Real Estate Debt Workout Tax Issues & Coping Strategies

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1 Real Estate Debt Workout Tax Issues & Coping Strategies Charles R. Beaudrot Partner, Tax and Real Estate Capital Markets Practices Timothy S. Pollock Partner, Tax, Real Estate and Real Estate Capital Markets Practices

2 INTRODUCTION Tax Issues Associated With Loan Workouts: Cancellation of Debt ( COD ) Income Debt Modifications Coping Strategies to Defer Recognition of the COD Income Purchasing Debt at a Discount 2

3 COD INCOME Debt Forgiveness: If satisfy $10M loan for $5M = $5M COD Income If Lender reduces $10M loan to $5M because that is what the property will support = $5M COD Income If the Borrower, or more typically, a person related to a Borrower*, buys the $10M note for $5M, and keeps the debt in place = $5M COD Income * Related Party determined under Sections 267 and 707 of the Code. Generally allows for up to 49.9% overlap in ownership with the Borrower. EXCEPTION: Purchase money debt reduction: Must be original Seller and original Buyer PROBLEM: COD Income is phantom income: COD Income is ordinary income 3

4 MODIFICATIONS TRIGGERING DEEMED EXCHANGES The Cottage Savings regulations trigger a deemed exchange on any significant modification. Regs

5 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) - While a single modification may not be significant on its own, modifications are looked at collectively and in the aggregate. - There are 10 bright-line tests and safe harbors: 1. Change in yield. Regs (e)(2)(ii); - 25 basis points (.25%) or 5% of the annual yield is deemed significant. 5

6 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 2. Change in timing of payment. Regs (e)(3)(i); - Payment is deferred more than the lesser of five years or 50% of the original term of the Note. - Apparently extension options in the Note are not considered unless Borrower can unilaterally extend without conditions. 6

7 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 3. Change in Obligor. Regs (e)(4)(ii); (Note: Not a change for non-recourse obligation, but it is for a recourse obligation); 4. An addition or deletion of a Co-Obligor. Regs (e)(4)(iii); if it affects likelihood of repayment; 7

8 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 5. Change in security or credit enhancement. Regs (e)(4)(iv); - Generally significant in recourse debt only if changes likelihood of repayment. - Generally significant in case of a non-recourse loan. 6. Change in priority of debt. Regs (e)(4)(v); - Significant if changes likelihood of repayment. 8

9 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 7. Change from debt to equity. Regs (e)(5)(vi); 8. Change in recourse nature. Regs (e)(5)(vii)(A); - Change from recourse to non-recourse is significant. - Change from non-recourse to recourse is significant. 9

10 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 9. Change in customary financial covenants. Regs (e)(6); - Generally not significant. 10. Indirect tax exempt bond modifications. Regs (f)(6). 10

11 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) CAREFUL: Two Most Common Modifications: Change in Yield and Deferral of Payments: EXAMPLE: Change in Yield: - Original Note Rate & Yield: 5.5% - Modified Yield: 5.0% Yield has deceased by 50 basis points; also yield has decreased by 9.09% (.5 5.5%). Conclusion is the modification was significant. 11

12 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) EXAMPLE: Modification: Conclusion: Change in Timing Original Term: Remaining Term: 5 Years 2 Years Maturity extended 2 years and next six months of payments deferred to maturity. While extension of maturity by 2 years does not exceed 50% of the original 5 year term, deferring the next six months payments to maturity is more than a 3 year deferral (2 year remaining term plus 2 year extension) which is more than 50% of original term. Therefore, modification is significant. 12

13 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) OTHER: Adding guaranty or additional collateral to non-recourse debt is generally significant. 13

14 GOOD NEWS: MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) COD income is only triggered if the principal balance of the "new" debt is less than the principal balance of "old" debt. Test is at the applicable federal rates. With low current applicable federal rates in the 3% range, this rarely happens. 14

