Insalata Mista Something to Help Keep the Pounds Off Real Estate Restructurings Thursday, April 28, :30 a.m. - 12:30 p.m.

Transcription

1 2011 ANNUAL SPRING INVESTMENT FORUM American College of Investment Counsel Chicago, IL Insalata Mista Something to Help Keep the Pounds Off Real Estate Restructurings Thursday, April 28, :30 a.m. - 12:30 p.m. Deanna Lee AIG Asset Management (Moderator) Matthew J. Coleman D. E. Shaw & Co., L.P. John J. Phillips Cornerstone Real Estate Advisers LLC Andrew D. Small Katten Muchin Rosenman LLP

2 BASICS OF COMMERCIAL MORTGAGE LOAN RESTRUCTURING: LENDER CONSIDERATIONS AND ISSUES RAISED BY COMMON RESTRUCTURE TECHNIQUES Prepared for the 2011 Annual Spring Investment Forum of The American College of Investment Counsel Deanna Lee Assistant General Counsel and Vice President AIG Asset Management Group I. Introduction. Commercial mortgage loans are perhaps most easily distinguished by three hallmarks: First, they are of course secured by commercial real estate. Second, foreclosure of real property collateral is always governed by the law of the state in which the property is located, notwithstanding any provision to the contrary contained in the loan documents. And third, these loans are typically non-recourse, meaning that in the case of borrower default, direct suits against the individual borrower are precluded and the lender s options are generally restricted to foreclosure on its real property collateral. 1 The non-recourse nature of the loan is nevertheless subject to limited exceptions. First, as a preliminary matter, it should be noted that borrower (and guarantor) almost always has personal liability for any and all environmental losses incurred by the lender; such obligations are usually documented by a separate environmental indemnity agreement. 2 In addition, there are two other categories of non-recourse exceptions, both of which are structured to prevent the borrower from engaging in certain bad acts. The first, commonly referred to as non-recourse carve-outs, apply to borrower actions which result in losses to the lender. In this instance the carve-out triggers borrower liability in the amount of loss incurred by the lender. 3 The second category of exceptions, commonly known as springing recourse items or springing recourse exceptions, apply to acts which trigger personal borrower liability for the full amount of the loan, regardless of whether the lender has actually incurred a loss as a result of those acts. 4 Because commercial mortgage lenders typically require the borrower to be a single purpose entity whose sole purpose is to own and operate the real property collateralizing the loan, the 1 Construction loans and bank loans are a notable exception to the non-recourse rule. Construction loans are typically full recourse until completion of the project, at which point the loan is paid off by funds advanced by a permanent or take-out lender who provides financing on a standard non-recourse basis. Construction lending occupies a separate niche in real estate lending, with its own unique issues, and is beyond the scope of this paper. 2 Borrowers will sometimes request the lender to accept an environmental policy in lieu of the guarantor providing an environmental indemnity. An environmental policy and an environmental indemnity are not functionally equivalent, so before granting any such request, a lender should carefully consider whether it is willing to accept the additional risk of foregoing the indemnity. The better practice is to require that the guarantor sign an environmental indemnity, but agree to pursue the policy first before exercising its rights under the environmental indemnity with respect to losses covered by the policy. 3 Non-recourse carve-outs commonly include liability for loss arising out of fraud, waste, misapplication of funds (condemnation awards, casualty proceeds, rents, tenant security deposits), accrued and unpaid taxes, assessments and utility charges, and failure to maintain insurance. 4 Springing recourse items (also known as springing recourse exceptions ) commonly include a breach or violation of due on sale or further encumbrance provisions, fraud or misrepresentation, criminal forfeiture of the property, any attempt by borrower, guarantor or any related party to materially delay lender s foreclosure or other exercise of remedies, the amendment or termination of any major lease without lender s prior written consent, and breach of single purpose entity covenants.

3 borrower s carve-out and springing recourse liability is almost always guaranteed by an upstream owner of the borrower with sufficient net worth, liquid assets, and control over the borrower. As might be expected, the non-recourse exceptions are often among the most negotiated provisions in a commercial mortgage loan transaction. 5 At the time of loan origination, neither borrower nor lender expects the lending relationship to end in default and foreclosure. However, a prudent lender will regularly review its portfolio, proactively identify potentially distressed loans, and evaluate the prospects of a given loan, such that in most cases the lender already will have a general idea of whether or not a loan is a likely candidate for restructure by the time the borrower initiates workout discussions. Ultimately, a restructure will only be successful if it makes more sense to the lender than outright foreclosure and either immediate or future sale of the asset. This paper will first discuss questions that a lender might ask itself in considering whether or not a restructure makes sense, and will then briefly explore the major issues involving common restructuring techniques. This paper is intended to provide a broad overview and general discussion of basic commercial mortgage loan restructuring issues, rather than an indepth legal analysis of each issue, many of which individually can be, and have been, the topic of entire papers unto themselves. Note that all references in this paper to lender refers to a lender whose loan is secured by a first priority lien against real property owned by the borrower. II. Lender Considerations. A. How will the lender fare if the borrower files bankruptcy? The same question, asked in a different way, would be is the borrower better off in bankruptcy? If the answer is yes, then the answer to the first question is likely that the lender will not fare well in bankruptcy court and will therefore be motivated to restructure. In determining the answer to this question, a lender will consider the following: 1. Does the real property collateral constitute single asset real estate under the bankruptcy code? The vast majority of commercial real estate loans are made to borrowers structured as single purpose entities, whose sole asset consists of the lender s real property collateral, whose sole business consists of owning and operating the lender s real property collateral, and whose sole debt (other than for ordinary trade payables) consists of the lender s loan. In addition, most commercial mortgage loan documents contain covenants requiring that the borrower maintain itself as a single purpose entity during the loan term. If the borrower has not violated its single purpose entity covenants during the term of the loan, then the real property collateral most likely constitutes single asset real estate for the purposes of the bankruptcy code. 6 5 They were also among the most frequently watered-down loan terms during the period U.S.C. 101(51B) defines single asset real estate as real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.

