Ask 10 Questions Before Leasing to a “Legal” Marijuana Business

Your due diligence must account for special legal risks.

 

 

At least some form of marijuana is now legal in all but six states. In addition to a wildly popular product, marijuana ventures have lots of capital and a pressing need for commercial space, especially in the 24 states (and the District of Columbia) that have legalized non-medicinal, recreational marijuana. They’re also prepared to pay premium rents. So, landlords that refuse even to consider leasing to a marijuana business may be missing out on major profits.

The Yin to this Yang are the landlords with dollar signs in their eyes who rush into marijuana leases without a full appreciation of the legal risks. While leasing to new and unproven ventures is a normal part of the business, marijuana purveyors aren’t like other startups that landlords deal with. Their survival and profitability depend not only on the normal vicissitudes of the market but also on unique regulatory factors, like the risk of being shut down at a moment’s notice. Loss of a tenant is a blow for any landlord; but leasing to “legal marijuana” operations also exposes landlords to risk of liability under federal criminal, banking, tax, and other laws.  

Accordingly, the standard financial checking and vetting that landlords perform on conventional startups won’t work for prospective tenants in the marijuana business. Landlords must broaden their due diligence to account for the special legal risks that leasing to a marijuana business involves. Here’s a briefing on how to do that.   

Background: The Myth of Legal Marijuana

The term “legal marijuana” is an oxymoron. Marijuana is illegal in all parts of the country, including states that have passed legislation purporting to legalize it in within their own borders (which we’ll refer to as “legal marijuana states.”). (See our state legalization map here.)

Explanation: In 1970, Congress passed a law called The Controlled Substances Act (CSA) grouping drugs and other substances into one of five schedules based on their potential for abuse, safety, and medical uses. Schedule I substances, including heroin, LSD, methamphetamine, and peyote are subject to the strictest regulation due to their deemed high potential for abuse and current absence of accepted medical treatment uses. Marijuana is a Schedule I substance. Federal criminal law also makes it a felony to lease or rent any place for the purpose of manufacturing, distributing, or using any controlled substance, including marijuana.

Implication: Landlords that lease commercial property to a marijuana business are violating federal law. That makes them a potential target for enforcement action and prosecution by the DOJ, DEA, IRS, and other federal authorities, including seizure of the property under laws providing for forfeiture of assets by those involved in drug trafficking. The risk of federal liability exists even if the leased property is located in a legal marijuana state.

Why Is a Federally Illegal Industry Allowed to Exist?

Federal law supersedes state law, including marijuana legalization laws. So, if it wanted to, the U.S. government could shut down the “legal marijuana” industry at any time and in any location—whether nationwide, inside a state, or one or more businesses in a state. The reason the industry exists is because the feds have decided not to use that authority. The current DOJ policy is not to drop the hammer as long as the legal marijuana states take effective action to look after federal interests such as by ensuring that the pot they produce doesn’t fund terrorist organizations or end up going to kids or neighboring states.

The problem is that unless and until Congress makes legislative changes, there’s nothing to stop the federal government from reversing its current policy. This is the risk you take when entering into a lease with a marijuana tenant.

THE 10 QUESTIONS YOU NEED TO ASK

These unique legal risks require landlords to vet prospective marijuana tenants differently than they do other tenants. Here’s a rundown of the 10 questions your legal due diligence should address.  

1. Does the Prospective Tenant Have All Required Licenses?

Problem: Not just anybody can open a marijuana business in a legal marijuana state. Companies need special licenses or permits from the state and local governments to operate. If the prospective tenant isn’t properly licensed, its business will be illegal under not only federal but also state and municipal law, which significantly magnifies the risks of prosecution and shutdown.

In addition, some jurisdictions have or are considering adopting laws making landlords liable for leasing to unlicensed marijuana businesses. Example: New York City Local Law 107 bans commercial landlords from knowingly leasing retail space to smoke shops that sell unlicensed marijuana, cigarette, or tobacco products, with penalties of $5,000 for a first offense and $10,000 for a second and each subsequent offense.

Solution: Require prospective marijuana tenants to provide you with copies of their state and local licenses, both before signing and renewing their leases. Verify that the licenses are currently valid and authorize the tenant to carry out the proposed business use that the lease provides for. Signing a lease with a prospective tenant that has applied for but not yet secured the required licenses is risky. Options to consider:

• Don’t sign the lease until the prospect obtains and provides you copies of the necessary licenses;
• Sign the lease but provide that it doesn’t take effect unless the tenant gets the license by a specified deadline; or
• Walk away from the deal.