15 Giving Up The Property TRANSFER OF PROPERTY TO THE LENDER Foreclosure and Voluntary Deed in Lieu Transfers Are Sales Tax Analysis Depends on Whether Loan was Recourse or Non-Recourse Liability 15

16 TRANSFER OF PROPERTY TO THE LENDER (CONT D.) (i) Non-Recourse Debt: Sale for the Debt Debt Minus Basis = Gain or Loss 1. Debt $1,000,000 $1,000,000 Basis 700,000 1,200,000 Gain(Loss) $ 300,000 $ ( 200,000) 16

17 TRANSFER OF PROPERTY TO THE LENDER (CONT D.) (ii) Recourse Debt: Part Sale and Part CODI FMV of Property (Up to Debt) Equals Sales Price Debt in Excess of FMV Equals Cancellation of Debt Income ( CODI ) 17

18 TRANSFER OF PROPERTY TO THE LENDER (CONT D.) Recourse Debt Example: FMV Property $ 700,000 Debt $1,000,000 Sale Gain: Sales Price $ 700,000 $ 700,000 Basis $(500,000) $(800,000) Gain(Loss) $ 200,000 $(100,000) CODI* $ 300,000 $ 300,000 *Debt in Excess of FMV. Of course if pay deficiency, then there is no COD income. 18

19 CODI is Ordinary Income TRANSFER OF PROPERTY TO THE LENDER (CONT D.) Character of Sale Gain or Loss depends on character of property Capital Gain (e.g. raw land held for investment) or 1231 Capital Gain (e.g. rental property) or Ordinary Income (e.g. subdivision/dealer property) Impact of 1231 loss on characterization of future gains - Five Year Rule 19

20 COPING STRATEGIES: EXCLUSIONS OF COD INCOME IRC 108(a)-Gross income does not include amounts from discharge of indebtedness if: - The discharge occurs in Title11 (bankruptcy) case - The discharge occurs when taxpayer is insolvent - The discharge relates to qualified farm indebtedness - The discharge relates to qualified real property indebtedness realized by a taxpayer other than a C corporation - The discharge relates to qualified principal residence indebtedness realized before January 1,

21 COPING STRATEGIES: EXCLUSIONS OF COD INCOME ATTRIBUTE REDUCTION (CONT D.) In effect, attribute reduction forces the debtor to trade current exclusion of income for future tax deductions. The debtor can elect to change the order of reductions and draw down on tax basis first. The attribute reduction occurs on the first day of the tax year following the year of discharge. As a result, there are various planning techniques to minimize gain on sales in the year of discharge, etc. 21

22 COPING STRATEGIES: MORTGAGE FORGIVENESS DEBT RELIEF ACT OF 2007 The Mortgage Forgiveness Debt Relief Act of 2007 added new 108(a)(1)(E), which excludes from gross income the discharge of qualified principal residence indebtedness which takes place on or after January 1, 2007 and before January 1,

23 COPING STRATEGIES: APPLICATION TO PASS-THROUGH ENTITIES Cancellation of partnership debt: The bankruptcy and insolvency exceptions apply at the partner level, rather than the partnership level. So, if a partnership or LLC has debts which are discharged, there is no exclusion of COD income at that level. Instead the COD income is allocated to the partners. Generally, a partner with COD income could not qualify for the bankruptcy exception, but possibly could qualify for the insolvency exception. 23

24 COPING STRATEGIES: APPLICATION TO PASS-THROUGH ENTITIES (CONT D.) Cancellation of S corporation debt: The bankruptcy and insolvency exceptions do apply at the entity level in the case of an S corporation. So, if an S corporation has debts which are discharged while in bankruptcy, then the COD income is excluded and does not pass through to shareholders. If an S corporation qualifies for the insolvency exception, only the balance of the COD income is passed through to the shareholders. Generally, the attribute reduction applies at the S corporation level and does not travel down to shareholders. 24