4 If single asset real estate is at issue, a lender may obtain relief from stay if the borrower has not (within the later of 90 days after filing or 30 days after a court determination that the case is a single asset real estate case) either filed a plan of reorganization with a reasonable possibility of being confirmed within a reasonable period of time, or commenced monthly interest-only payments (calculated on the secured portion of lender s claim) to the lender at the applicable non-default rate set forth in the lender s loan documents. If the borrower fails to satisfy one of the foregoing requirements within the applicable time period, stay relief is available even if the borrower still has equity in the property. 7 Generally speaking then, a borrower is less likely to file bankruptcy if the property in question qualifies as single asset real estate. 2. Is there equity in the property? Even if the case does not qualify for single asset real estate treatment, a lender is likely to prevail on a relief from stay motion under 11 U.S.C. 362(d)(1) if there is no equity in the property and the borrower is also unable to make adequate protection payments. 8 In addition, unless the borrower is able to provide adequate protection, the borrower will also be less likely to prevail on a motion for use of cash collateral. On the other hand, if no other deterrents to bankruptcy exist (see Who is the guarantor in Section II.B. below), the borrower also has nothing to lose by seeking to delay foreclosure as long as possible in the hopes that property values increase in the interim. Still, if the borrower is unable to provide adequate protection and/or the case qualifies for single asset real estate treatment, this delay is not likely to be very long. 3. Are there other creditors? If the lender is the only significant creditor in the case, then a plan that seeks to unfavorably modify the terms of the lender s commercial mortgage loan is not likely to be crammed down, or confirmed over the lender s objection, because there is not likely to be another class of impaired creditors available to vote in favor of the borrower s plan. 9 To the extent that another class of impaired creditors exists, but the total dollar amount of such claims is insignificant (e.g. trade creditors), the lender may be willing to purchase such claims in order to eliminate the risk of a cram down U.S.C. 362(d)(3) requires the court to grant relief with respect to a stay of an act against single asset real estate under subsection (a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the date that is 90 days after the entry of the order for relief (or such later date as the court may determine for cause by order entered within that 90-day period, or 30 days after the court determines that the debtor is subject to this paragraph, whichever is later (A) the debtor has filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or (B) the debtor has commenced monthly payments that -- (i) may, in the debtor s sole discretion, notwithstanding section 363(c)(2), be made from rents or other income generated before, on, or after the date of the commencement of the case by or from the property to each creditor whose claim is secured by such real estate (other than a claim secured by a judgment lien or by an unmatured statutory lien); and (ii) are in an amount equal to interest at the then applicable nondefault contract rate of interest on the value of the creditor s interest in the real estate U.S.C. 362(d)(1) requires the court to grant relief from stay for cause, including the lack of adequate protection of an interest in property of such party in interest. 11 U.S.C. 362(d)(2) requires the court to grant relief with respect to a stay of an act against [property of the estate]... if (A) the debtor does not have any equity in such property and (B) such property is not necessary to an effective reorganization. 9 See 11 U.S.C (10). See also 11 U.S.C. 1126(c).

5 4. Are there any tax benefits to the borrower in filing bankruptcy? See discussion in Section II.H.4(b) below. 5. Who is the guarantor? Perhaps the most important non-recourse exception in a commercial mortgage loan is the one that imposes personal liability for the full amount of the loan in the event the borrower, guarantor or any other related party materially impairs the lender s exercise of rights and remedies, including the filing of a bankruptcy action. A guarantor with significant assets at risk is much less likely to cause or consent to a bankruptcy action by the borrower. See Section II.B below for further discussion regarding guarantors. 6. Other considerations If the sponsors, or upstream owners of the borrower, are part of a larger real estate enterprise that owns other real property with near term financing needs, the sponsors may be less likely to cause the borrower to file bankruptcy due to the potential negative impact on their ability to raise funds in the near or future term. B. Who is the guarantor? As noted earlier, even though commercial mortgage loans are generally nonrecourse, borrowers will nonetheless have personal liability under the non-recourse exceptions set forth in the loan documents. The borrower s liability under those exceptions are almost always guaranteed by an upstream owner of the borrower. The non-recourse exceptions are intended to deter the borrower and guarantor from taking actions triggering personal liability under the non-recourse exceptions. As discussed above, standard non-recourse exceptions impose personal liability for the full amount of the debt on the borrower and guarantor if any attempt is made to materially delay any foreclosure or other exercise of remedies by the lender. Obviously, the deterrent value of the non-recourse exceptions rests on the quality of the guarantor. The best guarantor will be an individual with significant net worth and liquid assets located in the United States in other words, a guarantor that itself may be unwilling to file bankruptcy and has assets subject to a real risk of collection by the lender if the borrower or guarantor attempts to thwart or delay foreclosure by the lender. In determining the quality of a guarantor, the lender will consider the following: 1. How much is the guarantor worth? The guaranty is worth only as much as the guarantor. If the guarantor s net worth is primarily composed of investments in illiquid assets, the value of those assets may have declined significantly since loan origination, resulting in a guarantor with a substantially lower net worth than bargained for. Often, the bulk of a guarantor s assets consists of investments in multiple real estate projects (of which the lender s real property collateral will be

6 one), and in a real estate downturn, the guarantor s financial health could very well be in distress just when the lender needs to rely on it. Compounding the issue is that the guarantor has most likely guaranteed, in some form or another, multiple other loans, the bulk of which are likely to be other commercial real estate loans suffering the same stresses in a real estate down turn as the lender s loan. 2. Is the guarantor an individual? If the guarantor is an individual, or warm body, he or she will probably be less likely to file bankruptcy than a guarantor that is an entity. Unlike an entity guarantor, an individual guarantor is likely to have more diversified assets that he or she will not want to place subject to the claims of unsecured or undersecured creditors of the bankruptcy estate that otherwise might not have ready access to such assets. This concern, combined with the negative impact on the individual s credit as well as social stigma, might be sufficient to deter a warm body guarantor from filing bankruptcy solely as a means to escape recourse liability. Conversely, the assets of a non-individual guarantor are often composed primarily of investments in real estate (or in single purpose entities, like the borrower, that themselves own real estate), increasing the risk that it will file bankruptcy at or around the same time as the borrower. 3. Where are the guarantor s assets located? The deterrent value of the guaranty is significantly eroded if all or most of the guarantor s assets are located in a country or countries outside of the United States, even if the guarantor has appointed an agent located in the United States for service of process, consented to service of process on such agent, consented to lender s choice of law, and even if the country or countries in which the guarantor s assets are located grant comity to judgments obtained in the United States. This is because the guarantor knows that it will take significant additional time and cost in order to enforce and collect on such a guaranty, reducing the likelihood that the lender will actually sue the guarantor. C. Who controls the cash? If cash management was imposed on the borrower at loan origination, rents are deposited directly into an account held or controlled by the lender. Typically, all rents are automatically swept to the borrower until a trigger event occurs, at which point all rents are kept in the cash management account and disbursed pursuant to a waterfall for, among other things, budgeted operating expenses and debt service, with any excess funds retained as cash collateral for the loan. Ideally, a trigger event will include not only an event of default but a debt service coverage trigger (typically 1.20x). Upon an event of default, the lender will typically be entitled to apply any and all amounts to the loan. However, the lender should never apply cash collateral to the loan without first consulting with local counsel to determine the impact, if any, that it would have on the lender s other remedies. For example, with respect to loans secured by real property located in California, such an application of funds would violate California s security

