. Therefore, the Operating
Partnership may lack the corporate characteristic of limited liability.
c. Continuity of Life. Section 301.7701-2(b) of the Treasury
Regulations provides that if the bankruptcy, retirement, resignation,
expulsion, or other event of withdrawal of a general partner of a limited
partnership causes a dissolution of the partnership, continuity of life does
not exist, even if dissolution may be avoided by the remaining general partners
or by at least a majority in interest of all remaining partners agreeing to
continue the partnership. Under Section 13.1.B of the Operating Partnership
Agreement, the withdrawal of CREE. and the bankruptcy of Crescent Equities
cause the Operating Partnership to terminate, unless a majority in interest of
the remaining partners consent to continue the Partnership and appoint a new
general partner. Accordingly, the Operating Partnership will lack the
corporate characteristic of continuity of life.
d. Centralization of Management. Section 301.7701-2(c)(4) of
the Treasury Regulations provides that centralization of management ordinarily
will be found to exist in a limited partnership in which substantially all of
the partnership interests are held by the limited partners, and that it may
exist where the limited partners have a substantially unrestricted right to
remove the general partner. As noted above, under section 856(i) of the Code,
Crescent Equities will be treated as owning a one percent general partner
interest and an approximately 80 percent limited partnership interest in the
Operating Partnership. Furthermore, Section 7.1.A of the Operating Partnership
Agreement provides that the limited partners may not remove CREE as general
partner. Therefore, the Operating Partnership will lack the corporate
characteristic of centralization of management.
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Crescent Real Estate Equities, Inc.
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Page 19
e. Free Transferability of Interests. Section 301.7701-2(e)
of the Treasury Regulations provides that free transferability of interests
exists if the members owning all or substantially all of the interests in an
organization may substitute for themselves without the consent of the other
members a person who is not a member of the organization. Section 11.4.A of
the Operating Partnership Agreement provides that if a limited partner other
than CLP, Inc. transfers its interest in the Operating Partnership, the
transferee (unless it falls within certain enumerated categories of
transferees) will not become a substituted limited partner without the prior
consent of CREE. Accordingly, the Operating Partnership may lack the corporate
characteristic of free transferability of interests.
f. Summary. In sum, the Operating Partnership lacks
continuity of life and centralization of management and may lack limited
liability and free transferability. Based on the foregoing, it is our opinion
that the Operating Partnership will be treated as a partnership as defined in
sections 7701(a)(2) and 761(a) of the Code and not as an association taxable as
a corporation.
g. Publicly Traded Partnerships. Section 7704 of the Code
provides that certain publicly traded partnerships may be taxed as regular
corporations even though they otherwise meet all of the relevant tests for
treatment as a partnership for federal income tax purposes. A partnership is
considered to be a publicly traded partnership if interests in the partnership
are (or become) (i) traded on an established securities market or (ii) readily
tradable on a secondary market or the substantial equivalent thereof. In
Notice 88-75, 1988-2 C.B. 386, the IRS provided guidance as to the meaning of
"readily tradable on a secondary market or the substantial equivalent thereof."
Notice 88-75 states that interests in a partnership issued in a private
placement will not be treated as readily tradable on a secondary market or the
substantial equivalent thereof if all interests in the partnership were issued
in a transaction that was not registered under the Securities Act of 1933 and
either (i) the partnership does not have more than 500 partners or (ii)
interests in the partnership may not be sold in units whose initial offering
price would not have been at least $20,000.
On December 4, 1995, final regulations under section 7704(b) were
published in the Federal Register that modify the exclusion set forth in Notice
88-75 for partnership interests issued in a private placement. The relevant
modifications are as follows. First, under section 1.7704-1(h)(1)(ii) of the
Treasury Regulations, the exclusion will not apply if a partnership has more
than 100 partners at any time during the taxable year. Second, under section
1.7704-1(h)(3) of the Treasury Regulations, for purposes of determining whether
a partnership satisfies the 100 partner requirement, persons owning interests
in the partnership (the "lower-tier partnership") through another partnership,
an S corporation or a grantor trust (a "flow-through entity") will be treated
as partners in the lower-tier partnership if (i) substantially all the value of
the flow-through
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Crescent Real Estate Equities, Inc.
October 3, 1996
Page 20
entity is attributable to the lower-tier partnership, and (ii) a principal
purpose for the tiered arrangement is to permit the partnership to satisfy the
100 partner requirement. For partnerships that were actively engaging in an
activity before December 4, 1995 the final regulations will be effective for
taxable years beginning after December 31, 2005 (or such earlier date when the
partnership adds a substantial new line of business). Until such date, the
provisions of Notice 88-75 will continue to apply.
Based upon the structure and capitalization of the Operating
Partnership, representations of the Operating Partnership regarding its current
ownership, and Section 11.4.A of the Operating Partnership Agreement which
provides that if a limited partner other than CLP, Inc. transfers its interest
in the Operating Partnership, the transferee (unless it falls within certain
enumerated categories of transferees) will not become a substituted limited
partner without the prior consent of CREE, it is our opinion that the Operating
Partnership will qualify for the "private placement" exclusion contained in
Notice 88-75, and as a result, will not constitute a publicly traded
partnership for purposes of section 7704 for taxable years beginning before
January 1, 2006.
Moreover, based upon the structure and capitalization of the Operating
Partnership, representations of the Operating Partnership regarding its current
ownership, and Section 11.4.A of the Operating Partnership Agreement cited
above, it is our opinion that the Operating Partnership qualifies for the
"private placement" exclusion contained in section 1.7704-1(h) of the Treasury
Regulations, and as a result, the Operating Partnership will not constitute a
publicly traded partnership for purposes of section 7704 for taxable years
beginning after December 31, 2005.
7. Characterization of the Subsidiary Partnerships for U.S. Federal
Income Tax Purposes
a. Funding I. The Operating Partnership owns a 99.6 percent
interest in Funding I as a limited partner, while the remaining 0.4 percent
general partner's interest is owned by CRE Management I Corp., a wholly owned
subsidiary of CREE. (However, with respect to the Waterside Commons property,
which is held by Funding I, Waterside Commons Limited Partnership owns a 99
percent interest in Funding I as a limited partner, while the remaining 1
percent general partner's interest is owned by CRE Management I Corp.)
The Funding I Agreement provides in Sections 13.1.B and 13.1.D that
the dissolution, insolvency, bankruptcy or other event of withdrawal of the
general partner will cause the partnership to terminate, unless a majority in
interest of the remaining partners consent to continue the partnership and
appoint a new general partner. Accordingly, Funding I will lack the corporate
characteristic of continuity of life.
<PAGE> 21
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 21
In addition, the Funding I Agreement provides in Section 11.1.B that
no partner may transfer all or any portion of its interest in the partnership.
Accordingly, Funding I will lack the corporate characteristic of free
transferability of interests.
Based on the continued organization and operation of Funding I in
accordance with its partnership agreement and the Delaware Revised Uniform
Limited Partnership Act (the "Act"), Funding I will lack the corporate
characteristics of continuity of life and free transferability of interests.
Accordingly, it is our opinion that Funding I will be treated as a partnership
as defined in sections 7701(a)(2) and 761(e) of the Code and not as an
association taxable as a corporation.
In addition, based upon the structure and capitalization of Funding I,
its current ownership, and Section 11.1.B of the Funding I Agreement which
provides that no partner may transfer all or any portion of its interest in
Funding I, it is our opinion that Funding I qualifies for (a) the "private
placement" exclusion contained in Notice 88-75 and (b) the "private placement"
exclusion contained in section 1.7704-1(h) of the Treasury Regulations.(24) As
a result, it is our opinion that Funding I will not constitute a publicly
traded partnership for purposes of section 7704.
b. Funding II. The Operating Partnership owns a 99.8 percent
interest in Funding II as a limited partner, while the remaining 0.2 percent
general partner's interest is owned by CRE Management II Corp., a wholly owned
subsidiary of CREE.
The Funding II Agreement provides in Sections 13.1.B and 13.1.D that
the dissolution, insolvency, bankruptcy or other event of withdrawal of the
general partner will cause Funding II to terminate, unless a majority in
interest of the remaining partners consent to continue the partnership and
appoint a new general partner. Accordingly, Funding II will lack the corporate
characteristic of continuity of life.
In addition, the Funding II Agreement provides in Section 11.1.B that
no partner may transfer all or any portion of its interest in the partnership.
Accordingly, Funding II will lack the corporate characteristic of free
transferability of interests.
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(24) For purposes of this opinion, we have assumed that Funding I will not
be treated as having more than four partners (CRE Management I,
Corp., the Operating Partnership, Gerald Haddock and CW #1 Limited
Partnership) for purposes of section 1.7704-1(h) of the Treasury
Regulations. Although the Operating Partnership and CW #1 Limited
Partnership are flow-through entities for purposes of section
1.7704-1(h)(3), we have assumed that the partners in the Operating
Partnership and CW #1 Limited Partnership will not be treated as
partners in Funding I for purposes of the 100 partner requirement,
based upon your representation that Funding I will not represent
substantially all of the assets of either the Operating Partnership or
CW #1 Limited Partnership.
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Crescent Real Estate Equities, Inc.
October 3, 1996
Page 22
Based on the continued organization and operation of Funding II in
accordance with its partnership agreement and the Act, Funding II will lack the
corporate characteristics of continuity of life and free transferability of
interests. Accordingly, it is our opinion that Funding II will be treated as a
partnership as defined in sections 7701(a)(2) and 761(e) of the Code and not as
an association taxable as a corporation.
In addition, based upon the structure and capitalization of Funding
II, its current ownership, and Section 11.1.B of the Funding II Agreement which
provides that no partner may transfer all or any portion of its interest in
Funding II, it is our opinion that Funding II qualifies for (a) the "private
placement" exclusion contained in Notice 88-75 and (b) the "private placement"
exclusion contained in section 1.7704-1(h) of the Treasury Regulations.(25) As
a result, it is our opinion that Funding II will not constitute a publicly
traded partnership for purposes of section 7704.
c. Funding III, Funding IV and Funding V. The Operating
Partnership owns a 99 percent interest in each of Funding III, Funding IV and
Funding V as a limited partner. The remaining 1 percent general partner's
interest in Funding III is owned by CRE Management III Corp., CRE Management IV
Corp. owns a 1 percent general partner interest in Funding IV, and CRE
Management V Corp. owns a 1 percent general partner interest in Funding V. CRE
Management III Corp., CRE Management IV Corp. and CRE Management V Corp. are
each wholly owned subsidiaries of CREE. The Funding III Agreement, the
Funding IV Agreement and the Funding V Agreement (together, the "Funding
Agreements") are substantially identical with respect to the terms discussed
herein.
Each of the Funding Agreements provides in Paragraph 18 that the
partnership shall dissolve and be wound up upon the occurrence of any of the
following events: (i) the expiration of the term of the partnership on December
31, 2096 (unless terminated earlier); (ii) the sale or disposition of
substantially all of the assets of the partnership; (iii) the written election
of all of the partners to dissolve the partnership; and (iv) unless, the
limited partner elects within ninety days to continue the partnership, upon the
dissolution of the general partner or if the general partner (a) makes a
general assignment for the benefit of creditors, (b) is adjudicated bankrupt or
insolvent, or (c) files a voluntary petition in bankruptcy or in the event
there is an order for relief entered against the general partner under the
Federal Bankruptcy Code of 1978, as amended (or a similar
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(25) For purposes of this opinion, we have assumed that Funding II will
not be treated as having more than two partners (CRE Management II,
Corp. and the Operating Partnership) for purposes of section
1.7704-1(h) of the Treasury Regulations. Although the Operating
Partnership is a flow-through entity for purposes of section
1.7704-1(h)(3), we have assumed that the partners in the Operating
Partnership will not be treated as partners in Funding II for purposes
of the 100 partner requirement, based upon your representation that
Funding II will not represent substantially all of the assets of the
Operating Partnership.
<PAGE> 23
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 23
order under a successor statute). Accordingly, Funding III, Funding IV and
Funding V will each lack the corporate characteristic of continuity of life.
In addition, each of the Funding Agreements provides in Paragraph 14
that no partner may transfer all or any portion of its interest in the
partnership and that any purported transfer of a partnership interest will be
null and void. Accordingly, Funding III, Funding IV and Funding V will each
lack the corporate characteristic of free transferability of interests.
Based on the continued organization and operation of each of Funding
III, Funding IV and Funding V in accordance with its partnership agreement and
the Act, Funding III, Funding IV and Funding V will each lack the corporate
characteristics of continuity of life and free transferability of interests.
Accordingly, it is our opinion that Funding III, Funding IV and Funding V will
each be treated as a partnership as defined in sections 7701(a)(2) and 761(e)
of the Code and not as an association taxable as a corporation.
In addition, based upon the structure and capitalization of each of
Funding III, Funding IV and Funding V, the current ownership of Funding III,
Funding IV and Funding V, and Section 14 of each of the Funding Agreements,
which provides that no partner may transfer all or any portion of its interest
in the partnership, it is our opinion that each of Funding III, Funding IV, and
Funding V qualifies for (a) the "private placement" exclusion contained in
Notice 88-75 and (b) the "private placement" exclusion contained in section
1.7704-1(h) of the Treasury Regulations.(26) As a result, it is our opinion
that Funding III, Funding IV and Funding V will not constitute publicly traded
partnerships for purposes of section 7704.
d. Waterside. The Operating Partnership owns an 89 percent
interest in Waterside as a general partner, while the remaining 11 percent
limited partner's interest is owned by Associates (1 percent) and CW #1 Limited
Partnership (10 percent).
The Waterside Agreement provides in Section 7.1(c) that the bankruptcy
or other event of withdrawal of the general partner will cause the partnership
to terminate. Accordingly, Waterside will lack the corporate characteristic of
continuity of life.
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(26) For purposes of this opinion, we have assumed that each of Funding
III, Funding IV and Funding V will be treated as having no more than
two partners for purposes of section 1.7704-1(h) of the
Treasury Regulations. Although the Operating Partnership is a
flow-through entity for purposes of section 1.7704-1(h)(3), we have
assumed that the partners in the Operating Partnership will not be
treated as partners in Funding III, Funding IV or Funding V for
purposes of the 100 partner requirement, based upon your
representation that neither Funding III, Funding IV nor Funding V will
represent substantially all of the assets of the Operating
Partnership.
<PAGE> 24
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 24
As the general partner of Waterside, the Operating Partnership will be
personally liable for all the debts and obligations of Waterside and, as noted
above, the Operating Partnership will own an 89 percent interest in Waterside.
In addition, the Operating Partnership has represented that it will act
independently of CW #1 Limited Partnership in managing Waterside. Therefore,
Waterside will lack the corporate characteristics of limited liability and
centralization of management.
Based on the continued organization and operation of Waterside in
accordance with its partnership agreement and the Act, Waterside will lack the
corporate characteristics of continuity of life, limited liability and
centralization of management. Accordingly, it is our opinion that Waterside
will be treated as partnerships as defined in sections 7701(a)(2) and 761(e)
and not as an association taxable as a corporation.
In addition, based upon the structure and capitalization of Waterside,
its current ownership, and Article 6.1 of the Waterside Agreement prohibiting
all transfers of interests in Waterside by its limited partners without the
consent of the general partner, it is our opinion that Waterside qualifies for
(a) the "private placement" exclusion contained in Notice 88-75 and (b) the
"private placement" exclusion contained in section 1.7704-1(h) of the Treasury
Regulations.(27) As a result, it is our opinion that Funding II will not
constitute a publicly traded partnership for purposes of section 7704.
e. Associates. The Operating Partnership owns a 90 percent
interest in Associates, while the remaining 10 percent interest is owned by
CREE, Ltd.. The IRS has applied the same four-factor test, described above, in
determining whether limited liability companies, like Associates, which have
been formed under the Texas Limited Liability Company Act, are treated as
partnerships for federal income tax purposes.(28)
The IRS has issued Rev. Proc. 95-10, 1995-3 I.R.B. 20, which specifies
conditions which must be satisfied for a limited liability company to receive a
favorable advanced ruling that it will be classified as a partnership for
federal income tax purposes. Associates should satisfy these
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(27) For purposes of this opinion, we have assumed that Waterside will not
be treated as having more than three partners (CW #1 Limited
Partnership, CREE, Ltd. and the Operating Partnership) for purposes of
section 1.7704-1(h) of the Treasury Regulations. Although the
Operating Partnership and CW #1 Limited Partnership are flow-through
entities for purposes of section 1.7704-1(h)(3), we have assumed that
the partners in the Operating Partnership and CW #1 Limited
Partnership will not be treated as partners in Waterside for purposes
of the 100 partner requirement, based upon your representation that
Waterside will not represent substantially all of the assets of either
the Operating Partnership or CW #1 Limited Partnership.
(28) See, e.g., P.L.R. 9242025 (July 22, 1992) and P.L.R. 9218078 (January
31, 1992).
<PAGE> 25
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 25
conditions. However, such conditions are applicable only in determining
whether rulings will be issued and are not intended as substantive rules for
determination of partnership status.
Under section 301.7701-2(b)(3) of the Treasury Regulations, an
organization will be treated as possessing the corporate characteristic of
continuity of life, even if the agreement organizing an entity provides that it
is to continue only for a stated period, unless a member has the power to
dissolve the organization at an earlier time. Article 6.01 of the Texas
Limited Liability Company Act provides, in part, that except as otherwise
provided in the company's regulations, a limited liability company shall be
dissolved upon the death, retirement, resignation, expulsion, bankruptcy, or
dissolution of a member or the occurrence of any other event which terminates
the continued membership of a member in the limited liability company, unless
there is at least one remaining member and the business of the limited
liability company is continued by the consent by the number of members or class
thereof stated in the articles of organization or regulations of the limited
liability company or of not so stated, by all remaining members. Article 2 of
the Associates Articles provides that the duration of Associates is until the
close of business on December 31, 2014, or until its earlier dissolution in
accordance with the provisions of the Act or the Associates Regulations.
Article 10.2(a)(iii) of the Associates Regulations provides, in part, that
Associates shall be dissolved upon the withdrawal, death, retirement,
resignation, expulsion, bankruptcy, legal incapacity or dissolution of any
member, unless the business of Associates is continued by the consent of all
the remaining members within ninety days. Accordingly, Associates will lack
the corporate characteristic of continuity of life.
Article 4.05 of the Texas Limited Liability Company Act provides, in
part, that unless otherwise provided by the company's regulations, a membership
interest is assignable in whole or in part; an assignment of a member's
interest does not entitle the assignee to become, or to exercise rights or
powers of a member; and until the assignee becomes a member, the assignor
member continues to be a member and to have the power to exercise any rights or
powers of a member, except to the extent those rights or powers are assigned.
Article 4.07 of the Texas Limited Liability Company Act provides, in part, that
an assignee of a membership interest may become a member if and to the extent
that the company's regulations so provide, or all members consent. Article 9.1
of the Associates Regulations, as amended by the First Amendment to the
Associates Regulations, provides that no member shall have the right to
withdraw from Associates or transfer all or any portion of its interest in
Associates. Accordingly, Associates will lack the corporate characteristic of
free transferability of interests. Because Associates will lack the corporate
characteristics of continuity of life and free transferability of interests, it
will be treated as partnership for federal income tax purposes.
Based upon the structure and capitalization of Associates, its current
ownership, and the provision contained in Article 9.1 of the Associates
Regulations, as amended, that restricts the
<PAGE> 26
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 26
right of members of Associates to transfer interests in Associates without the
consent of the other members, it is our opinion that Associates qualifies for
(a) the "private placement" exclusion contained in Notice 88-75 and (b) the
"private placement" exclusion contained in section 1.7704-1(h) of the Treasury
Regulations.(29) As a result, it is our opinion that Associates will not
constitute a publicly traded partnership for purposes of section 7704.
f. Woodlands Partnership. The Operating Partnership owns a
75 percent interest in the Woodlands Partnership as a limited partner, while
the remaining 25 percent general partner's interest is owned by The Woodlands
Office Equities, Inc., a wholly owned subsidiary of The Woodlands Corporation
("TWC Sub").
The Woodlands Partnership Agreement provides in Articles 10.1 and 10.2
that the Woodlands Partnership will terminate upon any event affecting the
general partner that would cause the dissolution of a limited partnership under
the Texas Revised Limited Partnership Act, unless the limited partner consents
to continue the partnership and appoint a new general partner. Accordingly,
the Woodlands Partnership will lack the corporate characteristic of continuity
of life.
Article 7.2.1 of the Woodlands Partnership Agreement provides for
certain circumstances in which a partner may transfer their interest in the
Woodlands Partnership beginning after the eighth anniversary of the
Contribution Date. However, Article 7.2.2 of the Woodlands Partnership
Agreement provides that a person to whom an interest in the Woodlands
Partnership is transferred shall not be admitted to the Woodlands Partnership
without the prior written consent of the other partner, which consent may be
granted or withheld at the sole discretion of the other partner. Accordingly,
the Woodlands Partnership lacks the corporate characteristic of free
transferability of interests.
As noted above, the general partner of the Woodlands Partnership, TWC
Sub, owns a 25 percent interest in the Woodlands Partnership. Furthermore,
Article 9.3 of the Woodlands Partnership Agreement provides that the limited
partner may not remove TWC Sub as general partner, except upon the occurrence
of specified events of default. Accordingly, the Woodlands Partnership will
lack the corporate characteristic of centralization of management.
Based on the continued organization and operation of the Woodlands
Partnership in accordance with the Woodlands Partnership Agreement and the
Texas Revised Limited
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(29) For purposes of this opinion, we have assumed that Associates will
not be treated as having more than two partners for purposes of
section 1.7704-1(h) of the Treasury Regulations (CREE, Ltd. and the
Operating Partnership). Although the Operating Partnership is a
flow-through entity for purposes of section 1.7704-1(h)(3), we have
assumed that the partners in the Operating Partnership will not be
treated as partners in Associates for purposes of the 100 partner
requirement, based upon your representation that Associates will not
represent substantially all of the assets of the Operating
Partnership.
<PAGE> 27
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 27
Partnership Act, the Woodlands Partnership will lack the corporate
characteristics of continuity of life, free transferability of interests and
centralized management. Accordingly, it is our opinion that the Woodlands
Partnership will be treated as a partnership as defined in sections 7701(a)(2)
and 761(e) and not as an association taxable as a corporation.
Based upon the structure and capitalization of the Woodlands
Partnership, its current ownership, and the provisions contained in Article 7.2
of the Woodlands Partnership Agreement (i) prohibiting all transfers of
interests in the Woodlands Partnership by either partner for eight years
following the contribution of the Woodlands Properties, (ii) requiring written
consent of the other partner before the admission to the Woodlands Partnership
of any transferee of an interest in the Woodlands Partnership, and (iii)
requiring that each partner offer the other a right of first refusal with
respect to any proposed disposition of any portion of their interest in the
Woodlands Partnership, it is our opinion that the Woodlands Partnership
qualifies for (a) the "private placement" exclusion contained in Notice 88-75
and (b) the "private placement" exclusion contained in section 1.7704-1(h) of
the Treasury Regulations.(30) As a result, it is our opinion that the
Woodlands Partnership will not constitute a publicly traded partnership for
purposes of section 7704.
g. 301 Congress. The Operating Partnership owns a 49 percent
limited partner interest in 301 Congress, a Delaware limited partnership. The
one percent general partner interest in 301 Congress is owned by Crescent/301,
a Delaware limited liability company that is wholly owned by Operating
Partnership and CREE, Ltd., and the remaining 50 percent limited partner
interest in 301 Congress is owned by Aetna Life Insurance Company ("Aetna").
The 301 Congress Partnership Agreement provides in Section 2.6 that
301 Congress will terminate seven years from the effective date of the 301
Congress Partnership Agreement, unless dissolved earlier under Article X of
such agreement. Article X of the 301 Congress Partnership Agreement provides
that 301 Congress will be dissolved upon the first to occur of the following:
(1) the expiration of seven years from the effective date of the 301 Congress
Partnership Agreement; (2) the sale, transfer or other disposition of the 301
Congress assets; (3) the acquisition by one partner of all of the interests in
301 Congress; (4) the occurrence of any "Event of Withdrawal" with respect to
the general partner under the Delaware Limited Partnership Act, unless a
majority of the remaining partners consent within 90 days to continue the
partnership and
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(30) For purposes of this opinion, we have assumed that the Woodlands
Partnership will not be treated as having more than two
partners (TWC Sub and the Operating Partnership) for purposes of
section 1.7704-1(h) of the Treasury Regulations. Although the
Operating Partnership is a flow-through entity for purposes of section
1.7704-1(h)(3), we have assumed that the partners in the Operating
Partnership will not be treated as partners in the Woodlands
Partnership for purposes of the 100 partner requirement, based upon
your representation that the Woodlands Partnership will not represent
substantially all of the assets of the Operating Partnership.
<PAGE> 28
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 28
appoint a new general partner, effective as of the date of the Event of
Withdrawal; (5) the decision of all partners to dissolve 301 Congress; (6) the
election of a non-defaulting partner to dissolve 301 Congress upon a default of
another partner under Section 9.5 of the 301 Congress Partnership Agreement; or
(7) the entry of a judicial decree of dissolution. Accordingly, 301 Congress
will lack the corporate characteristic of continuity of life.
Section 9.2 of the 301 Congress Partnership Agreement provides that no
partner shall have the right, without the express written consent of each other
partner, to transfer an interest in 301 Congress Avenue, with the exception of
certain transfers between Aetna, Crescent/301 and the Operating Partnership and
their respective affiliates. However, in the case of transfers between Aetna,
Crescent/301 and the Operating Partnership and their respective affiliates,
Section 9.2 of the 301 Congress Partnership Agreement provides that the
transferee shall not be admitted as a substitute partner without the consent of
all other partners. Accordingly, 301 Congress lacks the corporate
characteristic of free transferability of interests.
Based on the continued organization and operation of 301 Congress
Avenue, L.P. in accordance with the 301 Congress Partnership Agreement and the
Delaware Revised Uniform Limited Partnership Act, 301 Congress will lack the
corporate characteristics of continuity of life and free transferability of
interests. Accordingly, it is our opinion that 301 Congress will be treated as
a partnership as defined in sections 7701(a)(2) and 761(e) and not as an
association taxable as a corporation.
Based upon the structure and capitalization of 301 Congress, its
current ownership, and the provisions contained in Section 9.2 of the 301
Congress Partnership Agreement requiring written consent of the other partners
before the admission to 301 Congress of any transferee of an interest in 301
Congress (other than certain transfers between Aetna, Crescent/301 and the
Operating Partnership and their respective affiliates), it is our opinion that
301 Congress qualifies for (a) the "private placement" exclusion contained in
Notice 88-75 and (b) the "private placement" exclusion contained in section
1.7704-1(h) of the Treasury Regulations.(31) As a result, it is our opinion
that 301 Congress will not constitute a publicly traded partnership for
purposes of section 7704.
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(31) For purposes of this opinion, we have assumed that 301 Congress will
not be treated as having more than three partners (CREE, Ltd.,
the Operating Partnership and Aetna) for purposes of section
1.7704-1(h) of the Treasury Regulations. Although the Crescent/301 is
a flow-through entity for purposes of section 1.7704-1(h)(3), we have
treated Crescent/301 as having only two members, CREE, Ltd. and the
Operating Partnership. The partners in the Operating Partnership will
not be treated as members of Crescent/301 for purposes of the 100
partner requirement, based upon your representation that the Operating
Partnership's investment in 301 Congress, through Crescent/301, will
not represent substantially all of the assets of the Operating
Partnership.
<PAGE> 29
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 29
h. Crescent/301. As noted above, the Operating Partnership
owns its general partner interest in 301 Congress through Crescent/301,
a Delaware limited liability company that is wholly owned by Operating
Partnership and CREE, Ltd. The IRS has applied the same four-factor test,
described above, in determining whether limited liability companies, like
Crescent/301, which have been formed under the Delaware Limited Liability
Company Act, are treated as partnerships for federal income tax purposes.(32)
As noted above, under section 301.7701-2(b)(3) of the Treasury
Regulations, an organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time. Section
18-801 of the Delaware Limited Liability Company Act provides that a limited
liability company dissolves upon the first to occur of the following: (1) at
the time specified in an LLC agreement or 30 years from the date of formation
of the LLC if no time is set forth in the LLC agreement, (2) upon the happening
of events specified in an LLC agreement, (3) by the written consent of all
members, (4) by the death, retirement, resignation, expulsion, bankruptcy, or
dissolution of a member or the occurrence of any other event which terminates
the continued membership of a member in the LLC, unless the business of the LLC
is continued by the consent of all the remaining members within 90 days
following the occurrence of any terminating event or pursuant to a right to
continue stated in the LLC agreement, or (5) by the entry of a decree of
judicial dissolution under the Delaware Limited Liability Company Act. Section
1.04 of the Crescent/301 Agreement provides that the duration of Crescent/301
is until the close of business on December 31, 2050, or until its earlier
dissolution upon an "Event of Dissolution" in accordance with Section 12.01 of
the Crescent 301/Agreement. Section 12.01 of the Crescent/301 Agreement
provides that Crescent/301 shall be dissolved prior to December 31, 2050 upon
the following "Events of Dissolution": (1) the mutual consent of all members,
(2) the withdrawal, death, retirement, resignation, expulsion, bankruptcy,
legal incapacity or dissolution of any member, (3) a sale by Crescent/301 of
its assets, or (4) a decree of judicial dissolution. However, Section 12.05 of
the Crescent/301 Agreement provides that if any Event of Dissolution occurs
with respect to CREE, Ltd., the business of Crescent/301 will be continued if,
within ninety days, the remaining members unanimously decide to continue the
business and to approve the admission of a new member, effective immediately
before the dissolution event. Accordingly, Crescent/301 will lack the
corporate characteristic of continuity of life.
Section 18-702(a) of the Delaware Limited Liability Company Act
provides, in part, that unless otherwise provided by the company's LLC
agreement, a membership interest is assignable in whole or in part; an
assignment of a member's interest does not entitle the assignee to
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(32) See, e.g., Rev. Rul. 93-38, 1993-21 I.R.B. 4, P.L.R. 9602012 (October
6, 1995) and P.L.R. 9507004 (November 8, 1994).
<PAGE> 30
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 30
participate in the management of the business and affairs of the LLC. Section
18-704(a) of the Delaware Limited Liability Company Act provides, in part, that
an assignee of a membership interest may become a member if and to the extent
that the company's LLC agreement so provides, or all members consent. Section
10.02 of the Crescent/301 Agreement provides that no member may withdraw from
Crescent/301 or transfer all or any part of its interest in Crescent/301 and
that any purported transfer of an interest in Crescent/301 shall be null and
void. Accordingly, Crescent/301 will lack the corporate characteristic of free
transferability of interests. Because Crescent/301 will lack the corporate
characteristics of continuity of life and free transferability of interests, it
will be treated as a partnership for federal income tax purposes.
Based upon the structure and capitalization of Crescent/301, its
current ownership, and the provision contained in Section 10.02 of the
Crescent/301 Agreement that prevents members of Crescent/301 from transferring
interests in Crescent/301, it is our opinion that Crescent/301 qualifies for
(a) the "private placement" exclusion contained in Notice 88-75 and (b) the
"private placement" exclusion contained in section 1.7704-1(h) of the Treasury
Regulations.(33) As a result, it is our opinion that Crescent/301 will not
constitute a publicly traded partnership for purposes of section 7704.
i. SMA. The Operating Partnership owns an interest in
SMA as a general partner. Section 9.1 of the SMA Agreement provides that the
dissolution or adjudication of bankruptcy or any other occurrence which would
constitute an event of withdrawal by the Operating Partnership as general
partner (or, if there is more than one general partner, by the last remaining
general partner) causes a dissolution of SMA. Section 9.2 of the SMA Agreement
provides that in the event of a dissolution under section 9.1, SMA may be
reconstituted and its business continued only if Spectrum Dallas Associates,
L.P. ("SDA") and other limited partners with partnership interests totaling
more than 50% of the partnership interests of all limited partners
affirmatively elect to reconstitute SMA, agree on the identity of a new general
partner and execute an instrument affirming such facts. Accordingly, SMA will
lack the corporate characteristic of continuity of life.