2. Does the Proposed Use Violate Local Zoning Laws?

Problem: A licensed marijuana business that’s legal under state law may be illegal in the municipality in which it wants to operate. Explanation: In some legal marijuana states, including California, individual jurisdictions have the right to decide whether to permit marijuana businesses within their boundaries. Common situation: After a state passes a law legalizing marijuana, cities within the state pass zoning ordinances banning use of business district property as a marijuana dispensary or retail establishment.

Solution: Review local zoning laws and regulations to ensure that the prospective tenant’s marijuana business is legal in that particular jurisdiction. Restrictions to be on the lookout for include:

• Limits on the types of marijuana businesses permitted, e.g., for cultivation but not retail, or vice versa;  
• Limits on numbers of marijuana businesses permitted—signing a lease with a medical marijuana dispensary tenant would be unwise if zoning laws allow for just one dispensary and there already is a medical dispensary in town;
• Bars on uses that create nuisances or have noxious or objectionable effects on neighborhoods or neighboring properties such as “emitting obnoxious odors that can be smelled outside of any building”;
• Zoning rules requiring a marijuana business to be located a minimum distance away from schools, daycares, alcohol or drug treatment clinics, and other types of buildings or facilities; and
• Head shop restrictions barring landlords from leasing all or part of retail property to any establishment selling or exhibiting drug-related paraphernalia or products.

3. Does the Proposed Use Require You to Obtain Any Special Permits?

Problem: Some jurisdictions require landlords to apply for conditional use permits before letting a tenant manufacture or distribute marijuana onsite. Securing these required permits can be a costly and time-consuming process.

Solution: Determine whether you need a conditional use or other kind of special permit to enter into the proposed lease. If so, calculate and factor the expected costs into the rental and other financial terms of the lease.

4. Will Entering into the Proposed Lease Put You in Default on Your Mortgage?

Problem: Mortgage documents typically include language requiring the borrower/landlord to ensure that the property is used only for purposes that are lawful under federal, state, and local law. Entering into a lease with a business that violates federal law may constitute a default allowing the mortgagor to accelerate the loan.

Solution: Check your mortgage. If the proposed marijuana lease is potentially problematic, you may have to walk away from the deal unless you can get the mortgagor to modify the mortgage agreement so that you don’t end up in default.  

5. What Are Your Bank’s Policies on Handling Marijuana-Related Funds?

Problem: As federally regulated operations, banks aren’t allowed to offer loans, checking, credit cards, and other financial services to marijuana businesses. Banks are also required to file what are known as Suspicious Activity Reports with the federal Financial Crimes Enforcement Network (FinCEN) when they receive deposits that they deem suspicious. Consequently, many banks steer clear of marijuana businesses and won’t accept rent checks from a landlord’s marijuana tenants.

Solution: Ask the bank that maintains your operating account about its policies on handling marijuana-related funds and whether leasing to a prospective tenant will create problems. Identifying all of the potential banking issues upfront will enable you to make an informed decision about whether to enter into the lease.

6. Does the Proposed Tenant Have Adequate Security Arrangements?

Problem: While it’s an issue with all tenants, security is a way bigger concern with marijuana tenants. The hazard stems from not just the nature of the product but the fact that banks won’t provide marijuana operations checking services, which forces them to operate as cash-only businesses. For these reasons, marijuana businesses must meet extremely stringent security requirements to obtain and maintain their licenses.   

Solution: Vet the security arrangements of prospective marijuana tenants far more closely than you normally do. In addition to the physical security arrangements—such as vaults, alarms, cameras, locks, gates, etc.—review the prospective tenant’s written agreement with its security guard company, focusing particularly on the insurance, risk transfer, and indemnification provisions. Verify that the insurance policies of both the tenant and security guard firm cover and do not exclude:

• Assault and battery;
• Firearms (if the tenant’s security company provides armed guards);
• Bodily injury to employees and independent contractors; or
• Construction activities (if tenant security improvements are to be constructed).

The tenant should also have a policy for damage to rented premises with a minimum limit of $300,000 and naming you as an additional insured.

7. Does Your Insurance Cover the Proposed Lease?

Problem: Because marijuana is a Schedule I substance that’s federally illegal to produce or sell, some insurance companies refuse to cover landlords that lease property to marijuana tenants. Accordingly, entering into the lease may result in being turned down for new insurance policies and/or revocation of existing ones. 

Solution: Do not seek to conceal the arrangement. Sooner or later, the insurance company is bound to find out that you’ve leased property to a marijuana business. If the insurer learns this after the fact, it will have grounds for denying your claims. So, get it all out in the open upfront. Let the insurer know what you’re doing, or at least considering, before you do it. Once you clarify the insurance coverage ramifications, you can identify your options, which may include aborting the lease deal, restructuring your coverage, or seeking a new insurer.