7 first and one-action rule, resulting in the loss of lender s lien against the real property security. 10 If, on the other hand, cash management is not in place, borrower or borrower s property manager (often an affiliate) will be collecting rents and other property revenues even after a default and will continue to do so until the lender acquires title to the property, unless the lender takes court action to appoint a receiver for the property. 11 The relative difficulty or ease of appointing a receiver varies by state, and sometimes by county; in some states, the lender has little input in the selection of the receiver, which gives rise to problems with potentially incompetent or rogue receivers handling property revenues and managing the property pending completion of the lender s foreclosure action. If a lender is unable to quickly appoint a receiver, the borrower can quickly stockpile a war chest of funds equal to the amount of cash flow not applied to property expenses. However, if a substantial guarantor is present, this risk is somewhat mitigated by the common recourse carve-out for waste and for rents collected after an event of default and not applied to property operating expenses. D. What are the property s cash needs and how will they be satisfied? Often, real property collateral for a distressed loan has significant cash needs, either for deferred maintenance or lease up costs (including any capital expenditures that may be required by a major tenant as a condition for renewal or by a new tenant as a condition to entering into a new lease) which, if not incurred, would result in further deterioration in the value of the asset. In such instances, the collateral is unlikely generating sufficient excess cash flow after debt service and operating expenses to pay for such costs, in which case the lender will need to determine whether the borrower s equity owners are willing and able to infuse additional capital into the property and, if not, under what terms the lender is willing to provide additional capital. The borrower may be either unwilling and/or unable to raise additional capital without the lender agreeing that a return on the additional equity contributed be disbursed out of the monthly property cash waterfall. Although the lender will usually never allow such equity return to be paid prior to payment of debt service on the loan, there are certain circumstances under which a lender might consider it. For example, if the outstanding loan balance exceeds the property value, the lender might consider dividing the loan into two separate notes a good debt note and a bad debt note, with the bad debt note effectively representing a hope certificate equal to the amount by which the existing loan balance exceeds the value of the property. In such an 10 California Code of Civil Procedure 726(a); see Security Pacific National Bank v. Wozab, 51 Cal. 3d 991, (1990) ( a creditor bank that violates section 726(a) by taking an improper extrajudicial setoff must be held to have waived [its] security interest in its depositor s real property. ); Walker v. Community Bank, 10 Cal. 3d 729, 734 (1974) ( since under section 726 [t]here can be but one form of action for the recovery of any debt secured by a mortgage or deed of trust on real property, where the creditor sues on the obligation and seeks a personal money judgment against the debtor without seeking therein foreclosure of such mortgage or deed of trust, he makes an election of remedies, electing the single remedy of a personal action, and thereby waives his right to foreclose on the security or to sell the security under a power of sale. ) 11 Even though most commercial mortgage loan documents provide the lender with authority to collect rents directly upon an event of default, lenders rarely avail themselves of this remedy due to the risk of being deemed a mortgagee in possession which carries with it liability to the borrower for acting unreasonably in application and use of the rents.

8 instance, the lender might agree that cash flow be made available to pay a return on borrower s additional equity after current debt service is paid on the good debt note, but to defer and accrue interest on the bad debt note until maturity to the extent remaining cash flow is insufficient to pay current interest on the bad debt note. In return for agreeing to subordinate current interest on the bad debt note to return on the borrower s additional equity, the lender will likely want a share of any increase in value over and above the total amounts due on the loan (including the outstanding balance and any deferred interest) at maturity or earlier refinance. The lender will not consider such a structure unless other considerations weigh in favor of the borrower (e.g. belief that the borrower is the best operator, the lender s lack of appetite/ skill set for owning and operating the property itself, accounting or regulatory benefits, etc ), and the lender will also need to structure the shared appreciation component of the structure carefully to avoid being recharacterized as equity. The lender will also evaluate whether it is willing to put up the additional capital itself. If so, the lender will want to determine whether it is willing and/ or able to provide additional financing to the borrower or whether the lender will be better off foreclosing and realizing the equity return itself. In making this determination, the lender will need to weigh all of the other considerations discussed in this Article II. E. Is the default a payment default or maturity default? If the default in question is a payment default rather than a maturity default, then in some states, the borrower might be able to reinstate the loan within days prior to a scheduled foreclosure sale date simply by bringing the loan current (including late fees and default interest) --- even if the lender has already accelerated the loan. For example, in California, a borrower may reinstate the loan in such a manner up to five business days prior to a trustee sale date. 12 F. Is the borrower the best operator? The lender will obviously be more inclined to foreclose if the borrower has engaged in an established pattern of providing less than accurate or complete information, has been less than forthcoming, and has not demonstrated sufficient commitment to the project or the capability to competently manage and operate the property (e.g. unwilling to commit the necessary capital to the property in order to attract tenants and sign new leases). Conversely, the lender will be more inclined to a restructure if the borrower brings unique skills and expertise to the operation and success of the property (e.g. where collateral consists of a grocery anchored retail center where the anchor tenant is up for renewal, borrower brings significant value to the asset if it is an expert in development of such centers and has strong, repeat business relationships with either the existing grocery anchor and/or other possible replacement grocery anchors). G. How palatable is property ownership to the Lender? Property ownership and management is far more labor intensive than management of a loan, and most lenders are not fully equipped to own and operate real property, and may not 12 See California Code of Civil Procedure 2924c(a)(1).

