AMERICAN BAR ASSOCIATION
Section of Real Property, Probate and Trust Law
11th Annual Spring CLE Symposia
March 22-26, 2000 – South Beach, Florida
The ABC’s of PUD’s (Part II): The Basics of Timesharing
March 23, 2000
Right to Use Timeshare Developments: Advantages,
Disadvantages and Matters to be Considered in Creation of a Plan
Robert S. Freedman, Esquire
Carlton, Fields, Ward, Emmanuel,
Smith & Cutler, P.A.
1. Introduction. Timeshare projects come in all shapes and sizes, and the manner of creation of these projects continues to evolve. This evolution is most often attributable to two factors: (1) the nature of the demand from the public for a specific type of product, and (2) the governing laws in the jurisdiction where the project is to be developed or offered for sale. The original timeshare developments were created in a rigid fashion, where an owner was conveyed by deed a fee simple interest in a specific week in a specific unit (most often a unit in a condominium). In this day, there are numerous other methods for creating a timeshare development, including those that do not involve the conveyance of a deeded interest to the timeshare user but rather a right to use or license. This paper will explore the advantages and disadvantages of right-to-use timeshare projects in comparison to deeded interests and matters that must be considered when creating a right-to-use plan. Finally, this paper will attempt to focus on the future of right-to-use plans.
2. Comparison of Deeded Interest Projects to Right-to-Use Projects. The following are intended to provide a contrast between a deeded interest and a right-to-use membership, and by no means should be considered exclusive:
a. Who Owns Title to the Timeshare Property? The original, traditional timeshare model involves a deeded conveyance of a specified period of time in a unit to an owner. Ultimately, the individual timeshare owners will become the sole fractional owners of the timeshare project. In comparison, the timeshare property in a right-to-use plan is not conveyed to the timeshare user; rather, title is vested in a third party, which can be the developer, an owners association, a trust or other entity (most often a not-for-profit corporation). If possible, such entity should be created to qualify as a “timeshare association” under Section 528 of the Internal Revenue Code for income tax exemption purposes.
b. Recording Fees. The deed must be recorded in order to be effective, meaning that, most often, recording fees and taxes must be paid in order to record a deed, most of which are usually passed on to the consumer. Additionally, most developers provided a deeded interest purchaser with a policy of title insurance, the cost of which is often borne by the purchaser through his purchase price. In contrast, a right-to-use interest is not recorded in the public records, meaning that no taxes and fees are incurred, and there is no specific land interest for which title insurance is issued to the purchaser.
c. Failure to Pay Assessments or Financing Payments. When the owner of a deeded timeshare interest fails to properly pay association assessments for the maintenance of the timeshare plan or to pay the financing payments pertaining to the purchase of the interest (usually mortgage payments), the association or the mortgagee has only two options: (1) sue the non-paying party for the amount of the indebtedness, or (2) foreclose to reacquire the deeded interest (a majority of jurisdictions still require judicial foreclosure, which is lengthy in time and costly in relation to the price of an individual interest, although certain states either have a streamlined judicial foreclosure process or permit non-judicial foreclosure). In that the costs associated with suits for damages against individuals most likely exceed the amount of the indebtedness and quite possibly could exceed the value of the interest, foreclosure is the only practical (to the extent it is practical) option. At times, an owner who wishes to “walk away” from a deeded interest may reconvey the property back to the developer (or where there is nonpayment of assessments, to the association) by deed in lieu of foreclosure, and this is the best means for resolution of the problem. Unfortunately, many owners, especially those who reside in foreign countries, are not reachable or do not understand the situation, and thus foreclosure becomes the only option.
In contrast, if a right-to-use owner fails to make his required payments for the purchase or for maintenance, pursuant to provisions contained in the timeshare membership documents, the secured party (the one owed the money) will have the right, following adherence to specified procedures, to “repossess” the right-to-use membership. This does not involve judicial proceedings, and most often is accomplished by the secured party merely canceling the membership and retaining the amounts already paid as liquidated damages. If the developer is the one retaking possession, there may be obligations for assessments which will need to be paid to the owners association or entity managing the timeshare plan, but the developer then can resell the membership at full price.
c. Reservation System and Administration of Project Rules. There is no substantive difference in the manner in which a reservation system would work for either type of development.