The Operating Partnership, as general partner of SMA, owns a large
majority of the partnership interests in SMA and therefore should be viewed as
managing SMA on its own behalf. Moreover, section 7.1 of the SMA Agreement
provides that the limited partners have no power or authority with respect to
SMA except as specifically provided in the SMA Agreement, which
- ----------------------------------
(33) For purposes of this opinion, we have assumed that Crescent/301 will
not be treated as having more than two partners for purposes of
section 1.7704-1(h) of the Treasury Regulations (CREE, Ltd. and the
Operating Partnership). Although the Operating Partnership is a
flow-through entity for purposes of section 1.7704-1(h)(3), we have
assumed that the partners in the Operating Partnership will not be
treated as members of Crescent/301 for purposes of the 100 partner
requirement, based upon your representation that Crescent/301 will not
represent substantially all of the assets of the Operating
Partnership.
<PAGE> 31
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 31
does not provide the limited partners with the power to remove the general
partner of SMA. Therefore, SMA will lack the corporate characteristic of
centralization of management.
As the general partner of SMA, the Operating Partnership will be
personally liable for all the debts and obligations of SMA. Moreover, the
Operating Partnership has substantial assets other than its general partner
interest in SMA. Furthermore, Crescent Equities has represented that the
Operating Partnership will act independently of the limited partners in SMA.
Therefore, SMA will lack the corporate characteristic of limited liability.
In sum, SMA will lack the corporate characteristics of limited
liability, continuity of life and centralization of management. Based on the
foregoing, it is our opinion that SMA will be treated as a partnership as
defined in sections 7701(a)(2) and 761(a) of the Code and not as an association
taxable as a corporation.
In addition, we believe that SMA should not be classified as a
publicly traded partnership under section 7704, Notice 88-75 and the final
regulations. Interests in SMA are not listed or traded on any established
securities market. The Operating Partnership has represented that (i) it has
not and will not take, and is not aware of any person taking, any action that
could cause interests in SMA to be treated as "readily tradable" on a secondary
market or the substantial equivalent thereof under the standards set forth in
Treas. Reg. Section 1.7704-1(c), and (ii) if it becomes aware of any such
market (or the substantial equivalent thereof), then to the maximum extent
permitted under the SMA Agreement (including exercising the general partner's
right to withhold consent to a transfer of a limited partner interest under
section 7.5 of the SMA Agreement), it will cause SMA to not recognize transfers
made on such market (or the substantial equivalent thereof) within the meaning
of Treas. Reg. Section 1.7704-1(d). Furthermore, we believe that the option
arrangement set forth in section 7.9 of the SMA Agreement should not cause the
interests in SMA to be treated as "readily tradable on a secondary market or
the substantial equivalent thereof" because this arrangement (i) is available
only to the partners of SDA and not directly available to the partners of SMA,
(ii) is subject to a variety of significant conditions, (iii) is available on a
one-time basis only, and (iv) more closely resembles a redemption, put or other
contract right rather than trading on the equivalent of a secondary market. We
are aware of no other arrangements or understandings relating to changes in the
ownership of SMA.
Moreover, SMA may be able to avoid being classified as a publicly
traded partnership on the basis of the 500 person "safe harbor" set forth in
Notice 88-75 or the 100 person "safe harbor" in the final regulations. Under
the final regulations, SMA may rely on Notice 88-75 for ten years (assuming it
does not add a new line of business). Section 7.11 of the SMA Agreement
specifically provides that the general partner "shall operate the Partnership
so that in no event will the Partnership have more than 500 partners at any
time during a taxable year of the Partnership,
<PAGE> 32
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 32
within the meaning of Notice 88-75, 1988-2 C.B. 368." Currently, SMA has
approximately eighty partners, all but seven of whom are individuals. As noted
above, section 7.5 of the SMA Agreement provides in part that the general
partner's prior written consent is required for a limited partner to sell or
otherwise transfer an interest in SMA, giving the Operating Partnership the
ability to prohibit direct transfers in SMA that might increase the number of
partners in SMA. However, because in addition to the Operating Partnership
there are six other partnerships (including SDA) with partnership interests in
SMA, and the Operating Partnership does not have the ability to limit transfers
of interests in those partnerships, it is possible that there may be more than
five hundred holders of interests in SMA within the meaning of Notice 88-75.
For purposes of applying the 100 person "safe harbor" of the final
regulations, however, indirect beneficial owners are treated as partners only
if "substantially all" of the value of the indirect interest is attributable
the underlying partnership and "a principal purpose" of the arrangement is to
satisfy the 100 partner limit. Each of the partnerships owning interests in
SMA also own other assets. Moreover, the tiered ownership of SMA was
established before the final regulations were issued. Finally, all of the
partnerships have been in existence for years and should not be viewed as
having "a principal purpose" of satisfying the 100 partner rule. Thus, SMA may
be able to satisfy the 100 person "safe harbor" of the final regulations.
Based upon the above, section 7704 of the Code and the final
regulations, Notice 88-75, the representations of the Operating Partnership,
and the structure and ownership of SMA, it is our opinion that SMA will not be
treated as a publicly traded partnership subject to tax under section 7704(a)
of the Code.
8. Accuracy of the Matters Described under the Heading "Federal
Income Tax Considerations" in the Prospectus Supplement.
It is our opinion that the description of the federal income tax
considerations discussed under the heading "Federal Income Tax Considerations"
in the Prospectus Supplement is accurate and fairly summarizes the federal
income tax considerations that are likely to be material to a holder of Common
Stock.
III. Additional Limitations
The foregoing opinions are limited to the specific matters covered
thereby and should not be interpreted to imply that the undersigned has offered
its opinion on any other matter. Moreover, Crescent Equities' ability to
achieve and maintain qualification and taxation as a REIT depends upon Crescent
Equities' ability to meet certain diversity of stock ownership requirements
and, through actual annual operating results, certain requirements under the
Code regarding its
<PAGE> 33
Crescent Real Estate Equities, Inc.
October 3, 1996
Page 33
income, assets and distribution levels. No assurance can be given that the
actual ownership of Crescent Equities' stock and its actual operating results
and distributions for any taxable year will satisfy the tests necessary to
achieve and maintain its status as a REIT.
IV. Consent to Filing
These opinions are furnished to you solely for use in connection with
the Registration Statement. We hereby consent to the incorporation by
reference of this letter as an exhibit to the Registration Statement and to
the use of our name under the captions "Tax Status" and "Federal Income Tax
Considerations" in the Prospectus Supplement.
Very truly yours,
SHAW, PITTMAN, POTTS & TROWBRIDGE
By: /s/ Charles B. Temkin, P.C.
-----------------------------------
Charles B. Temkin, P.C.
Attachments
<PAGE> 34
MEMORANDUM
TO: David Dean
FROM: Charles B. Temkin
Michael A. Jacobs
DATE: January 3, 1995
RE: Characterization of Income Derived from Hyatt Regency Beaver
Creek
I. OVERVIEW
Crescent Real Estate Equities Limited Partnership (the "Operating
Partnership") is about to purchase the Hyatt Regency Beaver Creek (the "Hotel
Property") from East West Properties (the "Current Owner"). Crescent Real
Estate Equities, Inc. (the "Company") is currently the sole shareholder of two
corporations, one of which is the sole general partner of and one of which is a
limited partner of the Operating Partnership. These two corporations
constitute qualified REIT subsidiaries within the meaning of section 856(i).(1)
This memorandum analyzes the impact that a purchase of the Hotel
Property will have on the ability of the Company to continue to qualify as a
real estate investment trust (a "REIT") under section 856(c). More
specifically, it analyzes whether the income the Operating Partnership will
derive from the Hotel Property will be treated as "qualifying income" for
purposes of the 75 percent and 95 percent gross income tests for REIT
qualification. This memorandum concludes that, subject to certain assumptions,
in our opinion (i) all of the income that the Operating Partnership derives
from the Hotel Property will be treated as "qualifying income" for purposes of
the 95 percent test and (ii) all of the income the Operating Partnership
derives from the Hotel Property, with the exception of certain interest income,
will be treated as "qualifying income" for purposes of the 75 percent test.
II. FACTS AND ASSUMPTIONS
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(1) All section references herein are to the Internal Revenue Code of 1986, as
amended (the "Code"), or to the regulations issued thereunder, unless otherwise
noted.
<PAGE> 35
The Current Owner has contracted with Hyatt Corporation ("Hyatt") to
operate the Hotel Property. Under the terms of the agreement between the
Current Owner and Hyatt dated December 11, 1987, as amended on September 12,
1988, February 15, 1990 and October 1, 1994 (the "Management Agreement"), Hyatt
is obligated to provide all services in relation to the operation of the Hotel
Property and collect all hotel receipts. In exchange for these services, Hyatt
is reimbursed for the costs of operating the Hotel Property and paid a
management fee. This fee is paid out of hotel receipts; it is based in part on
the gross hotel receipts and in part on the profits, if any, from operation of
the Hotel Property.
Section 15.2 of the Management Agreement requires that all
assignments of the Management Agreement be approved by Hyatt and that any
assignees expressly assume the obligations of the Current Owner under the
Management Agreement. Therefore, in connection with its purchase of the Hotel
Property, the Operating Partnership will assume all of the obligations of the
Current Owner under the Management Agreement.
When the Operating Partnership purchases the Hotel Property, it will
immediately lease it to Mogul Management LLC ("Mogul") pursuant to a Lease
Agreement dated January 3, 1995 (the "Lease"). Pursuant to Article 2 of the
Lease, the Operating Partnership will assign its interest in the Management
Agreement to Mogul; and pursuant to Section 15.2 of the Management Agreement,
Mogul will assume all of the Operating Partnership's obligations thereunder.
However, as a condition of its approval of the Lease, Hyatt will require that
the Operating Partnership remain liable for all obligations of the Operating
Partnership under the Management Agreement assumed by Mogul.
Currently, Walter P. Sprunt and Richard W. Adkisson each own a 45.5
percent interest in the assets and net profits of Mogul, while Gerald W.
Haddock and John C. Goff, the managers of Mogul, each own a 4.5 percent
interest in its assets and net profits.
For purposes of this memorandum, we have examined and relied upon (1)
the Management Agreement, (2) the Lease, (3) the Articles of Organization of
Mogul Management LLC (the "Mogul Articles"), (4) the Regulations of Mogul
Management LLC (the "Mogul Regulations"), (5) the First Amended and Restated
Articles of Incorporation of Crescent Real Estate Equities, Inc. (the "Crescent
Articles"), (6) the Contract of Sale between the Current Owner and the
Operating Partnership, (7) the Consent and Assumption Agreement between Hyatt
and the Operating Partnership, and (8) such other documents or information as
we deemed necessary for the opinions set forth below. In our examination, we
have assumed the genuineness of all signatures, the legal capacity of natural
persons, the authenticity of all documents submitted to us as originals, the
conformity to original documents of all documents submitted to us as certified
or photostatic copies, and the authenticity of the originals of such copies.
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<PAGE> 36
This memorandum is based upon existing provisions of the Code,
Treasury regulations, and the reported interpretations thereof by the Internal
Revenue Service ("IRS") and by the courts in effect (or, in the case of certain
proposed regulations, proposed) as of the date hereof, all of which are subject
to change, both retroactively or prospectively, and to possibly different
interpretations. We assume no obligation to update the opinions set forth in
this memorandum. We believe that the conclusions expressed herein, if
challenged by the IRS, would be sustained in court. However, because our
opinions are not binding upon the IRS or the courts, there can be no assurance
that contrary positions may not be successfully asserted by the IRS.
In addition, this memorandum is based on various assumptions and is
conditioned upon certain representations made by the Operating Partnership and
its sole general partner, Crescent Real Estate Equities, Ltd., as to factual
and other matters as set forth in the attached letter.
III. LEGAL BACKGROUND
A. 75 Percent and 95 Percent Tests
In order to qualify as a REIT for tax purposes, the Company must
satisfy certain tests with respect to the composition of its gross income on an
annual basis. First, at least 75 percent of the Company's gross income
(excluding gross income from certain prohibited transactions) for each taxable
year must consist of temporary investment income or of certain defined
categories of income derived directly or indirectly from investments relating
to real property or mortgages on real property. These categories include,
subject to various limitations, rents from real property, interest on mortgages
on real property, gains from the sale or other disposition of real property
(including interests in real property and mortgages on real property) not
primarily held for sale to customers in the ordinary course of business, income
from foreclosure property, and amounts received as consideration for entering
into either loans secured by real property or purchases or leases of real
property.(2) Second, at least 95 percent of the Company's gross income
(excluding gross income from certain prohibited transactions) for each taxable
year must be derived from income qualifying under the 75 percent test and from
dividends, other types of interest and gain from the sale or disposition of
stock or securities, or from any combination of the foregoing.(3)
In applying these income tests, REITs that are partners in a
partnership are required to include in their gross income their proportionate
share of the partnership's gross income. In addition, such REITs are to treat
this partnership gross income as retaining the same character as the items of
gross income of the partnership for purposes of section 856.(4) Thus, the
character of any
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(2) Section 856(c)(3).
(3) Section 856(c)(2).
(4) Treas. Reg. Section 1.856-3(g).
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<PAGE> 37
income derived by the Operating Partnership from the Hotel Property will affect
the ability of the Company to qualify as a REIT.
B. Rents from Real Property
Rents from real property satisfy both the 75 percent and 95 percent
tests for REIT qualification only if several conditions are met. First, the
amount of rent must not be based in whole or in part on the income or profits
of any person. An amount received or accrued generally will not be excluded
from the term "rents from real property" solely by reason of being based on a
fixed percentage or percentages of receipts or sales.(5) Second, the Code
provides that rents received from a tenant will not qualify as "rents from real
property" if the REIT, or an owner of 10 percent or more of the REIT, directly
or constructively, owns 10 percent or more of such tenant (a "Related Party
Tenant").(6) Third, if rent attributable to personal property leased in
connection with a lease of real property is greater than 15 percent of the
total rent received under the lease, then the portion of rent attributable to
such personal property will not qualify as "rents from real property."(7)
Finally, for rents to qualify as "rents from real property," a REIT generally
must not operate or manage the property or furnish or render services to the
tenants of such property, other than through an independent contractor from
whom the REIT derives no revenue. However, rents will be qualified as "rents
from real property" if a REIT directly performs services in connection with the
lease of the property, if those services are "usually or customarily rendered"
in connection with the rental of space for occupancy, and such services are not
considered to be rendered to the occupant of the property.(8)
C. Income from Foreclosure Property
Income from foreclosure property is treated as "qualifying income" for
purposes of the 75 percent and 95 percent tests (although any net income from
foreclosure property is taxed at the maximum corporate rate). Foreclosure
property is any real property, and any personal property incident to such real
property, acquired by a REIT through default under a mortgage or a lease. A
REIT may elect to treat such property as foreclosure property for a grace
period of up to two years.(9) However, such property will cease to qualify as
foreclosure property if it is used by the REIT in a trade or business more than
90 days after it is acquired and it is not operated through
- ----------------------------------
(5) Section 856(d)(2)(A).
(6) Section 856(d)(2)(B).
(7) Section 856(d)(1)(C).
(8) Sections 856(d)(1)(B), 856(d)(2)(C).
(9) Section 856(e).
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<PAGE> 38
an independent contractor from whom the REIT does not derive or receive any
income.(10) Moreover, property is not eligible to be treated as foreclosure
property if the lease is entered into with an intent to evict or foreclose, or
if the REIT knows or has reason to know that default would occur.(11)
I. DISCUSSION
A. Lease Will be Treated as a Lease for Federal Income Tax Purposes
In order for any income derived by the Operating Partnership from the
Hotel Property to constitute either "rents from real property," or in the case
of a default under the Lease, "gross income from foreclosure property," the
Lease must be treated as a lease for federal income tax purposes and not be
treated as a service contract, management contract or other type of
arrangement. This determination depends on an analysis of all the surrounding
facts and circumstances. In making this determination, courts have considered
a variety of factors, including the following: (i) the intent of the parties,
(ii) the form of the agreement, (iii) the degree of control over the business
conducted at the property that is provided to the lessee (e.g., whether the
lessee has substantial rights of control over the operation of the property and
its business), (iv) the extent to which the lessee has the risk of loss from
operations of the business conducted as the property (e.g., whether the lessee
bears the risk of increases in operating expenses and of decreases in
revenues), and (v) the extent to which the lessee has the opportunity to
benefit from operations of the business conducted at the property (e.g.,
whether the lessee benefits from decreased operating expenses or increased
revenues).(12)
In addition, section 7701(e) provides that a contract that purports to
be a service contract, partnership agreement, or another type of arrangement
will be treated instead as a lease of property if the contract is properly
treated as such, taking into account all relevant factors, including whether or
not: (i) the service recipient is in physical possession of the property, (ii)
the service recipient controls the property, (iii) the service recipient has a
significant economic or possessory interest in the property (e.g., the
property's use is likely to be dedicated to the service recipient for a
substantial portion of the useful life of the property, the recipient shares
the risk that the property will decline in value, the recipient shares in any
appreciation in the value of the property, the recipient shares in any savings
in the property's operating costs or the recipient bears the risk of damage to
or loss of the property), (iv) the service provider does not bear any risk of
substantially diminished receipts or substantially increased expenditures if
there is nonperformance under the contract, (v) the service provider does not
use the property concurrently to provide significant
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(10) Section 856(e)(4).
(11) Treas. Reg. Section 1.856-6(b)(3).
(12) See, e.g., Xerox Corp. v. U.S., 80-2 USTC Paragraph 9530 (Ct. Cl. Tr. Div.
1980), aff'd per curiam, 656 F.2d 659 (Ct. Cl. 1981).
-5-
<PAGE> 39
services to entities unrelated to the service recipient and (vi) the total
contract price does not substantially exceed the rental value of the property
for the contract period. Since the determination of whether a service
contract, partnership agreement, or some other type of arrangement should be
treated as a lease is inherently factual, the presence or absence of any single
factor may not be dispositive in every case.(13)
We have concluded that the Lease will be treated as a lease for
Federal income tax purposes, rather than a service contract, management
contract or other type of arrangement. This conclusion is based, in part, on
the following facts: (i) the Operating Partnership and Mogul intend their
relationship to be that of lessor and lessee (as evidenced by the terms of the
Lease), (ii) Mogul will have the right to exclusive possession, use and quiet
enjoyment of the Hotel Property during the term of the Lease and the right to
uninterrupted control in the operation of and business conducted at the Hotel
Property (subject to its assumption of the Management Agreement), (iii) Mogul
will bear the cost of, and be responsible for, capital expenditures, including
maintenance and repair of the Hotel Property, and will dictate how the Hotel
Property is maintained and improved, (iv) Mogul will bear all the costs and
expenses of operating the Hotel Property, (v) Mogul will benefit from any
savings in the costs of operating the Hotel Property during the term of the
Lease, (vi) in the event of damage or destruction to the Hotel Property, Mogul
will be at economic risk because its obligation to make rental payments will
not abate, (vii) Mogul will indemnify the Operating Partnership against all
liabilities imposed on the Operating Partnership during the term of the Lease
by reason of injury to persons or damage to property occurring at the Hotel
Property or Mogul's use, management, maintenance or repair of the Hotel
Property, (viii) Mogul is obligated to pay substantial fixed rent for the
period of use of the Hotel Property, regardless of whether its revenues exceed
its costs and expenses, and (ix) Mogul stands to incur substantial losses (or
derive substantial profits) depending on how successfully it operates the Hotel
Property.
We do not believe that our conclusion that the Lease of the Hotel
Property will be treated as a lease for Federal income tax purposes is affected
by the fact that Mogul will enter the Lease subject to its assumption of the
Operating Partnership's obligations under the preexisting Management Agreement.
The Management Agreement gives Hyatt control over the day-to-day operation of
the Hotel Property and will allow Hyatt to share with Mogul in the benefits of
any increases in revenues or cost savings in the operation of the Hotel
Property. However, Hyatt's operation of the Hotel Property will not be
controlled by the Operating Partnership, and the Management Agreement does not
affect the fact that Mogul bears most of the risk of loss if the Hotel Property
is not successful. Moreover, the IRS has issued a private letter ruling in
which it treated leases of several hotel properties as producing "rents from
real property" in a situation where the lessees had contracted with a third
party to conduct the day-to-day operations of the hotels.(14) This ruling
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(13) P.L.R. 8918012 (January 24, 1989).
(14) See, P.L.R. 8117036 (January 27, 1981).
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<PAGE> 40
suggests that the IRS will respect a lease of a hotel for federal income tax
purposes even if the hotel is operated by an independent contractor rather than
by the lessee.
B. Percentage Rent Provision is not Profit-Based
Pursuant to the Lease, Mogul will be obligated to pay the Operating
Partnership base rent and percentage rent. Under the regulations, percentage
rent based on a percentage of gross receipts or sales in excess of a floor
amount, which is how the percentage rent is structured under the Lease, will
not qualify as "rents from real property" unless (i) such floor amount does
not depend in whole or in part on the income or profits of the lessee, (ii) the
percentage and the floor amount are fixed at the time the lease is entered
into, (iii) the percentage and the floor amount are not renegotiated during the
term of the lease in a manner that has the effect of basing the percentage rent
on income or profits, and (iv) the percentage and the floor amount conform with
normal business practice.(15)
Under the terms of Article 4.2 of the Lease, Mogul will pay percentage
rent equal on an annual basis to the sum of (i) 17.5 percent of the excess of
annual gross receipts from room rentals over $9,300,000 and (ii) 2.5 percent of
the excess of annual gross receipts from the food and beverage facilities at
the Hotel Property over $3,000,000. This formula will effectively reward Mogul
for any increases in gross receipts from rooms and from other sources over the
threshold amounts. This type of formula does not base the percentage rent on
Mogul's income or profits, and similar formulas have been treated by the IRS as
generating "rents from real property."(16) Moreover, the Operating Partnership
has represented that (i) the floor amounts used to compute the percentage rent
under the Lease will not depend in whole or in part on the income or profits of
any person, (ii) the percentage rent provision of the Lease will not be
renegotiated during the term of the Lease or at the expiration or earlier
termination of the Lease in a manner that has the effect of basing the rent on
income or profits, and (iii) the percentage rent provision of the Lease
conforms with normal business practice. In addition, based on our experience
and an examination of the Lease and the Hotel Property projections, the Lease
appears to conform with normal business practice.
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(15) Treas. Reg. Section 1.866-4(b)(3).
(16) See, e.g., P.L.R. 8803007 (September 23, 1987) (percentage rent based on
gross revenues in excess of gross revenues for a base year treated as "rents
from real property"); cf. P.L.R. 9104018 (October 26, 1990) (interest based on
gross revenues in excess of a floor amount treated as qualifying interest under
section 856(f)).
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<PAGE> 41
C. Mogul is not a "Related Party Tenant"
Rents received from Mogul will not qualify as "rents from real
property" if Mogul is a "related party tenant." Mogul will be a "related party
tenant" if the Company, or an owner of 10 percent or more of the Company,
directly or constructively owns 10 percent or more of the assets or net profits
of Mogul.(17) Constructive ownership is determined for purposes of this test
by applying the rules of section 318(a) as modified by section 856(d)(5).
Those rules generally provide that if 10 percent or more in value of the stock
of the Company is owned, directly or indirectly, by or for any person, the
Company is considered as owning the stock owned, directly or indirectly, by or
for such person.
Mogul will not be treated as a "related party tenant" because two
individuals, Walter P. Sprunt and Richard W. Adkisson, currently each own a
45.5 percent interest in its assets and net profits. In reaching this
conclusion we recognize that Mr. Sprunt and Mr. Adkisson are the owners of
Greenbriar Associates, Inc., which is a 10 percent member of G/C Waterside
Associates, LLC, which is a 1 percent partner of Waterside Commons Limited
Partnership, a partnership whose 89 percent partner is the Operating
Partnership.(18) The Operating Partnership has represented that (i) neither
Mr. Sprunt nor Mr. Adkisson owns more than 10 percent of the value of the
Company's stock, (ii) neither Mr. Sprunt nor Mr. Adkisson is expected to own
more than 10 percent of the value of the Company's stock in the future and
(iii) neither the Operating Partnership nor the Company intends to acquire,
directly or constructively, an interest of 10 percent or more in the assets or
net profits of Mogul at any time in the future. Moreover, Article 37.5 of the
Lease limits the ability of Mogul and its members and managers to acquire,
directly or constructively, a 10 percent stock interest in the Company, and
Section 6.4 of the First Amended and Restated Articles of Incorporation of the
Company prevents Mogul and its members and managers from acquiring more than 8
percent of the Company's stock.
The conclusion that Mogul will not be treated as a "related party
tenant" is based on the assumption that Mogul will be treated as a partnership
for federal income tax purposes. If Mogul is not treated as a partnership for
federal income tax purposes, but is instead treated as an association taxable
as a corporation, then it is likely that Mogul will be treated as a "related
party tenant" and the rents derived under the terms of the Lease will not be
treated as "rents from real property." This is because, if Mogul were treated
as a corporation for federal income tax purposes, Gerald W. Haddock and John C.
Goff would likely be deemed to own all of its voting stock, because of the
extensive powers that they are granted as managers under the Mogul
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(17) Section 856(d)(2)(B)(ii).
(18) See Rev. Rul. 73-194, 1973-1 C.B. 355 (management company treated as an
independent contractor with respect to a REIT, where an affiliate of the
management company and the REIT were partners).
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<PAGE> 42
Regulations. If this were the case, the ownership of such voting stock would
be attributed to the Company under the constructive ownership rules described
above.(19)
An entity which has associates and an objective to carry on a business
for joint profit will be treated as a partnership for federal income tax
purposes, and not as an association taxable as a corporation, if it has not
more than two of the following four characteristics of a corporation: (i)
continuity of life; (ii) centralization of management; (iii) limited liability;
and (iv) free transferability of interests.(20) The entity must also have no
other characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics.(21) The IRS has applied this four-factor test in determining
whether limited liability companies formed under the Texas Limited Liability
Company Act (the "Act") are partnerships for federal income tax purposes.(22)
The IRS has issued Rev. Proc. 95-10, which specifies conditions which
must be satisfied for a limited liability company to receive a favorable
advanced ruling that it will be classified as a partnership for federal income
tax purposes.(23) Mogul should satisfy these conditions. However, such
conditions are applicable only in determining whether rulings will be issued
and are not intended as substantive rules for determination of partnership
status.
An organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time.(24)
Article 6.01 of the Act provides, in part, that except as otherwise provided in
the company's regulations, a limited liability company shall be dissolved upon
the death, retirement, resignation, expulsion,
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(19) Richard Rainwater, Gerald Haddock and John Goff are each partners in
FW-Irving Partners, Ltd. (and apparently they are partners in other
partnerships as well). Richard Rainwater also owns more than 10 percent of the
value of the stock of the Company. Thus, assuming that the ownership interests
in Mogul held by Gerald Haddock and John Goff constitute stock, such interests,
along with Richard Rainwater's stock interest in the Company, will be
attributed to FW-Irving Partners, Ltd. pursuant to section 318(a)(3)(A), which
provides that stock owned, directly or indirectly, by or for a partners shall
be considered as owned by the partnership. Then, FW-Irving Partners, Ltd.'s
deemed interest in Mogul would be attributed to the Company pursuant to section
318(a)(3)(C) (as modified by section 856(d)(5)), which provides that stock
owned by any person that owns 10 percent or more of the value of the stock in a
corporation shall be considered owned by the corporation.
(20) Treas. Reg. Section 301.7701-2(a).
(21) See Rev. Rul. 79-106, 1979-1 C.B. 448.
(22) See, e.g., P.L.R. 9242025 (July 22, 1992) and P.L.R. 9218078 (January 31,
1992).
(23) 1995-3 I.R.B [ ] .
(24) Treas. Reg. Section 301.7701-2(b)(3).
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<PAGE> 43
bankruptcy, or dissolution of a member or the occurrence of any other event
which terminates the continued membership of a member in the limited liability
company, unless there is at least one remaining member and the business of the
limited liability company is continued by the consent by the number of members
or class thereof stated in the articles of organization or regulations of the
limited liability company or of not so stated, by all remaining members.
Article 2 of the Mogul Articles provides that the duration of Mogul is until
the close of business on December 31, 2015, or until its earlier dissolution in
accordance with the provisions of the Act or the Regulations. Article 10.2 of
the Mogul Regulations provides, in part, that Mogul shall be dissolved upon the
withdrawal, death, retirement, resignation, expulsion, bankruptcy, legal
incapacity or dissolution of any member, unless the business of Mogul is
continued by the consent of all the remaining members within ninety days.
Accordingly, Mogul will lack the corporate characteristic of continuity of
life.
An organization will be treated as possessing the corporate
characteristic of free transferability of interests if the members owning all
or substantially all of the interests in an organization may substitute for
themselves without the consent of the other members a person who is not a
member of the organization.(25) Article 4.05 of the Act provides, in part,
that unless otherwise provided by the company's regulations, a membership
interest is assignable in whole or in part; an assignment of a member's
interest does not entitle the assignee to become, or to exercise rights or
powers of a member; and until the assignee becomes a member, the assignor
member continues to be a member and to have the power to exercise any rights or
powers of a member, except to the extent those rights or powers are assigned.
Article 4.07 of the Act provides, in part, that an assignee of a membership
interest may become a member if and to the extent that the company's
regulations so provide, or all members consent. Article 9.3 of the Mogul
Regulations provides, in part, that no member shall have the right to
substitute in its place a transferee unless consent is given by the Managers
and a majority of the other members, which consent may be withheld in the
discretion of the Managers or the other members. Accordingly, Mogul will lack
the corporate characteristic of free transferability of interests. Because
Mogul will lack the corporate characteristics of continuity of life and free
transferability of interests, it will be treated as partnership for federal
income tax purposes.
D. Incidental Personal Property
1. Rents Attributable to Personal Property Will Be Treated as
"Rents from Real Property"
As noted above, the rents attributable to the Operating Partnership's
personal property leased under or in connection with the Lease must not be
greater than 15 percent of the rents received under the Lease. The rent
attributable to personal property leased under or in connection with a lease of
real property is the amount that bears the same ratio to total rent for the
taxable
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(25) Treas. Reg. Section 301.7701-2(e).
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<PAGE> 44
year as (i) the average of the adjusted bases of the personal property leased
under or in connection with a lease of real property at the beginning and at
the end of the taxable year bears to (ii) the average of the aggregate adjusted
bases of the real and personal property subject to the lease at the beginning
and at the end of such taxable year (the "Adjusted Basis Ratio").(26) The
Operating Partnership has represented that the adjusted tax basis of the
personal property leased under or in connection with the Lease will not
represent more than 15 percent of the aggregate adjusted tax basis of the Hotel
Property at any time.
2. Payments Attributable to Mogul's Acquisition of Certain
Personal Property Will Not Be Treated as "Rents from Real
Property"
Article 4.7 of the Lease provides that Mogul will be deemed to have
acquired all of the furniture, fixtures and operating equipment associated with
the Hotel Property (the "FF & E") with the proceeds of a loan from the
Operating Partnership. It further provides that Mogul is to make payments of
principal and interest on this deemed loan.
The payments that the Operating Partnership receives with regard to
the FF & E under the terms of Article 4.7 of the Lease will not qualify as
"rents from real property." Instead, such payments will be treated for federal
income tax purposes as payments of principal and interest resulting from the
Operating Partnership's deemed financing of Mogul's purchase of the FF & E. In
reaching this conclusion we have relied on the representations of the Operating
Partnership that (i) the useful life of the FF & E will be less than the term
of the Lease, (ii) the residual value of the FF & E at the end of the term of
the Lease will generally be less than 20 percent of the value of the FF & E at
the beginning of the term of the Lease, and (iii) the Operating Partnership and
Mogul will treat Mogul as the owner of the FF & E for federal income tax
purposes.