9 have the expertise to do so. Even though actual management of the property is outsourced to a third party property manager, there are still many decisions and issues for which a property manager will need the lender-owner s input negotiation of new leases and/or amendments to existing leases, monitoring construction of tenant improvements, commencing a tax appeal, repair and maintenance decisions and review and approval of all the concomitant legal documentation. The lender s liability will also expand to include all those incident to ownership of real property potential tort claims, environmental liability, claims of mechanics and materialmen, repair and maintenance obligations, etc With that in mind, some lenders may have little appetite for property ownership and, as a result, may be more likely to entertain a restructure, discounted payoff or discounted sale of the loan. H. Are there any tax considerations for the borrower? The relative tax effect to the borrower of a loan restructure, discounted payoff or foreclosure may determine how cooperative a borrower is in connection with a lender foreclosure action, and for that reason is worth while for a lender to understand. In this regard, there are two types of taxable income that may result to the borrower: (1) cancellation of indebtedness income, which is taxed at ordinary income rates, and (2) capital gain income, which is taxed at capital gain rates. Generally, unless an exclusion applies, cancellation of indebtedness income is recognized by a borrower when a lender cancels or discharges all or a portion of a loan. 13 Since cancellation of indebtedness income is deemed to have been received by the borrower, but is not represented by actual cash flow, it can represent a significant expense for which the borrower has no actual cash flow to satisfy. Capital gain arising out of a transfer of title to the lender either through foreclosure or otherwise, is similarly unaccompanied by actual cash proceeds, therefore also representing a potentially large tax expense unless the borrower has available tax offsets. Whether or not, and to what degree, cancellation of indebtedness income and/or capital gain is recognized by the borrower turns on whether the real property collateral is transferred to the lender and whether the restructured loan is recourse or non-recourse. 1. Tax consequences to the borrower of a transfer of title, either through foreclosure or otherwise. Depending on the borrower s basis, either a capital gain or loss is recognized by the borrower upon a transfer of title to the real property collateral to the lender, whether through judicial or non-judicial foreclosure, deed-in-lieu of foreclosure or otherwise. The manner in which gain or loss is determined differs depending on whether the loan is recourse or non-recourse to the borrower. In the case of a non-recourse loan, the borrower will be treated as having sold the property in an amount equal to the outstanding principal balance of the loan, and will recognize a capital gain to the extent the borrower s basis in the property is lower than the then 13 Internal Revenue Code 61(a)(12).

10 outstanding principal balance. 14 The fair market value of the property at the time of foreclosure is irrelevant. 15 On a recourse loan, the borrower will be treated as having sold the property at fair market value, and the borrower will recognize a capital gain to the extent the fair market value of the property exceeds the borrower s basis in the property. 16 Because the outstanding loan balance will almost certainly exceed the fair market value of the property at the time of foreclosure or other transfer of title to the lender, the borrower will almost always recognize a greater capital gain on a non-recourse loan than on a recourse loan. Assuming that the foreclosure or other transfer of title to the lender is not also accompanied by debt reduction or forgiveness, no cancellation of indebtedness income is recognized at such time, whether or not the loan is recourse or non-recourse. 2. Tax consequences to the borrower of debt forgiveness. Cancellation of indebtedness income ( COD Income ) refers to income deemed received by a borrower in connection with the forgiveness of debt. While the general rule is that if a lender cancels, reduces or forgives a debt, in part or in whole, the borrower recognizes taxable income in the amount of debt forgiven, 17 the actual tax consequences to the borrower turn on whether (1) the debt forgiveness is accompanied by a transfer of the real property collateral securing the loan, and (2) the loan is recourse or non-recourse. If the debt reduction or forgiveness is not accompanied by a transfer to the lender of the real property collateral securing the loan (either through foreclosure or otherwise), then the borrower recognizes COD Income in the amount of debt forgiven, whether or not the loan is a recourse or non-recourse obligation. 18 Therefore, in a discounted payoff situation, where the borrower retains title to the real property collateral and the lender agrees to accept less than is owed in full payment of the debt, a borrower will realize COD Income in an amount equal to the discount, whether or not the loan is recourse or non-recourse. The same result occurs if the borrower buys the loan from the lender at the discounted amount. On the other hand, if the real property collateral is transferred to the lender in connection with the debt reduction, then COD Income in the amount of the debt reduction will only be recognized by the borrower if the loan was a recourse obligation. 19 With the exception 14 See 26 C.F.R (a)(1); see also, Crane v. Commissioner, 331 U.S. 1, 13 (1947) (holding that the outstanding balance of the mortgage must be included in the amount realized by the taxpayer). Since real property collateral is rarely sold at foreclosure for more than the outstanding loan balance, application of the rule set forth in Crane typically results in an amount realized to the borrower/ tax payer equal to the outstanding loan balance, and not more C.F.R (b); see also Commissioner v. Tufts, 461 U.S. 300, 316 (1983) (holding that, when a taxpayer sells or disposes of property encumbered by a nonrecourse obligation,... the outstanding amount of the obligation [must be included in the amount realized]. The fair market value of the property is irrelevant to this calculation. ). 16 See Rev. Rul ; 26 C.F.R (a)(2). 17 Internal Revenue Code of (a)(12) (gross income includes income from discharge of indebtedness). 18 See Gershkowitz v. Commissioner, 88 T.C. 984 (1987) (holding that cancellation of nonrecourse debt without the transfer of collateral securing the debt will result in cancellation of indebtedness income to the debtor/taxpayer) C.F.R As noted in the text at Section II.H.1, however, no COD Income is recognized if there is no corresponding debt forgiveness, whether or not Lender has acquired title through foreclosure or otherwise, and regardless of whether the debt is a recourse obligation. See Aizawa v. Commissioner, 99 T.C. 197 (1992) (holding that no cancellation of indebtedness income is recognized in connection with a foreclosure of property securing a recourse debt, where that portion of the debt in excess of the fair market value of the property (i.e. the deficiency judgment) was not correspondingly discharged); Webb v. Commissioner, 70 T.C.M. (CCH) 957 (1995) (holding that no cancellation of indebtedness income is recognized in