d. Flexibility. Under many traditional deeded interest projects, there is limited flexibility because of the inflexible nature of a real property interest. With a right-to-use plan, the membership rights of the members can be modified from time to time to adjust to current trends and desires. The current generation of right-to-use plans involve an assignment of points to the degree of membership, which can provide greater flexibility for an owner in exchanging use rights to permit occupancy at other projects. In a points system, a member who desires to increase the level of occupancy rights can do so through the purchase of additional points. In contrast, the only manner in which the owner of a deeded interest can increase the level of ownership in any fashion (and thereby occupancy) is to purchase an additional interest.
e. Inventory Control. In a deeded interest development, the only 100% accurate way to ensure that the developer does not sell more interests than legally exist involve an analysis of the recording index in the local public records. In a very large project, this can be a painstaking (and costly) process, and often, because of delays in indexing deeds, the information provided is incomplete. In contrast, where there are right-to-use memberships, the developer maintains the accurate records and thus has all information at hand needed to ensure that only proper sales are made.
f. Truth-In-Lending and RESPA Requirements. The conveyance of a deeded interest and any related financing transactions are subject to Truth-in-Lending and RESPA requirements (because of the conveyance of an interest in real property). In contrast, Truth-in-Lending and RESPA requirements do not apply to right-to-use memberships because such memberships are exempt intangible property.
g. Uniform Commercial Code Requirements. The conveyance of a deeded interest and any financing thereof involves security interests that are tied to the real property, meaning that a lien attaches to secure payment. In contrast, the security interest created in connection with a right-to-use membership is created under the Uniform Commercial Code or state equivalent statutes. A UCC-1 Filing Statement is filed with the Secretary of State of the state in which the member lives to perfect the interest. The filing of the UCC-1 is important to protect a developer from having another party obtain a higher priority right and thereby have greater rights.
h. Project Documentation. Generally speaking, the underlying timeshare property is subject to restrictive covenants of some fashion, being most likely a declaration of condominium or declaration of covenants, conditions and restrictions, and the developer must provide some form of disclosure document (usually called a public offering statement or prospectus). The difference in documentation primarily pertains to the manner in which one becomes a timeshare owner or member. In a deeded interest, there is a purchase contract, followed by a deed of conveyance and the execution of a promissory note and mortgage. In a right-to-use plan, there is a membership or vacation ownership agreement, a UCC-1 financing statement and a promissory note.
3. Other Considerations in Creating a Right-to-Use Project.
a. Taxation Issues – The Windrifter Situation. In 1977, the Internal Revenue Service issued a National Office Technical Advice Memorandum (#7803005, issued September 30, 1977) concerning the Windrifter project located in New England. At this project, the developer retained fee ownership of the underlying property, and the memberships granted to third parties (which were paid in full during the year of sale) occurred in such a fashion that the use of the membership reverted to the developer upon expiration of the 40 year membership term. The members did not have a right to extend or renew the membership. The developer was the sole manager of the timeshare property (and received a management fee paid by the members) and was responsible for conducting any repairs to the timeshare property, and all insurance proceeds in the event of casualty were to go to the developer. Finally, the membership was subordinated to the lien of the mortgage given by the developer to a lender over the entire timeshare property.
The question that arose was whether the developer had transferred to the members all of the benefits and burdens of ownership of an interest in real property. The IRS construed the Windrifter transactions to be leases – therefore interests in real property - and applied adverse tax consequences. This means that Windrifter tax consequences can exist even with regard to deeded interests, a fact that many do not understand. The consequence is that rather than being able to write off a portion of the development and acquisition costs upon the sale of an interest, the developer in a lease transaction cannot deduct the land costs and can only depreciate the costs of the improvements over an extended period (usually around 25-30 years) of time.
The “Windrifter Memorandum,” as it has become infamously known since its issuance, was based upon the conclusion that “the transaction must be properly characterized by relying on the economic substance of the transaction rather than the form in which it may be cast.” The IRS concluded that since the developer had not transferred the benefits and burdens of ownership, the developer was in effect the landlord and the members were tenants under a presumed lease of 40 years. The IRS stated that a critical factor in rendering the decision was that the timeshare project was not of a permanent nature, rather than the fact that a right-to-use membership, rather than a deeded interest, was the manner in which use rights were created.