The payments pursuant to this "deemed financing," to the extent they
constitute interest, will be "qualifying income" for purposes of the 75 percent
test. However, because the deemed financing will be secured by personal,
rather than real property, such interest will not be qualifying income for
purposes of the 95 percent test.
E. Provision of Services by the Operating Partnership
1. Income Derived under the Terms of the Lease
Although the Operating Partnership may treat charges for services
customarily furnished or rendered in connection with the rental of the Hotel
Property as "rents from real property," any services rendered to the occupants
of the Hotel Property must be furnished or rendered by an
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(26) Section 856(d)(1)(C).
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<PAGE> 45
independent contractor from whom the Company does not derive or receive any
income.(27) Moreover, to the extent that any independent contractors provide
noncustomary services to the occupants of the Hotel Property, the cost of such
services must not be borne by the Operating Partnership.(28)
Under the terms of the Lease, the Operating Partnership will not be
required to provide any services, customary or noncustomary, in connection with
the rental of the Hotel Property. Instead, all services relating to the
operation of the Hotel Property will be provided by Hyatt under the terms of
the Management Agreement. The Operating Partnership has represented that Hyatt
is an independent contractor within the meaning of section 856(d)(3), from
which the Company and the Operating Partnership will not derive or receive any
income. The Operating Partnership will not bear the cost of any of the
services provided by Hyatt. Instead, such costs will be borne by Mogul when it
assumes the Operating Partnership's Obligations under the Management Agreement.
Based on the foregoing, we believe that the provision of any
noncustomary services to the occupants of the Hotel Property by Hyatt will have
no effect on the qualification of the income derived from the Hotel Property as
"rents from real property." In fact, the IRS has issued a private letter
ruling in which it has treated the income derived from several leases of hotel
properties as "rents from real property" in a situation where the lessees had
contracted with a third-party to conduct the day to day operations of the
hotels.(29) Our conclusion is not altered by the fact that the Operating
Partnership will remain liable for any obligations arising under the Management
Agreement, to the extent that they are not satisfied by the Tenant. The
Operating Partnership should not be treated as bearing the cost of the services
provided by Hyatt merely because it is liable for Mogul's obligations under the
Management Agreement. The Operating Partnership is not retaining this liability
in an attempt to provide services to Mogul. Instead, it is retaining this
liability only as an accommodation, in order to gain Hyatt's consent to its
purchase of the Hotel Property. Moreover, the Operating Partnership believes
that it is highly unlikely that it will ever be required to reimburse Hyatt for
the costs and expenses of operating the Hotel Property. This is because (i)
the Hotel Property is projected to generate enough gross income to cover the
payments to Hyatt under the Management Agreement, (ii) in connection with the
Lease, Mogul will represent that it has a net worth of at least $400,000 , and
(iii) in the view of the Operating Partnership, Mogul's capitalization is
adequate to allow Mogul to assume Mogul's obligations under the Lease.
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(27) Sections 856(d)(1), 856(d)(2)(C); Treas. Reg. Section 1.512(b)-1(c)(5).
(28) Treas. Reg. Section 1.856-4(b)(5).
(29) See, P.L.R. 8117036 (January 27, 1981).
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<PAGE> 46
2. Income Derived in the Case of a Default under the Lease
If the Operating Partnership were required to reimburse Hyatt for the
costs of operating the Hotel Property because of a default by Mogul under the
terms of the Management Agreement, we have concluded that the income derived by
the Operating Partnership from the Hotel Property would be treated as
"qualifying income" for purposes of the 75 percent and 95 percent tests. This
is because, if the Operating Partnership were required to reimburse Hyatt for
the cost of operating the Hotel Property, this would constitute an event of
default under Article 16.1(c) of the Lease, allowing the Operating Partnership
to terminate Mogul's leasehold interest in the Hotel Property. As a result of
such a termination of the Lease, any income derived by the Operating
Partnership from the Hotel Property after the default would be treated as
income from foreclosure property.
The Operating Partnership would be able to continue to operate the
Hotel Property after any default under the Lease, without affecting its status
as foreclosure property, because Hyatt, an independent contractor, from whom
the Company will not derive any income, will provide all services relating to
its operation. As noted above, a REIT can use foreclosure property in the
conduct of an active trade or business, as long as this is done through the use
of an independent contractor, from whom the REIT does not derive or receive any
income.(30)
As noted above, real property acquired upon default under a lease is
not eligible to be treated as foreclosure property if the lease is entered into
with an intent to evict or foreclose, or if the REIT knows or has reason to
know that default would occur.(31) This is not the case in the present
situation because (i) the Hotel Property is projected to generate enough gross
income to produce a profit for Mogul, (ii) in connection with the Lease, Mogul
will represent that it has a net worth of at $400,000, and (iii) in the view of
the Operating Partnership, Mogul's capitalization is adequate to allow Mogul to
assume Mogul's obligations under the Lease.
The Hotel Property would in any event qualify as foreclosure property
only for a period of up to two years, beginning of the date of its acquisition
by the Operating Partnership, unless the Operating Partnership obtains an
extension of the grace period from the IRS.(32) Therefore, in the event the
Operating Partnership takes possession of the Hotel Property as a result of a
default under the lease, presumably the Operating Partnership will sell the
Hotel Property or within two years rent it to another tenant under a lease
that will produce "rents from real property."
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(30) Section 856(e)(4)(C). (The IRS clearly intended for REITs to be able to
treat hotels operated by independent contractors as foreclosure property. For
instance, the Treasury regulations defining foreclosure property refer to hotel
properties twice. See, Treas. Reg. Sections 1.856-6(b)(2), 1.856-6(d)(2). In
addition, the IRS has also recently issued a private letter ruling in which it
treated income received from hotels acquired pursuant to a bankruptcy petition
as income from foreclosure property, where the hotels were operated by third
party managers. P.L.R. 9420013 (2/15/94).)
(31) Treas. Reg. Section 1.856-6(b)(3).
(32) Section 856(e)(2).
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<PAGE> 47
CONCLUSION
Based on the assumptions stated above, it is our opinion that (i) all
of the income that the Operating Partnership derives from the Hotel Property
will be treated as "qualifying income" for purposes of the 95 percent test and
(ii) all of the income the Operating Partnership derives from the Hotel
Property, with the exception of the interest income attributable to the deemed
financing of Mogul's acquisition of the FF & E, will be treated as "qualifying
income" for purposes of the 75 percent test.
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<PAGE> 48
April 1, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue, Suite 1800
New York New York 10022
Ladies and Gentlemen:
On January 3, 1995 we provided you with a memorandum analyzing the
impact of the purchase of the Hyatt Regency Beaver Creek (the "Hotel Property")
by Crescent Real Estate Equities Limited Partnership (the "Operating
Partnership") would have on the ability of Crescent Real Estate Equities, Inc.
(the "Company") to continue to qualify as a real estate investment trust (a
"REIT") under section 856(c).(1) That memorandum concluded that, subject to
certain assumptions, in our opinion (i) all of the income that the Operating
Partnership derived from the Hotel Property would be treated as "qualifying
income" for purposes of the 95 percent gross income test for REIT qualification
under section 856(c)(2) (the "95 percent test") and (ii) all of the income that
the Operating Partnership derived from the Hotel Property, with the exception
of certain interest income, would be treated as "qualifying income" for
purposes of the 75 percent gross income test for REIT qualification under
section 856(c)(3) (the "75 percent test"). The January 3, 1995 memorandum was
based upon, among other items, our review of a Lease Agreement between dated
January 3, 1995 between the Operating Partnership, as lessor, and Mogul
Management LLC ("Mogul"), as lessee, dated January 3, 1995 (the "Original
Lease").
On October 6, 1995, the Original Lease was amended to provide for the
subordination of the leasehold estate created by the Original Lease to any lien
or encumbrance placed against all or any part of the Hotel Property and to
provide for the approval by the Operating Partnership of a proposed merger of
Mogul into RoseStar Management, LLC, a Texas limited liability company
("RoseStar"). Currently, Sanjay Varma owns a 91 percent interest in the assets
and net profits of RoseStar, while Gerald W. Haddock and John C. Goff, the
managers of RoseStar, each own a 4.5 percent interest in its assets and net
profits.
Also on October 6, 1995, the Operating Partnership conveyed all of its
interest as lessor under the Original Lease to Crescent Real Estate Funding II,
L.P., a Delaware limited
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(1) All section references are to the Internal Revenue Code of 1986, as
amended (the "Code"), or to the regulations issued thereunder, unless
otherwise noted.
<PAGE> 49
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 2
Partnership ("Funding II"). Funding II assumed all of the Operating
Partnership's liabilities and obligations under the Original Lease.
On January 1, 1996, the Funding II, Mogul and Rose Star executed an
Amended and Restated Lease Agreement for the Hotel Property (hereinafter the
Original Lease as amended and restated is referred to as the "Lease").
On February 9, 1996, Mogul was merged with and into RoseStar and
RoseStar succeeded Mogul as lessee under the Lease.
On March 29, 1996, pursuant to an Assignment and Assumption of
Leasehold Estate, RoseStar sold and assigned all of its interest and estate as
lessee under the Lease to RoseStar Southwest, LLC, a Delaware limited liability
company ("Southwest"). RoseStar owns a 99 percent interest in Southwest, while
the remaining one percent interest is owned by RSSW Corp., a Delaware
corporation.
On April 1, 1996, the Lease was amended to provide that, among other
things, (1) at all times during the term of the Lease, Southwest and RoseStar
would maintain a cumulative net worth equal to $200,000; and (2) Southwest
would retain all of the income it earned with respect to the Hotel Property
(except distributions to its beneficial owners in an amount sufficient to pay
their federal and state income taxes on the income) until such time as
Southwest and any affiliate of Southwest (including RoseStar) which has entered
into a long-term lease of a hotel with Funding II or any affiliate of Funding
II (including the Operating Partnership) have accumulated and are holding in
reserve funds in the aggregate which are sufficient to enable Southwest and any
affiliated entities to pay at least one monthly payment of base rent under each
lease between Southwest (or any affiliated entities) and Funding II or an
affiliate of Funding II.
This letter is intended to update the opinions expressed in our
January 3, 1995 memorandum to reflect the changes in the Lease Agreement and
the substitution of new parties as lessor and lessee of the Hotel Property.
The opinions set forth herein are based upon the existing provisions of the
Code, and the reported interpretations thereof by the IRS and by the courts in
effect as of the date hereof, all of which are subject to change, both
retroactively or prospectively, and to possibly different interpretations. We
assume no obligation to update the opinions set forth in this letter. We
believe that the conclusions expressed herein, if challenged by the IRS, would
be sustained in court. However, because our opinions are not binding upon the
IRS or the courts, there can be no assurance that contrary positions may not be
successfully asserted by the IRS.
<PAGE> 50
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 3
I. Documents and Representations
For the purpose of rendering this opinion, we have examined
and relied on originals, or copies certified or otherwise identified to our
satisfaction, of the following: (1) the Original Lease; (2) the Amendment to
Lease Agreement between the Operating Partnership and Mogul dated October 6,
1995; (3) the Lease; (4) the Assignment and Assumption of Leasehold Estate by
and between RoseStar and Southwest dated March 29, 1996; (5) the First
Amendment to the Lease dated April 1, 1996; (6) the Limited Guaranty Agreement
by Gerald Haddock, John Goff and Sanjay Varma, as guarantors in favor of
Funding II (the "Guaranty); (7) the Articles of Organization of RoseStar
Management, LLC (the "RoseStar Articles"); (8) the Regulations of RoseStar
Management, LLC (the "RoseStar Regulations"); (9) the Operating Agreement of
RoseStar Southwest, LLC; (10) the First Amended and Restated Articles of
Incorporation of Crescent Real Estate Equities, Inc. (the "Crescent Articles");
and (11) such other documents or information as we have deemed necessary for
the opinion set forth below. In our examination, we have assumed the
genuineness of all signatures, the legal capacity of natural persons, the
authenticity of all documents submitted to us as originals, the conformity to
original documents of all documents submitted to us as certified or photostatic
copies, and the authenticity of the originals of such copies.
For the purpose of rendering this opinion, we have also assumed that
all statements of facts and assumptions described in our January 3, 1995
memorandum remain correct, unless otherwise noted.
II. Opinions
A. Lease Will be Treated as a Lease for Federal Income Tax Purposes
In order for any income derived by Funding II from the Hotel Property
to constitute either "rents from real property," or in the case of a default
under the Lease, "gross income from foreclosure property," the Lease must be
treated as a lease for federal income tax purposes and not be treated as a
service contract, management contract or other type of arrangement. This
determination depends on an analysis of all the surrounding facts and
circumstances. In making this determination, courts have considered a variety
of factors, including the following: (i) the intent of the parties, (ii) the
form of the agreement, (iii) the degree of control over the business conducted
at the property that is provided to the lessee (e.g., whether the lessee has
substantial rights of control over the operation of the property and its
business), (iv) the extent to which the lessee has the risk of loss from
operations of the business conducted as the property (e.g., whether the lessee
bears the risk of increases in operating expenses and of decreases in
revenues), and (v) the extent to which the lessee has
<PAGE> 51
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 4
the opportunity to benefit from operations of the business conducted at the
property (e.g., whether the lessee benefits from decreased operating expenses
or increased revenues).(2)
In addition, section 7701(e) provides that a contract that purports to
be a service contract, partnership agreement, or another type of arrangement
will be treated instead as a lease of property if the contract is properly
treated as such, taking into account all relevant factors, including whether or
not: (i) the service recipient is in physical possession of the property, (ii)
the service recipient controls the property, (iii) the service recipient has a
significant economic or possessory interest in the property (e.g., the
property's use is likely to be dedicated to the service recipient for a
substantial portion of the useful life of the property, the recipient shares
the risk that the property will decline in value, the recipient shares in any
appreciation in the value of the property, the recipient shares in any savings
in the property's operating costs or the recipient bears the risk of damage to
or loss of the property), (iv) the service provider does not bear any risk of
substantially diminished receipts or substantially increased expenditures if
there is nonperformance under the contract, (v) the service provider does not
use the property concurrently to provide significant services to entities
unrelated to the service recipient and (vi) the total contract price does not
substantially exceed the rental value of the property for the contract period.
Since the determination of whether a service contract, partnership agreement,
or some other type of arrangement should be treated as a lease is inherently
factual, the presence or absence of any single factor may not be dispositive in
every case.(3)
We have concluded that the Lease will be treated as a lease for
Federal income tax purposes, rather than a service contract, management
contract or other type of arrangement. This conclusion is based, in part, on
the following facts: (i) Funding II and Southwest intend their relationship to
be that of lessor and lessee (as evidenced by the terms of the Lease), (ii)
Southwest has the right to exclusive possession, use and quiet enjoyment of the
Hotel Property during the term of the Lease and the right to uninterrupted
control in the operation of and business conducted at the Hotel Property
(subject to its assumption of the Management Agreement), (iii) Southwest will
bear the cost of, and be responsible for, capital expenditures, including
maintenance and repair of the Hotel Property, and will dictate how the Hotel
Property is maintained and improved (with the exception that Funding II, as
lessor, is responsible for the cost of certain capital expenditures in
situations where the funds available to Southwest are insufficient for such
expenditures), (iv) Southwest will bear all the costs and expenses of operating
the Hotel Property (with the exception of the costs of replacing certain
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(2) See, e.g., Xerox Corp. v. U.S., 80-2 USTC Paragraph 9530 (Ct. Cl. Tr.
Div. 1980), aff'd per curiam, 656 F.2d 659 (Ct. Cl. 1981).
(3) P.L.R. 8918012 (January 24, 1989).
<PAGE> 52
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 5
FF & E associated with the Hotel Property, which is to be funded by Funding
II), (v) Southwest will benefit from any savings in the costs of operating the
Hotel Property during the term of the Lease, (vi) in the event of damage or
destruction to the Hotel Property, Southwest will be at economic risk because
its obligation to make rental payments will not abate, (vii) Southwest will
indemnify Funding II against all liabilities imposed on Funding II during the
term of the Lease by reason of injury to persons or damage to property
occurring at the Hotel Property or Southwest's use, management, maintenance or
repair of the Hotel Property, (viii) Southwest is obligated to pay substantial
fixed rent for the period of use of the Hotel Property, regardless of whether
its revenues exceed its costs and expenses, and (ix) Southwest stands to incur
substantial losses (or derive substantial profits) depending on how
successfully it operates the Hotel Property.
We do not believe that our conclusion that the Lease of the Hotel
Property will be treated as a lease for Federal income tax purposes is affected
by the fact that Southwest assumed RoseStar's rights and obligations as lessor
under the Lease subject to its assumption of Funding II's obligations under the
preexisting Management Agreement. The Management Agreement gives Hyatt control
over the day-to-day operation of the Hotel Property and will allow Hyatt to
share with Southwest in the benefits of any increases in revenues or cost
savings in the operation of the Hotel Property. However, Hyatt's operation of
the Hotel Property is not controlled by Funding II, and the Management
Agreement does not affect the fact that Southwest bears most of the risk of
loss if the Hotel Property is not successful. Moreover, the IRS has issued a
private letter ruling in which it treated leases of several hotel properties as
producing "rents from real property" in a situation where the lessees had
contracted with a third party to conduct the day-to-day operations of the
hotels.(4) This ruling suggests that the IRS will respect a lease of a hotel
for federal income tax purposes even if the hotel is operated by an independent
contractor rather than by the lessee.
The Lease is currently structured in form so that Funding II retains
ownership of all the personal property leased to Southwest in connection with
Southwest's lease of the Hotel Property (the "FF&E"). However, if the term of
the Lease equals or exceeds the useful life of some or all of the FF&E, it is
possible that the Lease could be treated for federal income tax purposes as a
financing arrangement. In such a case, Southwest would be treated as having
acquired ownership of the FF&E for federal income tax purposes in exchange for
an obligation to make future payments of principal and interest to Funding II.
Nonetheless, we do not believe that the recharacterization of the Lease as a
financing arrangement with respect to the FF&E would have a material effect on
the ability of the Company to satisfy the requirements for taxation as a REIT.
We reach this conclusion on the basis that, if a portion of the payments made
by Southwest under the Lease were characterized as interest on
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(4) See, P.L.R. 8117036 (January 27, 1981).
<PAGE> 53
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 6
indebtedness secured by the FF&E, rather than rents from real property, that
portion would still satisfy the 95 percent gross income test (although it would
not satisfy the 75% gross income test).(5)
B. Percentage Rent Provision is not Profit-Based
Pursuant to the Lease, Southwest will be obligated to pay Funding II
base rent and percentage rent. Under the regulations, percentage rent based on
a percentage of gross receipts or sales in excess of a floor amount, which is
how the percentage rent is structured under the Lease, will not qualify as
"rents from real property" unless (i) such floor amount does not depend in
whole or in part on the income or profits of the lessee, (ii) the percentage
and the floor amount are fixed at the time the lease is entered into, (iii) the
percentage and the floor amount are not renegotiated during the term of the
lease in a manner that has the effect of basing the percentage rent on income
or profits, and (iv) the percentage and the floor amount conform with normal
business practice.(6)
Under the terms of Article 4.2 of the Lease, Southwest will pay
percentage rent equal on an annual basis to the sum of (i) 17.5 percent of the
excess of annual gross receipts from room rentals over $9,300,000 and (ii) 2.5
percent of the excess of annual gross receipts from the food and beverage
facilities at the Hotel Property over $3,000,000. This formula is unchanged
from the formula in the Original Lease between the Operating Partnership and
Mogul. It will effectively reward Southwest for any increases in gross
receipts from rooms and from other sources over the threshold amounts. This
type of formula does not base the percentage rent on Southwest's income or
profits, and similar formulas have been treated by the IRS as generating "rents
from real property."(7) Moreover, Funding II has represented that (i) the floor
amounts used to compute the percentage rent under the Lease do not depend in
whole or in part on the income or profits of any person, (ii) the percentage
rent provision of the Lease has not been and will not be renegotiated during
the term of the Lease or at the expiration or earlier termination of the Lease
in a manner that has the effect of basing the rent
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(5) If the Lease were recharacterized as a financing arrangement with
respect to the FF&E, it also might result in some minor timing
differences with respect to the Company's recognition of
income. These differences would result from (a) the
recharacterization of a portion Soutwest's payments under the Lease as
a return of principal and (b) the Company's loss of any depreciation
deductions attributable to the FF&E.
(6) Treas. Reg. Section 1.866-4(b)(3).
(7) See, e.g., P.L.R. 8803007 (September 23, 1987) (percentage rent based
on gross revenues in excess of gross revenues for a base year
treated as "rents from real property"); cf. P.L.R. 9104018 (October
26, 1990) (interest based on gross revenues in excess of a floor
amount treated as qualifying interest under section 856(f)).
<PAGE> 54
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 7
on income or profits, and (iii) the percentage rent provision of the Lease
conforms with normal business practice. In addition, based on our experience
and an examination of the Lease and the Hotel Property projections, the Lease
appears to conform with normal business practice.
C. Southwest is not a "Related Party Tenant"
Rents received from Southwest will not qualify as "rents from real
property" if Southwest is a "related party tenant." Southwest will be a
"related party tenant" if the Company, or an owner of 10 percent or more of the
Company, directly or constructively owns 10 percent or more of the assets or
net profits of Southwest.(8) Constructive ownership is determined for purposes
of this test by applying the rules of section 318(a) as modified by section
856(d)(5). Those rules generally provide that if 10 percent or more in value
of the stock of the Company is owned, directly or indirectly, by or for any
person, the Company is considered as owning the stock owned, directly or
indirectly, by or for such person.
Southwest will not be treated as a "related party tenant" because a 99
percent interest in Southwest's assets and net profits will be owned by
RoseStar, with the remaining one percent interest owned by RSSW Corp. An
individual, Sanjay Varma, currently owns a 91 percent interest in the assets
and net profits of RoseStar and RSSW Corp. In reaching this conclusion, we
recognize that Sanjay Varma owns certain Units of the Operating Partnership.(9)
Funding II has represented that (i) Sanjay Varma does not own more than 10
percent of the value of the Company's stock, (ii) Sanjay Varma is not expected
to own more than 10 percent of the value of the Company's stock in the future,
and (iii) neither the Funding II nor the Company intends to acquire, directly
or constructively, an interest of 10 percent or more in the assets or net
profits of RoseStar at any time in the future. Moreover, Article 7.8 of the
Lease limits the ability of Southwest or any person owning an interest in
Southwest (including RoseStar) to acquire, directly or constructively, a 6
percent stock interest in the Company, and Section 6.4 of the First Amended and
Restated Articles of Incorporation of the Company prevents RoseStar and its
members and managers from acquiring more than 8 percent of the Company's stock.
The conclusion that Southwest will not be treated as a "related party
tenant" is based on the assumption that its member RoseStar will be treated as
a partnership for federal income tax purposes. If RoseStar is not treated as a
partnership for federal income tax purposes, but
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(8) Section 856(d)(2)(B)(ii).
(9) See Rev. Rul. 73-194, 1973-1 C.B. 355 (management company treated as
an independent contractor with respect to a REIT, where an
affiliate of the management company and the REIT were partners).
<PAGE> 55
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 8
is instead treated as an association taxable as a corporation, then it is
possible that Southwest would be treated as a "related party tenant" and the
rents derived under the terms of the Lease would not be treated as "rents from
real property." This is because, if RoseStar were treated as a corporation for
federal income tax purposes, Gerald W. Haddock and John C. Goff would likely be
deemed to own all of its voting stock, because of the extensive powers that
they are granted as managers under the RoseStar Regulations. If this were the
case, the ownership of such voting stock (and ownership of Southwest) might be
attributed to the Company under a literal reading of the constructive ownership
rules described above.(10)
An entity which has associates and an objective to carry on a business
for joint profit will be treated as a partnership for federal income tax
purposes, and not as an association taxable as a corporation, if it has not
more than two of the following four characteristics of a corporation: (i)
continuity of life; (ii) centralization of management; (iii) limited liability;
and (iv) free transferability of interests.(11) The entity must also have no
other characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics.(12) The IRS has applied this four-factor test in determining
whether limited liability companies formed under the Texas Limited Liability
Company Act (the "Act") are partnerships for federal income tax purposes.(13)
The IRS has issued Rev. Proc. 95-10, which specifies conditions which must be
satisfied for a limited liability company to receive a favorable advanced
ruling that it will be classified as a partnership for federal income tax
purposes.(14) RoseStar should satisfy these conditions. However, such
conditions are
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(10) Richard Rainwater, Gerald Haddock and John Goff are each partners in
FW-Irving Partners, Ltd. (and apparently they are partners in
other partnerships as well). Richard Rainwater also owns more than 10
percent of the value of the stock of the Company. Thus, assuming that
the ownership interests in RoseStar held by Gerald Haddock and John
Goff constitute stock, such interests, along with Richard Rainwater's
stock interest in the Company, will be attributed to FW-Irving
Partners, Ltd. pursuant to section 318(a)(3)(A), which provides that
stock owned, directly or indirectly, by or for a partners shall be
considered as owned by the partnership. Then, FW-Irving Partners,
Ltd.'s deemed interest in RoseStar would be attributed to the Company
pursuant to section 318(a)(3)(C) (as modified by section 856(d)(5)),
which provides that stock owned by any person that owns 10 percent or
more of the value of the stock in a corporation shall be considered
owned by the corporation. As you are aware, however, we have opined
to you in a similar context that we do not believe that these
attribution rules should be read literally.
(11) Treas. Reg. Section 301.7701-2(a).
(12) See Rev. Rul. 79-106, 1979-1 C.B. 448.
(13) See, e.g., P.L.R. 9242025 (July 22, 1992) and P.L.R. 9218078 (January
31, 1992).
(14) 1995-3 I.R.B. 20.
<PAGE> 56
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 9
applicable only in determining whether rulings will be issued and are not
intended as substantive rules for determination of partnership status.
An organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time.(15)
Article 6.01 of the Act provides, in part, that except as otherwise provided in
the company's regulations, a limited liability company shall be dissolved upon
the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a
member or the occurrence of any other event which terminates the continued
membership of a member in the limited liability company, unless there is at
least one remaining member and the business of the limited liability company is
continued by the consent by the number of members or class thereof stated in
the articles of organization or regulations of the limited liability company or
of not so stated, by all remaining members. Article 2 of the RoseStar Articles
provides that the duration of RoseStar is until the close of business on
December 31, 2015, or until its earlier dissolution in accordance with the
provisions of the Act or the Regulations. Article 10.2 of the RoseStar
Regulations provides, in part, that RoseStar shall be dissolved upon the
withdrawal, death, retirement, resignation, expulsion, bankruptcy, legal
incapacity or dissolution of any member, unless the business of RoseStar is
continued by the consent of all the remaining members within ninety days.
Accordingly, RoseStar will lack the corporate characteristic of continuity of
life.
An organization will be treated as possessing the corporate
characteristic of free transferability of interests if the members owning all
or substantially all of the interests in an organization may substitute for
themselves without the consent of the other members a person who is not a
member of the organization.(16) Article 4.05 of the Act provides, in part,
that unless otherwise provided by the company's regulations, a membership
interest is assignable in whole or in part; an assignment of a member's
interest does not entitle the assignee to become, or to exercise rights or
powers of a member; and until the assignee becomes a member, the assignor
member continues to be a member and to have the power to exercise any rights or
powers of a member, except to the extent those rights or powers are assigned.
Article 4.07 of the Act provides, in part, that an assignee of a membership
interest may become a member if and to the extent that the company's
regulations so provide, or all members consent. Article 9.3 of the RoseStar
Regulations provides, in part, that no member shall have the right to
substitute in its place a transferee unless consent is given by the Managers
and a majority of the other members, which consent may be withheld in the
discretion of the Managers or the
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(15) Treas. Reg. Section 301.7701-2(b)(3).
(16) Treas. Reg. Section 301.7701-2(e).
<PAGE> 57
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 10
other members. Accordingly, RoseStar will lack the corporate characteristic of
free transferability of interests. Because RoseStar will lack the corporate
characteristics of continuity of life and free transferability of interests, in
our opinion it will be treated as partnership for federal income tax purposes.
D. Incidental Personal Property
1. Rents Attributable to Personal Property Will Be Treated as
"Rents from Real Property"
The rents attributable to Funding II's personal property leased under
or in connection with the Lease must not be greater than 15 percent of the
rents received under the Lease. The rent attributable to personal property
leased under or in connection with a lease of real property is the amount that
bears the same ratio to total rent for the taxable year as (i) the average of
the adjusted bases of the personal property leased under or in connection with
a lease of real property at the beginning and at the end of the taxable year
bears to (ii) the average of the aggregate adjusted bases of the real and
personal property subject to the lease at the beginning and at the end of such
taxable year (the "Adjusted Basis Ratio").(17) Funding II has represented that
the adjusted tax basis of the personal property leased under or in connection
with the Lease (including, for the period beginning on January 1, 1996, any
furniture, fixtures or equipment formerly treated as owned by Mogul, as
described below) has not represented and will not represent more than 15
percent of the aggregate adjusted tax basis of the Hotel Property at any time.
2. Payments Attributable to Mogul's Deemed Acquisition of Certain
Personal Property Will Not Be Treated as "Rents from Real
Property"
Article 4.7 of the Original Lease provided that Mogul was to be deemed
to have acquired all of the furniture, fixtures and operating equipment
associated with the Hotel Property (the "FF & E") with the proceeds of a loan
from the Operating Partnership. It further provided that Mogul was to make
payments of principal and interest on this deemed loan. Pursuant to Funding
II's assumption of all of the Operating Partnership's liabilities and
obligations under the Original Lease, after October 6, 1995, all payments of
principal and interest on this deemed loan were accrued by Funding II. On
January 1, 1996, in connection with the execution of the Lease, Article 4.7 of
the Original Lease ceased to be effective and the parties ceased to treat the
FF & E as owned by Mogul. Instead, beginning on January 1, 1996, the FF & E
has been treated by all parties as if it had been conveyed by Mogul to
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(17) Section 856(d)(1)(C).
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Crescent Real Estate Equities, Inc.
April 1, 1996
Page 11
Funding II in exchange for the cancellation the balance owed by Mogul under the
deemed financing arrangement established under the Original Lease.
The payments that the Operating Partnership and Funding II received
with regard to the FF & E under the terms of Article 4.7 of the Original Lease
prior to January 1, 1996 did not qualify as "rents from real property."
Instead, such payments were treated for federal income tax purposes as payments
of principal and interest resulting from a deemed financing of Mogul's purchase
of the FF & E.
The payments pursuant to this "deemed financing," to the extent they
constituted interest, were "qualifying income" for purposes of the 75 percent
test. However, because the deemed financing was secured by personal, rather
than real property, such interest was not qualifying income for purposes of the
95 percent test.
E. Provision of Services by the Funding II
1. Income Derived under the Terms of the Lease
Although Funding II may treat charges for services customarily
furnished or rendered in connection with the rental of the Hotel Property as
"rents from real property," any services rendered to the occupants of the Hotel
Property must be furnished or rendered by an independent contractor from whom
the Company does not derive or receive any income.(18) Moreover, to the extent
that any independent contractors provide noncustomary services to the occupants
of the Hotel Property, the cost of such services must not be borne by Funding
II.(19)
Under the terms of the Lease, Funding II will not be required to
provide any services, customary or noncustomary, in connection with the rental
of the Hotel Property. Instead, all services relating to the operation of the
Hotel Property will be provided by Hyatt under the terms of the Management
Agreement. Funding II has represented that Hyatt is an independent contractor
within the meaning of section 856(d)(3), from which the Company and Funding II
will not derive or receive any income. Funding II will not bear the cost of
any of the services provided by Hyatt. Instead, such costs are borne by
Southwest, because it has assumed Funding II's obligations, as owner, under the
Management Agreement.