11 of construction loans, almost all commercial real estate loans are non-recourse, and therefore the borrower will rarely recognize cancellation of indebtedness income if debt is forgiven in connection with a foreclosure. II.H.2 above. The following example illustrates the principals set forth in Sections II.H.1 and Outstanding Principal Balance of Loan: $1,000,000 FMV at Foreclosure/ Title Transfer of $900,000 vs. Discounted Payoff at $900,000 Basis: $800,000 Recourse Loan Non-Recourse Loan Foreclosure or other Title Transfer -- Discharge of $100,000 of debt Capital Gain (Loss) $100K ($900K - $800K) $200K ($1MM - $800K) COD Income $100K ($1MM - $900K) $0 -- No discharge of indebtedness Capital Gain (Loss) $100K ($900K - $800K) $200K ($1MM - $800K) COD Income $0 ($1MM - $900K = $100K, but $0 borrower recognizes no income because borrower still has personal liability for the debt, which has not been discharged) Discounted Payoff Capital Gain (Loss) $0 $0 -- COD Income $100K ($1MM - $900K) $100K ($1MM - $900K) 3. Tax consequences to the borrower of a significant modification. If a loan modification is considered significant for tax purposes, the borrower is deemed to have satisfied the original loan with an amount of money equal to the issue price of the modified loan. 21 This section first discusses what constitutes an significant modification and then explores the resulting tax consequences to the borrower. (a) What is a significant modification for tax purposes? A modification is significant if, after considering, in the aggregate, the totality of the modifications (and all of a series of modifications) under a facts and circumstances test, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. 22 connection with a foreclosure of property securing recourse debt, where the borrower s obligation for the deficiency judgment has not been released or cancelled). 20 In a discounted payoff, the difference between the amount accepted by the lender and the amount paid by the borrower is assumed to have been released, cancelled and discharged by the lender C.F.R (a), (b) C.F.R (e)(1) states, A modification is a significant modification only if, based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. In making a determination under this paragraph (e)(1), all modifications to the debt instrument (other than modifications subject to paragraphs (e)(2) through (6) of this section) are considered collectively, so that a series of such modifications may be significant when considered together although each modification, if considered alone, would not be significant.

12 purposes: Following are a few modifications considered significant for tax (i) Reduction in interest rate by more than the greater of 25 basis points or 5% of the existing per annum interest rate. 23 (ii) Deferral of scheduled payments by more than the lesser of five years or one-half of the original loan term. 24 A deferral refers to either an extension of the final maturity date or the deferral of payments prior to maturity. (iii) Change in obligor on a recourse loan. 25 In contrast, a change in obligor on a non-recourse loan is not a significant modification. 26 As noted by one commentator, the rationale for the distinction in such instance between recourse and nonrecourse debt, is that in the context of non-recourse debt, substituting a new obligor on a debt instrument for which the debtor will not be personally liable does not change the economics of the debt. 27 (iv) Addition or deletion of obligors resulting in a change (whether positive or negative) in the lender s payment expectations. 28 Under the same rationale as set forth in clause (iii) above, in a non-recourse loan, the addition or deletion of obligors should not result in a significant modification because a lender s payment expectations can hardly be said to have changed by the addition or deletion of obligors on a debt instrument for which the borrower is not personally liable. (v) Change in security or credit enhancement resulting in a change in the lender s payment expectations on a recourse loan. 29 In contrast, a change in security or credit enhancement will result in a significant modification on a non-recourse loan regardless of whether the lender s payment expectations have changed, unless an exception applies. 30 payment expectations. 31 (vi) Change in debt priority resulting in a change in lender s (vii) lender s payment expectations. 32 Change from debt to equity resulting in a change in C.F.R (e)(2) C.F.R (e)(3) C.F.R (e)(4) C.F.R (e)(4)(ii). 27 Joseph C. Mandarino, The Tax Effects of Debt Cancellation A Primer for Non-Tax Lawyers, PROBATE & PROPERTY, March/April 2010, at C.F.R (e)(4)(iii) C.F.R (e)(4)(iv)(A) C.F.R (e)(4)(iv)(B) C.F.R (e)(4)(v) C.F.R (e)(5)(i).

13 modification? (b) (viii) Change from recourse to non-recourse debt, or vice versa. 33 What are the consequences to a borrower of a significant As noted earlier, if a loan modification is considered significant for tax purposes, the borrower is deemed to have satisfied the original loan with an amount of money equal to the issue price of the modified loan. 34 In other words, for tax purposes, the modified loan is treated as a new loan, separate and apart from the original unmodified loan, and the new loan is treated as issued in full satisfaction of the original loan. If the loan is not publicly traded, then the new issue price generally equals the face amount of the note unless, as discussed in this section below, the interest rate on the new loan is not at least equal to the applicable federal rate under Section 1274 of the Internal Revenue Code. 35 Therefore, from a borrower s standpoint, if the principal balance of the new loan is lower than what was outstanding under the old loan, the borrower will realize COD Income in the amount of the difference. Because the outstanding principal balance of a loan is rarely reduced in the context of a loan modification, this rule does not have much practical impact on borrowers but, as discussed below in Section II.I.1(b), the rule can have devastating consequences for a lender who has bought debt at a discount. One instance in which a significant modification results in unexpected COD Income to the borrower even if the principal balance of the loan has not been reduced, is where the interest rate is lowered to a level below the applicable federal rate as described in Section 1274 of the Internal Revenue Code. 36 Under the imputed interest rules, a portion of the stated principal amount of the modified or new loan is recharacterized as imputed interest, and the face amount of the new note is correspondingly reduced, resulting in COD Income to the borrower in the amount of the principal reduction. This scenario also has negative tax consequences to the lender, as will be discussed in Section II.I.1(b) below. 4. Are any COD Income exclusions available to the borrower? Whether or not COD Income exclusions are available to the borrower may impact the borrower s preferred choice of restructure. For example, if the borrower has available COD Income exclusions, the borrower might prefer a discounted payoff resulting in COD Income but no capital gains, rather than a foreclosure resulting in capital gain income. Following are a few common COD Income exclusions: (a) Qualified Real Property Indebtedness C.F.R (e)(5)(ii). 34 See infra. note C.F.R (d)(1). If the debt instrument is publicly traded, then the issue price for the new debt instrument equals its fair market value. 26 C.F.R (c)(1) U.S.C. 1274; 26 C.F.R