There are 2 primary ways to avoid the Windrifter tax consequences. First, ensure that the term of the right to use is perpetual; the further one moves away from a perpetual right of use, the more likely that Windrifter consequences will occur. Second, the developer should ensure, through its offering documents and those creating the membership rights, that the materials benefits and burdens of ownership are transferred, both in terms of the individual memberships and the right-to-use project itself. Some of the items that must be considered are: who can make decisions regarding the timeshare project; upon casualty, who makes the decision to rebuild the timeshare improvements; who has the power to encumber or transfer the timeshare property; who is responsibility for maintaining and repairing the timeshare property; and who will receive insurance proceeds in the event of casualty.
b. Installment Sales. A right-to-use project can be created with the use of installment sales, meaning that the purchasing member pays for his membership over time (for IRS purposes, where installments are paid over more than one taxable year). Under Section 453 of the Internal Revenue Code, a developer can utilize the installment method of reporting income, meaning that the developer pays income tax only on monies received from the buyer. The question in a right-to-use plan is whether a developer can avail himself of this method of paying tax for the timeshare installment sale. The Internal Revenue Code provides that such installment reporting is available for the sale of a timeshare interest or a right-to-use membership. Thus, it is especially important to make sure that the Windrifter IRS taxation result is avoided where the developer is selling with an installment plan.
c. Jurisdiction. Quite often, the state in which the timeshare property is located will determine whether or not a right-to-use project can be developed. For example, in Florida, right-to-use plans are not catered to in the statutes, and in fact there are several provisions that create serious and potentially costly risks to a developer. Thus, most Florida projects are based upon some form of deeded interest, and a majority of states still adhere to this concept of timesharing. In comparison, the California statutes are kind to right-to-use plans. Over time and as the market demands changes, more states will have to become amenable to timeshare right-to-use plans in order to continue to entice development.
3. The Future of Right-to-Use Plans. As noted above, the future looks very bright for right-to-use plans. It is expected that numerous development models will find their way into the development process. One of these models may well be the European trust model, and attached is a outline of such a structure. In any event, this concept of right-to-use is one which is growing and which will continue to grow, and attorneys should be prepared to be flexible and creative in writing the documents and the models for these new projects. Consideration of the differences between a deeded and right-to-use project must be considered, as well as the potential tax implications for the developer.
THE TRADITIONAL EUROPEAN CLUB/TRUST STRUCTURE
Set out below is some information on the role which XYZ plays within the timeshare industry and on the “Club Trustee” structures which we set up and administer for timeshare resorts
XYZ currently acts as independent trustee for numerous timeshare resorts in various countries around the world including Spain, the Canary Islands, Portugal, Austria, Greece, Cyprus, Malta, the UK, USA, India and Africa and can justifiably claim to be the market leader in this highly specialized area of business.
In brief, the club trustee structure is a structure whereby:
a) Properties are made available for sale to multiple purchasers on a timeshare basis - sometimes in perpetuity but more usually for an 80 year term (being renewable for a further 80 years) so as to comply with the English legal Rule Against Perpetuities (also contained within Isle of Man law) and in many other cases for a shorter term of 25/30 years with a reversion of the underlying property back to the developer.
b) The purchasers’ funds are protected pending the completion and furnishing of the development and/or transfer of title.
c) The marketing of the development is entirely in the hands of the developer and his marketing agents.
d) On completion of the development, either the timeshare owners control and manage the property, or the developer will wish to ensure that the documentation is structured so that he can still control the on-going management. XYZ is able to structure the documentation to achieve either objective
The structure is underpinned by the “scheme documentation” which comprises a Constitution, a Deed of Trust and a Management Agreement.
The Constitution defines the structure of the club and how it is to be run in the best interests of its members. The Constitution also sets out in detail the rules by which every member of the club agrees to abide and establishes the rights and obligations of the members of the club.
The Deed of Trust defines the terms upon which the trustee is appointed in order to hold the assets of the club for the benefit of all of the members.
The Management Agreement defines the duties and obligations of the Management Company and the way in which the management fees payable by the members of the club are to be calculated.
Participants in the Structure
The structure is based on the participation in the development by the following:‑
a) The developer
b) One or more property owning companies
c) A club
d) A sales company
e) A management company
f) A trustee company
Operation of the Structure
a) The developer completes the construction or refurbishment and furnishing of the property or properties intended to be offered for sale;
b) Ownership of the completed properties is transferred by the developer to a property owning company, usually incorporated in the Isle of Man, UK or Republic of Ireland. Companies can be constituted in other jurisdictions;
c) The shares in the property owning company are transferred to XYZ, being the trustee company for the project. The trustee company thereafter controls the property owning company. It is worth noting that sometimes the property owning company will not be a company having share capital but rather a company limited by guarantee and in this context ownership and control of the company limited by guarantee is what is effectively given to the trustee.
d) A club is formed having a pre-determined limited number of memberships to be made available. The trustee issues Membership Certificates in respect of all proposed memberships to the sales company in return for the owning company being given to the trustee.