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(18) Sections 856(d)(1), 856(d)(2)(C); Treas. Reg. Section 1.512(b)-1(c)(5).
(19) Treas. Reg. Section 1.856-4(b)(5).
<PAGE> 59
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 12
Based on the foregoing, we believe that the provision of any
noncustomary services to the occupants of the Hotel Property by Hyatt will have
no effect on the qualification of the income derived from the Hotel Property as
"rents from real property." In fact, the IRS has issued a private letter
ruling in which it has treated the income derived from several leases of hotel
properties as "rents from real property" in a situation where the lessees had
contracted with a third-party to conduct the day to day operations of the
hotels.(20) Our conclusion is not altered by the fact that Funding II will
remain liable for any obligations arising under the Management Agreement, to
the extent that they are not satisfied by Southwest. Funding II should not be
treated as bearing the cost of the services provided by Hyatt merely because it
is liable for Southwest's obligations under the Management Agreement. Funding
II is not retaining this liability in an attempt to provide services to
Southwest. Instead, it is retaining this liability only as an accommodation to
Hyatt. Moreover, Funding II believes that it is highly unlikely that it will
ever be required to reimburse Hyatt for the costs and expenses of operating the
Hotel Property. This is because (i) the Hotel Property is projected to
generate enough gross income to cover the payments to Hyatt under the
Management Agreement, (ii) in connection with Section 7.7 the Lease, as
amended, Southwest has represented that it has a net worth of at least
$200,000, (iii) in connection with Section 7.9 of the Lease, as amended,
Southwest has agreed to retain all of the income it earns from the Hotel
Property (except distributions to its beneficial owners in an amount sufficient
to pay their federal and state income taxes on such income) until such time as
Southwest and any affiliate of Southwest (including RoseStar) which has entered
into a long-term lease of a hotel with Funding II or any affiliate of Funding
II (including the Operating Partnership) have accumulated and are holding in
reserve funds in the aggregate which are sufficient to enable Southwest and any
affiliated entities to pay at least one monthly payment of base rent under each
lease between Southwest and any such affiliated entities and Funding II or an
affiliate of Funding II, (iv) pursuant to the Guaranty, RoseStar's individual
members have guaranteed RoseStar's obligations under the Lease, and (v) in the
view of Funding II, Southwest's capitalization is adequate to allow Southwest
to assume its obligations as lessee under the Lease.
2. Income Derived in the Case of a Default under the Lease
If Funding II were required to reimburse Hyatt for the costs of
operating the Hotel Property because of a default by Southwest under the terms
of the Management Agreement, we have concluded that the income derived by
Funding II from the Hotel Property would be treated as "qualifying income" for
purposes of the 75 percent and 95 percent tests. This is because, if Funding
II were required to reimburse Hyatt for the cost of operating the Hotel
Property, this would constitute an event of default under Article 16.1(c) of
the Lease, allowing Funding II to terminate Southwest's leasehold interest in
the Hotel Property. As a
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(20) See, P.L.R. 8117036 (January 27, 1981).
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Crescent Real Estate Equities, Inc.
April 1, 1996
Page 13
result of such a termination of the Lease, any income derived by Funding II
from the Hotel Property after the default would be treated as income from
foreclosure property.
Funding II would be able to continue to operate the Hotel Property
after any default under the Lease, without affecting its status as foreclosure
property, because Hyatt, an independent contractor, from whom the Company will
not derive any income, will provide all services relating to its operation. A
REIT can use foreclosure property in the conduct of an active trade or
business, as long as this is done through the use of an independent contractor,
from whom the REIT does not derive or receive any income.(21)
Real property acquired upon default under a lease is not eligible to
be treated as foreclosure property if the lease is entered into with an intent
to evict or foreclose, or if the REIT knows or has reason to know that default
would occur.(22) This is not the case in the present situation because (i) the
Hotel Property is projected to generate enough gross income to cover the
payments to Hyatt under the Management Agreement, (ii) in connection with
Section 7.7 the Lease, as amended, Southwest has represented that it has a net
worth of at least $200,000, (iii) in connection with Section 7.9 of the Lease,
as amended, Southwest has agreed to retain all of the income it earns from the
Hotel Property (except distributions to its beneficial owners in an amount
sufficient to pay their federal and state income taxes on such income) until
such time as Southwest and any affiliate of Southwest (including RoseStar)
which has entered into a long-term lease of a hotel with Funding II or any
affiliate of Funding II (including the Operating Partnership) have accumulated
and are holding in reserve funds in the aggregate which are sufficient to
enable Southwest and any affiliated entities to pay at least one monthly
payment of base rent under each lease between Southwest and any such affiliated
entities and Funding II or an affiliate of Funding II, (iv) pursuant to the
Guaranty, RoseStar's individual members have guaranteed RoseStar's obligations
under the Lease, and (v) in the view of Funding II, Southwest's capitalization
is adequate to allow Southwest to assume its obligations as lessee under the
Lease.
The Hotel Property would in any event qualify as foreclosure property
only for a period of up to two years, beginning of the date of its acquisition
by Funding II, unless
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(21) Section 856(e)(4)(C). (The IRS clearly intended for REITs to be able
to treat hotels operated by independent contractors as
foreclosure property. For instance, the Treasury regulations defining
foreclosure property refer to hotel properties twice. See, Treas.
Reg. Sections 1.856-6(b)(2), 1.856-6(d)(2). In addition, the IRS has
also recently issued a private letter ruling in which it treated
income received from hotels acquired pursuant to a bankruptcy petition
as income from foreclosure property, where the hotels were operated by
third party managers. P.L.R. 9420013 (2/15/94).)
(22) Treas. Reg. Section 1.856-6(b)(3).
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Crescent Real Estate Equities, Inc.
April 1, 1996
Page 14
Funding II obtains an extension of the grace period from the IRS.(23)
Therefore, in the event Funding II takes possession of the Hotel Property as a
result of a default under the Lease, presumably Funding II will sell the Hotel
Property or, within two years, rent it to another tenant under a lease that
will produce "rents from real property."
F. Conclusions
Based on the assumptions and representations stated above, it is our
opinion that (i) all of the income that Funding II derives from the Hotel
Property will be treated as "qualifying income" for purposes of the 95 percent
test and (ii) all of the income that Funding II derives from the Hotel
Property, will be treated as "qualifying income" for purposes of the 75 percent
test. However, we note that certain interest income accrued prior to January
1, 1996 and attributable to the deemed financing of Mogul's acquisition of the
FF & E under Section 4.7 of the Original Lease has properly been treated by the
Operating Partnership and Funding II as qualifying income for purposes of the
95 percent test, but not for purposes of the 75 percent test.
III. Additional Limitations
The foregoing opinions are limited to the specific matters covered
thereby and should not be interpreted to imply that the undersigned has offered
its opinion on any other matter.
Very truly yours,
SHAW, PITTMAN, POTTS & TROWBRIDGE
By:
--------------------------------
Charles B. Temkin, P.C.
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(23) Section 856(e)(2).
<PAGE> 62
MEMORANDUM
TO: David Dean
FROM: Charles B. Temkin
Michael A. Jacobs
DATE: June 30, 1995
RE: Characterization of Income Derived from Denver Marriott City
Center
I. OVERVIEW
Crescent Real Estate Equities Limited Partnership (the "Operating
Partnership") is scheduled to purchase the Denver Marriott City Center (the
"Denver Marriott") from the Prudential Insurance Company of America
("Prudential"), the successor to the Denver Energy Center Hotel Partnership
(the "Original Owner"), on June 30, 1995. Crescent Real Estate Equities, Inc.
(the "Company") is currently the sole shareholder of two corporations, one of
which is the sole general partner of and one of which is a limited partner of
the Operating Partnership. These two corporations constitute qualified REIT
subsidiaries within the meaning of section 856(i).(1)
This memorandum analyzes the impact that the purchase of the Denver
Marriott will have on the ability of the Company to continue to qualify as a
real estate investment trust (a "REIT") under section 856(c). More
specifically, it analyzes whether the income the Operating Partnership will
derive from the Denver Marriott will be "qualifying income" for purposes of the
75 percent and 95 percent gross income tests for REIT qualification. This
memorandum concludes that, subject to certain assumptions, in our opinion (i)
all of the income that the Operating Partnership will derive from the Denver
Marriott will be treated as "qualifying income" for purposes of the 95 percent
test and (ii) all of the income the Operating Partnership will derive from the
Denver Marriott, with the exception of certain interest income, will be treated
as "qualifying income" for purposes of the 75 percent test.
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(1)All section references herein are to the Internal Revenue Code of 1986, as
amended (the "Code"), or to the regulations issued thereunder, unless otherwise
noted.
<PAGE> 63
II. FACTS AND ASSUMPTIONS
The Original Owner contracted with Marriott Corporation to operate
the Denver Marriott. Under the terms of the agreement between the Original
Owner and Marriott Corporation dated January 10, 1979, as amended on January
10, 1979, February 16, 1979, May 11, 1979, July 27, 1979, March 25, 1980,
December 18, 1980, July 15, 1981, January 4, 1982, and November 19, 1993. (the
"Management Agreement"), Marriott Corporation is obligated to provide all
services in relation to the operation of the Denver Marriott and collect all
hotel receipts. In exchange for these services, Marriott Corporation is to be
reimbursed for the costs of operating the Denver Marriott and paid a management
fee. This fee is paid out of hotel receipts; it is based on the profits, if
any, from operation of the Denver Marriott. Marriott International, Inc.
("Marriott") is currently operating the Denver Marriott as the successor to
Marriott Corporation.
Article 18.01 of the Management Agreement requires that all
assignments of the Management Agreement be approved by Marriott and that any
assignees expressly assume the obligations of the owner under the Management
Agreement. Therefore, in connection with its purchase of the Denver Marriott,
the Operating Partnership will assume all of the obligations of Prudential
under the Management Agreement.
When the Operating Partnership purchases the Denver Marriott, it will
lease it to RoseStar Management, LLC ("RoseStar") pursuant to a Lease Agreement
dated June 30, 1995, as amended and restated by an Amended and Restated Lease
Agreement dated June 30, 1995 (as amended and restated, the "Lease"). Pursuant
to Article 2 of the Lease, the Operating Partnership will assign its interest
in the Management Agreement to RoseStar; and pursuant to Article 18.01 of the
Management Agreement, RoseStar will assume all of the Operating Partnership's
obligations thereunder. However, as a condition of its approval of the Lease,
Marriott will require that the Operating Partnership remain liable for all
obligations of the Operating Partnership under the Management Agreement that
will be assumed by RoseStar.
Currently, Sanjay Varma owns a 91 percent interest in the assets and
net profits of RoseStar, while Gerald W. Haddock and John C. Goff, the
managers of RoseStar, each own a 4.5 percent interest in its assets and net
profits.
For purposes of this memorandum, we have examined and relied upon (1)
the Management Agreement, (2) the Lease, (3) the Articles of Organization of
RoseStar Management, LLC (the "RoseStar Articles"), (4) the Regulations of
RoseStar Management, LLC (the "RoseStar Regulations"), (5) the First Amended
and Restated Articles of Incorporation of Crescent Real Estate Equities, Inc.
(the "Crescent Articles"), (6) the Purchase and Sale Agreement between
Prudential and the Operating Partnership, (7) the Consent Agreement between
Marriott and the Operating Partnership, and (8) such other documents or
information as we deemed necessary for the opinions set forth below. In our
examination, we have assumed the genuineness of all
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<PAGE> 64
signatures, the legal capacity of natural persons, the authenticity of all
documents submitted to us as originals, the conformity to original documents of
all documents submitted to us as certified or photostatic copies, and the
authenticity of the originals of such copies.
This memorandum is based upon existing provisions of the Code,
Treasury regulations, and the reported interpretations thereof by the Internal
Revenue Service ("IRS") and by the courts in effect (or, in the case of certain
proposed regulations, proposed) as of the date hereof, all of which are subject
to change, both retroactively or prospectively, and to possibly different
interpretations. We assume no obligation to update the opinions set forth in
this memorandum. We believe that the conclusions expressed herein, if
challenged by the IRS, would be sustained in court. However, because our
opinions are not binding upon the IRS or the courts, there can be no assurance
that contrary positions may not be successfully asserted by the IRS.
In addition, this memorandum is based on various assumptions and is
conditioned upon certain representations made by the Operating Partnership and
its sole general partner, Crescent Real Estate Equities, Ltd., as to factual
and other matters as set forth in the attached letter.
III. LEGAL BACKGROUND
A. 75 Percent and 95 Percent Tests
In order to qualify as a REIT for tax purposes, the Company must
satisfy certain tests with respect to the composition of its gross income on an
annual basis. First, at least 75 percent of the Company's gross income
(excluding gross income from certain prohibited transactions) for each taxable
year must consist of temporary investment income or of certain defined
categories of income derived directly or indirectly from investments relating
to real property or mortgages on real property. These categories include,
subject to various limitations, rents from real property, interest on mortgages
on real property, gains from the sale or other disposition of real property
(including interests in real property and mortgages on real property) not
primarily held for sale to customers in the ordinary course of business, income
from foreclosure property, and amounts received as consideration for entering
into either loans secured by real property or purchases or leases of real
property.(2) Second, at least 95 percent of the Company's gross income
(excluding gross income from certain prohibited transactions) for each taxable
year must be derived from income qualifying under the 75 percent test and from
dividends, other types of interest and gain from the sale or disposition of
stock or securities, or from any combination of the foregoing.(3)
In applying these income tests, REITs that are partners in a
partnership are required to include in their gross income their proportionate
share of the partnership's gross income. In
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(2)Section 856(c)(3).
(3)Section 856(c)(2).
-3-
<PAGE> 65
addition, such REITs are to treat this partnership gross income as retaining
the same character as the items of gross income of the partnership for purposes
of section 856.(4) Thus, the character of any income derived by the Operating
Partnership from the Denver Marriott will affect the ability of the Company to
qualify as a REIT.
B. Rents from Real Property
Rents from real property satisfy both the 75 percent and 95 percent
tests for REIT qualification only if several conditions are met. First, the
amount of rent must not be based in whole or in part on the income or profits
of any person. An amount received or accrued generally will not be excluded
from the term "rents from real property" solely by reason of being based on a
fixed percentage or percentages of receipts or sales.(5) Second, the Code
provides that rents received from a tenant will not qualify as "rents from real
property" if the REIT, or an owner of 10 percent or more of the REIT, directly
or constructively, owns 10 percent or more of such tenant (a "Related Party
Tenant").(6) Third, if rent attributable to personal property leased in
connection with a lease of real property is greater than 15 percent of the
total rent received under the lease, then the portion of rent attributable to
such personal property will not qualify as "rents from real property."(7)
Finally, for rents to qualify as "rents from real property," a REIT generally
must not operate or manage the property or furnish or render services to the
tenants of such property, other than through an independent contractor from
whom the REIT derives no revenue. However, rents will be qualified as "rents
from real property" if a REIT directly performs services in connection with the
lease of the property, if those services are "usually or customarily rendered"
in connection with the rental of space for occupancy, and such services are not
considered to be rendered to the occupant of the property.(8)
C. Income from Foreclosure Property
Income from foreclosure property is treated as "qualifying income" for
purposes of the 75 percent and 95 percent tests (although any net income from
foreclosure property is taxed at the maximum corporate rate). Foreclosure
property is any real property, and any personal property incident to such real
property, acquired by a REIT through default under a mortgage or a lease. A
REIT may elect to treat such property as foreclosure property for a grace
period of up to two
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(4)Treas. Reg. Section 1.856-3(g).
(5)Section 856(d)(2)(A).
(6)Section 856(d)(2)(B).
(7)Section 856(d)(1)(C).
(8)Sections 856(d)(1)(B), 856(d)(2)(C).
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<PAGE> 66
years.(9) However, such property will cease to qualify as foreclosure property
if it is used by the REIT in a trade or business more than 90 days after it is
acquired and it is not operated through an independent contractor from whom the
REIT does not derive or receive any income.(10) Moreover, property is not
eligible to be treated as foreclosure property if the lease is entered into
with an intent to evict or foreclose, or if the REIT knows or has reason to
know that default would occur.(11)
IV. DISCUSSION
A. Lease Will be Treated as a Lease for Federal Income Tax Purposes
In order for any income derived by the Operating Partnership from the
Denver Marriott to constitute either "rents from real property," or in the case
of a default under the Lease, "gross income from foreclosure property," the
Lease must be treated as a lease for federal income tax purposes and not be
treated as a service contract, management contract or other type of
arrangement. This determination depends on an analysis of all the surrounding
facts and circumstances. In making this determination, courts have considered
a variety of factors, including the following: (i) the intent of the parties,
(ii) the form of the agreement, (iii) the degree of control over the business
conducted at the property that is provided to the lessee (e.g., whether the
lessee has substantial rights of control over the operation of the property and
its business), (iv) the extent to which the lessee has the risk of loss from
operations of the business conducted as the property (e.g., whether the lessee
bears the risk of increases in operating expenses and of decreases in
revenues), and (v) the extent to which the lessee has the opportunity to
benefit from operations of the business conducted at the property (e.g.,
whether the lessee benefits from decreased operating expenses or increased
revenues).(12)
In addition, section 7701(e) provides that a contract that purports to
be a service contract, partnership agreement, or another type of arrangement
will be treated instead as a lease of property if the contract is properly
treated as such, taking into account all relevant factors, including whether or
not: (i) the service recipient is in physical possession of the property, (ii)
the service recipient controls the property, (iii) the service recipient has a
significant economic or possessory interest in the property (e.g., the
property's use is likely to be dedicated to the service recipient for a
substantial portion of the useful life of the property, the recipient shares
the risk that the property will decline in value, the recipient shares in any
appreciation in the value of the property, the
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(9)Section 856(e).
(10)Section 856(e)(4).
(11)Treas. Reg. Section 1.856-6(b)(3).
(12)See, e.g., Xerox Corp. v. U.S., 80-2 USTC Paragraph 9530 (Ct. Cl. Tr. Div.
1980), aff'd per curiam, 656 F.2d 659 (Ct. Cl. 1981).
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<PAGE> 67
recipient shares in any savings in the property's operating costs or the
recipient bears the risk of damage to or loss of the property), (iv) the
service provider does not bear any risk of substantially diminished receipts or
substantially increased expenditures if there is nonperformance under the
contract, (v) the service provider does not use the property concurrently to
provide significant services to entities unrelated to the service recipient and
(vi) the total contract price does not substantially exceed the rental value of
the property for the contract period. Since the determination of whether a
service contract, partnership agreement, or some other type of arrangement
should be treated as a lease is inherently factual, the presence or absence of
any single factor may not be dispositive in every case.(13)
We have concluded that the Lease will be treated as a lease for
Federal income tax purposes, rather than a service contract, management
contract or other type of arrangement. This conclusion is based, in part, on
the following facts: (i) the Operating Partnership and RoseStar intend their
relationship to be that of lessor and lessee (as evidenced by the terms of the
Lease), (ii) RoseStar will have the right to exclusive possession, use and
quiet enjoyment of the Denver Marriott during the term of the Lease and the
right to uninterrupted control in the operation of the business conducted at
the Denver Marriott (subject to its assumption of the Management Agreement),
(iii) RoseStar will dictate how the Denver Marriott is maintained and improved,
(iv) Rose-Star will bear all the costs and expenses of operating the Denver
Marriott (with the exception of the cost of replacing certain FF & E, which is
to be funded by the Operating Partnership pursuant to Article 7.5 of the
Lease), (v) RoseStar will benefit from any savings in the costs of operating
the Denver Marriott during the term of the Lease, (vi) in the event of damage
or destruction to the Denver Marriott, RoseStar will be at economic risk
because its obligation to make rental payments will not abate, (vii) RoseStar
will indemnify the Operating Partnership against all liabilities imposed on the
Operating Partnership during the term of the Lease by reason of injury to
persons or damage to property occurring at the Denver Marriott or RoseStar's
use, management, maintenance or repair of the Denver Marriott, (viii) RoseStar
is obligated to pay substantial fixed rent for the period of use of the Denver
Marriott, regardless of whether its revenues exceed its costs and expenses, and
(ix) RoseStar stands to incur substantial losses (or derive substantial
profits) depending on how successfully it operates the Denver Marriott.
We do not believe that our conclusion that the Lease of the Denver
Marriott will be treated as a lease for Federal income tax purposes is affected
by the fact that RoseStar entered the Lease subject to its assumption of the
Operating Partnership's obligations under the preexisting Management Agreement.
The Management Agreement gives Marriott control over the d ay-to-day operation
of the Denver Marriott and allows Marriott to share with RoseStar in the
benefits of any increases in revenues or cost savings in the operation of the
Denver Marriott. However, Marriott's operation of the Denver Marriott will not
be controlled by the Operating Partnership, and the Management Agreement does
not affect the fact that RoseStar bears most of the risk of loss if the Denver
Marriott is not successful. Moreover, the IRS has issued a private letter
ruling
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(13)P.L.R. 8918012 (January 24, 1989).
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in which it treated leases of several hotel properties as producing "rents from
real property" in a situation where the lessees had contracted with a third
party to conduct the d ay-to-day operations of the hotels.(14) This ruling
suggests that the IRS will respect a lease of a hotel for federal income tax
purposes even if the hotel is operated by an independent contractor rather than
by the lessee.
The Lease is structured in form so that the Operating Partnership
retains ownership of all the personal property leased to RoseStar in connection
with RoseStar's lease of the Denver Marriott (the "FF&E"). However, if the
term of the Lease equals or exceeds the useful life of some or all of the FF&E,
it is possible that the Lease could be treated for federal income tax purposes
as a financing arrangement. In such a case, RoseStar would be treated as
having acquired ownership of the FF&E for federal income tax purposes in
exchange for an obligation to make future payments of principal and interest to
the Operating Partnership. Nonetheless, we do not believe that the
recharacterization of the Lease as a financing arrangement with respect to the
FF&E would have a material effect on the ability of the Company to satisfy the
requirements for taxation as a REIT. This is because, if a portion the of the
payments made by RoseStar under the Lease were characterized as interest on
indebtedness secured by the FF&E, rather than rents from real property, that
portion would still satisfy the 95 percent gross income test (although it would
not satisfy the 75% gross income test).(15)
B. Percentage Rent Provision is not Profit-Based
Pursuant to the Lease, RoseStar will be obligated to pay the Operating
Partnership base rent and percentage rent. Under the regulations, percentage
rent based on a percentage of gross receipts or sales in excess of a floor
amount, which is how the percentage rent is structured under the Lease, will
not qualify as "rents from real property" unless (i) such floor amount does
not depend in whole or in part on the income or profits of the lessee, (ii) the
percentage and the floor amount are fixed at the time the lease is entered
into, (iii) the percentage and the floor amount are not renegotiated during the
term of the lease in a manner that has the effect of basing the percentage rent
on income or profits, and (iv) the percentage and the floor amount conform with
normal business practice.(16)
Under the terms of Article 4.2 of the Lease, RoseStar will pay
percentage rent equal on an annual basis to the sum of (i) 22.5 percent of the
excess of annual gross receipts from room rentals over $9,800,000 and (ii) 4.0
percent of the excess of annual gross receipts from the food and
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(14)See, P.L.R. 8117036 (January 27, 1981).
(15)If the Lease were recharacterized as a financing arrangement with respect
to the FF&E, it also might result in some minor timing differences with respect
to the Company's recognition of income. These differences would result from
(a) the recharacterization of a portion RoseStar's payments under the Lease as
a return of principal and (b) the Company's loss of any depreciation
deductions attributable to the FF&E.
(16)Treas. Reg. Section 1.856-4(b)(3).
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beverage facilities at the Denver Marriott over $4,000,000. This formula
effectively rewards RoseStar for any increases in gross receipts from rooms
and from other sources over the threshold amounts. This type of formula does
not base the percentage rent on RoseStar's income or profits, and similar
formulas have been treated by the IRS as generating "rents from real
property."(17) Moreover, the Operating Partnership has represented that (i) the
floor amounts used to compute the percentage rent under the Lease do not depend
in whole or in part on the income or profits of any person, (ii) the percentage
rent provision of the Lease will not be renegotiated during the term of the
Lease or at the expiration or earlier termination of the Lease in a manner that
has the effect of basing the rent on income or profits, and (iii) the
percentage rent provision of the Lease conforms with normal business practice.
In addition, based on our experience and an examination of the Lease and the
Denver Marriott projections, the Lease appears to conform with normal business
practice.
C. RoseStar is not a "Related Party Tenant"
Rents received from RoseStar will not qualify as "rents from real
property" if RoseStar is a "related party tenant." RoseStar will be a "related
party tenant" if the Company, or an owner of 10 percent or more of the Company,
directly or constructively owns 10 percent or more of the assets or net profits
of RoseStar.(18) Constructive ownership is determined for purposes of this test
by applying the rules of section 318(a) as modified by section 856(d)(5).
Those rules generally provide that if 10 percent or more in value of the stock
of the Company is owned, directly or indirectly, by or for any person, the
Company is considered as owning the stock owned, directly or indirectly, by or
for such person.
RoseStar will not be treated as a "related party tenant" because an
individual, Sanjay Varma, currently owns a 91 percent interest in its assets
and net profits. In reaching this conclusion, we recognize that Sanjay Varma
owns certain Units of the Operating Partnership.(19) The Operating Partnership
has represented that (i) Sanjay Varma does not own more than 10 percent of the
value of the Company's stock, (ii) Sanjay Varma is not expected to own more
than 10 percent of the value of the Company's stock in the future, and (iii)
neither the Operating Partnership nor the Company intends to acquire, directly
or constructively, an interest of 10 percent or more in the assets or net
profits of RoseStar at any time in the future. Moreover, Article 7.8 of the
Lease limits the ability of RoseStar and its members and managers to acquire,
directly or constructively, a 6 percent stock interest in the Company, and
Section 6.4 of the First Amended and
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(17)See, e.g., P.L.R. 8803007 (September 23, 1987) (percentage rent based on
gross revenues in excess of gross revenues for a base year treated as "rents
from real property"); cf. P.L.R. 9104018 (October 26, 1990) (interest based on
gross revenues in excess of a floor amount treated as qualifying interest under
section 856(f)).
(18)Section 856(d)(2)(B)(ii).
(19)See Rev. Rul. 73-194, 1973-1 C.B. 355 (management company treated as an
independent contractor with respect to a REIT, where an affiliate of the
management company and the REIT were partners).
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Restated Articles of Incorporation of the Company prevents RoseStar and its
members and managers from acquiring more than 8 percent of the Company's stock.
In concluding that RoseStar will not be treated as a "related party
tenant," we have applied the definition of related party tenant set forth in
section 856(d)(2)(B)(ii), which applies to tenants which are not corporations.
If RoseStar is not treated as a partnership for federal income tax purposes,
but is instead treated as an association taxable as a corporation, then the
applicable definition of related party tenant is the one set forth in section
856(d)(2)(B)(i), which looks to control over voting securities. If RoseStar
were treated as a corporation for federal income tax purposes, Gerald W.
Haddock and John C. Goff would likely be deemed to own all of its voting stock,
because of the extensive powers that they are granted as managers under the
RoseStar Regulations. If this were the case, it would be necessary to consider
whether the ownership of such voting stock could possibly be attributed to the
Company under the constructive ownership rules described above or otherwise.
An entity which has associates and an objective to carry on a business
for joint profit will be treated as a partnership for federal income tax
purposes, and not as an association taxable as a corporation, if it has not
more than two of the following four characteristics of a corporation: (i)
continuity of life; (ii) centralization of management; (iii) limited liability;
and (iv) free transferability of interests.(20) The entity must also have no
other characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics.(21) The IRS has applied this four-factor test in determining
whether limited liability companies formed under the Texas Limited Liability
Company Act (the "Act") are partnerships for federal income tax purposes.(22)
The IRS has issued Rev. Proc. 95-10, which specifies conditions which must be
satisfied for a limited liability company to receive a favorable advanced
ruling that it will be classified as a partnership for federal income tax
purposes.(23) RoseStar should satisfy these conditions. However, such
conditions are applicable only in determining whether rulings will be issued
and are not intended as substantive rules for determination of partnership
status.
An organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time.(24)
Article 6.01
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(20)Treas. Reg. Section 301.7701-2(a).
(21)See Rev. Rul. 79-106, 1979-1 C.B. 448.
(22)See, e.g., P.L.R. 9242025 (July 22, 1992) and P.L.R. 9218078 (January 31,
1992).
(23)1995-3 I.R.B. 20.
(24)Treas. Reg. Section 301.7701-2(b)(3).
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of the Act provides, in part, that except as otherwise provided in the
company's regulations, a limited liability company shall be dissolved upon the
death, retirement, resignation, expulsion, bankruptcy, or dissolution of a
member or the occurrence of any other event which terminates the continued
membership of a member in the limited liability company, unless there is at
least one remaining member and the business of the limited liability company is
continued by the consent by the number of members or class thereof stated in
the articles of organization or regulations of the limited liability company or
of not so stated, by all remaining members. Article 2 of the RoseStar Articles
provides that the duration of RoseStar is until the close of business on
December 31, 2015, or until its earlier dissolution in accordance with the
provisions of the Act or the Regulations. Article 10.2 of the RoseStar
Regulations provides, in part, that RoseStar shall be dissolved upon the
withdrawal, death, retirement, resignation, expulsion, bankruptcy, legal
incapacity or dissolution of any member, unless the business of RoseStar is
continued by the consent of all the remaining members within ninety days.
Accordingly, RoseStar will lack the corporate characteristic of continuity of
life.
An organization will be treated as possessing the corporate
characteristic of free transferability of interests if the members owning all
or substantially all of the interests in an organization may substitute for
themselves without the consent of the other members a person who is not a
member of the organization.(25) Article 4.05 of the Act provides, in part, that
unless otherwise provided by the company's regulations, a membership interest
is assignable in whole or in part; an assignment of a member's interest does
not entitle the assignee to become, or to exercise rights or powers of a
member; and until the assignee becomes a member, the assignor member continues
to be a member and to have the power to exercise any rights or powers of a
member, except to the extent those rights or powers are assigned. Article 4.07
of the Act provides, in part, that an assignee of a membership interest may
become a member if and to the extent that the company's regulations so provide,
or all members consent. Article 9.3 of the RoseStar Regulations provides, in
part, that no member shall have the right to substitute in its place a
transferee unless consent is given by the Managers and a majority of the other
members, which consent may be withheld in the discretion of the Managers or the
other members. Accordingly, RoseStar will lack the corporate characteristic of
free transferability of interests. Because RoseStar will lack the corporate
characteristics of continuity of life and free transferability of interests, in
our opinion it will be treated as partnership for federal income tax purposes.
D. Incidental Personal Property
As noted above, in order for the rent under the Lease to be treated as
"rents from real property," the rents attributable to the Operating
Partnership's personal property leased under or in connection with the Lease
must not be greater than 15 percent of the rents received under the Lease. The
rent attributable to personal property leased under or in connection with a
lease of real property is the amount that bears the same ratio to total rent
for the taxable year as (i) the
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(25)Treas. Reg. Section 301.7701-2(e).
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<PAGE> 72
average of the adjusted bases of the personal property leased under or in
connection with a lease of real property at the beginning and at the end of the
taxable year bears to (ii) the average of the aggregate adjusted bases of the
real and personal property subject to the lease at the beginning and at the end
of such taxable year (the "Adjusted Basis Ratio").(26) The Operating
Partnership has represented that the adjusted tax basis of the personal
property leased under or in connection with the Lease will not represent more
than 15 percent of the aggregate adjusted tax basis of the Denver Marriott at
any time. Moreover, in Article 36.2 of the Lease, the parties agreed that the
adjusted tax basis of the personal property leased under or in connection with
the Lease will not represent more than 15 percent of the aggregate adjusted tax
basis of the Denver Marriott at any time.