14 Subject to certain limitations, 37 Section 108(c)(3) of the Internal Revenue Code permits exclusion of COD Income incurred in connection with the discharge of qualified real property business indebtedness, which is defined, in part, as debt that is incurred (i) in connection with real property used in the taxpayer s trade or business and that is secured by such real property, and (ii) to acquire, construct or substantially improve real property secured by such debt, or debt resulting from the refinancing thereof, but only to the extent the amount of such debt does not exceed the amount of debt being refinanced. 38 The excludible amount is limited to the amount by which the real property debt exceeds the property s fair market value. 39 However, the borrower is required to correspondingly reduce its basis in all other depreciable property it owns. 40 (b) Bankruptcy. Section 108(a)(1)(A) of the Internal Revenue Code allows the full amount of any debt discharged in bankruptcy to be excluded from gross income; however, the borrower s tax attributes must also be proportionately reduced. 41 The fair market value of the real property collateral is irrelevant. Because this exclusion is recognized at the upstream partner or member level, and not at the partnership or limited liability company level, the relevant bankruptcy would be the bankruptcy of the partner or member and not the partnership or limited liability company owning the real property collateral. (c) Insolvency. The insolvency exclusion is narrower than the bankruptcy exclusion in that the exclusion is limited to the amount by which the liabilities exceed the fair market value of the real property collateral, and the borrower s tax attributes must be proportionately reduced. 42 As with the bankruptcy exclusion, the insolvency exclusion is recognized at the partner or member level, and not at the partnership or limited liability company level. I. Are there tax consequences for the lender? 1. What are the lender s tax consequences upon a disposition of the debt? For tax purposes, a disposition can be either an actual disposition through a sale of distressed debt or a deemed disposition in the case of a significant modification 43 (a) Actual disposition sale of distressed debt. 37 See Internal Revenue Code, 108(a)(1)(A) and (D), 108(c)(2)(A) and (B). 38 Internal Revenue Code 108(c)(3), (4). 39 Internal Revenue Code 108(c)(2). 40 Internal Revenue Code 108(c)(1). 41 For the attribute reduction rules, see Internal Revenue Code 108(b). Because there is no such thing as a free lunch, the attribute reduction requirement forces the borrower to trade current exclusion of income for future tax deductions (e.g. to reduce net operating loss carryovers, tax credit carryovers, capital loss carryovers, tax basis in assets, passive loss carryovers and foreign tax credit carryovers). 42 Internal Revenue Code 108(a)(3), 108(b). 43 See infra. text at Section II.H.3(a) for a discussion of whether or not a modification is significant for tax purposes.

15 The sale of distressed debt by the originating lender will usually trigger a loss because in such circumstances, the sale price will generally be lower than the lender s adjusted tax basis in the debt instrument. This is not necessarily true if the selling lender had itself previously purchased the debt at a discount, even if the subsequent sales price is still lower than the face amount of the debt such a lender will generally still realize a gain to the extent the subsequent sales price exceeds the amount such lender originally paid for the loan. (b) Deemed disposition significant modifications. As mentioned above, if a loan modification is considered significant for tax purposes, the borrower is deemed to have satisfied the original loan with an amount of money equal to the issue price of the modified loan. 44 An originating lender will rarely suffer negative tax consequences resulting from the application of the significant modification rules since the originating lender s tax basis is likely to be higher than the new issue price of the modified loan. The same cannot be said for a subsequent lender that purchased the debt at a discount, in which case a taxable gain is almost always recognized in connection with a significant modification; therefore, purchasers of distressed debt on the secondary market are well advised to carefully consider whether a proposed restructure would constitute a significant modification before agreeing to its terms. For example, a 10 year loan with 7 years remaining, a face amount of $10,000,000, and a 7% stated interest rate that is modified to bifurcate the interest rate into a 3% current interest rate component and a 4% deferred interest rate component, such that interest calculated at the deferral rate is deferred until loan maturity, is considered a significant modification pursuant to 26 C.F.R (e)(3). 45 As a consequence, the lender is deemed to have exchanged the original debt for the new debt, resulting in recognition of gain or loss to the lender depending on whether the issue price of the original debt is lower or higher than the issue price of the new debt. As discussed in Section II.H.3(b) above, the new issue price for a non-publicly traded loan generally equals the face amount of the note. 46 Therefore, if this modification were made by the original lender, the original lender would recognize neither gain nor loss, since the old and new issue prices are identical. If, however, this modification were made by a subsequent lender who had purchased the $10,000,000 loan at a discounted price of $7,000,000, such subsequent lender s old issue price is equal to its basis in the debt, which in most cases will be equal to the amount such subsequent lender paid for the debt. In this example, the subsequent lender s old issue price or tax basis is $7,000,000 and the new issue price is $10,000,000, resulting in a $3,000,000 taxable gain to the lender. 44 See infra. note C.F.R (e)(3)(i) states, A modification that changes the timing of payments (including any resulting change in the amount of payments) due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments. 26 C.F.R (e)(3)(ii) goes on to state, The deferral of one or more scheduled payments within the safeharbor period is not a material deferral if the deferred payments are unconditionally payable no later than at the end of the safeharbor period. The safe-harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term of the instrument. For the purposes of this paragraph... the term of an instrument is determined without regard to any option to extend the original maturity and deferrals of de minimis payments are ignored. 46 C.F.R (d)(1). If the debt instrument is publicly traded, then the issue price for the new debt instrument equals its fair market value. 26 C.F.R (c)(1).