25 COPING STRATEGIES: QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS [QRPBI] A taxpayer can elect to exclude COD income that arises from Qualified Real Property Business Indebtedness Advantages exclusion does not require the debtor to be in bankruptcy or insolvent Disadvantages cannot be used by a C corporation amount excluded is generally equal to the balance of the debt less the FMV of the real property underlying the debt amount excluded cannot exceed the total tax basis of all the taxpayer s depreciable real property Triggers basis reduction on depreciable real property 25

26 What is QRPBI? COPING STRATEGIES: QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS [QRPBI] (CONT D.) Generally, any debt incurred or assumed in connection with and secured by real property used in the taxpayer s trade/business. Broad sense of what is covered land, improvements, mineral interests. Application by Partnerships Whether debt is QRPBI is determined at the entity level, but basis limitation and reduction are made at partner level. S Corporations Whether debt is QRPHI is determined at the entity level, as are basis limitation and basis reduction. 26

27 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION The American Recovery and Reinvestment Act of 2009 (the 2009 act), signed into law by President Obama on February 17, 2009, will have a significant impact on the retirement, modification, and restructuring of debt instruments during 2009 and

28 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION (CONT D.) New IRC 108(i) allows an issuer of debt to elect to defer the inclusion of certain cancellation of debt (COD) income realized in 2009 and

29 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION (CONT D.) If the election is made, COD income realized in calendar years 2009 and 2010 is generally includable ratably over a five-tax year period beginning in

30 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION (CONT D.) The benefit of the deferral may be significantly curtailed by a requirement to defer deductions for some forms of interest expense incurred regarding the new debt capital. 30

31 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION SPECIAL RULES FOR PARTNERSHIP First, in the case of partnerships, the election is made at the partnership, not the partner, level. 31

32 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION SPECIAL RULES FOR PARTNERSHIP (CONT D.) Second, in the case of partnerships and other non-c corporation issuers of debt instruments, the election is limited to COD arising from debt instruments issued in connection with the conduct of a trade or business by the issuer. 32

33 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION SPECIAL RULES FOR PARTNERSHIP (CONT D.) Third, the statute provides a specific mechanic for meshing the deferral of COD with general subchapter K principles: The partnership is treated as allocating the deferred COD income item to the partners immediately before the COD income realization event. 33

34 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION SPECIAL RULES FOR PARTNERSHIP (CONT D.) There is a special rule to ensure that the relief of liabilities giving rise to the COD income under 752 does not create 731(a) gain to the partners, which would otherwise effectively defeat the purpose of the COD deferral. 34

35 COPING STRATEGIES: COD INCOME DEFERRAL ELECTION: THE 2009 LEGISLATION COMMENT AND OBSERVATIONS New IRC 108(i) is a deferral provision, which effectively creates an interest-free loan from the government. For this reason, tax attributes of the taxpayer are not reduced. 35

36 COPING STRATEGIES: LIKE KIND EXCHANGE NO EXCHANGE Non-Recourse Debt $10,000,000 Basis $( 5,000,000) Gain $ 5,000,000 Tax (State + Fed: 20%) $ 1,000,000 EXCHANGE Need to purchase replacement property for $10M or more. Instead of paying Uncle Sam $1M taxes, use the $1M to fund equity. Need $9M+ loan. 36

37 COPING STRATEGIES: LIKE KIND EXCHANGE (CONT D.) Seller financing or additional equity needed? Out of own pocket Add additional investors to the borrower partnership; admission of new investors generally is not a sale or exchange and the borrower partnership s tax ID number does not change. 37

38 Keep the Debt Outstanding OR: COPING STRATEGY: PURCHASE THE NOTE - Unrelated Friendly Party Purchaser: - Borrower may want to participate in discount by allowing a pre-payment discount upon satisfaction of specified conditions. - Discount upon mere passage of time? - Form NEWCO Purchaser: - Up to 49.9% overlapping ownership allowed. - For reasons discussed below, want debt modifications made prior to transfer. 38