E. Provision of Services by the Operating Partnership
1. Income Derived under the Terms of the Lease
Although the Operating Partnership may treat charges for services
customarily furnished or rendered in connection with the rental of the Denver
Marriott as "rents from real property," any services rendered to the occupants
of the Denver Marriott must be furnished or rendered by an independent
contractor from whom the Company does not derive or receive any income.(27)
Moreover, to the extent that any independent contractors provide noncustomary
services to the occupants of the Denver Marriott, the cost of such services
must not be borne by the Operating Partnership.(28) Under the terms of the
Lease, the Operating Partnership will not be required to provide any services,
customary or noncustomary, in connection with the rental of the Denver
Marriott. Instead, all services relating to the operation of the Denver
Marriott will be provided by Marriott to RoseStar under the terms of the
Management Agreement. The Operating Partnership will not bear the cost of any
of the services provided by Marriott to RoseStar. Instead, such costs will be
borne by RoseStar pursuant to its assumption of the Operating Partnership's
obligations under the Management Agreement.
Based on the foregoing, we believe that the provision of any
noncustomary services to the occupants of the Denver Marriott by Marriott will
have no effect on the qualification of the income derived from the Denver
Marriott as "rents from real property." In fact, the IRS has issued a private
letter ruling in which it has treated the income derived from several leases of
hotel properties as "rents from real property" in a situation where the lessees
had contracted with a third-party to conduct the day-to-day operations of the
hotels.(29) Our conclusion is not altered by the
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(26)Section 856(d)(1)(C).
(27)Sections 856(d)(1), 856(d)(2)(C); Treas. Reg. Section 1.512(b)-1(c)(5).
(28)Treas. Reg. Section 1.856-4(b)(5).
(29)See, P.L.R. 8117036 (January 27, 1981).
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<PAGE> 73
fact that the Operating Partnership will remain liable for any obligations
arising under the Management Agreement, to the extent that they are not
satisfied by the Tenant. The Operating Partnership should not be treated as
bearing the cost of the services provided by Marriott merely because it will be
liable for RoseStar's obligations under the Management Agreement. The Operating
Partnership will not be retaining this liability in an attempt to provide
services to RoseStar. Instead, it will be retaining this liability only as an
accommodation, in order to gain Marriott's consent to its purchase of the
Denver Marriott. Moreover, the Operating Partnership believes that it is
highly unlikely that it will ever be required to reimburse Marriott for the
costs and expenses of operating the Denver Marriott because of a default by
RoseStar under the Management Agreement. This is because (i) the Denver
Marriott is projected to generate enough gross income to cover the payments to
Marriott under the Management Agreement, (ii) in connection with Section 7.7 of
the Lease, RoseStar represents that it has a net worth of at least $200,000,
(iii) in connection with Section 7.9 of the Lease, RoseStar covenants that it
will retain all of the income it earns from the Denver Marriott and shall not
distribute any earnings to its beneficial owners, except as needed for federal
and state income taxes payable on taxable income from the Denver Marriott,
until it has accumulated and is holding in reserve funds which are sufficient
to pay at least one monthly payment of Base Rent under the Lease, plus at least
one monthly payment of Base Rent under all other leases between it and the
Operating Partnership, and (iv) in the view of the Operating Partnership,
RoseStar's capitalization is adequate to allow RoseStar to assume RoseStar's
obligations under the Lease.
2. Income Derived in the Case of a Default under the Lease
If the Operating Partnership were required to reimburse Marriott for
the costs of operating the Denver Marriott because of a default by RoseStar
under the terms of the Management Agreement, we have concluded that the income
derived by the Operating Partnership from the Denver Marriott would be treated
as "qualifying income" for purposes of the 75 percent and 95 percent tests,
assuming that such default does not occur before May 1, 1996. This is because,
if the Operating Partnership were required to reimburse Marriott for the cost
of operating the Denver Marriott, this would constitute an event of default
under Article 16.1 of the Lease, allowing the Operating Partnership to
terminate RoseStar's leasehold interest in the Denver Marriott. As a result of
such a termination of the Lease, any income derived by the Operating
Partnership from the Denver Marriott after the default would be treated as
income from foreclosure property.
The Operating Partnership would be able to continue to operate the
Denver Marriott after any default under the Lease, without affecting its status
as foreclosure property, assuming that any such default does not occur before
May 1, 1996. This is because Marriott will provide all services relating to
the operation of the Denver Marriott and starting on May 1, 1996, Marriott will
qualify as an independent contractor from whom the Company will not derive any
income . As noted above, a REIT can use foreclosure property in the conduct of
an active trade or business, as long
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as this is done through the use of an independent contractor, from whom the
REIT does not derive or receive any income.(30)
As noted above, real property acquired upon default under a lease is
not eligible to be treated as foreclosure property if the lease is entered into
with an intent to evict or foreclose, or if the REIT knows or has reason to
know that default would occur.(31) This is not the case in the present
situation because (i) the Denver Marriott is projected to generate enough gross
income to produce a profit for RoseStar, (ii) in connection with Section 7.7 of
the Lease, RoseStar will represent that it has a net worth of at least
$200,000, (iii) in connection with Section 7.9 of the Lease, RoseStar covenants
that it will retain all of the income it earns from the Denver Marriott and
shall not distribute any earnings to its beneficial owners, except as needed
for federal and state income taxes payable on taxable income from the Denver
Marriott, until it has accumulated and is holding in reserve funds which are
sufficient to pay at least one monthly payment of Base Rent under the Lease,
plus at least one monthly payment of Base Rent under all other leases between
it and the Operating Partnership, and (iv) in the view of the Operating
Partnership, RoseStar's capitalization is adequate to allow RoseStar to assume
RoseStar's obligations under the Lease.
The Denver Marriott would in any event qualify as foreclosure property
only for a period of up to two years, beginning on the date of its acquisition
by the Operating Partnership, unless the Operating Partnership obtains an
extension of the grace period from the IRS.(32) Therefore, in the event the
Operating Partnership takes possession of the Denver Marriott as a result of a
default under the lease, presumably the Operating Partnership will sell the
Denver Marriott or within two years rent it to another tenant under a lease
that will produce "rents from real property."
Prior to May 1, 1996, Crescent may be treated as deriving income from
Marriott, because on April 24, 1995 the Operating Partnership received a
payment of $600,000 and a note in the principal amount of $1,800,000 from
Marriott in connection with its sale of certain contract rights and investments
rights to Marriott. The principal balance of the note and all accrued interest
thereon are to be paid by Marriott in a single payment on April 30, 1996. As a
consequence, prior to May 1, 1996 the Operating Partnership will be treated as
deriving interest income and capital
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(30)Section 856(e)(4)(C). The IRS clearly intended for REITs to be able to
treat hotels operated by independent contractors as foreclosure property. For
instance, the Treasury regulations defining foreclosure property refer to hotel
properties twice. See, Treas. Reg. Sections 1.856-6(b)(2), 1.856-6(d)(2). In
addition, the IRS has also recently issued a private letter ruling in which it
treated income received from hotels acquired pursuant to a bankruptcy petition
as income from foreclosure property, where the hotels were operated by third
party managers. P.L.R. 9420013 (2/15/94).
(31)Treas. Reg. Section 1.856-6(b)(3).
(32)Section 856(e)(2).
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<PAGE> 75
gains income from Marriott. Therefore, during the period prior to May 1, 1996,
Marriott will not qualify as an independent contractor from whom the Company
does not derive any income.(33)
V. CONCLUSION
Based on the assumptions stated above, it is our opinion that (i) all
of the income that the Operating Partnership derives from the Denver Marriott
will be treated as "qualifying income" for purposes of the 95 percent test and
(ii) all of the income the Operating Partnership derives from the Denver
Marriott, will be treated as "qualifying income" for purposes of the 75 percent
test.
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(33)The fact that the Operating Partnership will derive income from Marriott
at a time prior to any default under the Lease should not have any affect on
the treatment of any income that the Operating Partnership derives from the
Denver Marriott after any default under the Lease. See, Tax Management
Memorandum, p. 7 (November 7, 1975), as cited in Allen and Fisher, 107-5th
T.M., Real Estate Investment Trusts , p. A-77 (the IRS has ruled privately that
an entity should be treated as an independent contractor from whom a REIT
derived no income for the period such entity managed the REIT's rental
properties, despite the fact that the entity purchased foreclosure property
from the REIT immediately after the termination of its management contract).
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September 27, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue, Suite 1800
New York New York 10022
Ladies and Gentlemen:
On June 30, 1995 we provided you with a memorandum analyzing the
impact of the purchase of the Denver Marriott City Center (the "Hotel
Property") by Crescent Real Estate Equities Limited Partnership (the "Operating
Partnership") would have on the ability of Crescent Real Estate Equities, Inc.
(the "Company") to continue to qualify as a real estate investment trust (a
"REIT") under section 856(c).(1) That memorandum concluded that, subject to
certain assumptions, in our opinion (i) all of the income that the Operating
Partnership derived from the Hotel Property would be treated as "qualifying
income" for purposes of the 95 percent gross income test for REIT qualification
under section 856(c)(2) (the "95 percent test") and (ii) all of the income that
the Operating Partnership derived from the Hotel Property would be treated as
"qualifying income" for purposes of the 75 percent gross income test for REIT
qualification under section 856(c)(3) (the "75 percent test"). The June 30,
1995 memorandum was based upon, among other items, our review of an Amended and
Restated Lease Agreement between dated June 30, 1995 between the Operating
Partnership, as lessor, and RoseStar Management, LLC ("RoseStar"), as lessee
(the "Lease"). The ownership of RoseStar remains the same as described in our
June 30, 1995 memorandum.
This letter is intended to update the opinions expressed in our June
30, 1995 memorandum. The opinions set forth herein are based upon the existing
provisions of the Code, and the reported interpretations thereof by the IRS and
by the courts in effect as of the date hereof, all of which are subject to
change, both retroactively or prospectively, and to possibly different
interpretations. We assume no obligation to update the opinions set forth in
this letter. We believe that the conclusions expressed herein, if challenged
by the IRS, would be sustained in court. However, because our opinions are not
binding upon the IRS or the courts, there can be no assurance that contrary
positions may not be successfully asserted by the IRS.
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(1) All section references are to the Internal Revenue Code of 1986, as
amended (the "Code"), or to the regulations issued thereunder, unless
otherwise noted.
<PAGE> 77
Crescent Real Estate Equities, Inc.
September 27, 1996
Page 2
I. Documents and Representations
For the purpose of rendering this opinion, we have examined and
relied on originals, or copies certified or otherwise identified to our
satisfaction, of the following: (1) the Lease; (2) the Limited Guaranty
Agreement by Gerald Haddock, John Goff and Sanjay Varma, as guarantors in favor
of the Operating Partnership (the "Guaranty); (3) the Articles of Organization
of RoseStar Management, LLC (the "RoseStar Articles"), (4) the Regulations of
RoseStar Management, LLC (the "RoseStar Regulations"), (5) the First Amended
and Restated Articles of Incorporation of Crescent Real Estate Equities, Inc.
(the "Crescent Articles"); and (6) such other documents or information as we
have deemed necessary for the opinion set forth below. In our examination, we
have assumed the genuineness of all signatures, the legal capacity of natural
persons, the authenticity of all documents submitted to us as originals, the
conformity to original documents of all documents submitted to us as certified
or photostatic copies, and the authenticity of the originals of such copies.
For the purpose of rendering these opinions, we have also assumed
that all statements of facts and assumptions described in our June 30, 1995
memorandum remain correct, unless otherwise noted.
II. Opinions
Based on the foregoing, it is our opinion that (i) the Lease will be
treated as a lease for federal income tax purposes, (ii) all of the income that
the Operating Partnership derives from the Hotel Property will be treated as
"qualifying income" for purposes of the 95 percent test, and (iii) all of the
income that Operating Partnership derives from the Hotel Property will be
treated as "qualifying income" for purposes of the 75 percent test.
In giving these opinions, we note that Marriott International, Inc.
("Marriott") which operates the Hotel Property as successor to Marriott
Corporation under the terms of the agreement between the Original Owner and
Marriott Corporation dated January 10, 1979, as amended on January 10, 1979,
February 16, 1979, May 11, 1979, July 27, 1979, March 25, 1980, December 18,
1980, July 15, 1981, January 4, 1982, and November 19, 1993 (the "Management
Agreement") is currently subleasing space from Gaskins Real Estate Brokerage,
Inc. ("Gaskins"), a tenant at 301 Congress Avenue, a property in which the
Operating Partnership owns an indirect interest. Under the terms of Gaskins'
prime lease, Gaskins is required make a payment to the lessor (an "excess rent
payment") equal to the amount by which any rents under a sublease exceed the
amount that Gaskins is required to pay to the lessor under the terms of the
lease. Gaskins' sublease to Marriott was entered into before the Operating
Partnership acquired its interest in 301 Congress Avenue and it is scheduled to
<PAGE> 78
Crescent Real Estate Equities, Inc.
September 27, 1996
Page 3
expire at the end of February 1997. Marriott has already vacated the premises
sublet from Gaskins at 301 Congress Avenue and the Operating Partnership will
use its best efforts to prevent any extension or renewal of this sublease. We
do not believe that the existence of the sublease of space in 301 Congress
Avenue by Gaskins to Marriott will affect the opinion expressed in our June 30,
1995 memorandum regarding the treatment of amounts derived from the Hotel
Property in the event of a default under the Lease, to the extent any such
default occurs after the termination of the sublease to Marriott. In our June
30, 1995 memorandum we indicated that amounts derived from the Hotel Property
in the event of a default under the Lease would qualify as income from
foreclosure property, if, among other things, at the time of the default,
Marriott qualifed as an independent contractor from whom the Company did not
derive any income. We do not believe that the Company will be treated as
indirectly deriving income from Marriott as a result of accruing any Excess
Rent Payments under the terms of Gaskins' lease at 301 Congress, and in any
event, even if the Company is treated as indirectly deriving income from
Marriott, it will cease to be treated as derivng such income from Marriott
after the end of February 1996, if Marriott's sublease terminates at that time.
III. Additional Limitations
The foregoing opinions are limited to the specific matters covered
thereby and should not be interpreted to imply that the undersigned has offered
its opinion on any other matter.
Very truly yours,
SHAW, PITTMAN, POTTS & TROWBRIDGE
By:
--------------------------------
Charles B. Temkin, P.C.
<PAGE> 79
MEMORANDUM
TO: David Dean
FROM: Charles B. Temkin
Michael A. Jacobs
DATE: December 19, 1995
RE: Characterization of Income Derived from the Hyatt Regency
Albuquerque Plaza
I. OVERVIEW
Crescent Real Estate Equities Limited Partnership (the "Operating
Partnership") purchased the Hyatt Regency Albuquerque Plaza (the "Albuquerque
Hyatt") from Albuquerque Plaza Partners (the "Prior Owner"), on December 19,
1995. Crescent Real Estate Equities, Inc. (the "Company") is currently the
sole shareholder of two corporations, one of which is the sole general partner
of and one of which is a limited partner of the Operating Partnership. These
two corporations constitute qualified REIT subsidiaries within the meaning of
section 856(i).(1)
This memorandum analyzes the impact that the purchase of the
Albuquerque Hyatt will have on the ability of the Company to continue to
qualify as a real estate investment trust (a "REIT") under section 856(c).
More specifically, it analyzes whether the income the Operating Partnership
derives from the Albuquerque Hyatt is "qualifying income" for purposes of the
75 percent and 95 percent gross income tests for REIT qualification. This
memorandum concludes that, subject to certain assumptions, in our opinion (i)
all of the income that the Operating Partnership derives from the Albuquerque
Hyatt will be treated as "qualifying income" for purposes of the 95 percent
test and (ii) all of the income the Operating Partnership derives from the
Albuquerque Hyatt will be treated as "qualifying income" for purposes of the 75
percent test.
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(1) All section references herein are to the Internal Revenue Code of 1986, as
amended (the "Code"), or to the regulations issued thereunder, unless otherwise
noted.
<PAGE> 80
II. FACTS AND ASSUMPTIONS
The Prior Owner contracted with Hyatt Corporation ("Hyatt") to operate
the Albuquerque Hyatt. Under the terms of the agreement between the Prior
Owner and Hyatt dated October 11, 1988, as amended on February 14, 1990, and
August 30, 1994 (the "Management Agreement"), Hyatt is obligated to provide all
services in relation to the operation of the Albuquerque Hyatt and collect all
hotel receipts. In exchange for these services, Hyatt is to be reimbursed for
the costs of operating the Albuquerque Hyatt and paid a management fee. This
fee is paid out of hotel receipts; it is based on the profits, if any, from
operation of the Albuquerque Hyatt. Article 15.2 of the Management Agreement
requires that all assignments of the Management Agreement be approved by Hyatt
and that any assignees expressly assume the obligations of the owner under the
Management Agreement. Therefore, in connection with its purchase of the
Albuquerque Hyatt, the Operating Partnership assumed all of the obligations of
the Prior Owner under the Management Agreement.
When the Operating Partnership purchased the Albuquerque Hyatt, it
immediately leased it to RoseStar Management, LLC ("RoseStar") pursuant to a
Lease Agreement dated December 19, 1995 (the "Lease"). Pursuant to Article 2
of the Lease, the Operating Partnership assigned its interest in the Management
Agreement to RoseStar; and pursuant to Article 15.2 of the Management
Agreement, RoseStar assumed all of the Operating Partnership's obligations
thereunder. However, as a condition of its approval of the Lease, Hyatt
required that the Operating Partnership remain liable for all obligations of
the Operating Partnership under the Management Agreement that was assumed by
RoseStar.
Currently, Sanjay Varma owns a 91 percent interest in the assets and
net profits of RoseStar, while Gerald W. Haddock and John C. Goff, the
managers of RoseStar, each own a 4.5 percent interest in its assets and net
profits. RoseStar currently leases another hotel, located in Denver, Colorado
(the "Denver Marriott"), from the Operating Partnership. We have provided you
with a memorandum dated June 30, 1995 regarding the characterization of income
derived by the Operating Partnership from the lease of the Denver Marriott to
RoseStar.
For purposes of this memorandum, we have examined and relied upon (1)
the Management Agreement, (2) the Lease, (3) the Articles of Organization of
RoseStar Management, LLC (the "RoseStar Articles"), (4) the Regulations of
RoseStar Management, LLC (the "RoseStar Regulations"), (5) the First Amended
and Restated Articles of Incorporation of Crescent Real Estate Equities, Inc.
(the "Crescent Articles"), and (6) such other documents or information as we
deemed necessary for the opinions set forth below. In our examination, we have
assumed the genuineness of all signatures, the legal capacity of natural
persons, the authenticity of all documents submitted to us as originals, the
conformity to original documents of all documents submitted to us as certified
or photostatic copies, and the authenticity of the originals of such copies.
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<PAGE> 81
This memorandum is based upon existing provisions of the Code,
Treasury regulations, and the reported interpretations thereof by the Internal
Revenue Service ("IRS") and by the courts in effect as of the date hereof, all
of which are subject to change, both retroactively or prospectively, and to
possibly different interpretations. We assume no obligation to update the
opinions set forth in this memorandum. We believe that the conclusions
expressed herein, if challenged by the IRS, would be sustained in court.
However, because our opinions are not binding upon the IRS or the courts, there
can be no assurance that contrary positions may not be successfully asserted by
the IRS.
In addition, this memorandum is based on various assumptions and is
conditioned upon certain representations made by the Operating Partnership and
its sole general partner, Crescent Real Estate Equities, Ltd., as to factual
and other matters as set forth in the attached letter.
III. LEGAL BACKGROUND
A. 75 Percent and 95 Percent Tests
In order to qualify as a REIT for tax purposes, the Company must
satisfy certain tests with respect to the composition of its gross income on an
annual basis. First, at least 75 percent of the Company's gross income
(excluding gross income from certain prohibited transactions) for each taxable
year must consist of temporary investment income or of certain defined
categories of income derived directly or indirectly from investments relating
to real property or mortgages on real property. These categories include,
subject to various limitations, rents from real property, interest on mortgages
on real property, gains from the sale or other disposition of real property
(including interests in real property and mortgages on real property) not
primarily held for sale to customers in the ordinary course of business, income
from foreclosure property, and amounts received as consideration for entering
into either loans secured by real property or purchases or leases of real
property.(2) Second, at least 95 percent of the Company's gross income
(excluding gross income from certain prohibited transactions) for each taxable
year must be derived from income qualifying under the 75 percent test and from
dividends, other types of interest and gain from the sale or disposition of
stock or securities, or from any combination of the foregoing.(3)
In applying these income tests, REITs that are partners in a
partnership are required to include in their gross income their proportionate
share of the partnership's gross income. In addition, such REITs are to treat
this partnership gross income as retaining the same character as the items of
gross income of the partnership for purposes of section 856.(4) Thus, the
character of any
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(2)Section 856(c)(3).
(3)Section 856(c)(2).
(4)Treas. Reg. Section 1.856-3(g).
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<PAGE> 82
income derived by the Operating Partnership from the Albuquerque Hyatt will
affect the ability of the Company to qualify as a REIT.
B. Rents from Real Property
Rents from real property satisfy both the 75 percent and 95 percent
tests for REIT qualification only if several conditions are met. First, the
amount of rent must not be based in whole or in part on the income or profits
of any person. An amount received or accrued generally will not be excluded
from the term "rents from real property" solely by reason of being based on a
fixed percentage or percentages of receipts or sales.(5) Second, the Code
provides that rents received from a tenant will not qualify as "rents from real
property" if the REIT, or an owner of 10 percent or more of the REIT, directly
or constructively, owns 10 percent or more of such tenant (a "Related Party
Tenant").(6) Third, if rent attributable to personal property leased in
connection with a lease of real property is greater than 15 percent of the
total rent received under the lease, then the portion of rent attributable to
such personal property will not qualify as "rents from real property."(7)
Finally, for rents to qualify as "rents from real property," a REIT generally
must not operate or manage the property or furnish or render services to the
tenants of such property, other than through an independent contractor from
whom the REIT derives no revenue. However, rents will be qualified as "rents
from real property" if a REIT directly performs services in connection with the
lease of the property, if those services are "usually or customarily rendered"
in connection with the rental of space for occupancy, and such services are not
considered to be rendered to the occupant of the property.(8)
C. Income from Foreclosure Property
Income from foreclosure property is treated as "qualifying income" for
purposes of the 75 percent and 95 percent tests (although any net income from
foreclosure property is taxed at the maximum corporate rate). Foreclosure
property is any real property, and any personal property incident to such real
property, acquired by a REIT through default under a mortgage or a lease. A
REIT may elect to treat such property as foreclosure property for a grace
period of up to two years.(9) However, such property will cease to qualify as
foreclosure property if it is used by the REIT in a trade or business more than
90 days after it is acquired and it is not operated through
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(5)Section 856(d)(2)(A).
(6)Section 856(d)(2)(B).
(7)Section 856(d)(1)(C).
(8)Sections 856(d)(1)(B), 856(d)(2)(C).
(9)Section 856(e).
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<PAGE> 83
an independent contractor from whom the REIT does not derive or receive any
income.(10) Moreover, property is not eligible to be treated as foreclosure
property if the lease is entered into with an intent to evict or foreclose, or
if the REIT knows or has reason to know that default would occur.(11)
IV. DISCUSSION
A. Lease Will be Treated as a Lease for Federal Income Tax
Purposes
In order for any income derived by the Operating Partnership from the
Albuquerque Hyatt to constitute either "rents from real property," or in the
case of a default under the Lease, "gross income from foreclosure property,"
the Lease must be treated as a lease for federal income tax purposes and not be
treated as a service contract, management contract or other type of
arrangement. This determination depends on an analysis of all the surrounding
facts and circumstances. In making this determination, courts have considered
a variety of factors, including the following: (i) the intent of the parties,
(ii) the form of the agreement, (iii) the degree of control over the business
conducted at the property that is provided to the lessee (e.g., whether the
lessee has substantial rights of control over the operation of the property and
its business), (iv) the extent to which the lessee has the risk of loss from
operations of the business conducted as the property (e.g., whether the lessee
bears the risk of increases in operating expenses and of decreases in
revenues), and (v) the extent to which the lessee has the opportunity to
benefit from operations of the business conducted at the property (e.g.,
whether the lessee benefits from decreased operating expenses or increased
revenues).(12)
In addition, section 7701(e) provides that a contract that purports to
be a service contract, partnership agreement, or another type of arrangement
will be treated instead as a lease of property if the contract is properly
treated as such, taking into account all relevant factors, including whether or
not: (i) the service recipient is in physical possession of the property, (ii)
the service recipient controls the property, (iii) the service recipient has a
significant economic or possessory interest in the property (e.g., the
property's use is likely to be dedicated to the service recipient for a
substantial portion of the useful life of the property, the recipient shares
the risk that the property will decline in value, the recipient shares in any
appreciation in the value of the property, the recipient shares in any savings
in the property's operating costs or the recipient bears the risk of damage to
or loss of the property), (iv) the service provider does not bear any risk of
substantially diminished receipts or substantially increased expenditures if
there is nonperformance under the contract, (v) the service provider does not
use the property concurrently to provide significant
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(10)Section 856(e)(4).
(11)Treas. Reg. Section 1.856-6(b)(3).
(12)See, e.g., Xerox Corp. v. U.S., 80-2 USTC Paragraph 9530 (Ct. Cl. Tr. Div.
1980), aff'd per curiam, 656 F.2d 659 (Ct. Cl. 1981).
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<PAGE> 84
services to entities unrelated to the service recipient and (vi) the total
contract price does not substantially exceed the rental value of the property
for the contract period. Since the determination of whether a service
contract, partnership agreement, or some other type of arrangement should be
treated as a lease is inherently factual, the presence or absence of any single
factor may not be dispositive in every case.(13)
We have concluded that the Lease will be treated as a lease for
Federal income tax purposes, rather than a service contract, management
contract or other type of arrangement. This conclusion is based, in part, on
the following facts: (i) the Operating Partnership and RoseStar intend their
relationship to be that of lessor and lessee (as evidenced by the terms of the
Lease), (ii) RoseStar will have the right to exclusive possession, use and
quiet enjoyment of the Albuquerque Hyatt during the term of the Lease and the
right to uninterrupted control in the operation of the business conducted at
the Albuquerque Hyatt (subject to its assumption of the Management Agreement),
(iii) RoseStar will dictate how the Albuquerque Hyatt is maintained and
improved, (iv) RoseStar will bear all the costs and expenses of operating the
Albuquerque Hyatt other than the replacement of furniture, fixtures and
equipment, (v) RoseStar will benefit from any savings in the costs of operating
the Albuquerque Hyatt during the term of the Lease, (vi) in the event of damage
or destruction to the Albuquerque Hyatt, RoseStar will be at economic risk
because its obligation to make rental payments will not abate, (vii) RoseStar
will indemnify the Operating Partnership against all liabilities imposed on the
Operating Partnership during the term of the Lease by reason of injury to
persons or damage to property occurring at the Albuquerque Hyatt or RoseStar's
use, management, maintenance or repair of the Albuquerque Hyatt, (viii)
RoseStar is obligated to pay substantial fixed rent for the period of use of
the Albuquerque Hyatt, regardless of whether its revenues exceed its costs and
expenses, and (ix) RoseStar stands to incur substantial losses (or derive
substantial profits) depending on how successfully it operates the Albuquerque
Hyatt.
We do not believe that our conclusion that the Lease of the
Albuquerque Hyatt will be treated as a lease for Federal income tax purposes is
affected by the fact that RoseStar entered the Lease subject to its assumption
of the Operating Partnership's obligations under the preexisting Management
Agreement. The Management Agreement gives Hyatt control over the day-to-day
operation of the Albuquerque Hyatt and allows Hyatt to share with RoseStar in
the benefits of any increases in revenues or cost savings in the operation of
the Albuquerque Hyatt. However, Hyatt's operation of the Albuquerque Hyatt
will not be controlled by the Operating Partnership, and the Management
Agreement does not affect the fact that RoseStar bears most of the risk of loss
if the Albuquerque Hyatt is not successful. Moreover, the IRS has issued a
private letter ruling in which it treated leases of several hotel properties as
producing "rents from real property" in a situation where the lessees had
contracted with a third party to conduct the day-to-day
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(13)P.L.R. 8918012 (January 24, 1989).
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<PAGE> 85
operations of the hotels.(14) This ruling suggests that the IRS will respect a
lease of a hotel for federal income tax purposes even if the hotel is operated
by an independent contractor rather than by the lessee.
The Lease is structured in form so that the Operating Partnership
retains ownership of all the personal property leased to RoseStar in connection
with RoseStar's lease of the Albuquerque Hyatt (the "FF&E"). However, if the
term of the Lease equals or exceeds the useful life of some or all of the FF&E,
it is possible that the Lease could be treated for federal income tax purposes
as a financing arrangement. In such a case, RoseStar would be treated as
having acquired ownership of the FF&E for federal income tax purposes in
exchange for an obligation to make future payments of principal and interest to
the Operating Partnership. Nonetheless, we do not believe that the
recharacterization of the Lease as a financing arrangement with respect to the
FF&E would have a material effect on the ability of the Company to satisfy the
requirements for taxation as a REIT. This is because, if a portion the of the
payments made by RoseStar under the Lease were characterized as interest on
indebtedness secured by the FF&E, rather than rents from real property, that
portion would still satisfy the 95 percent gross income test (although it would
not satisfy the 75% gross income test).(15)
B. Percentage Rent Provision is not Profit-Based
Pursuant to the Lease, RoseStar will be obligated to pay the Operating
Partnership base rent and percentage rent. Under the regulations, percentage
rent based on a percentage of gross receipts or sales in excess of a floor
amount, which is how the percentage rent is structured under the Lease, will
not qualify as "rents from real property" unless (i) such floor amount does not
depend in whole or in part on the income or profits of the lessee, (ii) the
percentage and the floor amount are fixed at the time the lease is entered
into, (iii) the percentage and the floor amount are not renegotiated during the
term of the lease in a manner that has the effect of basing the percentage rent
on income or profits, and (iv) the percentage and the floor amount conform with
normal business practice.(16)
Under the terms of Article 4.2 of the Lease, RoseStar will pay
percentage rent equal on an annual basis to the sum of (i) 17.5 percent of the
excess of annual gross receipts from room rentals over $6,000,000 and (ii) 2.5
percent of the excess of annual gross receipts from the food and beverage
facilities at the Albuquerque Hyatt over $2,000,000. This formula effectively
rewards
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(14)See, P.L.R. 8117036 (January 27, 1981).
(15)If the Lease were recharacterized as a financing arrangement with respect
to the FF&E, it also might result in some minor timing differences with respect
to the Company's recognition of income. These differences would result from
(a) the recharacterization of a portion RoseStar's payments under the Lease as
a return of principal and (b) the Company's loss of any depreciation
deductions attributable to the FF&E.
(16)Treas. Reg. Section 1.866-4(b)(3).
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<PAGE> 86
RoseStar for any increases in gross receipts from rooms and from other sources
over the threshold amounts. This type of formula does not base the percentage
rent on RoseStar's income or profits, and similar formulas have been treated by
the IRS as generating "rents from real property."(17) Moreover, the Operating
Partnership has represented that (i) the floor amounts used to compute the
percentage rent under the Lease do not depend in whole or in part on the income
or profits of any person, (ii) the percentage rent provision of the Lease will
not be renegotiated during the term of the Lease or at the expiration or
earlier termination of the Lease in a manner that has the effect of basing the
rent on income or profits, and (iii) the percentage rent provision of the Lease
conforms with normal business practice. In addition, based on our experience
and an examination of the Lease and the Albuquerque Hyatt projections, the
Lease appears to conform with normal business practice.