16 Another example in which a modification may result in unexpected income to the lender would be where the interest rate is lowered to a level below the applicable federal rate as described in Section 1274 of the Internal Revenue Code, resulting in a portion of the stated principal amount of the new loan being recharacterized as imputed interest, which results in phantom interest income to the lender as well as a potential bad debt deduction resulting from the corresponding reduction of principal What are the lender s tax consequences upon foreclosure or deed-in-lieu of foreclosure? Are there transfer tax considerations? A lender s acquisition of title to the real property collateral, whether through foreclosure or deed-in-lieu of foreclosure, is treated as a payment on the note equal to the fair market value of the property. 48 If the loan is non-recourse, and the property s fair market value is greater than the indebtedness, then the lender will recognize a bad debt deduction in the amount by which the fair market value exceeds the lender s adjusted tax basis in the debt. If the loan is recourse, a bad debt deduction may not be taken unless and until the deficiency judgment becomes a worthless debt for the purposes of Section 166 of the Internal Revenue Code. A foreclosing lender who purchased the debt at a discount may have an adjusted tax basis in the debt lower than the property s fair market value at foreclosure, resulting in taxable income to the lender. In deciding whether to foreclose or accept a deed-in-lieu of foreclosure, a lender should determine whether transfer tax is applicable and, if so, how it is calculated and whether an exemption is available under either scenario. The difference between the amount of transfer tax payable on a deed-in-lieu versus a foreclosure might be dispositive in whether a lender will agree to accept a deed-in-lieu; some states impose taxes on the transfer of property through deed-in-lieu of foreclosure, but not on the transfer of property through foreclosure, while other states impose a transfer tax on both foreclosure and deed-in-lieu transactions, but calculate the amount of tax differently depending on the type of transaction. 49 The manner in which the lender chooses to take title will also depend on the applicable transfer tax rules -- in some states, transfer tax exemptions are available only if the grantee named in the deed of conveyance is identical to the lender named in the mortgage. III. Common Restructuring Techniques. A. Deed in Escrow. In return for agreeing to restructure an already defaulted loan or to forbear from exercising remedies, the lender will sometimes request a deed-in-escrow in order to quickly C.F.R Rev. Rul , C.B. 154; Rev. Rul , C.B For example, Florida imposes a transfer tax upon the recording of a deed-in-lieu of foreclosure or certificate of foreclosure sale in the amount of $0.70 per $100 of consideration (1)(a), Florida Statutes. In a foreclosure, the consideration on which the transfer tax is calculated is the amount bid at foreclosure, which will almost always be lower than the outstanding principal balance of the loan. In a deed-in-lieu transaction, the transfer tax is instead calculated on the outstanding principal balance.

17 acquire title to the real property collateral in the event of a subsequent default on the modified terms -- without having to go through what may be a lengthy foreclosure process in some states. In such case, concurrently with executing loan modification documents, the parties will enter into a deed-in-escrow agreement pursuant to which the borrower (i) delivers into the hands of a third party escrow agent, a fully executed and acknowledged deed conveying title to the real property collateral to lender, and (ii) agrees that in the event of a subsequent default, the lender may, in its sole discretion, demand that the escrow agent release and record the deed. While the deed-in-escrow is conceptually appealing, it is subject to challenge (i) as an impermissible clog on the borrower s equity of redemption, and on redemption rights of subordinate lien holders or (ii) as an equitable mortgage. In addition, because a deed-in-escrow is essentially a deed-in-lieu of foreclosure transaction agreed to by the borrower in advance of a subsequent default, the acceptance and recordation of the deed-in-escrow is subject to the same attacks that a typical deed-in-lieu of foreclosure transaction would be subject to. 1. Clogging Issues. The anti-clogging doctrine dictates that a lender may not contractually prevent a borrower from redeeming and retaining ownership of the real property collateral by paying its loan in full prior to entry of a foreclosure judgment. Because a deed-in-escrow effectively prevents the borrower from exercising its redemption rights after the occurrence of a subsequent default, a borrower may attempt to challenge such a structure as an impermissible clog. While a deed-in-escrow delivered as part of a loan origination is unlikely to survive such a challenge, courts have found such structures to be enforceable when implemented in connection with the workout of a defaulted loan, particularly if both parties are sophisticated and represented by counsel. 50 Subordinate lien holders also have rights of redemption. Therefore, a senior lien holder seeking to record a deed-in-escrow should first run a title search to check for the presence of junior lien holders, whose consent to recordation of a deed-in-escrow should be obtained. 2. Recharacterization Issues. An equitable mortgage is a document that, while not on its face a mortgage or security instrument, is recharacterized as a mortgage by the courts. If recharacterized as an equitable mortgage, a deed purporting to convey title to the lender pursuant to a deed-in-escrow arrangement would instead itself be treated as a mortgage, requiring the lender to foreclose on the instrument in order to obtain actual title to the property, defeating the whole purpose of the deed-in-escrow structure. In order to minimize the risk of a recharacterization, the lender should avoid agreements to reconvey the property back to the borrower if the borrower subsequently repays the loan, to share the proceeds of a subsequent sale with the borrower, or to give the borrower a repurchase option. Structured carefully, in most cases, a deed will not be recharacterized as a mortgage when given as part of the workout of an existing mortgage loan John C. Murray, Mortgage Workouts: Deeds in Escrow, 41 REAL PROPERTY, PROBATE AND TRUST JOURNAL, at 9 (Summer 2006). 51 Id., at 7.

18 3. Issues common to all deeds accepted in lieu of foreclosure. As noted earlier, a deed-in-escrow is essentially an agreement between the lender and borrower that upon a subsequent default, the lender may, in lieu of foreclosure, immediately record a deed conveying the property to the lender, which deed was previously signed and delivered by the borrower into escrow. As such, a deed-in-escrow arrangement is subject to the following issues inherent in a standard deed-in-lieu of foreclosure transaction: (a) attack as a preferential transfer or fraudulent conveyance, and (b) extinguishment of the lender s lien through the doctrine of merger. (a) Attack as preferential transfer or fraudulent conveyance. If the borrower files bankruptcy after release and recordation of the deed-in-escrow, the borrower or bankruptcy trustee may seek to avoid the conveyance as a preferential or fraudulent transfer if the bankruptcy is filed within the preference (90 days) 52 or fraudulent transfer limitation period (two years). 53 A preferential transfer is one (i) made to or for the benefit of a creditor, (ii) made for or on account of antecedent debt, (iii) made while the debtor is insolvent, (iv) made within 90 days prior to the bankruptcy filing, and (v) that enables the creditor to receive more than it would have in a chapter 7 liquidation. 54 A fraudulent transfer is a transfer (i) made by the debtor within 2 years prior to the bankruptcy filing, (ii) made while the debtor was insolvent or which caused the debtor to become insolvent, or that left the debtor with unreasonably small capital, and (iii) for which the debtor received less than reasonably equivalent value. 55 In the case of a preferential transfer challenge, if there is no equity in the property at the time the deed is conveyed, the creditor cannot be said to have received more than it would have in a chapter 7 liquidation. Similarly, in the context of a fraudulent transfer challenge, if the outstanding loan balance exceeded the fair market value of the property at the time the property is transferred to the lender, the debtor arguably received reasonably equivalent value in the form of debt satisfaction. Therefore, in order to minimize a successful preferential or fraudulent transfer avoidance action, a lender is well-served to obtain a third party opinion of value or appraisal establishing the lack of equity prior to the release and recordation of a deed-inescrow. If the appraisal indicates that the property s value exceeds the loan balance, the lender should not record the deed-in-escrow, but should instead proceed to foreclose through the usual channels. Where there is still equity in the property, the only way to avoid a fraudulent conveyance action is to foreclose U.S.C. 547(b)(4) U.S.C. 548(a)(1) U.S.C. 547(b) U.S.C. 548(a)(1)(B). 56 See BFP v. Resolution Trust Corporation, 511 U.S. 531, 545 (1994) (holding that fair market value is not the measure of reasonably equivalent value for the purposes of 548(a)(1) in the foreclosure sale context, and a foreclosure sale conducted in accordance with all the requirements of a state s foreclosure laws cannot be set aside as a fraudulent transfer).