39 COPING STRATEGY: JOINT VENTURE WITH LENDER Form NEWCO Borrower contributes property and Lender contributes cash to repay debt vs Lender cancels debt as capital contribution - Latter (and maybe former) approach requires analysis of FMV of partnership interest received by the Lender. To the extent FMV is less than face amount of debt, COD Income may result. - Former: Disguised sale issues? Recourse vs non-recourse debt. 39

40 COPING STRATEGY: JOINT VENTURE WITH LENDER (CONT D.) Query: If Lender receives $7M capital account for $10M debt, is there $3M COD Income? - What if $7M came back first with 12% per annum preferred return? If use applicable federal rate to determine value of partnership interest, can we conclude FMV equals $10M or do I need to get supporting appraisal? - Also, 752 analysis required to make sure elimination of debt does not trigger hypothetical cash distribution in excess of basis = gain (but it would be capital gain). - See earlier discussion of new COD deferral rules. 40

41 DISTRESSED DEBT FUND:TAX TRAPS - Fund formed for the purposes of purchasing non-performing or under performing debt. DANGER! DANGER! DANGER! - Modification of debt after acquisition requires same debt exchange analysis as described earlier. - Recall that a reduction in the interest rate or deferral of payments typically is not a problem for the Borrower because the present value of the new note under the applicable federal rate is still equal to face amount of the old note. 41

42 DISTRESSED DEBT FUND: TAX TRAPS (CONT D.) BORROWER: Amount Owed/New Note $10M Amount Owed/Old Note $10M COD Income $ 0 ORIGINAL LENDER: Not a problem for the original Lender either because its basis in the old note equals the original loan amount (i.e. the face amount of the old Note) Lender: FMV of New Note $10M Basis in Old Note: $10M Gain $ 0 42

43 PURCHASER OF DEBT: DISTRESSED DEBT FUND: TAX TRAPS (CONT D.) For the new holder of the note, however, this could be a big problem. FMV of New Note: $10M Basis in Old Note (e.g. discounted purchase price) $ 7M Phantom Gain* $ 3M * Short term capital gain or ordinary income depending on activities of holder of the note. 43

44 DISTRESSED DEBT FUND: TAX TRAPS LOAN MODIFICATIONS Solution: - If possible all modifications should be made by original lender prior to purchase of note. REMEMBER: MODIFY BEFORE YOU BUY 44

45 DISTRESSED DEBT FUND: TAX TRAPS (CONT D.) - Accrual Of Interest At Stated Rate (regardless of risk of non-payment)? - Original Issue Discount: - Purchaser inherits existing OID status phantom income? 45

46 MARKET DISCOUNT RULES: DISTRESSED DEBT FUND: TAX TRAPS (CONT D.) Amount of purchase discount is treated as interest equivalent. Periodic accrual of portion of the discount over the remaining term of the loan affects character of income associated with debt service payments (i.e. payments treated as ordinary income vs. return of capital). Also, gain on subsequent sale of debt is ordinary income to extent of accrued market discount. 46

47 CONCLUSIONS COD can crop up in surprising situations, particularly debt modifications. Transferring property in satisfaction of debt is usually a better tax result. 47

48 CONCLUSIONS (CONT D.) Coping strategies: Exclusion/ attribute reduction Deferral election Like-kind exchanges Friendly debt purchase 48

49 CONCLUSIONS (CONT D.) Buying debt has tax risks for the purchaser. It is usually better to modify debt before purchase. 49

50 Thank You For Joining Us for Real Estate Debt Workout Tax Issues & Coping Strategies Please contact our speakers with any questions after the presentation. Charles R. Beaudrot Partner, Tax and Real Estate Capital Markets Practices Timothy S. Pollock Partner, Tax, Real Estate and Real Estate Capital Markets Practices

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