C. RoseStar is not a "Related Party Tenant"
Rents received from RoseStar will not qualify as "rents from real
property" if RoseStar is a "related party tenant." RoseStar will be a "related
party tenant" if the Company, or an owner of 10 percent or more of the Company,
directly or constructively owns 10 percent or more of the assets or net profits
of RoseStar.(18) Constructive ownership is determined for purposes of this
test by applying the rules of section 318(a) as modified by section 856(d)(5).
Those rules generally provide that if 10 percent or more in value of the stock
of the Company is owned, directly or indirectly, by or for any person, the
Company is considered as owning the stock owned, directly or indirectly, by or
for such person.
RoseStar will not be treated as a "related party tenant" because an
individual, Sanjay Varma, currently owns a 91 percent interest in its assets
and net profits. In reaching this conclusion, we recognize that Sanjay Varma
owns certain Units of the Operating Partnership.(19) The Operating Partnership
has represented that (i) Sanjay Varma does not own more than 10 percent of the
value of the Company's stock, (ii) Sanjay Varma is not expected to own more
than 10 percent of the value of the Company's stock in the future, and (iii)
neither the Operating Partnership nor the Company intends to acquire, directly
or constructively, an interest of 10 percent or more in the assets or net
profits of RoseStar at any time in the future. Moreover, Article 7.8 of the
Lease limits the ability of RoseStar and its members and managers to acquire,
directly or constructively, a 6 percent stock interest in the Company, and
Section 6.4 of the First Amended and
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(17)See, e.g., P.L.R. 8803007 (September 23, 1987) (percentage rent based on
gross revenues in excess of gross revenues for a base year treated as "rents
from real property"); cf. P.L.R. 9104018 (October 26, 1990) (interest based on
gross revenues in excess of a floor amount treated as qualifying interest under
section 856(f)).
(18)Section 856(d)(2)(B)(ii).
(19)See Rev. Rul. 73-194, 1973-1 C.B. 355 (management company treated as an
independent contractor with respect to a REIT, where an affiliate of the
management company and the REIT were partners).
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<PAGE> 87
Restated Articles of Incorporation of the Company prevents RoseStar and its
members and managers from acquiring more than 8 percent of the Company's stock.
In concluding that RoseStar will not be treated as a "related party
tenant," we have applied the definition of related party tenant set forth in
section 856(d)(2)(B)(ii), which applies to tenants which are not corporations.
If RoseStar is not treated as a partnership for federal income tax purposes,
but is instead treated as an association taxable as a corporation, then the
applicable definition of related party tenant is the one set forth in section
856(d)(2)(B)(i), which looks to control over voting securities. If RoseStar
were treated as a corporation for federal income tax purposes, Gerald W.
Haddock and John C. Goff would likely be deemed to own all of its voting stock,
because of the extensive powers that they are granted as managers under the
RoseStar Regulations. If this were the case, it would be necessary to consider
whether the ownership of such voting stock could possibly be attributed to the
Company under the constructive ownership rules described above or otherwise.
An entity which has associates and an objective to carry on a business
for joint profit will be treated as a partnership for federal income tax
purposes, and not as an association taxable as a corporation, if it has not
more than two of the following four characteristics of a corporation: (i)
continuity of life; (ii) centralization of management; (iii) limited liability;
and (iv) free transferability of interests.(20) The entity must also have no
other characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics.(21) The IRS has applied this four-factor test in determining
whether limited liability companies formed under the Texas Limited Liability
Company Act (the "Act") are partnerships for federal income tax purposes.(22)
The IRS has issued Rev. Proc. 95-10, which specifies conditions which must be
satisfied for a limited liability company to receive a favorable advanced
ruling that it will be classified as a partnership for federal income tax
purposes.(23) RoseStar should satisfy these conditions. However, such
conditions are applicable only in determining whether rulings will be issued
and are not intended as substantive rules for determination of partnership
status.
An organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time.(24)
Article 6.01
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(20)Treas. Reg. Section 301.7701-2(a).
(21)See Rev. Rul. 79-106, 1979-1 C.B. 448.
(22)See, e.g., P.L.R. 9242025 (July 22, 1992) and P.L.R. 9218078 (January 31,
1992).
(23)1995-3 I.R.B. 20.
(24)Treas. Reg. Section 301.7701-2(b)(3).
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<PAGE> 88
of the Act provides, in part, that except as otherwise provided in the
company's regulations, a limited liability company shall be dissolved upon the
death, retirement, resignation, expulsion, bankruptcy, or dissolution of a
member or the occurrence of any other event which terminates the continued
membership of a member in the limited liability company, unless there is at
least one remaining member and the business of the limited liability company is
continued by the consent by the number of members or class thereof stated in
the articles of organization or regulations of the limited liability company or
of not so stated, by all remaining members. Article 2 of the RoseStar Articles
provides that the duration of RoseStar is until the close of business on
December 31, 2015, or until its earlier dissolution in accordance with the
provisions of the Act or the Regulations. Article 10.2 of the RoseStar
Regulations provides, in part, that RoseStar shall be dissolved upon the
withdrawal, death, retirement, resignation, expulsion, bankruptcy, legal
incapacity or dissolution of any member, unless the business of RoseStar is
continued by the consent of all the remaining members within ninety days.
Accordingly, RoseStar will lack the corporate characteristic of continuity of
life.
An organization will be treated as possessing the corporate
characteristic of free transferability of interests if the members owning all
or substantially all of the interests in an organization may substitute for
themselves without the consent of the other members a person who is not a
member of the organization.(25) Article 4.05 of the Act provides, in part,
that unless otherwise provided by the company's regulations, a membership
interest is assignable in whole or in part; an assignment of a member's
interest does not entitle the assignee to become, or to exercise rights or
powers of a member; and until the assignee becomes a member, the assignor
member continues to be a member and to have the power to exercise any rights or
powers of a member, except to the extent those rights or powers are assigned.
Article 4.07 of the Act provides, in part, that an assignee of a membership
interest may become a member if and to the extent that the company's
regulations so provide, or all members consent. Article 9.3 of the RoseStar
Regulations provides, in part, that no member shall have the right to
substitute in its place a transferee unless consent is given by the Managers
and a majority of the other members, which consent may be withheld in the
discretion of the Managers or the other members. Accordingly, RoseStar will
lack the corporate characteristic of free transferability of interests. Because
RoseStar will lack the corporate characteristics of continuity of life and free
transferability of interests, in our opinion it will be treated as partnership
for federal income tax purposes.
D. Incidental Personal Property
As noted above, the rents attributable to the Operating Partnership's
personal property leased under or in connection with the Lease must not be
greater than 15 percent of the rents received under the Lease. The rent
attributable to personal property leased under or in connection with a lease of
real property is the amount that bears the same ratio to total rent for the
taxable year as (i) the average of the adjusted bases of the personal property
leased under or in connection
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(25) Treas. Reg. Section 301.7701-2(e).
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<PAGE> 89
with a lease of real property at the beginning and at the end of the taxable
year bears to (ii) the average of the aggregate adjusted bases of the real and
personal property subject to the lease at the beginning and at the end of such
taxable year (the "Adjusted Basis Ratio").(26) The Operating Partnership has
represented that, assuming that the Lease is not characterized as a financing
arrangement with respect to the FF&E, the adjusted tax basis of the FF&E will
not represent more than 15 percent of the aggregate adjusted tax basis of the
Albuquerque Hyatt at any time.
E. Provision of Services by the Operating Partnership
1. Income Derived under the Terms of the Lease
Although the Operating Partnership may treat charges for services
customarily furnished or rendered in connection with the rental of the
Albuquerque Hyatt as "rents from real property," any services rendered to the
occupants of the Albuquerque Hyatt must be furnished or rendered by an
independent contractor from whom the Company does not derive or receive any
income.(27) Moreover, to the extent that any independent contractors provide
noncustomary services to the occupants of the Albuquerque Hyatt, the cost of
such services must not be borne by the Operating Partnership.(28) Under the
terms of the Lease, the Operating Partnership will not be required to provide
any services, customary or noncustomary, in connection with the rental of the
Albuquerque Hyatt. Instead, all services relating to the operation of the
Albuquerque Hyatt will be provided by Hyatt to RoseStar under the terms of the
Management Agreement. The Operating Partnership will not bear the cost of any
of the services provided by Hyatt to RoseStar. Instead, such costs will be
borne by RoseStar pursuant to its assumption of the Operating Partnership's
obligations under the Management Agreement.
Based on the foregoing, we believe that the provision of any
noncustomary services to the occupants of the Albuquerque Hyatt by Hyatt will
have no effect on the qualification of the income derived from the Albuquerque
Hyatt as "rents from real property." In fact, the IRS has issued a private
letter ruling in which it has treated the income derived from several leases of
hotel properties as "rents from real property" in a situation where the lessees
had contracted with a third-party to conduct the day-to-day operations of the
hotels.(29) Our conclusion is not altered by the fact that the Operating
Partnership will remain liable for any obligations arising under the Management
Agreement, to the extent that they are not satisfied by the Tenant. The
Operating Partnership should not be treated as bearing the cost of the services
provided by Hyatt merely because it will be liable for RoseStar's obligations
under the Management Agreement. The Operating
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(26)Section 856(d)(1)(C).
(27)Sections 856(d)(1), 856(d)(2)(C); Treas. Reg. Section 1.512(b)-1(c)(5).
(28)Treas. Reg. Section 1.856-4(b)(5).
(29)See, P.L.R. 8117036 (January 27, 1981).
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<PAGE> 90
Partnership will not be retaining this liability in an attempt to provide
services to RoseStar. Instead, it will be retaining this liability only as an
accommodation, in order to gain Hyatt's consent to its purchase of the
Albuquerque Hyatt. Moreover, the Operating Partnership believes that it is
highly unlikely that it will ever be required to reimburse Hyatt for the costs
and expenses of operating the Albuquerque Hyatt because of a default by
RoseStar under the Management Agreement. This is because (i) the Albuquerque
Hyatt is projected to generate enough gross income to cover the payments to
Hyatt under the Management Agreement, (ii) in the event that the Albuquerque
Hyatt does not generate enough gross income to cover the payments to Hyatt
under the Management Agreement, RoseStar may still be able to make such
payments out of gross income generated by the Denver Marriott, (iii) in
connection with the Lease, RoseStar has represented that it has a net worth of
at least $200,000, (iv) in the view of the Operating Partnership, RoseStar's
capitalization is adequate to allow RoseStar to assume RoseStar's obligations
under the Lease, and (v) in connection with the Lease, RoseStar has agreed to
limit distributions to its members to an amount necessary to pay federal and
state income taxes on income from the Albuquerque Hyatt until RoseStar is
holding sufficient reserves funds to enable it to pay at least one monthly
payment of base rent under the Lease and all other leases between RoseStar and
the Operating Partnership.
2. Income Derived in the Case of a Default under the Lease
If the Operating Partnership were required to reimburse Hyatt for the
costs of operating the Albuquerque Hyatt because of a default by RoseStar under
the terms of the Management Agreement, we have concluded that the income
derived by the Operating Partnership from the Albuquerque Hyatt would be
treated as "qualifying income" for purposes of the 75 percent and 95 percent
tests. This is because, if the Operating Partnership were required to
reimburse Hyatt for the cost of operating the Albuquerque Hyatt, this would
constitute an event of default under Article 16.1 of the Lease, allowing the
Operating Partnership to terminate RoseStar's leasehold interest in the
Albuquerque Hyatt. As a result of such a termination of the Lease, any income
derived by the Operating Partnership from the Albuquerque Hyatt after the
default would be treated as income from foreclosure property.
The Operating Partnership would be able to continue to operate the
Albuquerque Hyatt after any default under the Lease, without affecting its
status as foreclosure property. This is because Hyatt, which will provide all
services relating to the operation of the Albuquerque Hyatt, qualifies as an
independent contractor from whom the Company does not derive any income. As
noted above, a REIT can use foreclosure property in the conduct of an active
trade or business, as long as this is done through the use of an independent
contractor, from whom the REIT does not derive or receive any income.(30)
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(30)Section 856(e)(4)(C). The IRS clearly intended for REITs to be able to
treat hotels operated by independent contractors as foreclosure property. For
instance, the Treasury regulations defining foreclosure property refer to hotel
Footnote continued on next page
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<PAGE> 91
As previously noted, real property acquired upon default under a lease
is not eligible to be treated as foreclosure property if the lease is entered
into with an intent to evict or foreclose, or if the REIT knows or has reason
to know that default would occur.(31) This is not the case in the present
situation because (i) the Albuquerque Hyatt is projected to generate enough
gross income to cover the payments to Hyatt under the Management Agreement,
(ii) in the event that the Albuquerque Hyatt does not generate enough gross
income to cover the payments to Hyatt under the Management Agreement, RoseStar
may still be able to make such payments out of gross income generated by the
Denver Marriott, (iii) in connection with the Lease, RoseStar has represented
that it has a net worth of at least $200,000, (iv) in the view of the Operating
Partnership, RoseStar's capitalization is adequate to allow RoseStar to assume
RoseStar's obligations under the Lease, and (v) in connection with the Lease,
RoseStar has agreed to limit distributions to its members to an amount
necessary to pay federal and state income taxes on income from the Albuquerque
Hyatt until RoseStar is holding sufficient reserves funds to enable it to pay
at least one monthly payment of base rent under the Lease and all other leases
between RoseStar and the Operating Partnership.
The Albuquerque Hyatt will in any event qualify as foreclosure
property only for a period of up to two years, beginning on the date of its
acquisition by the Operating Partnership, unless the Operating Partnership
obtains an extension of the grace period from the IRS.(32) Therefore, in the
event the Operating Partnership takes possession of the Albuquerque Hyatt as a
result of a default under the lease, presumably the Operating Partnership will
sell the Albuquerque Hyatt or within two years rent it to another tenant under
a lease that will produce "rents from real property."
V. CONCLUSION
Based on the assumptions stated above, it is our opinion that (i) all
of the income that the Operating Partnership derives from the Albuquerque Hyatt
will be treated as "qualifying income" for purposes of the 95 percent test and
(ii) all of the income the Operating Partnership derives from the Albuquerque
Hyatt will be treated as "qualifying income" for purposes of the 75 percent
test.
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Footnote continued from previous page
properties twice. See, Treas. Reg. Sections 1.856-6(b)(2), 1.856-6(d)(2). In
addition, the IRS has also recently issued a private letter ruling in which it
treated income received from hotels acquired pursuant to a bankruptcy petition
as income from foreclosure property, where the hotels were operated by
third-party managers. P.L.R. 9420013 (2/15/94).
(31)Treas. Reg. Section 1.856-6(b)(3).
(32)Section 856(e)(2).
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<PAGE> 92
April 1, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue, Suite 1800
New York New York 10022
Ladies and Gentlemen:
On December 19, 1995 we provided you with a memorandum analyzing the
impact that the purchase of the Hyatt Regency Albuquerque Plaza (the
"Albuquerque Hyatt") by Crescent Real Estate Equities Limited Partnership (the
"Operating Partnership") would have on the ability of Crescent Real Estate
Equities, Inc. (the "Company") to continue to qualify as a real estate
investment trust (a "REIT") under section 856(c).(1) That memorandum concluded
that, subject to certain assumptions, in our opinion (i) all of the income that
the Operating Partnership derived from the Albuquerque Hyatt would be treated
as "qualifying income" for purposes of the 95 percent gross income test for
REIT qualification and (ii) all of the income that the Operating Partnership
derived from the Albuquerque Hyatt would be treated as "qualifying income" for
purposes of the 75 percent gross income test for REIT qualification. The
December 19, 1995 memorandum was based upon, among other items, our review of a
Lease Agreement between the Operating Partnership, as lessor, and RoseStar
Management, LLC ("RoseStar"), as lessee, dated December 19, 1995 (the "Lease").
On March 11, 1996, the Operating Partnership conveyed all of its
interest as lessor under the Lease to Crescent Real Estate Funding II, L.P., a
Delaware limited Partnership ("Funding II"). Funding II assumed all of the
Operating Partnership's liabilities and obligations under the Original Lease.
On March 29, 1996, pursuant to an Assignment and Assumption of
Leasehold Estate, RoseStar sold and assigned all of its interest and estate as
lessee under the Lease to RoseStar Southwest, LLC, a Delaware limited liability
company ("Southwest"). RoseStar owns a 99 percent interest in Southwest, while
the remaining one percent interest is owned by RSSW Corp., a Delaware
corporation. The ownership of RoseStar is unchanged from December 19, 1995.
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(1) All section references are to the Internal Revenue Code of 1986, as
amended (the "Code"), or to the regulations issued thereunder, unless
otherwise noted.
<PAGE> 93
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 2
On April 1, 1996, the Lease was amended to provide that, among other
things, (1) at all times during the term of the Lease, Southwest and RoseStar
would maintain a cumulative net worth equal to $200,000; and (2) Southwest
would retain all of the income it earns from the Albuquerque Hyatt (except
distributions to its beneficial owners in an amount sufficient to pay their
federal and state income taxes on such income) until such time as Southwest and
any affiliate of Southwest (including RoseStar) which has entered into a
long-term lease of a hotel with Funding II or any affiliate of Funding II
(including the Operating Partnership) have accumulated and are holding in
reserve funds in the aggregate which are sufficient to enable Southwest and any
affiliated entities to pay at least one monthly payment of base rent under each
lease between Southwest and any such affiliated entities and Funding II or an
affiliate of Funding II.
This letter is intended to update the opinions expressed in our
December 19, 1995 memorandum to reflect the changes in the Lease and the
substitution of new parties as lessor and lessee of the Albuquerque Hyatt. The
opinions set forth herein are based upon the existing provisions of the Code,
and the reported interpretations thereof by the IRS and by the courts in effect
as of the date hereof, all of which are subject to change, both retroactively
or prospectively, and to possibly different interpretations. We assume no
obligation to update the opinions set forth in this letter. We believe that
the conclusions expressed herein, if challenged by the IRS, would be sustained
in court. However, because our opinions are not binding upon the IRS or the
courts, there can be no assurance that contrary positions may not be
successfully asserted by the IRS.
I. Documents and Representations
For the purpose of rendering this opinion, we have examined and
relied on originals, or copies certified or otherwise identified to our
satisfaction, of the following: (1) the Lease; (2) the Assignment and
Assumption of Leasehold Estate by and between RoseStar and Southwest dated
March 29, 1996; (3) the First Amendment to the Lease dated April 1, 1996; (4)
the Limited Guaranty Agreement by Gerald Haddock, John Goff and Sanjay Varma,
as guarantors in favor of Funding II (the "Guaranty); (5) the Articles of
Organization of RoseStar Management, LLC (the "RoseStar Articles"), (6) the
Regulations of RoseStar Management, LLC (the "RoseStar Regulations"), (7) the
First Amended and Restated Articles of Incorporation of Crescent Real Estate
Equities, Inc. (the "Crescent Articles"); and (8) such other documents or
information as we have deemed necessary for the opinion set forth below. In
our examination, we have assumed the genuineness of all signatures, the legal
capacity of natural persons, the authenticity of all documents submitted to us
as originals, the conformity to original documents of all documents submitted
to us as certified or photostatic copies, and the authenticity of the originals
of such copies.
<PAGE> 94
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 3
For the purpose of rendering this opinion, we have also assumed that
all statements of facts and assumptions described in our December 19, 1995
memorandum remain correct, unless otherwise noted.
II. Opinions
A. Lease Will be Treated as a Lease for Federal Income Tax Purposes
In order for any income derived by Funding II from the Albuquerque
Hyatt to constitute either "rents from real property," or in the case of a
default under the Lease, "gross income from foreclosure property," the Lease
must be treated as a lease for federal income tax purposes and not be treated
as a service contract, management contract or other type of arrangement. This
determination depends on an analysis of all the surrounding facts and
circumstances. In making this determination, courts have considered a variety
of factors, including the following: (i) the intent of the parties, (ii) the
form of the agreement, (iii) the degree of control over the business conducted
at the property that is provided to the lessee (e.g., whether the lessee has
substantial rights of control over the operation of the property and its
business), (iv) the extent to which the lessee has the risk of loss from
operations of the business conducted as the property (e.g., whether the lessee
bears the risk of increases in operating expenses and of decreases in
revenues), and (v) the extent to which the lessee has the opportunity to
benefit from operations of the business conducted at the property (e.g.,
whether the lessee benefits from decreased operating expenses or increased
revenues).(2)
In addition, section 7701(e) provides that a contract that purports
to be a service contract, partnership agreement, or another type of arrangement
will be treated instead as a lease of property if the contract is properly
treated as such, taking into account all relevant factors, including whether or
not: (i) the service recipient is in physical possession of the property, (ii)
the service recipient controls the property, (iii) the service recipient has a
significant economic or possessory interest in the property (e.g., the
property's use is likely to be dedicated to the service recipient for a
substantial portion of the useful life of the property, the recipient shares
the risk that the property will decline in value, the recipient shares in any
appreciation in the value of the property, the recipient shares in any savings
in the property's operating costs or the recipient bears the risk of damage to
or loss of the property), (iv) the service provider does not bear any risk of
substantially diminished receipts or substantially increased expenditures if
there is nonperformance under the contract, (v) the service provider does not
use the property concurrently to provide significant services to entities
unrelated to the service recipient and (vi) the total contract price does not
substantially exceed the rental
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(2) See, e.g., Xerox Corp. v. U.S., 80-2 USTC Paragraph 9530 (Ct. Cl. Tr.
Div. 1980), aff'd per curiam, 656 F.2d 659 (Ct. Cl. 1981).
<PAGE> 95
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 4
value of the property for the contract period. Since the determination of
whether a service contract, partnership agreement, or some other type of
arrangement should be treated as a lease is inherently factual, the presence or
absence of any single factor may not be dispositive in every case.(3)
We have concluded that the Lease will be treated as a lease for
Federal income tax purposes, rather than a service contract, management
contract or other type of arrangement. This conclusion is based, in part, on
the following facts: (i) Funding II and Southwest intend their relationship to
be that of lessor and lessee (as evidenced by the terms of the Lease), (ii)
Southwest has the right to exclusive possession, use and quiet enjoyment of the
Albuquerque Hyatt during the term of the Lease and the right to uninterrupted
control in the operation of and business conducted at the Albuquerque Hyatt
(subject to its assumption of the Management Agreement), (iii) Southwest will
bear the cost of, and be responsible for, capital expenditures, including
maintenance and repair of the Albuquerque Hyatt, and will dictate how the
Albuquerque Hyatt is maintained and improved (with the exception that Funding
II, as lessor, is responsible for the cost of certain capital expenditures in
situations where the funds available to Southwest are insufficient for such
expenditures), (iv) Southwest will bear all the costs and expenses of operating
the Albuquerque Hyatt (with the exception of the costs of replacing certain FF
& E associated with the Albuquerque Hyatt, which are to be funded by Funding
II), (v) Southwest will benefit from any savings in the costs of operating the
Albuquerque Hyatt during the term of the Lease, (vi) in the event of damage or
destruction to the Albuquerque Hyatt, Southwest will be at economic risk
because its obligation to make rental payments will not abate, (vii) Southwest
will indemnify Funding II against all liabilities imposed on Funding II during
the term of the Lease by reason of injury to persons or damage to property
occurring at the Albuquerque Hyatt or Southwest's use, management, maintenance
or repair of the Albuquerque Hyatt, (viii) Southwest is obligated to pay
substantial fixed rent for the period of use of the Albuquerque Hyatt,
regardless of whether its revenues exceed its costs and expenses, and (ix)
Southwest stands to incur substantial losses (or derive substantial profits)
depending on how successfully it operates the Albuquerque Hyatt.
We do not believe that our conclusion that the Lease of the
Albuquerque Hyatt will be treated as a lease for Federal income tax purposes is
affected by the fact that Southwest assumed RoseStar's rights and obligations
as lessor under the Lease subject to its assumption of Funding II's obligations
under the preexisting Management Agreement. The Management Agreement gives
Hyatt control over the day-to-day operation of the Albuquerque Hyatt and will
allow Hyatt to share with Southwest in the benefits of any increases in
revenues or cost savings in the operation of the Albuquerque Hyatt. However,
Hyatt's operation of the
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(3) P.L.R. 8918012 (January 24, 1989).
<PAGE> 96
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 5
Albuquerque Hyatt is not controlled by Funding II, and the Management Agreement
does not affect the fact that Southwest bears most of the risk of loss if the
Albuquerque Hyatt is not successful. Moreover, the IRS has issued a private
letter ruling in which it treated leases of several hotel properties as
producing "rents from real property" in a situation where the lessees had
contracted with a third party to conduct the day-to-day operations of the
hotels.(4) This ruling suggests that the IRS will respect a lease of a hotel
for federal income tax purposes even if the hotel is operated by an
independent contractor rather than by the lessee.
The Lease is structured in form so that Funding II retains ownership
of all the personal property leased to Southwest in connection with Southwest's
lease of the Albuquerque Hyatt (the "FF&E"). However, if the term of the Lease
equals or exceeds the useful life of some or all of the FF&E, it is possible
that the Lease could be treated for federal income tax purposes as a financing
arrangement. In such a case, Southwest would be treated as having acquired
ownership of the FF&E for federal income tax purposes in exchange for an
obligation to make future payments of principal and interest to Funding II.
Nonetheless, we do not believe that the recharacterization of the Lease as a
financing arrangement with respect to the FF&E would have a material effect on
the ability of the Company to satisfy the requirements for taxation as a REIT.
This is because, if a portion the of the payments made by Southwest under the
Lease were characterized as interest on indebtedness secured by the FF&E,
rather than rents from real property, that portion would still satisfy the 95
percent gross income test (although it would not satisfy the 75% gross income
test).(5)
B. Percentage Rent Provision is not Profit-Based
Pursuant to the Lease, Southwest will be obligated to pay Funding II
base rent and percentage rent. Under the regulations, percentage rent based on
a percentage of gross receipts or sales in excess of a floor amount, which is
how the percentage rent is structured under the Lease, will not qualify as
"rents from real property" unless (i) such floor amount does not depend in
whole or in part on the income or profits of the lessee, (ii) the percentage
and the floor amount are fixed at the time the lease is entered into, (iii) the
percentage and the floor amount are not renegotiated during the term of the
lease in a manner that has the effect
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(4) See, P.L.R. 8117036 (January 27, 1981).
(5) If the Lease were recharacterized as a financing arrangement with
respect to the FF&E, it also might result in some minor timing differences
with respect to the Company's recognition of income. These differences
would result from (a) the recharacterization of a portion Southwest's
payments under the Lease as a return of principal and (b) the Company's
loss of any depreciation deductions attributable to the FF&E.
<PAGE> 97
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 6
of basing the percentage rent on income or profits, and (iv) the percentage and
the floor amount conform with normal business practice.(6)
Under the terms of Article 4.2 of the Lease, Southwest will pay
percentage rent equal on an annual basis to the sum of (i) 17.5 percent of the
excess of annual gross receipts from room rentals over $6,000,000 and (ii) 2.5
percent of the excess of annual gross receipts from the food and beverage
facilities at the Albuquerque Hyatt over $2,000,000. It will effectively
reward Southwest for any increases in gross receipts from rooms and from other
sources over the threshold amounts. This type of formula does not base the
percentage rent on Southwest's income or profits, and similar formulas have
been treated by the IRS as generating "rents from real property."(7) Moreover,
Funding II has represented that (i) the floor amounts used to compute the
percentage rent under the Lease do not depend in whole or in part on the income
or profits of any person, (ii) the percentage rent provision of the Lease has
not been and will not be renegotiated during the term of the Lease or at the
expiration or earlier termination of the Lease in a manner that has the effect
of basing the rent on income or profits, and (iii) the percentage rent
provision of the Lease conforms with normal business practice. In addition,
based on our experience and an examination of the Lease and the Albuquerque
Hyatt projections, the Lease appears to conform with normal business practice.
C. Southwest is not a "Related Party Tenant"
Rents received from Southwest will not qualify as "rents from real
property" if Southwest is a "related party tenant." Southwest will be a
"related party tenant" if the Company, or an owner of 10 percent or more of the
Company, directly or constructively owns 10 percent or more of the assets or
net profits of Southwest.(8) Constructive ownership is determined for purposes
of this test by applying the rules of section 318(a) as modified by section
856(d)(5). Those rules generally provide that if 10 percent or more in value
of the stock of the Company is owned, directly or indirectly, by or for any
person, the Company is considered as owning the stock owned, directly or
indirectly, by or for such person.
Southwest will not be treated as a "related party tenant" because a
99 percent interest in Southwest's assets and net profits will be owned by
RoseStar, with the remaining one
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(6) Treas. Reg. Section 1.866-4(b)(3).
(7) See, e.g., P.L.R. 8803007 (September 23, 1987) (percentage rent based on
gross revenues in excess of gross revenues for a base year treated as
"rents from real property"); cf. P.L.R. 9104018 (October 26, 1990)
(interest based on gross revenues in excess of a floor amount treated as
qualifying interest under section 856(f)).
(8) Section 856(d)(2)(B)(ii).
<PAGE> 98
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 7
percent interest owned by RSSW, Corp. An individual, Sanjay Varma, currently
owns a 91 percent interest in the assets and net profits of RoseStar and RSSW,
Corp. In reaching this conclusion, we recognize that Sanjay Varma owns certain
Units of the Operating Partnership.(9) Funding II has represented that (i)
Sanjay Varma does not own more than 10 percent of the value of the Company's
stock, (ii) Sanjay Varma is not expected to own more than 10 percent of the
value of the Company's stock in the future, and (iii) neither Funding II nor
the Company intends to acquire, directly or constructively, an interest of 10
percent or more in the assets or net profits of RoseStar at any time in the
future. Moreover, Article 7.8 of the Lease limits the ability of Southwest or
any person owning an interest in Southwest (including RoseStar) to acquire,
directly or constructively, a 6 percent stock interest in the Company, and
Section 6.4 of the First Amended and Restated Articles of Incorporation of the
Company prevents RoseStar and its members and managers from acquiring more than
8 percent of the Company's stock.
The conclusion that Southwest will not be treated as a "related party
tenant" is based on the assumption that its member RoseStar will be treated as
a partnership for federal income tax purposes. If RoseStar is not treated as a
partnership for federal income tax purposes, but is instead treated as an
association taxable as a corporation, then it is possible that Southwest would
be treated as a "related party tenant" and the rents derived under the terms of
the Lease would not be treated as "rents from real property." This is because,
if RoseStar were treated as a corporation for federal income tax purposes,
Gerald W. Haddock and John C. Goff would likely be deemed to own all of its
voting stock, because of the extensive powers that they are granted as managers
under the RoseStar Regulations. If this were the case, the ownership of such
voting stock (and ownership of Southwest) might be attributed to the Company
under a literal reading of the constructive ownership rules described above.(10)
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(9) See Rev. Rul. 73-194, 1973-1 C.B. 355 (management company treated as an
independent contractor with respect to a REIT, where an affiliate of the
management company and the REIT were partners).
(10) Richard Rainwater, Gerald Haddock and John Goff are each partners in
FW-Irving Partners, Ltd. (and apparently they are partners in other
partnerships as well). Richard Rainwater also owns more than 10 percent
of the value of the stock of the Company. Thus, assuming that the
ownership interests in RoseStar held by Gerald Haddock and John Goff
constitute stock, such interests, along with Richard Rainwater's stock
interest in the Company, will be attributed to FW-Irving Partners, Ltd.
pursuant to section 318(a)(3)(A), which provides that stock owned,
directly or indirectly, by or for a partners shall be considered as owned
by the partnership. Then, FW-Irving Partners, Ltd.'s deemed interest in
RoseStar would be attributed to the Company pursuant to section
318(a)(3)(C) (as modified by section 856(d)(5)), which provides that stock
owned by any person that owns 10 percent or more of the value of the stock
in a corporation shall be considered owned by the corporation. As you are
aware, however, we have opined to you in a similar context that we do not
believe that these attribution rules should be read literally.