8. What Are the Prospective Tenant’s Utility Demands?

Problem: Landlords be warned: Marijuana cultivation and storage consume copious amounts of water and energy. According to Forbes, an indoor module for handling just four marijuana plants uses as much electricity as 29 standard refrigerators. In addition to abnormally high costs, increased use of water and electricity may heighten the risk of fire, electrical blowouts, explosion, and mold.

Solution: Require prospective marijuana tenants to disclose exactly how much electricity, water, HVAC, and other utilities they need to carry out the business use under the proposed lease. Then consider whether the capacity of your building’s systems and infrastructure are capable of meeting those demands, along with how much to charge the tenant for its relatively high rates of consumption.

9. What Are the Prospective Tenant’s Extraction Methods?

Problem: You need to understand some basic things about a prospective marijuana tenant’s production methods, especially if they involve extraction of cannabidiol oil (CBD). Explanation: There are different methods of extracting CBD, each of which carries different health, safety, and environmental risks.

Solution: Find out which extraction method the prospective tenant uses. While CO2 extraction is generally the safest and most environmentally friendly, it’s also capital intensive because it requires special kinds of equipment. On the other side of the spectrum are the CBD extraction methods that require the handling, use, and storage of flammable, combustible, and volatile chemicals, including ethanol and especially butane. The chart on this page provides a brief summary of the three most commonly used CBD extraction methods and their associated hazards.

Strategic Pointer: Consider requiring a third-party consultant to inspect the extraction location, standard operating procedures, equipment, safety policies, and staff training at the tenant’s expense.

Landlord Briefing on CBD Extraction Methods

Extraction Method	Description	Hazards
Butane extraction	Butane is poured into a steel or glass “blasting” tube containing tightly packed marijuana plant material to dissolve certain chemicals; the extract passes through the filtered end of the tube, leaving a solid waste-product that undergoes purging to separate out the butane leaving a residue that’s low in butane and high in THC	Butane is highly flammable and may explode when exposed to even a tiny spark or source of heat, making fire and ventilation measures imperative
Carbon dioxide (CO2) extraction	Pressurized CO2 is pumped into an extractor chamber filled with ground marijuana plant material to dissolve certain chemical impurities; the CO2 is then filtered out to yield CBD residues high in THC	While less hazardous than butane, CO2 is toxic and can cause asphyxiation; CO2 extraction also requires expensive special equipment
Ethanol extraction	The marijuana plant is soaked in ethanol to extract the THC and remove impurities; the yielding product then undergoes a refining process to enhance its purity	Ethanol is a flammable gas that can cause explosions detonated by sparks or sources of heat

10. Will the Proposed Lease Get You into Trouble with the IRS?

Problem: The federal income tax code allows businesses to deduct certain ordinary costs of doing business from their taxable income. However, Section 280E of the Internal Revenue Service Tax Code bans businesses engaged in trafficking of marijuana from claiming these deductions. As a result, they have to pay higher taxes. Of course, you want all of your tenants to do well. But Section 280E is the marijuana tenant’s problem, not yours. Right?

Maybe, maybe not. The problem is that the IRS has made it clear that it interprets Section 280E marijuana trafficking restrictions broadly as applying not just to marijuana growers and sellers but also their business associates, even if those firms are totally independent entities. And at least one federal court has agreed. In 2018, a tax court ruled that a third-party management company set up to run the daily operations of a marijuana dispensary couldn’t claim deductions on its related business expenses because it was subject to Section 280E, even though the firm had no ownership of any of the marijuana-related assets [Alt. Health Care Advocates v. Comm’r, 151 T.C. No. 13, Dec. 20, 2018].

Solution: The principals of the Alt Health Care Advocates case could also apply to landlords. While there hasn’t been a wave of enforcement, there are at least reports that the IRS has initiated a Compliance Initiative Program setting out guidelines for auditing landlords and other independent third parties that do business with marijuana businesses in legal marijuana states for potential Section 280E violations. Accordingly, you should consider talking to a tax attorney or consultant before entering into marijuana leases.

From Due Diligence to Marijuana Leasing

Vetting prospective tenants is just the first phase in managing the unique liability risks of marijuana leases. The next challenge is the lease itself. Specifically, you must identify and modify the provisions of your standard lease that won’t work when the tenant is in the business of producing, distributing, and selling a federally illegal product. The Insider will show you how to do that in next month’s issue.