19 (b) Extinguishment of lender s lien through the doctrine of merger. Pursuant to the common law doctrine of merger, when a greater estate in land (such as fee simple ownership) and a lesser estate in land (such as a lien) are combined in a single person or entity, with no intervening transfers, the lesser estate is extinguished and merges into the greater estate. Therefore, in the absence of clear language otherwise, a lender s lien against real property collateral disappears upon such lender s acceptance of a deed-in-lieu of foreclosure. The significance of a loss of the lender s lien due to merger is two fold. First, a lender accepting a deed-in-lieu of foreclosure takes title subject to all encumbrances, including encumbrances junior to its lien, which junior encumbrances would otherwise have been wiped out in a foreclosure of the lender s senior lien. Second, in a subsequent bankruptcy of the borrower, the borrower or trustee in bankruptcy may attempt to avoid the conveyance as a fraudulent or preferential transfer. If the avoidance action is successful, the property is brought into the borrower s bankruptcy estate free of the lender s lien, which was extinguished by merger. To prevent the loss of its lien through merger, a lender should include clear non-merger language in the deed of conveyance, consider taking title in the name of an affiliated designee, avoid releasing the underlying debt. If these steps are taken, and the lender s lien preserved, the lender will not only retain its lien in a subsequent bankruptcy action by the borrower, but be able to undertake a subsequent foreclosure action if necessary in order to eliminate junior lien holders. B. Vanishing Guaranty. One way to avoid the clogging risk inherent in a deed-in-escrow transaction is to require a vanishing guaranty from a direct or indirect upstream owner of the borrower with substantial net worth. A vanishing guaranty is a document pursuant to which the guarantor guarantees the entire loan in full, but the lender agrees to forbear from exercising its remedies under the guaranty unless and until the occurrence of specified forbearance termination events. Forbearance termination events generally include a bankruptcy filing by borrower or guarantor and/or the failure of the borrower, guarantor and/or their respective affiliates to fully cooperate with transferring title to the real property collateral to lender via a deed-in-lieu of foreclosure or stipulated foreclosure judgment following a subsequent event of default. The clogging issue is avoided because under this structure, the borrower may choose not to deed the property to the lender, thereby preserving its right of redemption at the expense of causing the guarantor to incur full personal liability for the loan. Under the terms of the vanishing guaranty, the guarantor acknowledges that the lender may elect upon a subsequent default to take title via deed-in-lieu of foreclosure, stipulated foreclosure, or by going through the full foreclosure sale process. If the lender elects to take title via deed-in-lieu of foreclosure, such transfer is obviously subject to all of the issues inherent in a deed-in-lieu of foreclosure transaction, including the risk that such a transfer will be avoided as

20 preferential or fraudulent transfer in a subsequent bankruptcy of the borrower. Therefore, the guarantor should not be released until after the expiration of all applicable statutes of limitations periods within which a preferential or fraudulent transfer action may be brought. C. Shared Appreciation Agreement. In some restructures, the lender will ask for an equity kicker, or a share in the future appreciation of the property over and above the loan balance, measured upon the occurrence of capital events such as a loan payoff, condemnation, casualty, refinance or sale of the property. The shared appreciation payment is usually described as contingent deferred interest due under the loan, and is calculated as a percentage of the net proceeds actually received or deemed to have been received by the borrower upon the occurrence of a capital event. Where a third party sale, casualty or condemnation is involved, the shared appreciation payment is calculated on the actual net proceeds received by the borrower. However, in the case of a refinance, loan payoff or sale to a related party, the actual net proceeds received by the borrower (if any) may not be an accurate measure of the property s value at that time. In such cases, the shared appreciation payment is calculated on net proceeds deemed to have been received by the borrower based on deemed gross proceeds in an amount equal to the fair market value of the property as determined by a current appraisal ordered by the lender. Because the shared appreciation payment may be quite large, the lender should check the applicable state s usury limitations, and in any event, make sure that the usury savings clause in the loan documents is expansive enough to allow exclusion of amounts received in respect of the shared appreciation payment. If not documented carefully, shared appreciation agreements risk being recharacterized as equity, potentially causing the entire relationship between the parties to be recharacterized as that of a joint venture or partnership rather than a debtor-creditor relationship, with the resultant imposition of fiduciary responsibilities on the lender in favor of the joint venture. Some states have promulgated statutory provisions defining shared appreciation loans and specifically stating that if a loan falls within such definition, the relationship between the borrower and lender in such loan will not be construed to be a joint venture or partnership. If such statute exists in the state in which the property is located, the lender should be sure to structure and document the transaction in accordance with such statutory provisions. 57 Documentation should clearly indicate that the shared appreciation payment represents contingent deferred interest. In any event, the lender should not assume any duties of an equity owner this includes, among other things, NOT being involved in the management of the borrower s business or in the management and control of the borrower. D. Cross-Collateralization and Cross-Default. A lender s mortgage loan portfolio is likely to include groups of individual loans, each of which may have been made to a different borrowing entity (with each such entity being a single purpose entity whose sole purpose is to own and operate the relevant real property collateral), but that are related by virtue of a commonality in the respective borrowers upstream 57 See, e.g., California Civil Code