<PAGE> 99
Crescent Real Estate Equities, Inc.
April 1, 1996
Page 8
An entity which has associates and an objective to carry on a
business for joint profit will be treated as a partnership for federal income
tax purposes, and not as an association taxable as a corporation, if it has not
more than two of the following four characteristics of a corporation: (i)
continuity of life; (ii) centralization of management; (iii) limited liability;
and (iv) free transferability of interests.(11) The entity must also have no
other characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics.(12) The IRS has applied this four-factor test in determining
whether limited liability companies formed under the Texas Limited Liability
Company Act (the "Act") are partnerships for federal income tax purposes.(13)
The IRS has issued Rev. Proc. 95-10, which specifies conditions which must be
satisfied for a limited liability company to receive a favorable advanced
ruling that it will be classified as a partnership for federal income tax
purposes.(14) RoseStar should satisfy these conditions. However, such
conditions are applicable only in determining whether rulings will be issued
and are not intended as substantive rules for determination of partnership
status.
An organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time.(15)
Article 6.01 of the Act provides, in part, that except as otherwise provided in
the company's regulations, a limited liability company shall be dissolved upon
the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a
member or the occurrence of any other event which terminates the continued
membership of a member in the limited liability company, unless there is at
least one remaining member and the business of the limited liability company is
continued by the consent by the number of members or class thereof stated in
the articles of organization or regulations of the limited liability company or
of not so stated, by all remaining members. Article 2 of the RoseStar Articles
provides that the duration of RoseStar is until the close of business on
December 31, 2015, or until its earlier dissolution in accordance with the
provisions of the Act or the Regulations. Article 10.2 of the RoseStar
Regulations provides, in part, that RoseStar shall be dissolved upon the
withdrawal, death, retirement, resignation, expulsion, bankruptcy, legal
incapacity or dissolution of any member, unless the business of RoseStar is
continued by the consent of all the remaining members
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(11) Treas. Reg. Section 301.7701-2(a).
(12) See Rev. Rul. 79-106, 1979-1 C.B. 448.
(13) See, e.g., P.L.R. 9242025 (July 22, 1992) and P.L.R. 9218078 (January
31, 1992).
(14) 1995-3 I.R.B. 20.
(15) Treas. Reg. Section 301.7701-2(b)(3).
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April 1, 1996
Page 9
within ninety days. Accordingly, RoseStar will lack the corporate
characteristic of continuity of life.
An organization will be treated as possessing the corporate
characteristic of free transferability of interests if the members owning all
or substantially all of the interests in an organization may substitute for
themselves without the consent of the other members a person who is not a
member of the organization.(16) Article 4.05 of the Act provides, in part, that
unless otherwise provided by the company's regulations, a membership interest
is assignable in whole or in part; an assignment of a member's interest does
not entitle the assignee to become, or to exercise rights or powers of a
member; and until the assignee becomes a member, the assignor member continues
to be a member and to have the power to exercise any rights or powers of a
member, except to the extent those rights or powers are assigned. Article 4.07
of the Act provides, in part, that an assignee of a membership interest may
become a member if and to the extent that the company's regulations so provide,
or all members consent. Article 9.3 of the RoseStar Regulations provides, in
part, that no member shall have the right to substitute in its place a
transferee unless consent is given by the Managers and a majority of the other
members, which consent may be withheld in the discretion of the Managers or the
other members. Accordingly, RoseStar will lack the corporate characteristic of
free transferability of interests. Because RoseStar will lack the corporate
characteristics of continuity of life and free transferability of interests, in
our opinion it will be treated as partnership for federal income tax purposes.
D. Incidental Personal Property
As noted in the December 19, 1995 memorandum, in order for the rent
under the Lease to be treated as "rents from real property," the rents
attributable to personal property leased under or in connection with the Lease
must not be greater than 15 percent of the rents received under the Lease. The
rent attributable to personal property leased under or in connection with a
lease of real property is the amount that bears the same ratio to total rent
for the taxable year as (i) the average of the adjusted bases of the personal
property leased under or in connection with a lease of real property at the
beginning and at the end of the taxable year bears to (ii) the average of the
aggregate adjusted bases of the real and personal property subject to the lease
at the beginning and at the end of such taxable year (the "Adjusted Basis
Ratio").(17) Funding II has represented that the adjusted tax basis of the
personal property leased under or in connection with the Lease has not
represented and will not represent more than 15 percent of the aggregate
adjusted tax basis of the Albuquerque
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(16) Treas. Reg. Section 301.7701-2(e).
(17) Section 856(d)(1)(C).
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Page 10
Hyatt at any time. Moreover, in Article 36.2 of the Lease, the parties agreed
that the adjusted tax basis of the personal property leased under or in
connection with the Lease will not represent more than 15 percent of the
aggregate adjusted tax basis of the Albuquerque Hyatt at any time.
E. Provision of Services by the Funding II
1. Income Derived under the Terms of the Lease
Although Funding II may treat charges for services customarily
furnished or rendered in connection with the rental of the Albuquerque Hyatt as
"rents from real property," any services rendered to the occupants of the
Albuquerque Hyatt must be furnished or rendered by an independent contractor
from whom the Company does not derive or receive any income.(18) Moreover, to
the extent that any independent contractors provide noncustomary services to
the occupants of the Albuquerque Hyatt, the cost of such services must not be
borne by the Funding II.(19)
Under the terms of the Lease, Funding II will not be required to
provide any services, customary or noncustomary, in connection with the rental
of the Albuquerque Hyatt. Instead, all services relating to the operation of
the Albuquerque Hyatt will be provided by Hyatt under the terms of the
Management Agreement. Funding II has represented that Hyatt is an independent
contractor within the meaning of section 856(d)(3), from which the Company and
Funding II will not derive or receive any income. Funding II will not bear the
cost of any of the services provided by Hyatt. Instead, such costs are borne
by Southwest, because it has assumed Funding II's obligations, as owner, under
the Management Agreement.
Based on the foregoing, we believe that the provision of any
noncustomary services to the occupants of the Albuquerque Hyatt by Hyatt will
have no effect on the qualification of the income derived from the Albuquerque
Hyatt as "rents from real property." In fact, the IRS has issued a private
letter ruling in which it has treated the income derived from several leases of
hotel properties as "rents from real property" in a situation where the lessees
had contracted with a third-party to conduct the day to day operations of the
hotels.(20) Our conclusion is not altered by the fact that Funding II will
remain liable for any obligations arising under the Management Agreement, to
the extent that they are not satisfied by Southwest. Funding II should not be
treated as bearing the cost of the services provided by
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(18) Sections 856(d)(1), 856(d)(2)(C); Treas. Reg. Section 1.512(b)-1(c)(5).
(19) Treas. Reg. Section 1.856-4(b)(5).
(20) See, P.L.R. 8117036 (January 27, 1981).
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Crescent Real Estate Equities, Inc.
April 1, 1996
Page 11
Hyatt merely because it is liable for Southwest's obligations under the
Management Agreement. Funding II is not retaining this liability in an attempt
to provide services to Southwest. Instead, it is retaining this liability only
as an accommodation to Hyatt. Moreover, Funding II believes that it is highly
unlikely that it will ever be required to reimburse Hyatt for the costs and
expenses of operating the Albuquerque Hyatt. This is because (i) the
Albuquerque Hyatt is projected to generate enough gross income to cover the
payments to Hyatt under the Management Agreement, (ii) in connection with
Section 7.7 the Lease, as amended, Southwest has represented that it has a net
worth of at least $200,000, (iii) in connection with Section 7.9 of the Lease,
as amended, Southwest has agreed to retain all of the income it earns from the
Albuquerque Hyatt (except distributions to its beneficial owners in an amount
sufficient to pay their federal and state income taxes on such income) until
such time as Southwest and any affiliate of Southwest (including RoseStar)
which has entered into a long-term lease of a hotel with Funding II or any
affiliate of Funding II (including the Operating Partnership) have accumulated
and are holding in reserve funds in the aggregate which are sufficient to
enable Southwest and any affiliated entities to pay at least one monthly
payment of base rent under each lease between Southwest and any such affiliated
entities and Funding II or an affiliate of Funding II, (iv) pursuant to the
Guaranty, RoseStar's individual members have guaranteed RoseStar's obligations
under the Lease, and (v) in the view of Funding II, Southwest's capitalization
is adequate to allow Southwest to assume its obligations as lessee under the
Lease.
2. Income Derived in the Case of a Default under the Lease
If Funding II were required to reimburse Hyatt for the costs of
operating the Albuquerque Hyatt because of a default by Southwest under the
terms of the Management Agreement, we have concluded that the income derived by
Funding II from the Albuquerque Hyatt would be treated as "qualifying income"
for purposes of the 75 percent and 95 percent tests. This is because, if
Funding II were required to reimburse Hyatt for the cost of operating the
Albuquerque Hyatt, this would constitute an event of default under Article
16.1(c) of the Lease, allowing Funding II to terminate Southwest's leasehold
interest in the Albuquerque Hyatt. As a result of such a termination of the
Lease, any income derived by Funding II from the Albuquerque Hyatt after the
default would be treated as income from foreclosure property.
Funding II would be able to continue to operate the Albuquerque Hyatt
after any default under the Lease, without affecting its status as foreclosure
property, because Hyatt, an independent contractor, from whom the Company will
not derive any income, will provide all services relating to its operation. A
REIT can use foreclosure property in the conduct of an
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Page 12
active trade or business, as long as this is done through the use of an
independent contractor, from whom the REIT does not derive or receive any
income.(21)
Real property acquired upon default under a lease is not eligible to
be treated as foreclosure property if the lease is entered into with an intent
to evict or foreclose, or if the REIT knows or has reason to know that default
would occur.(22) This is not the case in the present situation because (i) the
Albuquerque Hyatt is projected to generate enough gross income to cover the
payments to Hyatt under the Management Agreement, (ii) in connection with
Section 7.7 the Lease, as amended, Southwest has represented that it has a net
worth of at least $200,000, (iii) in connection with Section 7.9 of the Lease,
as amended, Southwest has agreed to retain all of the income it earns from the
Albuquerque Hyatt (except distributions to its beneficial owners in an amount
sufficient to pay their federal and state income taxes on such income) until
such time as Southwest and any affiliate of Southwest (including RoseStar)
which has entered into a long-term lease of a hotel with Funding II or any
affiliate of Funding II (including the Operating Partnership) have accumulated
and are holding in reserve funds in the aggregate which are sufficient to
enable Southwest and any affiliated entities to pay at least one monthly
payment of base rent under each lease between Southwest and any such affiliated
entities and Funding II or an affiliate of Funding II, (iv) pursuant to the
Guaranty, RoseStar's individual members have guaranteed RoseStar's obligations
under the Lease, and (v) in the view of Funding II, Southwest's capitalization
is adequate to allow Southwest to assume its obligations as lessee under the
Lease.
The Albuquerque Hyatt would in any event qualify as foreclosure
property only for a period of up to two years, beginning of the date of its
acquisition by Funding II, unless Funding II obtains an extension of the grace
period from the IRS.(23) Therefore, in the event Funding II takes possession
of the Albuquerque Hyatt as a result of a default under the Lease, presumably
Funding II will sell the Albuquerque Hyatt or, within two years, rent it to
another tenant under a lease that will produce "rents from real property."
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(21) Section 856(e)(4)(C). (The IRS clearly intended for REITs to be able to
treat hotels operated by independent contractors as foreclosure property.
For instance, the Treasury regulations defining foreclosure property
refer to hotel properties twice. See, Treas. Reg. Sections 1.856-6(b)(2),
1.856-6(d)(2). In addition, the IRS has also recently issued a private
letter ruling in which it treated income received from hotels acquired
pursuant to a bankruptcy petition as income from foreclosure property,
where the hotels were operated by third party managers. P.L.R.
9420013 (2/15/94).)
(22) Treas. Reg. Section 1.856-6(b)(3).
(23) Section 856(e)(2).
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Crescent Real Estate Equities, Inc.
April 1, 1996
Page 13
F. Conclusions
Based on the assumptions and representations stated above, it is our
opinion that (i) all of the income that Funding II derives from the Albuquerque
Hyatt will be treated as "qualifying income" for purposes of the 95 percent
test and (ii) all of the income that Funding II derives from the Albuquerque
Hyatt, will be treated as "qualifying income" for purposes of the 75 percent
test.
III. Additional Limitations
The foregoing opinions are limited to the specific matters covered
thereby and should not be interpreted to imply that the undersigned has offered
its opinion on any other matter.
Very truly yours,
SHAW, PITTMAN, POTTS & TROWBRIDGE
By:
---------------------------------
Charles B. Temkin, P.C.
<PAGE> 105
July 26, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue
Suite 1800
New York, New York 10022
Re: Canyon Ranch
Ladies and Gentlemen:
You have requested certain opinions regarding the application of U.S.
federal income tax laws to Crescent Real Estate Equities, Inc. (the "Company")
and Crescent Real Estate Equities Limited Partnership (the "Operating
Partnership") in connection with the acquisition of Canyon Ranch, a health and
fitness resort located in Tucson, Arizona from Canyon Ranch, Inc. ("CRI").
I. TRANSACTION DOCUMENTS
In rendering the opinions expressed below, we have examined and relied
upon the following documents (collectively, the "Transaction Documents"):
(i) the Contribution Agreement between CRI and the Operating
Partnership, dated July 26, 1996 ("the Contribution
Agreement");
(ii) the Lease Agreement between CRI and Canyon Ranch Leasing,
L.L.C. ("CRL"), dated July 26, 1996 (the "Lease");
(iii) the Management Agreement between CRI and Canyon Ranch
Management, L.L.C. ("CRM"), dated July 26, 1996 (the
"Management Agreement");
(iv) the Assignment and Assumption of Management Agreement between
CRI and the Operating Partnership, dated July 26, 1996 (the
"Assignment and Assumption Agreement");
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 2
(v) the Assignment and Assumption of Master Lease between CRI and
the Operating Partnership, dated July 26, 1996;
(vi) the Assignment and Assumption of Contracts between CRI and
the Operating Partnership, dated July 26, 1996;
(vii) the Assignment and Assumption of Store Leases between CRI and
the Operating Partnership, dated July 26, 1996;
(viii) the Asset Purchase Agreement between CRL, CRI and the
Operating Partnership, dated July 26, 1996 (the "FF & E
Purchase Agreement");
(ix) the Contract of Sale between CRI and CRL, dated July 26, 1996
(the "Life Share Contract");
(x) the Promissory Note for $2,400,000 with CRL as maker and the
Operating Partnership as payee bearing interest at the rate
of 10.75 percent, dated July 26, 1996 (the "Crescent FF & E
Note");
(xi) the Promissory Note in the amount of $648,360 with CRL as
maker and the Operating Partnership as payee bearing interest
at the rate of 10.75 percent per annum, dated July 26, 1996
(the "Life Share Note");
(xii) the Security Agreement between CRL and the Operating
Partnership, dated July 26, 1996 (the "Security Agreement");
(xiii) the Promissory Note in the amount of $162,090 with CRL as
maker and RoseStar Management, L.L.C. ("RoseStar") as payee
bearing interest at the rate of 10.75 percent per annum,
dated July 26, 1996 ("RoseStar Life Share Note");
(xiv) the Guaranty Agreement between RoseStar as GUARANTOR and the
Operating Partnership, dated July 26, 1996 (the "Guaranty");
(xv) the Limited Guaranty Agreement between Gerald Haddock, John
C. Goff and Sanjay Varma, together, as guarantors and the
Operating Partnership, dated July 26, 1996 (the "Limited
Guaranty");
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 3
(xvi) the Agreement Between CRI as Lessee and the Operating
Partnership as Substitute Lessor, dated July 26, 1996;
(xvii) the Option Agreement between Melvin Zuckerman ("Zuckerman")
and RoseStar, dated July 26, 1996 (the "Zuckerman Option
Agreement");
(xviii) the Option Agreement between Jerry Cohen ("Cohen") and RSCR
Arizona Corp., a Delaware Corporation ("RSCR"), dated July
26, 1996 (the "Cohen Option Agreement");
(xix) the Option Agreement between CRL and the Operating
Partnership, dated July 26, 1996 (the "Life Share Option
Agreement");
(xx) the Articles of Organization of RoseStar (the "RoseStar
Articles");
(xxi) the Regulations of RoseStar (the "RoseStar Regulations");
(xxii) the Articles of Organization of CRL (the "CRL Articles");
(xxiii) the Regulations of CRL (the "CRL Regulations");
(xxiv) the Articles of Incorporation of RSCR;
(xxv) the Bylaws of RSCR;
(xxvi) the First Amended and Restated Articles of Incorporation of
Crescent Real Estate Equities, Inc. (the "Crescent
Articles"); and
(xxvii) such other documents or information as we deemed necessary
for the opinions set forth below.
II. BACKGROUND OF TRANSACTION
A. The Management Agreement: Under the Management Agreement, CRI,
as owner of Canyon Ranch, has contracted with CRM to manage and operate Canyon
Ranch, to collect all Canyon Ranch receipts, and to manage certain related
properties and time share programs (as described more fully below). In
addition, CRM has also agreed to honor resort memberships issued to various
persons by CRI. CRM was also granted the right to issue
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 4
additional memberships in the resort in the future. In exchange for these
services, CRM is to be paid a profits-based management fee collected from the
gross receipts of the resort.
Under the Management Agreement, CRI, as owner, is obligated to
establish a capital improvement reserve to be funded from gross receipts from
the resort. CRM, as manager, is entitled to withdraw funds from this reserve
to pay for capital improvements and additions to the furniture, fixtures and
equipment used in connection with the resort.
Section 15.2 of the Management Agreement requires that all assignments
of the Management Agreement (other than certain assignments to permitted
transferees) be approved by CRM and under Section 15.3 of the Management
Agreement any assignees are bound by the obligations of the owner under the
Management Agreement.
B. The Lease: Under the terms of the Lease, CRL leased the
following property (the "Leased Property") from CRI: (i) the land, buildings,
fixtures and other improvements commonly known as Canyon Ranch; (ii) various
contracts entitling persons to use the guest rooms and/or the resort
facilities; (iii) various contracts (excluding employment contracts) relating
to the operation of the resort; (iv) CRI's interest as owner under the
Management Agreement (including the obligation to fund the capital improvement
reserve); (v) CRI's interest under certain Individual Unit Management
Agreements and a Common Element Management Agreement relating to the Canyon
Ranch Casitas (described more fully below); (vi) CRI's interest under certain
Individual Unit Management Agreements relating to the Canyon Ranch Estates
(described more fully below); (vii) CRI's interest under all existing leases of
the resort property; and (viii) certain personal property used in connection
with the resort. The Leased Property does not include certain machinery,
equipment, fixtures, furniture, vehicles, artwork, signage and other decorative
items located in or used in connection with the operation of the resort (the
"FF & E"), which was sold by CRI to CRL (as described more fully below).
C. The Zuckerman and Cohen Option Agreements: Under the
Zuckerman Option Agreement, Zuckerman granted to RoseStar, a Texas limited
liability company, the exclusive option to purchase, on or after December 15,
1996, but not after December 31, 1996, his 99 percent interest in CRL, the
Delaware limited liability company that is lessee under the Lease. In order to
exercise this option, RoseStar must give notice to Zuckerman and pay him $1.00.
In addition, under the Zuckerman Option Agreement, Zuckerman has the right to
require RoseStar to purchase his 99 percent interest in CRL for $1.00 at any
time on or after December 15, 1996, but not after December 31, 1996.
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 5
Currently, Sanjay Varma owns a 91 percent interest in the assets and
net profits of RoseStar, while Gerald W. Haddock and John C. Goff, the managers
of RoseStar, each own a 4.5 percent interest in its assets and net profits.
Under the Cohen Option Agreement, Cohen granted to RSCR the exclusive
option to purchase, on or after December 15, 1996, but not after December 31,
1996, his one percent interest in CRL. In order to exercise this option, RSCR
must give notice to Cohen and pay him $1.00. In addition, under the Cohen
Option Agreement, Cohen has the right to require RSCR to purchase his one
percent interest in CRL for $1.00 at any time on or afterDecember 15, 1996, but
not after December 31, 1996.
Sanjay Varma owns 91 percent of the stock of RSCR. Gerald W. Haddock
and John C. Goff each own 4.5 percent of the stock of RSCR.
D. The Contribution Agreement and the Assignment and Assumption
Agreement: Under the Contribution Agreement, CRI contributed the land,
buildings, fixtures and other improvements commonly known as Canyon Ranch, as
well as certain personal property used in connection with the operation of the
resort to the Operating Partnership, subject to the Lease and the Management
Agreement, in exchange for Units in the Operating Partnership. Under the
Contribution Agreement, the Operating Partnership also acquired CRI's interest
as owner under the Management Agreement and as lessor under the Lease.
Under the Assignment and Assumption Agreement, the Operating
Partnership assumed and agreed to perform all obligations of CRI as owner under
the Management Agreement to the extent that such obligations are not performed
by CRL as lessee under the Lease.
E. FF & E: As noted above, the Operating Partnership did not
acquire any of the FF & E. Instead, CRL purchased the FF & E from CRI under
the Asset Purchase Agreement with the proceeds of a loan. The loan, in the
principal amount of $2,400,000, was made to CRL by the Operating Partnership,
is evidenced by the Crescent FF & E Note, and is secured by the FF & E under
the terms of the Security Agreement.
F. Canyon Ranch Casitas: Adjacent to Canyon Ranch is the Canyon
Ranch Casitas Subdivision, consisting of 47 platted lots. Immediately prior to
the execution of the Contribution Agreement and the Life Share Property
Contract, CRI owned interests in 19 of these lots. The interests owned by CRI
consisted of: (a) the fee interest in 10 developed lots, which are used for
accommodations just like other rooms contained in Canyon Ranch proper, (b) the
fee interest in 6 unimproved lots, and (c) the fee interest in three improved
lots (the
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 6
"Casitas Time Share Lots") dedicated to the Canyon Ranch Casitas time share
program (described more fully below). Under the terms of the Contribution
Agreement, CRI's fee interest in the 10 developed and 6 undeveloped lots in
the Casitas Subdivision was contributed to the Operating Partnership subject to
the Lease and the Management Agreement. As a consequence, CRM will be
responsible for operating these lots for CRL. CRI sold its interest in the
Casitas Time Share Lots to CRL under the terms of the Life Share Property
Contract. CRL borrowed funds pursuant to the Life Share Note to acquire these
lots.
The other 28 lots in the Canyon Ranch Casitas subdivision are not
owned by CRI (one is owned by Zuckerman and the other 27 are owned by third
parties) and have not been contributed to the Operating Partnership. However,
under the terms of the Management Agreement, CRM has assumed the obligation to
manage approximately 20 of these lots under the terms of certain Individual
Unit Management Agreements between CRI and the owners of these lots. CRM has
also assumed CRI's obligation to maintain certain common areas in the Canyon
Ranch Casitas subdivision under the terms of a Common Element Management
Agreement. Under prior agreements, CRI granted third parties using the Casitas
units the right to use the resort facilities in exchange for an additional fee.
Under the terms of the Management Agreement, CRM has assumed CRI's obligations
under these prior agreements.
G. Canyon Ranch Estates: Also adjacent to Canyon Ranch is the
Canyon Ranch Estates Subdivision. Immediately prior to the execution of the
Contribution Agreement, CRI owned interests in five units in the Canyon Ranch
Estates Subdivision. The interests owned by CRI consisted of: (a) the fee
interest in one house in the Canyon Ranch Estates Subdivision used for
accommodations just like other rooms contained in Canyon Ranch proper, and (b)
the fee interest in three improved lots (the "EstatesTime Share Lots")
dedicated to the Canyon Ranch Hacienda time share program (described more fully
below). Under the terms of the Contribution Agreement, CRI's fee interest in
the house in the Canyon Ranch Estates subdivision was contributed to the
Operating Partnership subject to the Lease and the Management Agreement. As a
consequence, CRM will be responsible for operating this unit for CRL. CRI sold
its interest in the Estates Time Share Lots to CRL under the terms of the Life
Share Property Contract. CRL borrowed funds pursuant to the Life Share Note to
acquire these lots.
The other units in the Canyon Ranch Estates Subdivision were not
contributed to the Operating Partnership.
H. Time Share Arrangements: Time share arrangements exist with
respect to the Casitas Time Share Lots and the Estates Time Share Lots.
Purchasers of time share interests
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 7
in these properties ("Interval Owners") entered into agreements with CRI that
allow the Interval Owners to (i) become members of Canyon Ranch, (ii) use the
time share accommodations for a certain period of time each year, and (iii)
receive certain personal health benefits. However, an Interval Owner must pay
to CRI additional fees for use of the spa, for meals and any special services
utilized. Interval Owners must also pay an annual maintenance fee to their
life share association (described more fully below). Under the Management
Agreement, CRM has agreed to perform all duties of CRI, as owner, under these
time share arrangements, to the extent such duties do not arise after the
termination of the Management Agreement. CRM has also agreed not to sell any
more time share interests under any of the above described programs.
III. REQUESTED OPINIONS
You have asked for our opinion concerning the impact that the purchase
of Canyon Ranch will have on the ability of the Company to continue to qualify
as a real estate investment trust (a "REIT") under section 856.(1)
Specifically, you have requested that we render opinions addressing the
following:
1. whether the Lease will be treated as a lease for federal
income tax purposes;
2. whether the income that the Operating Partnership derives from
the Lease will be treated as "qualifying income" for purposes
of the 95 percent and 75 percent gross income tests for REIT
qualification under section 856(c); and
3. whether the income that the Operating Partnership derives from
the Crescent FF & E Note and the Life Share Note will be
treated as "qualifying income" for purposes of the 75 percent
gross income test for REIT qualification under section
856(c)(3).
IV. LEGAL BACKGROUND
A. 75 Percent and 95 Percent Tests
In order to qualify as a REIT for tax purposes, the Company must
satisfy certain tests with respect to the composition of its gross income on an
annual basis. First, at least 75 percent of the Company's gross income
(excluding gross income from certain prohibited
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(1) All section references herein are to the Internal Revenue Code of 1986,
as amended (the "Code"), or to the regulations issued thereunder, unless
otherwise noted.
<PAGE> 112
Crescent Real Estate Equities, Inc.
July 26, 1996
Page 8
transactions) for each taxable year must consist of temporary investment income
or of certain defined categories of income derived directly or indirectly from
investments relating to real property or mortgages on real property. These
categories include, subject to various limitations, rents from real property,
interest on mortgages on real property, gains from the sale or other
disposition of real property (including interests in real property and
mortgages on real property) not primarily held for sale to customers in the
ordinary course of business, income from foreclosure property, and amounts
received as consideration for entering into either loans secured by real
property or purchases or leases of real property.(2) Second, at least 95
percent of the Company's gross income (excluding gross income from certain
prohibited transactions) for each taxable year must be derived from income
qualifying under the 75 percent test and from dividends, other types of
interest and gain from the sale or disposition of stock or securities, or from
any combination of the foregoing.(3)
In applying these income tests, REITs that are partners in a
partnership are required to include in their gross income their proportionate
share of the partnership's gross income. In addition, such REITs are to treat
this partnership gross income as retaining the same character as the items of
gross income of the partnership for purposes of section 856.(4) Thus, the
character of any income derived by the Operating Partnership from Canyon Ranch
will affect the ability of the Company to qualify as a REIT.
B. Rents from Real Property
Rents from real property satisfy both the 75 percent and 95 percent
tests for REIT qualification only if several conditions are met. First, the
amount of rent must not be based in whole or in part on the income or profits
of any person. An amount received or accrued generally will not be excluded
from the term "rents from real property" solely by reason of being based on a
fixed percentage or percentages of receipts or sales.(5) Second, the Code
provides that rents received from a tenant will not qualify as "rents from real
property" if the REIT, or an owner of 10 percent or more of the REIT, directly
or constructively, owns 10 percent or more of such tenant (a "Related Party
Tenant").(6) Third, if rent attributable to personal property leased in
connection with a lease of real property is greater than 15 percent of the
total rent received under the lease, then the portion of rent attributable to
such personal
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(2) Section 856(c)(3).
(3) Section 856(c)(2).
(4) Treas. Reg. Section 1.856-3(g).
(5) Section 856(d)(2)(A).
(6) Section 856(d)(2)(B).
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 9
property will not qualify as "rents from real property."(7) Finally, for rents
to qualify as "rents from real property," a REIT generally must not operate or
manage the property or furnish or render services to the tenants of such
property, other than through an independent contractor from whom the REIT
derives no revenue. However, rents will be qualified as "rents from real
property" if a REIT directly performs services in connection with the lease of
the property, if those services are "usually or customarily rendered" in
connection with the rental of space for occupancy, and such services are not
considered to be rendered to the occupant of the property.(8)
C. Income from Foreclosure Property
Income from foreclosure property is treated as "qualifying income" for
purposes of the 75 percent and 95 percent tests (although any net income from
foreclosure property is taxed at the maximum corporate rate). Foreclosure
property is any real property, and any personal property incident to such real
property, acquired by a REIT through default under a mortgage or a lease. A
REIT may elect to treat such property as foreclosure property for a grace
period of up to two years.(9) However, such property will cease to qualify as
foreclosure property if it is used by the REIT in a trade or business more than
90 days after it is acquired and it is not operated through an independent
contractor from whom the REIT does not derive or receive any income.(10)
Moreover, property is not eligible to be treated as foreclosure property if the
lease is entered into with an intent to evict or foreclose, or if the REIT
knows or has reason to know that default would occur.(11)
V. OPINIONS
A. Lease Will be Treated as a Lease for Federal Income Tax
Purposes
In order for any income derived by the Operating Partnership from
Canyon Ranch to constitute either "rents from real property," or in the case of
a default under the Lease, "gross income from foreclosure property," the Lease
must be treated as a lease for federal income tax
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(7) Section 856(d)(1)(C).
(8) Sections 856(d)(1)(B), 856(d)(2)(C).
(9) Section 856(e).
(10) Section 856(e)(4).
(11) Treas. Reg. Section 1.856-6(b)(3).
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Page 10
purposes and not be treated as a service contract, management contract or other
type of arrangement. This determination depends on an analysis of all the
surrounding facts and circumstances. In making this determination, courts have
considered a variety of factors, including the following: (i) the intent of the
parties, (ii) the form of the agreement, (iii) the degree of control over the
business conducted at the property that is provided to the lessee (e.g.,
whether the lessee has substantial rights of control over the operation of the
property and its business), (iv) the extent to which the lessee has the risk of
loss from operations of the business conducted at the property (e.g., whether
the lessee bears the risk of increases in operating expenses and of decreases
in revenues), and (v) the extent to which the lessee has the opportunity to
benefit from operations of the business conducted at the property (e.g.,
whether the lessee benefits from decreased operating expenses or increased
revenues).(12)
In addition, section 7701(e) provides that a contract that purports to
be a service contract, partnership agreement, or another type of arrangement
will be treated instead as a lease of property if the contract is properly
treated as such, taking into account all relevant factors, including whether or
not: (i) the service recipient is in physical possession of the property, (ii)
the service recipient controls the property, (iii) the service recipient has a
significant economic or possessory interest in the property (e.g., the
property's use is likely to be dedicated to the service recipient for a
substantial portion of the useful life of the property, the recipient shares
the risk that the property will decline in value, the recipient shares in any
appreciation in the value of the property, the recipient shares in any savings
in the property's operating costs or the recipient bears the risk of damage to
or loss of the property), (iv) the service provider does not bear any risk of
substantially diminished receipts or substantially increased expenditures if
there is nonperformance under the contract, (v) the service provider does not
use the property concurrently to provide significant services to entities
unrelated to the service recipient and (vi) the total contract price does not
substantially exceed the rental value of the property for the contract period.