e) The sales company proceeds to sell the Membership Certificates on the open market. Under a scheme which operates on the basis of fixed weeks in fixed units, each Membership Certificate corresponds to the occupancy rights of the fixed week but there are variations on this theme with floating weeks/floating units, points-based systems and multi-location clubs. All sales documentation in Europe must comply with the new regulations which enacted the EU Directive on Timeshare which came into force in 1997 in the EU.
f) On the completion of each sale, the purchase moneys are paid by the purchaser to the trustee company, usually through an escrow account. These moneys are immediately released to the developer by the trustee company unless it is necessary for the funds or part of them to be retained - e.g. if work is required on the property or if title to the unit has yet to be transferred to the owning company under the trustee’s control.
Protection Offered by the Structure
The structure is designed to provide the greatest possible protection for the purchasers and also for the developer. The documentation is drawn to provide, on balance, greater protection for the purchasers. Indeed, one could argue that the structure is designed to assist the sales company in attracting purchasers.
Once the developer has transferred title to the property owning company, he ceases to have any title to or control over these properties. The property owning company holds the properties upon trust for the members of the club on the terms set out in a Deed of Trust.
The sales company and management company usually cause the club to be formed and are its Founder Members. The club will issue not more than 51 Membership Certificates for each unit forming part of the timeshare scheme with one week being retained for maintenance and refurbishment purposes.
The club issues to the sales company all 51 Membership Certificates for each unit.
The club is controlled by a committee comprising two nominees of the Founder Members (i.e. the sales company and the management company) and three ordinary members, elected at the First Annual General Meeting of the club.
A Membership Certificate is transferred by the sales company to each individual purchaser on completion of his purchase. Thus, the club is controlled by the sales company (as one of the Founder Members) until it has issued more than 50% of the Membership Certificates in respect of each property. The Constitution of the club states that any Membership Certificates not issued by the company to an ordinary member will belong to the sales company who shall be entitled to be regarded as an ordinary member entitled to all rights and privileges attaching to that Membership Certificate but also subject to the obligations pertaining thereto including the payment of maintenance charges on the unsold Membership Certificates.
When the trustee company receives the purchase moneys from each purchaser, the funds are lodged in a bank account controlled by the trustee. This account is specifically designated as being an escrow account for the benefit of the members of the club so that the funds in the account do not at any time form part of the assets of XYZ. Such funds cannot be made available to the general creditors should anything adverse befall XYZ.
Essentially, the protection for the purchaser derives from the fact that XYZ will at all times firstly control the company which owns the properties and secondly, control the application of the purchasers’ funds through the medium of the escrow account. Thus the trustee company will ensure that the property owning company acquires good, marketable, unencumbered title to the properties, that the properties have been properly constructed and are in suitable condition for sales to the public. At that point, the developer will have transferred his entire interest and title in the property to the property owning company, the shares of which are held by XYZ absolutely.
The Deed of Trust proclaims that the properties are held upon trust for the members of the club. Therefore, the developer will, initially, be the person for whom the property is held upon trust, as he will be the sole owner of all Membership Certificates through his ownership of the Founder Member Sales Company. As sales take place, the developer will transfer Membership Certificates to purchasers and will receive cash in return from the purchasers through the trustee company. When more than 50% of the club memberships have been sold, the developer in theory loses control of the club. Nevertheless, the portion of the property represented by the remaining minority club Membership Certificates will be held upon trust for the developer. Ultimately, the developer’s position thereafter depends entirely upon the successful sales of the remaining club memberships.
This, then, is a general overview of the manner in which the basic scheme operates.
Declaration of Trust
XYZ produces a Declaration of Trust which would confirm that the developer of the project was the beneficial owner of the sales and management companies although the legal owners would in fact be XYZ’s nominees.
XYZ provides a full and comprehensive contract processing service in its headquarters. Upon receipt of a signed contract (membership application) from the developer or his duly appointed marketers, XYZ administration staff enter details of the client into the computer and check that the week and apartment which they have purchased has not been “double-sold”. If everything is in order a copy of the contract, countersigned by the trustee, is sent back to the client as confirmation of his application for membership to the club. This could be reproduced in the USA.
Once the full purchase price of the week(s) in question has been received by XYZ, a Membership Certificate is generated by the computer and dispatched to the client. This Membership Certificate evidences his right to use that particular unit and week each year for the duration of the timeshare scheme.
XYZ employs highly trained staff and state of the art computer technology in order to ensure that it maintains an accurate and up-to-date register of members at each and every club for which it acts as trustee.