Since the determination of whether a service contract, partnership agreement,
or some other type of arrangement should be treated as a lease is inherently
factual, the presence or absence of any single factor may not be dispositive in
every case.(13)
We have concluded that the Lease will be treated as a lease for
Federal income tax purposes, rather than a service contract, management
contract or other type of arrangement. This conclusion is based, in part, on
the following facts: (i) the Operating Partnership and CRL intend their
relationship to be that of lessor and lessee (as evidenced by the terms of the
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(12) See, e.g., Xerox Corp. v. U.S., 80-2 USTC Paragraph 9530 (Ct. Cl. Tr.
Div. 1980), aff'd per curiam, 656 F.2d 659 (Ct. Cl. 1981).
(13) P.L.R. 8918012 (January 24, 1989).
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Page 11
Lease), (ii) CRL, as tenant under the Lease, will have the right to exclusive
possession, use and quiet enjoyment of Canyon Ranch during the term of the
Lease and the right to uninterrupted control in the operation of the business
conducted at Canyon Ranch (subject to its assumption of the Management
Agreement), (iii) CRL will dictate how Canyon Ranch is maintained and improved,
(iv) CRL will bear all the costs and expenses of operating Canyon Ranch, (v)
CRL will benefit from any savings in the costs of operating Canyon Ranch during
the term of the Lease, (vi) in the event of damage or destruction to Canyon
Ranch, CRL will be at economic risk because its obligation to make rental
payments will not abate, (vii) CRL will indemnify the Operating Partnership
against all liabilities imposed on the Operating Partnership during the term of
the Lease by reason of injury to persons or damage to property occurring at
Canyon Ranch or CRL's use, management, maintenance or repair of Canyon Ranch,
(viii) CRL is obligated to pay substantial fixed rent for the period of use of
Canyon Ranch, regardless of whether its revenues exceed its costs and expenses,
and (ix) CRL stands to incur substantial losses (or derive substantial profits)
depending on how successfully it operates Canyon Ranch.
We do not believe that our conclusion that the Lease of Canyon Ranch
will be treated as a lease for Federal income tax purposes is affected by the
fact that CRL entered the Lease subject to its assumption of CRI's obligations
under the preexisting Management Agreement. The Management Agreement gives CRM
control over the day-to-day operation of Canyon Ranch and allows CRM to share
with CRL in the benefits of any increases in revenues or cost savings in the
operation of Canyon Ranch. However, CRM's operation of Canyon Ranch will not
be controlled by the Operating Partnership, and the Management Agreement does
not affect the fact that CRL bears most of the risk of loss if Canyon Ranch is
not successful. Moreover, the IRS has issued a private letter ruling in which
it treated leases of several hotel properties as producing "rents from real
property" in a situation where the lessees had contracted with a third party to
conduct the day-to-day operations of the hotels.(14) This ruling suggests that
the IRS will respect a lease of a hotel for federal income tax purposes even if
the hotel is operated by an independent contractor rather than by the lessee.
B. Percentage Rent Provision is not Profit-Based
Pursuant to the Lease, CRL will be obligated to pay the Operating
Partnership base rent and percentage rent. Under the regulations, percentage
rent based on a percentage of gross receipts or sales in excess of a floor
amount, which is how the percentage rent is structured under the Lease, will
not qualify as "rents from real property" unless (i) such floor amount does not
depend in whole or in part on the income or profits of the lessee, (ii) the
percentage and the floor amount are fixed at the time the lease is entered
into, (iii) the
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(14) See, P.L.R. 8117036 (January 27, 1981).
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Crescent Real Estate Equities, Inc.
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Page 12
percentage and the floor amount are not renegotiated during the term of the
lease in a manner that has the effect of basing the percentage rent on income
or profits, and (iv) the percentage and the floor amount conform with normal
business practice.(15)
Under the terms of Article 4.2 of the Lease, the Lessee will pay
percentage rent during the first seven years of the Lease on an annual basis
equal to the sum of (i) 15 percent of the amount by which gross receipts from
the Leased Property exceed $29,000,000 (with such amount not exceeding
$4,000,000), (ii) 11 percent of the amount by which gross receipts from the
Leased Property exceed $33,000,000 (with such amount not exceeding $7,000,000),
and (iii) 8.5 percent of the amount by which gross receipts from the Leased
Property exceed $40,000,000. During years eight through ten of the Lease the
Lessee will pay percentage rent equal to the sum of (i) 20 percent of the
amount by which gross receipts from the Leased Property exceed $29,000,000
(with such amount not exceeding $4,000,000), (ii) 16 percent of the amount by
which the gross receipts from the Leased Property exceed $33,000,000 (with such
amounts not exceeding $7,000,000) and (iii) 15 percent of the amount by which
gross receipts from the Leased Property exceed $40,000,000. This formula
effectively rewards the tenant for any increases in gross receipts over the
threshold amounts. This type of formula does not base the percentage rent on
the tenant's income or profits, and similar formulas have been treated by the
IRS as generating "rents from real property."(16) Moreover, the Operating
Partnership has represented that (i) the floor amounts used to compute the
percentage rent under the Lease do not depend in whole or in part on the income
or profits of any person, (ii) the percentage rent provision of the Lease will
not be renegotiated during the term of the Lease or at the expiration or
earlier termination of the Lease in a manner that has the effect of basing the
rent on income or profits, and (iii) the percentage rent provision of the Lease
conforms with normal business practice. In addition, based on our experience
and an examination of the Lease and certain projections regarding Canyon
Ranch's expected future performance, the Lease appears to conform with normal
business practice.
C. CRL is not a "Related Party Tenant"
Rents derived under the Lease will not qualify as "rents from real
property" if CRL is treated as a "related party tenant." CRL will be treated
as a "related party tenant" if the Company, or an owner of 10 percent or more
of the Company, directly or constructively owns
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(15) Treas. Reg. Section 1.866-4(b)(3).
(16) See, e.g., P.L.R. 8803007 (September 23, 1987) (percentage rent based on
gross revenues in excess of gross revenues for a base year treated as
"rents from real property"); cf. P.L.R. 9104018 (October 26, 1990)
(interest based on gross revenues in excess of a floor amount treated as
qualifying interest under section 856(f)).
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Crescent Real Estate Equities, Inc.
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Page 13
10 percent or more of the entity's assets or net profits.(17) Constructive
ownership is determined for purposes of this test by applying the rules of
section 318(a) as modified by section 856(d)(5). Those rules generally provide
that if 10 percent or more in value of the stock of the Company is owned,
directly or indirectly, by or for any person, the Company is considered as
owning the stock owned, directly or indirectly, by or for such person. In
determining whether CRL is a "related party tenant" it is necessary to consider
not only CRL's current ownership, but also its potential ownership after the
exercise of the Zuckerman and Cohen Options. This is because, for federal
income tax purposes, the Zuckerman and Cohen Options are likely to be treated
as currently exercised. These options are likely to be treated as currently
exercised, because each is composed of a matching put and call option for CRL
stock with a nominal exercise price.
1. CRL's Current Ownership
CRL will not be treated as a "related party tenant" under its current
ownership because two individuals, Zuckerman and Cohen, collectively own a 100
percent interest in CRL's assets and net profits. In reaching this conclusion,
we recognize that Zuckerman and Cohen each own certain Units of the Operating
Partnership as a result of the Acquisition Transaction.(18) We also recognize
that the Operating Partnership has an option to acquire a 30 percent interest
in a management company that will also be owned by Zuckerman. The Operating
Partnership has represented that (i) Zuckerman and Cohen do not individually,
or as a group, own more than 10 percent of the value of the Company's stock,
(ii) in the future Zuckerman and Cohen are not expected to own more than 10
percent of the value of the Company's stock individually, or as a group, and
(iii) neither the Operating Partnership nor the Company intends to acquire,
directly or constructively, an interest of 10 percent or more in the assets or
net profits of CRL at any time in the future. Moreover, Article 7.8 of the
Lease will prevent CRL and its members and managers from acquiring, directly or
constructively, a greater than six percent stock interest in the Company
without the Operating Partnership's prior written consent, and Section 6.4 of
the First Amended and Restated Articles of Incorporation of the Company
prevents CRL and its members and managers from acquiring more than 8 percent of
the Company's stock.
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(17) Section 856(d)(2)(B)(ii).
(18) See Rev. Rul. 73-194, 1973-1 C.B. 355 (management company treated as an
independent contractor with respect to a REIT, where an affiliate of the
management company and the REIT were partners).
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 14
2. CRL's Ownership-Treating the Zuckerman and Cohen
Options as Exercised
CRL will not be treated as a "related party tenant" if the Zuckerman
and Cohen Options are treated as exercised because after exercise of these
options a 99 percent interest in CRL's assets and net profits will be owned by
RoseStar, with the remaining one percent interest owned by RSCR. An
individual, Sanjay Varma, currently owns a 91 percent interest in the assets
and net profits of RoseStar and 91 percent of the stock of RSCR. In reaching
this conclusion, we recognize that Sanjay Varma owns certain Units of the
Operating Partnership.(19) The Operating Partnership has represented that (i)
Sanjay Varma does not own more than 10 percent of the value of the Company's
stock, (ii) Sanjay Varma is not expected to own more than 10 percent of the
value of the Company's stock in the future, and (iii) neither the Operating
Partnership nor the Company intends to acquire, directly or constructively, an
interest of 10 percent or more in the assets or net profits of RoseStar at any
time in the future. In concluding that CRL will not be treated as a "related
party tenant" if the Zuckerman and Cohen Options are treated as exercised, we
have applied the definition of related party tenant set forth in section
856(d)(2)(B)(ii), which applies to tenants which are not corporations. If CRL
is not treated as a partnership for federal income tax purposes, but is instead
treated as an association taxable as a corporation, then the applicable
definition of related party tenant is the one set forth in section
856(d)(2)(B)(i), which looks to control over voting securities. If CRL were
treated as a corporation for federal income tax purposes, Gerald W. Haddock and
John C. Goff could possibly be deemed to control all of its voting stock,
because of the extensive powers that they are granted as managers of RoseStar
under the RoseStar Regulations. If this were the case, it would be necessary
to consider whether the ownership of such voting stock could possibly be
attributed to the Company under the constructive ownership rules described
above or otherwise.
An entity which has associates and an objective to carry on a business
for joint profit will be treated as a partnership for federal income tax
purposes, and not as an association taxable as a corporation, if it has not
more than two of the following four characteristics of a corporation: (i)
continuity of life; (ii) centralization of management; (iii) limited liability;
and (iv) free transferability of interests.(20) The entity must also have no
other characteristics which are significant in determining its classification.
Generally, other factors are considered only insofar as they relate to the
determination of the presence or absence of the foregoing corporate
characteristics.(21) The IRS has applied this four-factor test in determining
whether
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(19) See Rev. Rul. 73-194, 1973-1 C.B. 355 (described above).
(20) Treas. Reg. Section 301.7701-2(a).
(21) See Rev. Rul. 79-106, 1979-1 C.B. 448.
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 15
limited liability companies formed under the ArizonaLimited Liability Company
Act (Ariz. Rev. Stat. Ann., Title 29, Chapter 4, sections 29-601 through 29-857
(1992), referred to herein as the "Act") are partnerships for federal income
tax purposes.(22) The IRS has issued Rev. Proc. 95-10, which specifies
conditions which must be satisfied for a limited liability company to receive a
favorable advanced ruling that it will be classified as a partnership for
federal income tax purposes.(23) CRL should satisfy these conditions.
However, such conditions are applicable only in determining whether rulings
will be issued and are not intended as substantive rules for determination of
partnership status.
An organization will be treated as possessing the corporate
characteristic of continuity of life, even if the agreement organizing an
entity provides that it is to continue only for a stated period, unless a
member has the power to dissolve the organization at an earlier time.(24)
Section 29-781.A of the Act provides that an LLC organized under the Act is
dissolved on the occurrence of the first of the following: (1) at the time or
on the happening of the events specified for dissolution in the articles of
organization or an operating agreement; (2) the written consent to dissolve by
all members; (3) an event of withdrawal of a member under section 29-733 of the
Act, unless the business of the LLC is continued by one or more managers or
members pursuant to a right to continue stated in an operating agreement or, if
an operating agreement does not provide a right to continue, by agreement or
consent of all of the remaining members within 90 days after the event of
withdrawal; (4) entry of a judgment of dissolution under section 29-785 of the
Act; or (5) acquisition by a single person of all outstanding interests in the
LLC. Section 29-733 of the Act provides that, except as approved by the
written consent of all members at the time, a person ceases to be a member of
an LLC on the occurrence of any of the following events of withdrawal: (1) the
member withdraws from the LLC as provided in section 29-734; (2) on assignment
of all the member's interest and admission of one or more of the assignees as a
member; (3) the member is expelled as a member pursuant to the articles of
organization or a operating agreement; (4) unless otherwise provided in an
operating agreement, the member does any of the following: (a) makes an
assignment for the benefit of creditors, (b) files a voluntary petition in
bankruptcy, (c) is adjudicated as bankrupt or insolvent, (d) files a petition
or answer seeking for himself any reorganization, arrangement, composition,
readjustment, liquidation or similar relief under any statute, law or rule, (e)
files an answer or other pleading admitting or failing to contest the material
allegations of a petition filed against him in a bankruptcy, insolvency,
reorganization or similar proceeding, (f) seeks, consents to or acquiesces in
the appointment of a trustee, receiver or liquidator of the member or of all or
any substantial part of the
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(22) See, e.g., Rev. Rul. 93-93, 1993-42 I.R.B. 13; and P.L.R. 9321047
(February 25, 1993).
(23) 1995-3 I.R.B. 20.
(24) Treas. Reg. Section 301.7701-2(b)(3).
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Crescent Real Estate Equities, Inc.
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Page 16
member's property; or (5) if a member is a natural person, the member's death,
or the entry of an order or judgment by a court of competent jurisdiction
adjudicating the member incompetent to manage the member's person or the
member's estate. Section 7.1.1 of the CRL Articles provides that CRL shall be
dissolved upon any withdrawal event, as defined in Section 29-733 of the Act,
unless a majority in interest of the remaining members consent to continue CRL
(and CRL has a least two remaining members). Accordingly, CRL will lack the
corporate characteristic of continuity of life.An organization will be treated
as possessing the corporate characteristic of free transferability of interests
if the members owning all or substantially all of the interests in an
organization may substitute for themselves without the consent of the other
members a person who is not a member of the organization.(25) Section 29-732.A
of the Act provides that an interest in an LLC is personal property and, is
assignable in whole or in part; an assignment of an interest in an LLC does not
dissolve the LLC or entitle the assignee to participate in the management of
the business and affairs of the LLC or to become a member or to exercise the
rights of a member, unless the assignee is admitted as a member as provided in
section 29-731 of the Act. Section 29-731.B.2 of the Act provides that after
an LLC's initial articles of organization are filed, a person who is an
assignee of all or part of a member's interest in an LLC may become a member on
the approval or consent of all members or of any one or more members who have
the right under an operating agreement to admit additional members. Section
29-731.B.3 provides that if the person is an assignee of an interest in the LLC
of a member who has the power under an operating agreement to grant the
assignee the right to become a member, the assignee may become a member on the
exercise of the power in compliance with all conditions limiting the member's
exercise of the power. Article 5 of the CRL Articles provides, in part, that
no member shall have the right to substitute in its place a transferee.
Accordingly, CRL will lack the corporate characteristic of free transferability
of interests.
An organization will be treated as lacking the corporate
characteristic of centralization of management if management decisions are made
by a vote of the majority of beneficial owners.(26) Section 3.1 of the CRL
Articles provides that CRL's management is vested in its members. Accordingly,
CRL will lack the corporate characteristic of centralization of management.
Because CRL will lack the corporate characteristics of continuity of life ,
free transferability of interests and centralization of management, in our
opinion it will be treated as partnership for federal income tax purposes.
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(25) Treas. Reg. Section 301.7701-2(e).
(26) Treas. Reg. Section 301.7701-2(g), Ex. (7).
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Crescent Real Estate Equities, Inc.
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Page 17
D. Incidental Personal Property
1. Rents Attributable to Personal Property Will Be
Treated as "Rents from Real Property"
As noted above, the rents attributable to the Operating Partnership's
personal property leased under or in connection with the Lease must not be
greater than 15 percent of the rents received under the Lease. The rent
attributable to personal property leased under or in connection with a lease of
real property is the amount that bears the same ratio to total rent for the
taxable year as (i) the average of the adjusted bases of the personal property
leased under or in connection with a lease of real property at the beginning
and at the end of the taxable year bears to (ii) the average of the aggregate
adjusted bases of the real and personal property subject to the lease at the
beginning and at the end of such taxable year (the "Adjusted Basis Ratio").(27)
Section 36.2 of the Lease provides that the average of the adjusted bases of
the personal property leased to the lessee under the Lease at the beginning and
end of any calendar year shall not exceed 15 percent of the average of the
adjusted tax bases of the Leased Property at the beginning and at the end of
each such calendar year. In addition, the Operating Partnership has
represented that the adjusted tax basis of the personal property leased under
or in connection with the Lease will not represent more than 15 percent of the
aggregate adjusted tax basis of Canyon Ranch at any time.
2. Payments Attributable to RoseStar's Acquisition of Certain
Personal Property Will Not Be Treated as "Rents from Real
Property"
Pursuant to Article I of the Contribution Agreement, the conveyance to
the Operating Partnership did not include the FF & E. Instead, the FF & E was
sold by CRI to CRL in exchange for the proceeds of loans from the Operating
Partnership. Under the terms of Article 7.5 of the Lease, however, the lessee
is obligated to transfer and assign the FF & E upon termination of the Lease to
a person designated by the lessor at a price equal to the then existing fair
market value of the FF & E.
The Operating Partnership will not be treated as the tax owner of the
FF & E. The FF & E is owned by CRL. The payments that the Operating
Partnership will receive under the Crescent FF & E Note will not qualify as
"rents from real property." Instead, such payments will be treated for federal
income tax purposes as payments of principal and interest resulting from the
Operating Partnership's financing of CRL's purchase of the FF & E. The
payments pursuant to this financing, to the extent they constitute interest,
will be "qualifying income" for
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(27) Section 856(d)(1)(C).
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Crescent Real Estate Equities, Inc.
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Page 18
purposes of the 75 percent test. However, because the financing will be
secured by personal property under the terms of the Security Agreement, rather
than real property, such interest will not be "qualifying income" for purposes
of the 95 percent test. Similarly , interest accruing under the Life Share
Note, which is also secured by the FF & E under the terms of the Security
Agreement, will also be treated as "qualifying income" for purposes of the 75
percent test, but not for purposes of the 95 percent test.
E. Provision of Services by the Operating Partnership
1. Income Derived under the Terms of the Lease
Although the Operating Partnership may treat charges for services
customarily furnished or rendered in connection with the rental of Canyon Ranch
as "rents from real property," any services rendered to the occupants of Canyon
Ranch must be furnished or rendered by an independent contractor from whom the
Company does not derive or receive any income.(28) Moreover, to the extent
that any independent contractors provide noncustomary services to the occupants
of Canyon Ranch, the cost of such services must not be borne by the Operating
Partnership.(29) Under the terms of the Lease, the Operating Partnership will
not be required to provide any services, customary or noncustomary, in
connection with the rental of Canyon Ranch. Instead, all services relating to
the operation of Canyon Ranch will be provided by CRM under the terms of the
Management Agreement. The Operating Partnership will not bear the cost of any
of the services provided by CRM. Instead, such costs will be borne by CRL,
which as lessee under the Lease has assumed the obligations of the owner under
the Management Agreement.
Based on the foregoing, we believe that the provision of any
noncustomary services to the occupants of Canyon Ranch by CRM will have no
effect on the qualification of the income derived from Canyon Ranch as "rents
from real property." In fact, the IRS has issued a private letter ruling in
which it has treated the income derived from several leases of hotel properties
as "rents from real property" in a situation where the lessees had contracted
with a third-party to conduct the day-to-day operations of the hotels.(30) Our
conclusion is not altered by the fact that the Operating Partnership will
remain liable for any obligations arising under the Management Agreement, to
the extent that they are not satisfied by CRL, as lessee under the Lease. The
Operating Partnership should not be treated as bearing the cost of the services
provided by CRM merely because it could possibly be held liable for CRL's
obligations under
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(28) Sections 856(d)(1), 856(d)(2)(C); Treas. Reg. Section 1.512(b)-1(c)(5).
(29) Treas. Reg. Section 1.856-4(b)(5).
(30) See, P.L.R. 8117036 (January 27, 1981).
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 19
the Management Agreement. The Operating Partnership is not retaining this
liability in an attempt to provide services to CRL. Instead, it is retaining
this liability only as an accommodation, in order to gain CRM's consent to its
purchase of Canyon Ranch. Moreover, the Operating Partnership believes that it
is highly unlikely that it will ever be required to reimburse CRM for the costs
and expenses of operating Canyon Ranch because of a default by CRL in its
obligations as owner under the Management Agreement. This is because (i)
Canyon Ranch is projected to generate enough gross income to cover the payments
to CRM under the Management Agreement, (ii) in connection with Section 7.7 of
the Lease, CRL represents that it has a net worth of at least $200,000, (iii)
in connection with Section 7.9 of the Lease, CRL covenants that it will retain
all income generated by the Leased Property and shall not distribute any
earnings to its beneficial owners, except as needed for federal and state
income taxes payable on taxable income from the Leased Property, until the
tenant has accumulated and is holding in reserve funds which are sufficient to
pay at least one monthly payment of Base Rent under the Lease, plus at least
one monthly payment of Base Rent under all other leases between lessor and
lessee, (iv) RoseStar has guaranteed CRL's obligations under the Lease and its
individual members have guaranteed CRL's obligations under the Lease (as well
as the Crescent FF & E Note and the Life Share Note) up to $200,000, and (v) in
the view of the Operating Partnership, RoseStar's capitalization is adequate to
allow RoseStar to assume its obligations as guarantor under the Guaranty.
2. Income Derived in the Case of a Default under the Lease
If the Operating Partnership were required to reimburse CRM for the
costs of operating Canyon Ranch because of a default by the Tenant under the
terms of the Management Agreement, we have concluded that the income derived by
the Operating Partnership from Canyon Ranch would be treated as "qualifying
income" for purposes of the 75 percent and 95 percent tests. This is because,
if the Operating Partnership were required to reimburse CRM for the cost of
operating Canyon Ranch, this would constitute an event of default under Article
16.1(c) of the Lease, allowing the Operating Partnership to terminate the
lessee's leasehold interest in Canyon Ranch. As a result of such a termination
of the Lease, any income derived by the Operating Partnership from Canyon Ranch
after the default would be treated as income from foreclosure property.
The Operating Partnership would be able to continue to operate Canyon
Ranch after any default under the Lease, without affecting its status as
foreclosure property. This is because CRM will provide all services relating
to the operation of Canyon Ranch and CRM will qualify as an independent
contractor from whom the Company will not derive any income. As noted above, a
REIT can use foreclosure property in the conduct of an active trade or
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 20
business, as long as this is done through the use of an independent
contractor, from whom the REIT does not derive or receive any income.(31)
As noted above, real property acquired upon default under a lease is
not eligible to be treated as foreclosure property if the lease is entered into
with an intent to evict or foreclose, or if the REIT knows or has reason to
know that default would occur.(32) This is not the case in the present
situation because (i) Canyon Ranch is projected to generate enough gross income
to produce a profit for CRL, (ii) in connection with Section 7.7 of the Lease,
the Tenant represents that it has a net worth of at least $200,000, (iii) in
connection with Section 7.9 of the Lease, the tenant covenants that it will
retain all income generated by the Leased Property and shall not distribute any
earnings to its beneficial owners, except as needed for federal and state
income taxes payable on taxable income from the Leased Property, until the
tenant has accumulated and is holding in reserve funds which are sufficient to
pay at least one monthly payment of Base Rent under the Lease, plus at least
one monthly payment of Base Rent under all other leases between lessor and
lessee, (iv) RoseStar has guaranteed CRL's obligations under the Lease and its
individual members have guaranteed CRL's obligations under the Lease (as well
as the Crescent FF & E Note and the Life Share Note) up to $200,000, and (v) in
the view of the Operating Partnership, RoseStar's capitalization is adequate to
allow RoseStar to assume its obligations as guarantor under the Guaranty.
Canyon Ranch would qualify as foreclosure property only for a period
of up to two years, beginning on the date of its acquisition by the Operating
Partnership, unless the Operating Partnership obtains an extension of the grace
period from the IRS.(33) Therefore, in the event the Operating Partnership
takes possession of Canyon Ranch as a result of a default under the Lease,
presumably the Operating Partnership will sell Canyon Ranch or within two years
rent it to another tenant under a lease that will produce "rents from real
property."
VI. ASSUMPTIONS AND REPRESENTATIONS
In providing these opinions, we have with your permission assumed the
following: (i) the due authorization, execution and delivery by all parties
thereto of the Transaction
- --------------------
(31) Section 856(e)(4)(C). The IRS clearly intended for REITs to be able to
treat hotels operated by independent contractors as foreclosure property. For
instance, the Treasury regulations defining foreclosure property refer to hotel
properties twice. See, Treas. Reg. Sections 1.856-6(b)(2), 1.856-6(d)(2). In
addition, the IRS has also recently issued a private letter ruling in which it
treated income received from hotels acquired pursuant to a bankruptcy petition
as income from foreclosure property, where the hotels were operated by third
party managers. P.L.R. 9420013 (2/15/94).
(32) Treas. Reg. Section 1.856-6(b)(3).
(33) Section 856(e)(2).
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 21
Documents, (ii) the authenticity of the originals of the Transaction Documents
and the genuineness of all signatures; (iii) the conformity to the original of
all documents submitted to us as copies; (iv) the absence of any evidence
extrinsic to the provisions of the written agreements between the parties that
the parties intended a meaning contrary to that expressed by those provisions;
(v) that each party to the Transaction Documents has the power and authority to
enter into and perform all of its obligations thereunder; (vi) that each of the
Transaction Documents is a legal, valid and binding obligation, enforceable in
accordance with its terms; and (vii) that each legal entity that is a party to
the Transaction Documents validly existing and in good standing under the laws
of the United States of America or one of the States thereof or the District of
Columbia. As to questions of fact material to such opinions, we have with your
permission, when relevant facts were not independently established. relied
upon, and assumed the truth, accuracy and completeness of, written and oral
statements and representations made by or on behalf of the parties to the
Transaction Documents by their respective officers or agents. With your
permission, we have further assumed that each of the parties to each of the
Transaction Documents fully complies with its obligations thereunder.
In addition, these opinions are conditioned upon certain
representations made by the Company and the Operating Partnership as to factual
and other matters as set forth in the attached letter. Unless facts material
to the opinions expressed herein are specifically stated to have been
independently established or verified by us, we have relied as to such facts
solely upon the representations made by the Company and the Operating
Partnership. We are not, however, aware of any facts or circumstances contrary
to or inconsistent with the representations. To the extent the representations
are with respect to matters set forth in the Code or Treasury Regulations, we
have reviewed with the individuals making such representations the relevant
provisions of the Code, the Treasury Regulations and published administrative
interpretations.
Our opinions contained herein are based in part upon our conclusion
that the U.S. federal income tax treatment of the transactions contemplated by
the Transaction Documents will be determined based on their economic substance.
Although there can be no assurance that the IRS will not take one or more
contrary positions, it is our opinion that none of those positions, if asserted
by the IRS, would prevail. However, because our opinions are not binding on
the IRS or the courts, there can be no assurance that contrary positions may
not be successfully asserted by the IRS. Our opinions are based upon the
present provisions of the Code, the regulations promulgated thereunder,
administrative rulings, judicial decisions, and any other applicable
authorities published and in effect on the date hereof (all of which are
subject to change, both prospectively and retroactively).
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Crescent Real Estate Equities, Inc.
July 26, 1996
Page 22
This letter and the opinions contained herein are based solely upon
our knowledge of the relevant facts. In this opinion, the words "our
knowledge" or words to similar effect signify that, in the course of our
representation of the Company or the Operating Partnership, in matters with
respect to which we have been engaged as counsel by such entity, no information
has come to the attention of those attorneys in our firm having detailed
knowledge of this transaction and the substance of this opinion that gives such
attorneys current, actual knowledge that any such opinions are not accurate.
In rendering this opinion, we have undertaken no investigation with respect to
such matters and we have not undertaken to communicate the details of this
transaction to all members or employees of our firm who may have performed, and
are currently performing, services for the Company or the Operating
Partnership, or any other person or entity.
The opinions contained herein are issued, and our opinions herein are
expressed, as of the date hereof. These opinions and this letter are limited
to the matters expressly set forth herein, and no statements or opinions may be
inferred beyond such matters. We do not assume any responsibility to update
these opinions or advise you of changes resulting from events (whether or note
they come to our attention) that may occur after the date hereof, including,
without limitation, future transactions or other actions under the Transaction
Documents, or any inaccuracy in any of the representations or warranties upon
which we have relied in rendering these opinions.
VII. CONCLUSION
Based on the assumptions stated above, it is our opinion that (i) the
Lease will be treated as a lease for federal income tax purposes, (ii) all of
the income that the Operating Partnership derives under the Lease will be
treated as "qualifying income" for purposes of the 95 percent test, and (iii)
all of the income the Operating Partnership derives under the Crescent FF & E
Note and the Life Share Note will be treated as "qualifying income" for
purposes of the 75 percent test.
Very Truly Yours,
SHAW, PITTMAN, POTTS & TROWBRIDGE
<PAGE> 1
EXHIBIT 8.02
[LOCKE PURNELL RAIN HARRELL LETTERHEAD]
October 4, 1996
Crescent Real Estate Equities, Inc.
900 Third Avenue, Suite 1800
New York, New York 10022
Gentlemen:
We have acted as special tax counsel to Crescent Real Estate Equities,
Inc. ("Crescent Equities") in connection with the registration statement on
Form S-3, No. 33-97794, which was originally filed with the Securities and
Exchange Commission on October 14, 1995, and which, as amended, was declared
effective on June 18, 1996. Such registration statement (the "Registration
Statement") includes a prospectus supplement filed on October 4, 1996 (the
"Prospectus Supplement") to the prospectus (the "Prospectus") contained in the
Registration Statement. Capitalized terms used hereunder but not defined have
the meaning ascribed to them in the Registration Statement.
In rendering this opinion we have examined such documents as we have
deemed relevant or necessary, including the Prospectus and Prospectus
Supplement, and our conclusions are based upon the facts contained in the
Prospectus and Prospectus Supplement. The initial and continuing accuracy of
these facts constitutes an integral basis for the opinion expressed herein.
In our opinion, the discussion contained in the final Prospectus
Supplement filed as part of the final Registration Statement in the subsection
entitled "Federal Income Tax Considerations - State and Local Taxes" accurately
summarizes the Texas franchise tax matters that are likely to be material to a
holder of common stock of Crescent Equities. The foregoing opinion is limited
to the specific matter covered hereby and does not apply to any other matters
discussed under the heading "Federal Income Tax Considerations." This opinion
is based upon existing State of Texas statutes and regulations and positions of
the Texas State Comptroller of Public Accounts as of the date hereof, all of
which are subject to change, both retroactively or prospectively.
This opinion is furnished to you solely for use in connection with the
Registration Statement. We hereby consent to the incorporation by reference of
this opinion as an exhibit to the Registration Statement and to the reference
to our Firm in the Registration Statement under the caption "Federal Income Tax
<PAGE> 2
Crescent Real Estate Equities, Inc.
October 4, 1996
Page 2
Considerations - State and Local Taxes" and "Legal Matters." In giving this
consent we do not thereby admit that we come within the category of persons
whose consent is required under the Securities Act of 1933, as amended, or the
rules and regulations of the Securities and Exchange Commission promulgated
thereunder.
Very truly yours,
LOCKE PURNELL RAIN HARRELL
(A Professional Corporation)
By: /s/ C. RONALD KALTEYER
-------------------------
C. RONALD KALTEYER
